Blog post

Financial panic and the Great Recession

A debate on the roles of financial panic in the Great Recession has been pitting Ben Bernanke against Paul Krugman in what has been characterised as “

Publishing date
08 October 2018
Silvia Merler

Ben Bernanke has a paper on the real effects of disrupted credit with evidence from the Global Financial Crisis (GFC). He argues that besides failing to predict the global financial crisis, economists also underestimated its consequences for the broader economy. Post-crisis research on the role of credit factors in the decisions of households, firms, and financial intermediaries provides broad support for the view that credit market developments deserve greater attention from macroeconomists, not only for analysing the economic effects of financial crises but in the study of ordinary business cycles as well.

Bernanke provides evidence on the channels by which the recent financial crisis depressed economic activity in the United States. Although the deterioration of household balance sheets and the associated deleveraging likely contributed to the initial economic downturn and the slowness of the recovery, he finds that the unusual severity of the Great Recession was primarily due to the panic in funding and securitisation markets, which disrupted the supply of credit.

Dean Baker argues that the primary story of the downturn was a collapsed housing bubble, not the financial crisis. Prior to the downturn, the housing bubble had been driving the economy, pushing residential construction to record levels as a share of GDP. The housing wealth effect also led to a consumption boom. The saving rate reached a record low. When the bubble burst, it was inevitable that these sources of demand would disappear and there were no easy options for replacing them, except very large government budget deficits.

Paul Krugman agrees with Baker and argues that the reason why financial stability did not bring a rapid bounce-back is that financial disruption wasn’t at the heart of the slump: the bursting of the housing bubble was. Regarding Bernanke’s paper, Krugman is not convinced by the reduced-form analysis aimed at identifying factors in the credit markets and using time series to estimate their impact on output (VAR). He also has trouble seeing the “transmission mechanism” – i.e. the way in which the financial shock is supposed to have affected actual spending, to the extent necessary to justify a finance-first account of the slump.

Bernanke responds to Krugman with a long post on transmission mechanism. While not disputing that the housing bubble and its unwinding was an essential cause of the recession, Bernanke argues that besides their direct effects on demand, the problems in housing and mortgage markets provided the spark that ignited the panic.

But the key point in Bernanke’s argument is that if the financial system had been strong enough to absorb the collapse of the housing bubble without falling into panic, the Great Recession would have been significantly less great. By the same token, if the panic had not been contained by a forceful government response, the economic costs would have been much greater. A further piece of evidence, in Bernanke’s view, is the fact that macroeconomic forecasts made in 2008 typically incorporated severe declines in house prices and construction among their assumptions, but still failed to anticipate the severity of the downturn.

Dean Baker responded to Bernanke’s post, arguing that while the crisis surely hastened the decline in consumption and the implied rise in saving rate, the saving rate 10 years later is still roughly 7% – the same level it reached in the Great Recession. Baker thinks that it is very hard to see how consumption was excessively depressed by the financial crisis, as opposed to simply returning to normal levels following the collapse of the bubble.

According to him, the basic story is that demand plummeted first and foremost because of the collapse of the housing bubble, along with the collapse of the bubble in non-residential construction that arose as the housing bubble began to deflate. The financial crisis undoubtedly hastened these collapses, but a steep drop in demand was made inevitable by these unsustainable bubbles that had been driving the recovery from the 2001 recession.

Krugman also responded to Bernanke’s response, stating that while Bernanke is talking about “steeper”, Baker and Krugman are talking about “deeper”. Bernanke offers evidence that the pace of decline accelerated a lot during 2008-2009, which Krugman agrees with – but he does not think that financial disruption made the decline deeper as well as steeper.

The unemployment rate averaged 9.6% in 2010 and 8.9% in 2011. How much did the financial crisis contribute to these extremely high levels of economic slack, long after the disruption had ended? Krugman thinks that the slump didn’t have much to do with finance – but is willing to concede that the slump would have been much worse had the financial system been allowed to implode. In that, he disagrees with Baker’s view that saving the financial system was pointless.

Bernanke sums up both positions and opens it up for debate on the AEA forum. Bradford DeLong is of the opinion that if the financial crisis had been managed – if the Bagehot Rule had been followed, and if there had been authorities to lend freely at a penalty rate on collateral that was good in normal times – and if 2008 had passed without a crash, then our problems would have been over. It was not the case that the economy in November 2008 "needed a recession" as John Cochrane liked to claim. The expenditure-switching had already happened. All that needed to be done was to keep demand for safe assets from exploding.

Edward Lambert argues that the depth and breadth of the crisis was a function, in large part, of the drop in labour share, and that the inaction on the part of the government and the Federal Reserve to reverse this drop points to the role of labour shares. The 2008 crisis was the only recession since the 1950s that was not preceded by a rise in labour share. So going into the recession, labour share had not buffered aggregate demand. Then after the 2008 crisis, labour share still has not rebounded, unlike in the past post-recession periods.

The drop in labour share holds down capacity utilisation, which holds down inflationary pressures, which in turn holds down pressures to raise interest rates. So the Fed rate has stayed low, while liquidity among capital has increased and liquidity among labour has not.

About the authors

  • Silvia Merler

    Silvia Merler, an Italian citizen, is the Head of ESG and Policy Research at Algebris Investments.

    She joined Bruegel as Affiliate fellow at Bruegel in August 2013. Her main research interests include international macro and financial economics, central banking and EU institutions and policy making.

    Before joining Bruegel, she worked as Economic Analyst in DG Economic and Financial Affairs of the European Commission (ECFIN). There she focused on macro-financial stability as well as financial assistance and stability mechanisms, in particular on the European Stability Mechanism (ESM), providing supportive analysis for the policy negotiations.


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