Post-Keynesian Observations

Understanding the Macroeconomy

11. The Subprime Crisis: Systemic Factors

with 8 comments

[NOTE: Be sure you have read part 10 before this one! This is part of a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

Finally, I’m going to talk about the current crisis! In this installment, I will focus on the systemic factors that I’ve been reviewing to this point. In the next part, I’ll go into what was unique.

Most of what is going on right now occurs over and over in the economy. If you go back over parts 1 through 10, you’ll see that I focused on investment goods, consumer durables, rising debt, and panic. I’ll cover each of these in turn and offer evidence in terms of charts I made using the web page. On each, I set them for 1983 to the present (I went that far back to give you three recessions, so you could see if the patterns really do show up time and again). Also, the shaded regions are the recessions. Here we go!

I said that this was the big driver of both expansions and recessions, the number one factor. As you see below, sure enough, before every recession there is a dip in investment.


The only weird thing about the current downturn is how long it took for the recession to hit after investment started falling. Otherwise, it fits the typical pattern.

Consumer Durables
As I have suggested, while durables react somewhat like investment, they don’t play as big a role. Nevertheless, for two of the three recessions shown, a fall in consumer durables did lead the recession (see 90-91 and our current one on the chart below).

Consumer Durables

So, our most recent troubles were caused by both a fall in investment and consumer durables spending.

Another factor mentioned in the blog was the run up of debt. Take for example household debt, shown below (measured as debt/GDP, where the latter gives a sense of ability to pay so that as debt/GDP rises, households are closer to being unable to manage).

Household Debt

While debt rose pretty much over the entire period, note the rapid increase in the slope right up to this recession. Not good, as it put us in an increasingly precarious position.

Panic/Animal Spirits
The last thing I mentioned was the panic, and though that’s awfully hard to see in general, the stock market should give us a general idea. Here is a plot of the S&P 500 as divided by GDP.

S&P 500

Note that as this rises, it means that the stock market is growing faster than the rest of the economy. Think about that for a moment–how can the value of the firms in the economy grow faster than the economy? They can’t, it should be exactly the same (though to be fair you could expect stock prices to rise a little faster since only the biggest, fastest growing firms would tend to sell stock). So most of the reason for the excess of stock prices over GDP growth is just animal spirits/spontaneous optimism. Note the incredible slope you see in the 1990s expansion. It’s ridiculous, and yet even economists were declaring it a “New Economy.” No it wasn’t, it was the same one we had all along–and you can see what happened. Furthermore, it is no coincidence that investment and stock prices tend to fall at about the same time. If the S&P is a barometer of our animal spirits, it sure didn’t look good around that 01 recession and it doesn’t look good now.

Everything that has been argued thus far about recessions being a function of the current organization of our system holds up, including for the crisis we are currently experiencing. Investment and consumer durables fell, debt rose, and panic set in, making us four-for-four. We do not need to look for unique factors to explain what is going on. This is how our market economy works.

That said, there were some special circumstances that are combining to make it worse. More on those next time!


Written by rommeldak

January 28, 2009 at 11:40 am

8 Responses

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  1. so the special circumstances are the toxic debt and large-scale fraud and hedge-fund factor? those are the things that have me crapping myself..


    January 29, 2009 at 1:05 am

  2. I was going to focus on the subprime mortgages and the bailout package, but I’d be glad to include these as well. In fact, that’s a good idea, to have you let me know what you want to see discussed. After all, this whole blog started because of a question from you!


    January 29, 2009 at 1:17 am

  3. well, i only asked the questions because i got really worried when i was watching a market careen out of control for years all the while saying “wow that looks like it’s going to be really, really bad when it collapses – oh well, i guess the people in charge know something i don’t know since it’s so obviously out-of-control” and then it collapsed and everyone in charge went “holy crap where did this come from?!?” and then i went “wow, i better ask prof. harvey what the hell is happening ’cause the folks in charge have no clue”

    as it turns out there is indeed a lot about it that i don’t know the details of, but the main gist i already knew (after reading all of this) and i’m just baffled that everything was left to go ahead full steam into a brick wall without anyone asking any questions..


    January 29, 2009 at 10:06 am

  4. Animal spirits, apparently, affect the ones who are supposed to be watching as well as those who watch! I’ll do my best to address your questions.


    January 29, 2009 at 11:12 am

  5. On the radio recently I heard a guy going on about how great the free market is. He was saying that the free market assumes perfect information and lack of economic coercion in order to work, and if it’s not working, that means we need to make sure there’s perfect information and no economic coercion. I was reminded of my high school physics teacher, who taught us a bunch of equations that pretty much all assumed there was no friction involved. I always thought that was amusing, since obviously the real world is full of friction, but whenever I asked about it he said “There are more complicated formulas that do account for friction, but they’re beyond the scope of this class.” In other words, physics recognizes that in the real world there IS friction, and takes it into account in the more advanced equations. Whereas in economics, the free-market guys want to make the real-world “friction” go away so that their simple theory works, instead of coming up with a more complex theory that accounts for lack of perfect info and some amount of economic coercion. That seems like a very backwards approach to me, fitting the real world to your theory instead of fitting your theory to the real world. Not sure that has anything to do with this blog post specifically, but I thought of you when I heard it Rommel.


    January 30, 2009 at 1:01 am

  6. Brother, you nailed it. It’s exactly like that, and I speak as a guy who was once a physics major and remember those lectures. It is just like econ, where we (or, rather, the mainstream) assume away all of the world’s problems so that we can come to our cherished, preordained conclusion: the market works perfectly! You should have seen some of the crap I had to learn in grad school. I remember in particular an international trade theory class. It was very rigorous and I was always proud that I made the highest grade–but I could have not have even begun to tell you who our trading partners were or what we imported or exported. It was all calculus and matrix algebra. Playing with math, but calling it economics–and never adding too much friction because all the equations broke down!

    But, I (no joke) came into my grad student office one day and found “An Introduction to Post Keynesian Economics” on my desk, picked it up, and started reading it–and I knew then what kind of econ I wanted to do. It was all about understanding the real world and letting the premises lead to the conclusions.


    January 30, 2009 at 6:19 am

  7. I’ve read them all, and all your articles make good sense to me. Just like when we were in class. I don’t really care for politics, and am glad this is more fact based compared with the politically biased stuff you read everywhere else. I also have extreme dislike for the media, which plays a special role in all this as well.

    Regarding the latest comment, you should try engineering. We don’t let the friction go by. Think of engineering as physics applied to the real world.


    January 31, 2009 at 4:28 am

  8. “Ignore the friction.” I remember that well. It is amazing how a few statistics courses can put reality into perspective. The idealists only see the mean (average) and ignore the variance/deviation (or worse, focus on the best case only). Reality must deal with the edge cases (variance, both high and low). National/global economics has so many variables that it is great getting a refresher course in the basics. Thx Rommel.


    February 3, 2009 at 4:47 am

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