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One of the primary reasons why we can’t get out of our current malaise is due to the fact that our government continues to misallocate resources and impede the recovery by completely misdiagnosing our problems. Over the last few years we have constantly referred to our problems as a “credit crisis” or a “banking crisis”. But this was never a banking crisis. It was a household crisis. The American balance sheet recession is a direct result of the fact that households took on too much debt and when their debt position became unsustainable the economy sank into a deep recession as American households went into deleveraging mode. This ultimately led to a banking crisis which was merely a symptom of a much bigger problem.

Unfortunately, the neoclassical economists who dominate policy these days convinced us all that we are in the midst of a banking crisis. The implication here was the usual medicine – if we cut rates to 0%, bailout banks and implement aggressive monetary easing we will solve the banking crisis and the party can continue. Of course, this misses the root cause of the problem.

And in a paper out of the Dallas Fed this morning, we see that this myth is still being promoted by our central bankers:

Unlike all other post-World War II recessions, the 2008–09 episode was precipitated by a banking crisis. A number of researchers have shown that downturns associated with banking crises tend to be more severe, and furthermore, in their aftermath, output takes a lot longer to recover.[5] In some cases, the crisis seems to persistently affect the trend rate of growth, while in other cases, the growth path of activity seems to shift down.

This is like watching a group of doctors in the ER hammering away on some poor old man’s leg when it’s clear that he has a broken arm. And the doctors keeping tearing the leg apart in surgery only to reconstruct it and find that the man is still suffering extraordinary pain. Of course, they’re not working on the right part of the patient so it is irrational to expect the patient to recover in due time….

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