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Mountains and Mole Hills

March 5, 2010

Gary Gorton’s questions and answers to the Financial Crisis Inquiry Commission is an excellent must-read for anyone wishing to firm up their grasp on the events of the financial crisis. But, I think he mentions something that is very, very important, that he fails to elaborate upon (at least sufficiently for me, and I would assume Scott Sumner).

The outstanding amount of subprime bonds was not large enough to cause a systemic financial crisis by itself. It does it explain the figure above. No popular theory (academic or otherwise) explains the above figure. Let me repeat that another way. Common “explanations” are too vague and general to be of any value. They do not explain what actually happened. The issue is why all bond prices plummeted.

Q. Wasn’t the panic due to subprime mortgages going bad due to house prices falling?

A. No. This cannot be the whole story. Outstanding subprime securitization was not large enough by itself to have caused the losses that were experienced. Further, the timing is wrong. Subprime mortgages started to deteriorate in January 2007, eight months before the panic in August. [emphasis mine]

Of course the subprime crisis doesn’t explain the systemic problems that happened from 2008:Q3 onward. Financial crises never “explain” the cause of deep recessions. That’s because financial crises are never the cause of deep recessions. The underlying cause is always falling NGDP. Financial crises are the result of a deflationary trend of monetary policy.

Sadly, Gorton never once mentions monetary policy. Nevertheless, the paper is well worth the read.

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