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The Cure Depends on the Disease

What a great piece here by Mark Thoma.  Not only does he engage in some very useful introspection about things he might have misunderstood about the crisis, but he displays a degree of flexibility in his views that is extremely admirable.

This is my favorite part though – unlike so many academics who rely on static models of the world with a sort of plug-and-play set of solutions, Thoma says we need to approach each recession as though it is its own unique event:

“The Cure Depends upon the Disease: When teaching monetary and fiscal policy in a classroom setting, the policies are generic. If demand falls, policymakers should cut interest rates, increase government spending, and/or cut taxes and the problem is solved instantly. Exactly what the money is spent on and whose taxes are cut is left unspecified. But in real world applications, it’s much more complicated, something I didn’t fully understand when the recession hit.

Recessions have a variety of causes, for example spikes in oil prices as in the 1970s, Fed induced increases in the interest rate to fight inflation as in the Volcker era, housing price bubbles and financial meltdowns as in the Great Recession, and so on. The Great Recession was a “balance sheet recession” meaning that one of the big problems was that bank and financial balance sheets were wiped out as housing and asset prices plunged.

One of the biggest mistakes we made in fighting the recession was the failure to target and repair household balance sheets. Bank balance sheets were restored, but household balance sheets were left in shambles. The result is that the economy has suffered as households have used their paychecks to restore what has been lost, and pay off debt instead of consuming goods and services.

In the future, we must do a better job of targeting the problem that is causing the economy to function poorly.”

I couldn’t agree more.  Recessions are not the result of some singular cause.  Each business cycle is somewhat unique and can have differing drivers that ultimately lead to recessions.  We need to approach each cycle and each recession as if it’s its own disease.  And curing each specific disease requires a unique understanding so we can pinpoint the cause and identify potential cures.

PS – And yes, I obviously agree that we didn’t solve the household balance sheet problem.  Unlike most economic experts I specifically identified household debt as the cause of the weak economyand was very critical of the government’s focus on Wall Street (as opposed to to Main Street) back in 2009.

Related: What Causes Recessions?