The Causes of the Recession

Several articles by leading economists and journalists, including Nobel Prize winner Paul Krugman in The New York Times Magazine, Nobel Prize winner Joseph E. Stiglitz in Vanity Fair, and John Cassidy in The New Yorker, have identified the major causes of the Recession and have explained the collapse of conservative economic theory.

In his Times article, “How did Economists Get It So Wrong,” Paul Krugman, Professor of Economics at Princeton University, described how the profession of economics is divided between “saltwater” economists, located mainly in East Coast universities such as Harvard, M.I.T., and Princeton, and “freshwater” economists, located mainly in Midwestern schools like the University of Chicago.

The saltwater economists follow the teachings of John Maynard Keynes who, in his 1936masterwork, “The General Theory of Employment, Interest, and Money,” explained that markets do not always follow logical patterns of self-correction and that governmental regulation and intervention are often necessary to make the economy work properly.

The freshwater economists adhere to the teachings of men like Milton Friedman of the University of Chicago who developed the theory called “Monetarism.” Under Monetarism, the only governmental action necessary to prevent depressions is for central banks to keep the nation’s money supply (the sum of cash in circulation and bank deposits) growing on a steady path.

Freshwater economists believe that because markets are self-adjusting, there is little or no need for governmental regulation of and intervention in the economy. This concept is called the “Efficient Market Theory.” Under the Efficient Market Theory as propounded by University of Chicago economists like Robert Lucas, Eugene Fama, and John Cochrane, the prices of stocks and other financial assets accurately reflect all of the available information about economic fundamentals. Along with this, the freshwater economists believe in the “rational-expectations theory,” which posits that (Wall Street) individuals and firms are hyper-intelligent decision makers, and that the combined effect of their good decisions is a market that continuously adjusts to changing conditions and accurately reflects the state of the economy.

The big problem with the theories of the freshwater economists is that the recession proved them to be all wet. The adoption of their theories by the Bush Administration and the Republicans in Congress led to the recession. As stated by Paul Krugman: “They (the freshwater economists) turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.”

All three writers show how the recession was caused by the deregulation of the banks and securities markets. When the Republican Congress lifted the bans on predatory lending by banks, erased the strict separation of banks and securities houses, lowered the reserve requirements for financial institutions, and permitted Wall Street to engage in wildly speculative trading in derivatives, the entire structure that was supposed to be self-correcting came crashing down.

While a number of freshwater economists, such as Fama, Lucas, and Cochrane, refused to admit their mistakes, several others courageously admitted the failure of their theories. During hearings on Capitol Hill, Alan Greenspan, a freshwater conservative, acknowledged that his economic philosophy was flawed and that the embrace of this philosophy by America—and much of the rest of the world—made it inevitable that the economy would crash. Another conservative, Richard A. Posner, admitted that “The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.”

The nation is lucky that after the recession hit, President Obama and the Democrats took-over the economy, and by means of bailouts and stimulus were able to avert a major depression.