Evan Soltas
Jun 16, 2012

Demand (and) Better Policy

Today I want to focus on the fundamentals and offer a perspective on, though hardly a complete answer to, a question of great importance: What caused the recession of 2008?

This question means a lot to me, and (I think) in a unique sort of way.  I became interested in economics during, even because of, the 2008 recession. It has shaped how I think about economics, as I imagine it has for much of my generation, in a way for which the only historical precedent seems to be the wave of Keynesian economists forged by the Great Depression who swept academic and policy circles in the 1940s, 50s, and 60s.

So what caused the recession of 2008? A drop in aggregate demand which was caused by, or not counteracted by, monetary policy. Full stop.

That's what the chart above should show you. What I've done is create a simple graph of real GDP and the PCE price index in P-Y space. And what you see is that, starting in the southwest corner of the graph, real GDP (Y) had grown steadily, and the price level (P) had risen, from 2005 until the first quarter of 2008, when a supply shock increased inflation. (That's why the graph appears to draw two parallel lines of positive slope.) Notice that real GDP remains roughly constant during this time; the real shock is not what caused the recession.

Then, in the fourth quarter of 2008, suddenly both P and Y collapse, as represented by the sudden jump  in the southwesterly direction. Notice that there are only three data points along the downward leg, testifying to the sudden collapse of aggregate demand during this time.

A real shock cannot explain the sharp decline in both the price level and real output, nor can it the fact that, as the economy recovered, it almost returned to the same price/output combination as existed before the recession, almost sealing up the lacuna in our graph.

The 2008 recession was almost entirely about a sudden collapse in aggregate demand, engineered by a fall in nominal spending or NGDP.

For more on the 2008 recession, here is a post I wrote about the primacy of investment in all of this, another about why the housing bubble is a frankly lousy explanation, and yet another about the concept of the "balance-sheet recession."