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Sorry for the big post. I tried to explain it thoroughly
Originally Posted by rong
This is simply looking at the behavior and actions of the fed given the crisis that the sub prime mortgage market was in.
Exactly. There would have a been a small subprime recession regardless of what the Fed did. That recession also started long before the 08 crisis hit.
The buildup to the subprime recession is a far more complex issue that I think mostly has to do with moral hazards created by certain laws and institutions (*cough* Fannie and Freddie guaranteeing bad mortgage-backed securities *cough*), not so much the banks. Regardless, after activity in subprime lending decreased, every other sector was doing fine. This continued for months. Even after the assets on the books looked frivolous, the economy was doing okay. It was only after the Fed let it get so bad (*cough* doing nothing about Lehman *cough*) that there were expectations of financial catastrophe, deflation, and NGDP collapse. That is when the crisis hit, not when subprime lending became an issue.
Here are a few important points to put into perspective why the common sense "the banks did it" line doesn't work:
1. If it was true, then it would be more true now. Not just a little more true, but much more true. This is because the one and only thing that stopped and reversed the plummet is Fed stabilization and stimulus. The stimulus has been colossal, the Fed has basically guaranteed trillions in assets. If it was true that we were on fundamentally shaky ground before, it would be game over now. But it's not game over now, so that means the conventional wisdom is flawed.
2. Because the Fed is the sole responsible party in stopping and reversing the plummet through stimulus, it could have done the same thing to prevent the plummet in the first place. The Fed had the opportunity to address the drop in NGDP when it first happened, but didn't. It was only after the drop was so severe, it realized it made a mistake. The fact that the Fed could bring the economy back from -2% NGDP to 4% NGDP (more or less) means it could have much more easily done it before NGDP expectations got so low in the first place
3. If the "bubble theory" and all the bad lending stuff was true, Canada's larger-than-US housing bubble would have popped a long time ago. But it hasn't. China also would have collapsed too, and it would have been so epicly huge that the 08 crisis would have been miniature in comparison. But it hasn't. Australia also would have collapsed. The truth about bubbles is that they don't exist. The only time you will ever see anybody talk about a "known" bubble, is in some vague Captain Hindsight way. That's because they're not real
Which leads me into the fourth point, which addresses what Spoon said
4. The idea of "dumb people buying dumb shit they can't pay for" isn't a macroeconomic reality. Macro is not intuitive like micro, and we suffer from having so few macro experts that micro views take precedence. The "economy" is an illusion. It's a social construct that works only because arbiters within it agree it works. There is no "real" reason why gold is priced how it is, no "real" reason songs are priced the way they are, and no "real" reason underlying the value of a house. The value of all things in an economy is intertwined with other facets, and this demonstrates the value isn't "real". For example, let's say everything is exactly the same tomorrow except President Obama is assassinated. What would happen to the economy? Well, we'd have a small recession, just like we did after 9/11. A great national catastrophe would momentarily change behavior and the economy would adjust. All sorts of goods and services that are "real" would decrease in value. But if it was the case that they're "real", why would something so unaffiliated with the "real" value of those goods and services have an impact on them? Because they're not "real" in the first place. They're a part of a social construct where value is an illusion based on the behavior of its actors. Virtually anything can rise or lower in value for not "real" reason, and that is precisely what has happened in our economies.
What does this mean about the Fed? We went through this same scenario in 08 and 09, just more severe. There was a whole lot of "real" value in all sorts of things, but only after the Fed downgraded NGDP outlook, did that value become less valuable. This has happened before in US history too. Getting more into it involves getting into monetary policy, of which I'm still kind of a newb. But the basics are that monetary policy is king i.e. the exact level of growth or shrinking the economy undergoes is the exact level that monetary policy allows. When policy is such a way that NGDP drops, it will look like a bubble popped and all sorts of things lost their value. We'll say those things never had any true value and we'll not see the culprit was merely the central bank. The details are pretty complicated, but it is well established historically that the Fed's policy is king
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