How Government Policy May Have Contributed To The Recession

This is from Lee E. Ohanian of the Federal Reserve Bank of Minnesota. See Accounting for the Great Recession. He discusses many causes and contributing factors, so he is definitely not saying it was all bad policy. Excerpt:

"If the financial explanation is not entirely convincing, particularly for the failure of employment to recover after the crisis, is there another story that could account more fully for the macroeconomic fluctuations of 2007-09? Many researchers offer a policy explanation—that poorly designed economic policies enacted in response to early stages of the financial crisis significantly contributed to the Great Recession by distorting incentives and increasing uncertainty. The policy explanation suggests that government initiatives such as the 2008 tax rebate, the Troubled Asset Relief Program (TARP), the American Recovery and Reinvestment Act, Cash for Clunkers and U.S. Treasury mortgage modification programs aggravated early weakness in the economy and led to a full-blown recession.

Casey Mulligan, for example, studies the effect of Treasury mortgage modification programs on the employment rate; he finds that eligibility requirements for these programs raised implicit income tax rates on some households to levels exceeding 100 percent.

John Taylor contends that a broad set of policies substantially contributed to the recession and supports his argument with a number of studies. In one recent article, for instance, he shows that some interest rate spreads, and both U.S. and foreign stock prices, deteriorated much more rapidly at the times of the TARP announcement and President Bush’s warning of a possible Great Depression than they did around the Lehman bankruptcy or other major financial events. In another study, he shows that daily sales at Target department stores dropped substantially right after the announcement of TARP on Sept. 19, 2008, but not immediately after the Lehman bankruptcy on Sept. 15. Taylor concludes that government policies contributed significantly to the recession, perhaps because policymaker communication regarding underlying economic strength increased public uncertainty.

Uncertainty, in fact, may be a primary reason why the recession deepened and persisted into 2009, well after the worst of the financial crisis. High uncertainty raises the value of delaying decisions in many economic models, which can depress economic activity. Recent and ongoing research on the impact of uncertainty on economic activity suggests that it can indeed induce recessions; in one forthcoming theoretical article, for example, uncertainty about the accuracy of government pronouncements regarding macroeconomic strength can lead households to reduce the labor hours they supply."