Understanding the Great Financial Crisis

[UPDATE AUGUST 2020: Scott Sumner and Kevin Erdmann published their joint paper, Housing Policy, Monetary Policy, and the Great Recession.]

Humans learn best through stories. Using stories, we can avoid a balanced view of the evidence. In fact, we can stop looking for new evidence once we have found the evidence that best fits our preferred narrative. So the best storytellers own the market in understanding the world, but they are usually the wrong people to understand a problem in the first place. Those who write books and give talks onstage are contest winners and storytellers, not statisticians and scientists.

Because our brains prefer simple narratives to complexity, storytelling wins the Darwinian contest of spreading memes. So we all end up with a collection of stories and anecdotes that have very little to do with reality. And that becomes our reality.

Can you see this might not be the best way to build a mental toolkit for understanding the world?

A good way to see the storytelling effect is to look at the “common wisdom” of the Great Financial Crisis of 2008/9, an event that impacted every person on earth and destroyed a billion jobs. Almost everyone got the story wrong. Michael Lewis’s book and movie, The Big Short, was popular but completely missed the true cause and effect. So did Niall Ferguson and many experts.

You may be familiar with the common narrative: that government agencies set policies to help low-income people buy their own homes, banks offered cheap loans and robo-stamped them, very low down payments, complex securitization products, misleading ratings, teaser interest rates, and everyone was incentivized to borrow, borrow, borrow and lend, lend, lend. The construction industry built more and more homes that weren’t really needed. When the music stopped, the adjustable-rate mortgages left tens of thousands of homeowners with underwater mortgages and the whole thing collapsed. That makes for a pleasing story, where politicians and bankers are the evil antagonists and people just seeking the American Dream to buy their first home were caught in a colossal train wreck that was bound to take the US banking system down and the world economy with it.

In reality, two people — Kevin Erdmann, an investor and Scott Sumner, an economist — have shown that the “common wisdom” does not fit the facts.Using the scientific method and hard evidence, they show that the GFC was a result of bad reactions to scarce resources. It happened in four phases:

  1. A housing shortage that from 2000 to 2006 drove up home prices in both “closed access” cities and “contagion” cities and displaced workers in the US. (Not government incentives, lax lending standards, and predatory banks encouraging low-income home buyers to overleverage.)
  2. In early 2008, this caused US economic output to fall dramatically. The Fed — fearing inflation — set a contractionary monetary policyby not aggressively lowering interest rates and immediately injecting money into circulation. (Not a credit bubble, not an overheated economy.)
  3. This, along with several contractionary banking rules and policies, caused a general seizure of financial markets, resulting in foreclosures, market illiquidity, a huge drop in lending, and a general fear that “the banking system has failed.” (Not toxic debt derivatives sold by greedy investment banks — though there were some of those. Not perverse risk ratings — though there were some of those.)
  4. A similar reaction by most central banks imposed tight-money policies in most countries. This phase would not end until $3 trillion of quantitative easing had added enough money to the US money supply (and similar operations were conducted in Europe) to stimulate growth. Even so, the world lost about $1 trillion in human productivity forever. (Not “too big to fail” banks with inadequate balance sheets — though there was some fragility in the banking sector.)

The housing bust was not caused by too much money, too many mortgages, or too many homes. It was caused by not enough.
Kevin Erdmann

This sounds heretical and wrong, I know. It’s easy to just go to the next Medium.com article. But I’m saying that you’ve been lied to, and not on purpose. Simply because the common narrative took hold and was told and retold over and over and over. That doesn’t make it true. In fact, most of what I write about is designed to show that what we commonly believe simply isn’t supported by the facts.

Though the Great Financial Crisis is the defining event for an entire generation (Millennials), this story hasn’t been told, and most people are confused about the true cause. The data does not support the common narrative, and that narrative still has a strong effect on policy and politics today. If we don’t understand the mistakes of the past, we are bound to repeat them (in fact, we may be about to repeat them).

You may still have your opinion. You may not be open to looking at the data. But, if you are, these resources will guide you in your journey of discovery.

Read Kevin’s book, Shut Out:

Watch Scott Sumner on the Great Recession right here:

Another Scott Sumner lecture on the Great Recession:

This is an excerpt from Inreality.show.

This is part of the Digital Money Book.

Provocateur, professional heretic, slayer of myths, speaker of truthiness to powerfulness, and defender of the Oxford comma.

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