Paul Krugman is doubting that financial collapse was a key part of the recession

My take on the US economic crisis has increasingly been that banks were less central than many people think, while the housing bubble and household debt are the key players — which is why financial stabilization by itself wasn’t enough to produce a V-shaped recovery.

I am not sure how central people think the banks were so I am not sure how hard to push back.

My take is that household debt and the banking collapse were symbiotic in their destructive nature. At the center of the story, however, is money and credit.

Highly leveraged households meant that consumers were very sensitive to economic disruption. The danger in having a lot of leverage is that when things go bad they go really bad. The flipside of course is that when things go good they go really good. We have to have some story about how things started to go bad before household debt can be invoked to explain why things went really bad.

Debt is ultimately just a promise.  Lots of debt is precarious when there are many interlocking promises that depend crucially on one another. If one person flakes – as eventually one person will – the whole network could crashing down.

When the banking sector collapsed it created a huge flake. Lending fell dramatically. Projects and production that were dependent on a smooth supply of lending could not go through. This rocked many households who were themselves in locked into sensitive promissory positions.

Now knowing that a flake was possible we might step back and ask either “why did we allow such sensitive networks to develop” or “why were housing prices allowed to climb on top of these tightly wound promises”

However, the more fundamental mistake was thinking that the Fed was prepared to firewall this whole thing if it went bad. It wasn’t that people couldn’t see the debt or the housing bubble building. Its that they thought it didn’t matter. The phrase commonly thrown around was “the Fed doesn’t target asset prices.”

That’s a more convoluted way of saying, this business with housing and mortgages may be a house of cards, but “so what?”

I don’t want to sound like I am pointing fingers here. I was deeply sympathetic to that view. Sufficiently powerful monetary policy I thought, and honestly still believe, could offset virtually any shock.

What we wasn’t appreciated fully enough was the fact that monetary policy would not be powerful enough; that central bankers are only human and that they will be hesitant to take extreme action.

In the light of those limitations it becomes more important to manage precarious situations as they arise. However, from the point of view of understanding the economy we also need to note, as Matt Yglesias reminds us to do, what powerful monetary policy can indeed accomplish. 

I had been urging the Fed to effectively “go negative” by promising inflation. In Sweden, the central bank went literally negative.

For a world first, the announcement came with remarkably little fanfare.

But last month, the Swedish Riksbank entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits.

Even at the deepest point of Japan’s financial crisis, the country’s central bank shied away from such a measure, which is designed to encourage commercial banks to boost lending.

The result was a surging Swedish economy. Indeed, as the FT reports, the fastest growth on record. This is coming out of a worldwide economic collapse.

This is also despite a long-run price to income profile that’s not that far off from the United States and peaked around the same time


I don’t think Krugman is doing this, but it is easy to get too caught up in thinking the macroeconomy is an extension personal finance. Having bought a house you couldn’t afford seems like a really bad situation to be in, and if everyone is in that situation then it seems like that ought to be really bad for the economy.

However, keep always in the front of your mind that a recession is not simply a series of unfortunate events.  A recession is when the economy produces less. For example,  the AIDS epidemic in Botswana is a horrible event for millions of people that uprooted lives and destroyed families and promises to leave a generation of orphans.

However, Botswana’s GDP growth didn’t turn negative until Lehman Brothers went under. 


That a Global Financial Crisis could do what rampant death and disease could not, is an important indicator of the nature of recession.

A recession isn’t when bad things happen, whether that’s loosing your house to foreclosure or your parents to AIDS. A recession is when the economy produces less.

Somehow you have to make a link between the bad thing happening and the economy producing less. I maintain that, that link almost always runs through the supply of money and credit.