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Explaining the Great Recession

Professor Tyler Cowen explains that the Great Recession was the result of a number of different problems. While many economists tend to be dedicated to one particular model of downturns, Prof. Cowen finds evidence that elements from many different models played a factor in the recent recession.

He briefly outlines how the following models could be used to explain, in part, the causes of the Great Recession:

  • Keynesian Business Cycle Theory
  • Real Business Cycle Theory
  • Austrian Business Cycle Theory
  • Monetary Policy

As Prof. Cowen says, “When you have Keynesian, aggregate demand, monetarist, Austrian, real business-cycle theories all pushing in the same direction, first an initial boom and then later a subsequent bust, and the economy has a lot of distinct problems, that’s exactly when you get the biggest messes.”

Taleb on Black Swans [podcast]: Nassim Taleb discussing black swans on Econtalk


Macroeconomics Keynesian Models [educational website]: A webpage illustrating the role of aggregate demand in various Keynesian models


Austrian Business Cycle Theory: A Brief Explanation [article]: A Mises Daily illustrating the Austrian business cycle theory


Of shocks and horrors [article]: The Economist explains various theories about what causes business cycles, including the current one


Karl Marx: The Origin of Business Crises [article]: An explication of the Marxist theory of what causes business cycles, which shares similarities with real business cycle theory


What we find today is an economic debate where a lot of economists are very dedicated to one particular model of downturns. But again, if we go back and look at the very worst downturns, what we tend to see is a lot of different problems. Let's think about the recent Great Recession. It's pretty clear to me that there's been a shortfall in aggregate demand. Credit contracted, households had less wealth because people's homes were worth less, because people lost their jobs. There was this cutback in aggregate demand. Wages did not completely adjust. There’s been higher unemployment. The aggregate demand model, there, to me, definitely applies. And at the very peak of the problems, our Federal Reserve System actually was pursuing a fairly tight monetary policy, and this made the aggregate demand problem worse.

That all said, I don't think our recent Great Recession is simply a Keynesian or monetarist or aggregate-demand story. I think real business-cycle theory has a lot to say about the event. One thing we have seen across the board in a lot of countries is that what economists call the risk premium, it has gone up. Investors are more cautious. People are more afraid that something, some terrible economic event will happen that they hadn't foreseen. There's more worry about so-called black swans. So the risk premium is higher. We have a sector, banking, which we thought worked pretty well, and now we realize it had been working really quite horribly. So there's been a decline in the perceived quality of financial intermediation and also a significant real shock to housing and construction. So the real business-cycle model applies, too.

On top of that, I think the Austrian model applies somewhere. There was loose monetary policy in the earlier part of the decade. It may or may not have been the main cause of the boom in the housing bubble, but it was one cause. It made it worse. You had the Federal Reserve and monetary policy feeding something and encouraging it when they should have been leaning against the wind. And when you have Keynesian, aggregate demand, monetarist, Austrian, real business-cycle theories all pushing in the same direction, first an initial boom and then later a subsequent bust, and the economy has a lot of distinct problems, that's exactly when you get the biggest messes.

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