Game of Theories: The Great Recession

Course Outline

Game of Theories: The Great Recession

There’s an old analogy about blind men grasping an elephant.

Elephants are huge creatures. If you’re touching the trunk, but you can’t see the whole elephant, you’re going to have a very different perspective from someone touching a leg. It doesn’t mean that either of you are wrong in your perspective; you’re just focused on different parts of the whole.

You can use this analogy when thinking about the business cycle theories we’ve explored in recent videos and how they can be applied to economic downturns. To grasp the elephant that is the Great Recession, for instance, we’d need to take into account these different perspectives.

In Game of Theories, we’ve covered the basics of what proponents of Keynesian, monetarist, real business cycle, and Austrian theories think about why economies go through booms and bust. We’ve also dealt with some of the shortcomings of each.

Now let’s turn to how they might explain a recent historical example: the Great Recession of 2008.

Teacher Resources


So let's consider in more detail four major theories of business cycles—Keynesian theory, real business-cycle theory, monetarist approaches, and also the Austrian School of Economics. One way to get a better grasp on these differing theories is to see how they might attempt to explain a very specific historical event. And for that I have in mind the Great Recession of 2008.


I'm reminded of the old analogy about the four blind men grasping an elephant. The elephant is a big, complex creature, and in this context, you can think of the Great Recession, or indeed the economy more broadly, as being the elephant. And we, as economists, we're like blind men. We're grasping the elephant. Some of us are touching the trunk. Some of us are touching the tail. Some of us are touching the leg. We see, feel, and process different aspects of the elephant. And it's not a question of one person's perspective being correct and the others' being wrong, but rather to understand the elephant, to grasp the Great Recession, what's important to do is to bring together these multiple and differing perspectives.



So what would Keynesian economics say about the Great Recession? Well, a core Keynesian idea is the shortfall in aggregate demand. When there's a shortfall in aggregate demand, there are then declines in output and in employment, and that's when a recession ensues. So, for Keynes, the key components of aggregate demand were consumption, plus investment, plus government—and, indeed, all of those were falling. Why was consumption falling? Well, the American economy had a housing bubble. Home prices were going up. Everyone was happy, spending and borrowing a lot of money. But when that bubble burst people then felt poorer and more in debt, and then consumer spending fell. What about investment? Well, here there was a problem with the banks. Banks held a lot of mortgages, but when the real estate bubble burst, those mortgage securities, those home loans—they were worth a lot less. A lot of banks were either insolvent or near insolvency, and they just wanted to hold onto their cash. That meant less credit creation, and it eventually meant less business investment, so that component of aggregate demand fell as well. Finally, what about government? Well, you have less output, you have less employment, governments are taking in less money in the form of taxes, and that had a negative impact on government spending. So all these key components of aggregate demand were falling, and as Keynesian economics predicts, well, you ended up with a pretty big recession.



Okay, so what might real business-cycle theorists say about the Great Recession? Well, one possibility would be to go back a little further in time and ask why the American economy had so many structural problems to begin with. And if you look at the data on productivity, in fact, the rate of growth in American productivity—it slowed down dramatically, so there was something wrong with the supply side of the economy. So maybe the Keynesians are right that circa 2008, 2009, there was a big problem with aggregate demand. But, where did that problem come from? It came from the fact that we were, ultimately, creating less wealth. Imagine it being in America, where people were spending and borrowing as if productivity were growing at about 3% a year, but in reality productivity was only growing at about 1% a year. So, a more fundamental explanation, from the point of view of a real business-cycle theorist, is to focus on the problems, the structural issues in the American economy, even before that 2008 crash came along.



Real business-cycle theorists also would look at the period of recovery and ask why was recovery so slow and so painful? Some of that was the continuation of a low rate of productivity growth, but also there was a lot of policy uncertainty. In some cases, taxes went up, or subsidies were applied in such a way that individuals had an incentive not to re-enter the labor force as quickly as possible.



Okay, so what about the monetarists? Well, the monetarists, in some ways, take the side of the Keynesians—that is, they see aggregate demand as the big problem in the Great Recession. But they talk much more about monetary policy. And here I'm thinking of one offshoot of monetarism in general—it's sometimes called "market monetarism." The market monetarists look at 2008, just when trouble was starting to break. Now, according to monetarism, you want the Federal Reserve to be maintaining a pretty constant flow of nominal expenditure through the economy so that aggregate demand doesn't fall. Trouble was about to break loose in 2008, but at the Federal Reserve, a lot of people in the central bank didn't know this. They were still worried about rates of price inflation being too high. So the Federal Reserve did not perform the kind of expansionary monetary policy that would have been called for. So in the market monetarist view, yes, there was an aggregate demand problem; mostly, we can blame the Federal Reserve system, and the key moment there is, say, fall of 2008 when the Fed should have been much more expansionary.



Okay, so what might the Austrian School of Economics have to say about the Great Recession? Well, like some of the real business-cycle theorists, the Austrians want to go back a bit further in time and ask what are the historical roots of the problems of 2008-2009? Some of the Austrians have been very critical of Fed policy. So, starting at around 2001—credit conditions were fairly loose, interest rates were quite low, and a lot of stimulus was given to credit, and also to housing markets. And it wasn't just the central bank—there were actually a lot of different government programs to encourage mortgages, guarantee mortgages, and, of course, the American tax system also encourages borrowing to buy more homes. So you have this overinvestment, and, indeed, malinvestment in real estate, and according to the Austrian point of view, well, a lot of that came from government in the first place. So the Austrians admit there was a housing bubble, but they want to take a deeper perspective and ask, why did the housing bubble get so bad to begin with? Some of the Austrians also—when they look at the length and severity of the recession—they cite some of the factors that the real business-cycle theorists have talked about.



So, putting all of those perspectives together, when you ask the question, what are the solutions to the problems the American economy has faced? There is indeed some need to choose across differing schools of thought. The Keynesians and the monetarists have different recipes for addressing aggregate demand, whereas the Austrians and real business-cycle theorists—their concerns are really quite different, and very often they focus more on simply letting markets adjust. But, putting aside solutions, if we're just trying to understand how did this all happen? What was the entire series of events? I would go back to this metaphor of the elephant. Economies and macroeconomies, they're very complex, and we, as economists, we are operating somewhat blind. But we can grasp different sides or different angles of economies, like the blind men can grasp the elephant. But it's not enough just to touch or talk about one part of what happened. So when we put together all of these differing and multiple perspectives—that actually gives us a deeper and wiser understanding of what the Great Recession was all about.



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