A New Old Explanation For Recessions & Financial Crises

Edward Conard, a retired executive of Bain Capital and a major donor to Mitt Romney’s presidential campaign, tells us that the precipitating cause of the 2008 financial crisis was a surge in demand for liquidity. He’s right, of course. The appetite for safety went into overdrive in the final months of that fateful year. This may be a controversial explanation in some circles, but it shouldn’t be. Divisive or not, Conard’s accounting of how the economy nearly melted down is an excuse to consider how far we’ve come (or not) in dissecting the business cycle when it goes negative in the extreme. It’s also an opportunity for a refresher course on considering the practical policy responses.

“A lot of people don’t realize that what happened in 2008 was nearly identical to what happened in 1929,” Conard tells The New York Times Magazine. “Depositors ran to the bank to withdraw their money only to discover, like the citizens of Bedford Falls [in the movie It’s a Wonderful Life] that there was no money in the vault. All that money had been lent.”
Conard’s views would be of minimal interest if he was just another voice in the black hole of economic opinion these days. But as a wealthy individual who’s contributed at least $1 million to help Romney reach the White House, his thoughts on the dismal science are destined to attract more than casual scrutiny. In fact, Conard welcomes the attention, considering that he’s the author of a new book slated for publication next month–a book that’s sure to inflame debate about the nature and role of wealth in America: Unintended Consequences: Why Everything You’ve Been Told About the Economy Is Wrong.
As for Conard’s views on 2008’s meltdown, his argument that the economy was blindsided by a bank run, albeit a 21st century version with lots of moving parts, is largely correct. Granted, the definition of “bank” has expanded dramatically since the days of FDR, but the underlying concept still holds. The details on why everyone suddenly demanded safe assets in late-2008 is a frenzy of debate, however. The explanations via the book trade in this niche, for instance, run the gamut, from Richard Posner’s A Failure of Capitalism to Robert Hetzel’s explanation of “monetary disorder” in The Great Recession to Bethany McLean and Joe Nocera’s narrative that financial securitization via Wall Street unleashed the recession, as they report in All the Devils Are Here, to name but a few of the titles.
The truth is that no one’s really sure what sets off recessions, i.e., why liquidity demand surges. The smoking gun for thinking so is the reality that the recessions keep coming. But the presumption for thinking that it’s all clear is a constant. Take the argument that it was the housing bubble that crashed and killed the boom. Sounds plausible, and for some it’s the last word on what went wrong. To some extent, it’s a reasonable assessment. But as you dig into the details, it becomes clear that the bull market in housing had started deflating several years before the financial system went into freefall in the fall of 2008. What changed to make 2008 the straw that broke the economy’s back? There are a host of theories on this point alone. Indeed, the recession officially began in January 2008, according to NBER, but the calamity didn’t arrive until September. Unsurprisingly, there’s precious little consensus here either. Was letting Lehman Brothers go under the crucial event? The answer varies, depending on who’s at the podium.
Even if we could definitively figure out cause and effect, it’s not likely that the details will hold lessons for preventing/responding to the next recession. Recessions, like murder and fingerprints, are unique. There are common traits, but it’s not obvious that this information provides us with clear solutions for responding to future downturns. But if there’s rarely agreement on what triggers slumps (economists are still debating what’s behind the Great Depression of the 1930s), there’s at least a fair amount of harmony on how to keep the whole system from collapsing when disaster strikes. In a recent paper presented at the Russell Sage Foundation’s “Rethinking Finance” conference, professor Brad DeLong reminds that Walter Bagehot 1873 book Lombard Street still offers advice on how to respond to financial crises that’s “remarkably close to the best we can do, even today.”
The lender of last resort theory will remain the state-of-the-art response as long as the crises keep coming. It’s tempting to think that This Time Is Different in macro, but it never is, at least not when it comes to the fundamentals. The reason why Bagehot’s advice remains practical is because the recessions keep coming and no one’s sure how to stop this ebb and flow (or even tame it). That doesn’t stop anyone from trying, or arguing that the business cycle has finally been deciphered. Perhaps, but I’ll keep a copy of Lombard Street handy just in case.