Effause and Causfect?

Dean Baker does not think the financial crisis was the cause of the recession:

Spain is noteworthy because it now has an unemployment rate of more than 19%, the highest rate in any of the wealthy countries. Spain did not have a financial crisis. In fact, its well-regulated financial system is often held up as model for the United States.


Spain did have a horrific housing bubble. As a result, the share of construction in the economy rose from less than 8% of GDP at the end of the 90s to 12.3% in 2007

I am sympathetic to this view. I don’t think there is any evidence that states that severe recessions are ever “caused” by financial crises. Indeed, I believe that causality runs exactly reverse — falling NGDP exacerbates problems in troubled (and creates problems in otherwise functioning) sectors of the economy, which then causes a downward spiral into deep recession. This is what the vast majority of economists believe (at least when it comes to the Great Depression). Tracing the timeline of the most recent recession, this is the pattern. Of course, this time is different! Not really.

However, Baker is long on prognosis — short on remedy. Indeed, he makes the sort of prescription that you see often. One that intimates that there are variables that we need to control. Specifically, the exchange rate:

Restoring the economy to health is about finding a replacement for the demand lost as a result of the collapse of the bubble. In the short-term, this means increased government spending and tax cuts. Deficits put money in the economy, and using the old-fashioned view that people work for money, we can determine how much money we need to spend for the government to get the economy back towards full employment levels of output.

In the longer term, we need to move towards more balanced trade, with higher exports and fewer imports making up for the demand lost due to collapse of the housing bubble. This will require a lower-valued dollar – everything else in the trade picture is just for show.

I don’t share his desire for control. Do “we” need a weaker dollar? It’s possible…but it’s not something I’m willing to make a long-term bet on (I have no position in EURUSD or USDJPY at the moment). I believe that “we”, or rather, the Federal Reserve needs to stabilize the trend rate of growth of a nominal variable (NGDP) in the long run, and smooth short-term fluctuation in this variable through level targeting. If achieving this goal requires a “weak dollar”, then that is the equilibrium that the market will trend toward.

My nitpicks with his conclusions aside, Arnold Kling sums it up best:

If Baker is correct, then the financial crisis was not the real problem. Which means that TARP, the bailouts, and turning the Fed into a piggy bank were not the solution.

Unfortunately, Baker is correct.


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