Sunday, March 10, 2013

Chickens and eggs, financial crises and AD shocks

It should be fairly straightforward to understand why an AD shock can cause a financial crisis. An underperforming economy means underperforming assets and if it's all a surprise to people that can lead to a financial crisis, particularly if there are major systemic linkages.

All fine.

I'm a little confused about why certain usual suspets are so sure the chicken came before the egg in this case (or is it that the egg came before the chicken?).

Why is it so hard to imagine a financial crisis causing an AD shock? Securitization, bad models, and poor risk rating plus a "this time is different" mentality cause a financial crisis. We get these things in laboratories without AD shocks, after all. Systemic connections lead to tight credit and balance sheet problems generally and now you have an AD problem.

I'm no financial economist, but the problems with mortgage securitization and credit rating seem pretty well documented to me independent of any AD problem. But of course we don't have to choose - if we think both stories are reasonable then obviously we also believe in the potential for feedback loops.

What I can't figure out is why some people seem to think the financial crisis to AD channel is so objectionable.


  1. I think the way they believe it works is the financial crisis exposes the falseness and unsustainability of what went before, and collapse of AD is just the result, but that is structural. What we need is real endogenous growth to fill in the hole exposed, and that is hard and long, and can't be faked with monetary or fiscal policy, that it is essentially a real business cycle.

    1. Oh I am actually thinking of some things the market monetarists have been saying lately - just treating the direction of causality going from AD to financial crises as a truism rather than as one of two very sensible possibilities.

  2. I think the market monetarist argument is that proper demand-side management through good monetary policy will prevent financial crisis contagion. So really, it's the bad management of AD that causes the mortgage crisis to become a financial crisis.


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