Macro myths: 18 misconceptions about the Great Recession

By Scott Sumner. 

1. There was a housing bubble that peaked in early 2006. The term ‘bubble’ often refers to excessive rates of new home building and/or irrationally inflated home prices. The US was not building too many homes in 2005-06; if we were you’d expect falling house prices, not rising prices. Indeed the inadequate level of home building during recent decades (due to the excesses of Nimbyism) is arguably the biggest economic problem in America. It is one of the most important reasons that living standards for the middle class have been rising more slowly than during the mid-20th century. In addition, there is no evidence that housing prices were irrationally high during the 2005-06 boom. If high housing prices caused the Great Recession, why didn’t the equally high (real) housing prices of 2022 cause a recession? The high housing prices of recent years are fully justified by the “fundamentals”.

   2. The big drop in housing construction played a major role in the 2008 recession. This is factually inaccurate. The vast majority of the decline in home building occurred between January 2006 and April 2008, when residential construction declined by more than 50%. During that period of time, the unemployment rate barely budged, edging up from 4.7% to 5.0%. In a well functioning economy with adequate NGDP growth, a sharp decline on one sector, even a big sector, does not cause a recession. Other parts of the US economy continued to boom throughout 2006 and 2007. Unemployment only rose sharply after the spring of 2008, when tight money sharply reduced NGDP growth, leading to employment declines across a wide range of sectors.

   3. The subprime mortgage fiasco largely explains the banking crisis. Most of the bank failures during the Great Recession occurred because of defaults on commercial loans, not subprime mortgages. This is exactly what you’d expect to occur when there is an unusually dramatic decline in NGDP growth. The banking crisis is not a puzzle that needs to be explained; the puzzle would be if an 8% drop in NGDP growth rates did not cause a banking crisis.

   4. The banking crisis caused the Great Recession. The post-Lehman banking crisis occurred 9 months after the recession began, just as the banking crises of the 1930s occurred well after the Great Depression began. Again, banking crises are a symptom of falling NGDP, not a cause. Think of nominal GDP as the income that people and business have available to repay nominal debt.

   5. A rapid economy recovery is not possible after a financial crisis. The fastest growth in industrial production in US history occurred in the spring and summer of 1933, despite much of the banking system being shut down. That’s because dollar devaluation led to rapid growth in NGDP. Monetary policy drives NGDP, and NGDP drives the business cycle in highly diversified economies like the US.

   6. After the debt crisis, it was appropriate for aggregate demand to decline. Americans needed to “tighten their belts.” This conflates aggregate demand with consumption. When you’ve gone too far in debt, it makes sense to work harder, not take a long vacation. For a country, the response to too much debt should be more employment, more work effort, more production, not less. That’s how you “sacrifice”.

   7. The Fed adopted an easy money policy in 2008. This is a textbook example of reasoning from a price change. Nominal interest rates did decline in 2008, but the natural interest rate declined even more rapidly. Other than short-term nominal interest rates, every other financial market indicator suggested that money got tighter over the course of 2008. Interest rates are not a good policy indicator.

   8. Perhaps nominal rates are misleading, but surely the real interest rate is a good indicator of monetary policy. No, for the same reason that nominal rates are unreliable. Real interest rates also move around for a wide variety of reasons, not just monetary policy. In any case, real interest rates rose sharply throughout September, October, and November 2008, so if you believe real rates are the correct policy indicator, then you should agree with my claim that a tight money policy caused the Great Recession.

   9. The Fed certainly did not cause the Great Recession, at most they did too little to avert it. The recession was triggered by falling velocity, not slower money growth. This is factually inaccurate. At the point where the economy first tipped into recession (December 2007), growth in the monetary base was slowing sharply, whereas base velocity was increasing. Between August 2007 and May 2008, the monetary base increased by only 0.2%, far below the previous trend of roughly 5%/year. Velocity actually increased over that 9-month period. To be clear, the base is not a reliable indicator of the stance of monetary policy (as it rose sharply in late 2008.) But the problem in late 2007 and early 2008 was more than simply errors of omission by the Fed. It was tight money.

   10. The Fed did all it could to boost the economy in 2008; it simply ran out of ammunition. There are two problems with this claim. The Fed didn’t even cut its target interest rate to a level close to zero (actually 0.25%) until mid-December 2008, by which time most of the decline in NGDP had already occurred. In addition, the Fed has many tools that it can use after interest rates hit zero. Fiat money central banks never “run out of ammunition.”

   11. The Fed did not intend its new program of interest on bank reserves to have a contractionary effect on the economy. Yes, it did. As Susan Woodward and Robert Hall pointed out, the Fed’s own explanation for the policy “amounts to a confession of the contractionary effect.” The Fed indicated that they implemented the policy to prevent interest rates from falling. The policy was enacted a few weeks after Lehman failed, when the global economy was plunging into a deep slump. An unforced error.

   12. The zero lower bound problem held back the recovery during the early 2010s. When interest rates rose above the zero lower bound in late 2015, the economic recovery did not accelerate. This suggests that the sluggish growth in NGDP during the early 2010s was not caused by interest rates being stuck at zero.

   13. Blaming the recession on falling NGDP is almost a tautology. If that were true, then poor countries could produce prosperity simply by printing lots of money, which would boost inflation, and thus NGDP growth. Does that seem likely to work? It’s true that in the US (but not Zimbabwe) there is a positive correlation between NGDP and real GDP, just as there is often a positive correlation between NGDP and other variables such as the money supply and interest rates. But any theory that NGDP causes changes in RGDP requires a plausible causal mechanism. In my view, that mechanism is sticky nominal wages.

   14. The US caused the Great Recession, and Europe was hit by the ripple effects of the US crisis. The recession began at the same time in the Eurozone, and from the very beginning it was at least as bad in Europe. That’s because the hawkish ECB’s monetary policy was even more contractionary than Fed policy. If it were true that the US housing/banking crisis caused the recession, then it would have been much worse in the US.

   15. The Eurozone debt crisis explains why Europe’s recession ended up being much worse than the US recession during the 2010s. Again, this confuses cause and effect. The ECB sharply tightened monetary policy in 2011, causing a double dip recession. That’s what triggered the eurozone debt crises (although irresponsible fiscal policies in places like Greece also played a role.)

   16. The US policy of fiscal austerity slowed the recovery in 2013. This is what Keynesian economists like Paul Krugman predicted, indeed he suggested that 2013 would be a sort of test of the market monetary model. If so, we passed with flying colors, as GDP growth sped up after fiscal austerity began in January 2013. The Fed anticipated the fiscal tightening, and offset the effects with a more expansionary policy of monetary stimulus. Conversely, the tax rebates of the spring of 2008 failed to boost spending because the Fed offset them with tighter money.

   17. High unemployment in the US during the 2010s was mostly due to “structural problems”. Contrary to the claims of many on the right, most of the unemployment was due to a shortfall in aggregate demand, and the unemployment rate fell back to a low level once wages fully adjusted. Don’t be a supply-sider or a demand-sider, be a supply and demand-sider.

   18. More generous unemployment benefits led to increased aggregate demand, and this helped to boost employment. Contrary to the claims of many on the left, higher unemployment benefits do discourage work and lead to less employment. Don’t be a supply-sider or a demand-sider, be a supply and demand-sider. Keynesians predicted that employment growth would not accelerate after the extended unemployment benefit program lapsed in early 2014. They were wrong—employment growth did strongly accelerate in 2014.

   In a recent post, I suggested that when people say, “The consensus view is X, but Y is actually true”, they intend their comment as a sort of prediction of future belief, a claim that, “Eventually, society will come to see Y as being true.” Think of this post as a prediction of the future consensus view. For instance, in late 2008 I complained that monetary policy was too tight. In his 2015 memoir, Ben Bernanke acknowledged that the Fed had erred in not cutting interest rates during the Fed meeting immediately after Lehman failed in September 2008.

   Unfortunately, the vast majority of economists still believe most of these myths. If you’d like a more complete defense of my counterarguments, check out my book entitled The Money Illusion

Your showerhead is lying to you

Higher pressure is a blessing in more ways than one

By Mark Lasswell of The Wahsington Post. Excerpts:

"Intrepid researchers at the University of Surrey had placed sensors in 290 showers around campus, recording data for 39 weeks from 86,421 individual shower sessions. “Water consumption,” the study found, sensationally, “was reduced by up to 56% with high water pressure.”

The researchers, seeming puzzled by the results, recommended more study. But they also offered a theory along these lines: When a showerhead delivers a good, fizzing spray, people pop in and briskly get their business done, unlike when faced with a drizzle that prompts them to wonder if the Head & Shoulders will ever be adequately washed off their head and shoulders.

One researcher, perhaps trying to reassure eco-warriors distressed by the news, noted: “The best of all worlds is high pressure, low flow.” This is true, just as in the cake realm the best of all worlds is having it and eating it too. The showering ideal might be achievable in controlled laboratory conditions, but we all know what happens in the tiled wild."

Russ and Pete's Excellent Adventure into the Socialist Calculation Debate

By David Henderson.

"For the last 20 years that I taught at the Naval Postgraduate School, I always covered, in every course I taught, Friedrich Hayek’s famous 1945 article “The Use of Knowledge and Society,” American Economic Review, September 1945. It’s well worth reading.

Russ Roberts’s recent EconTalk interview of Peter Boettke, “Who Won the Socialist Calculation Debate?,” February 17, 2025, is well worth listening to or reading the transcript of. For in it, Pete, with input from Russ, tracks the history of the debate. Pete notes that Hayek moved one step beyond his mentor Ludwig von Mises. As well as talking about information that central planners didn’t have, Mises had focused on the lack of incentives within socialism. Hayek’s next step was to emphasize that even if lack of incentives were not a problem, central planners could not have the information they needed to plan an economy efficiently. That information was revealed only by market prices, and market prices came about because of hundreds of millions (now billions) of people acting on their own information. Although Hayek never used the term “local knowledge,” that is the term we Hayekians now use to refer to this decentralized information.

In the interview, they briefly discuss the issue of tin prices. Here’s the tin discussion, from Hayek’s 1945 article:

Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all his without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.

Hayek then writes:

The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or “normal” level.

Why a marvel? Hayek answers:

I have deliberately used the word “marvel” to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do. But those who clamor for “conscious direction”—and who cannot believe that anything which has evolved without design (and even without our understanding it) should solve problems which we should not be able to solve consciously—should remember this: The problem is precisely how to extend the span of out utilization of resources beyond the span of the control of any one mind; and therefore, how to dispense with the need of conscious control, and how to provide inducements which will make the individuals do the desirable things without anyone having to tell them what to do.

When I taught this, I paused at the sentence, “I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.” I then said to my students that if the mechanism had been the result of deliberate human design, the human would almost have certainly have won the Nobel Prize in economics.

Along the way, Russ and Pete give a very nice treatment of various economic thinkers. On the site are mentioned the bios of over 20 economists. All of the bios are from David R. Henderson, ed., The Concise Encyclopedia of Economics. I wrote all of them, except the one on Karl Marx, which Janet Beales Kaidantzis wrote."

See also Socialism by Robert Heilbroner. Excerpt:

"The effects of the “bureaucratization of economic life” are dramatically related in The Turning Point, a scathing attack on the realities of socialist economic planning by two Soviet economists, Nikolai Smelev and Vladimir Popov, that gives examples of the planning process in actual operation. In 1982, to stimulate the production of gloves from moleskins, the Soviet government raised the price it was willing to pay for moleskins from twenty to fifty kopecks per pelt. Smelev and Popov noted:

State purchases increased, and now all the distribution centers are filled with these pelts. Industry is unable to use them all, and they often rot in warehouses before they can be processed. The Ministry of Light Industry has already requested Goskomtsen [the State Committee on Prices] twice to lower prices, but “the question has not been decided” yet. This is not surprising. Its members are too busy to decide. They have no time: besides setting prices on these pelts, they have to keep track of another 24 million prices. And how can they possibly know how much to lower the price today, so they won’t have to raise it tomorrow?

This story speaks volumes about the problem of a centrally planned system. The crucial missing element is not so much “information,” as Mises and Hayek argued, as it is the motivation to act on information. After all, the inventories of moleskins did tell the planners that their production was at first too low and then too high. What was missing was the willingness—better yet, the necessity—to respond to the signals of changing inventories. A capitalist firm responds to changing prices because failure to do so will cause it to lose money. A socialist ministry ignores changing inventories because bureaucrats learn that doing something is more likely to get them in trouble than doing nothing, unless doing nothing results in absolute disaster."

Stop Blaming Rising Egg Prices on Market Power

By Brian Albrecht. Excerpt:

"But nothing in economics says large price changes require large reductions in supply. The size of the price change depends on both supply AND demand elasticities, which are about how easily the quantity supplied and quantity demanded respond to price changes.

In egg production, supply is essentially vertical in the short run due to chicken lifecycles. You can’t instantly produce more eggs when prices rise; you need to raise more chickens first, which takes months. This means that even small supply disruptions can generate large price changes.

Eggs are a perfect example of inelastic demand in practice. Jayson Lusk wrote a great post during the last major bout of avian flu. He said that a commonly assumed value for egg-demand elasticity is -0.15, meaning a 1% increase in price only reduces quantity demanded by 0.15%.[1] Put differently, if the quantity supplied drops by 1%, prices will rise by about 6.67%. In this case, the quantity of eggs dropped around 10%, which would generate a 67% increase in prices. Prices have been volatile, so it’s hard to get a true comparison, but prices have about doubled over the past year. That’s not far off the crude estimate.

This makes intuitive sense when you think about how people use eggs. They’re a dietary staple that’s difficult to substitute. You can’t easily switch to another product when making an omelet or baking a cake. Restaurants with egg-heavy breakfast menus can’t quickly overhaul their offerings. And since eggs are typically a small part of a household’s total food budget, price changes may not drive large consumption changes. When demand is inelastic like this, it takes bigger price increases to reduce the quantity demanded enough to match the lower supply.

Think about your Econ 101 graphs. With a vertical supply curve, any leftward shift of supply (from avian-flu losses) results in the same quantity reduction, but potentially huge price increases. This isn’t evidence of market manipulation but exactly what we expect to see in competitive markets with highly inelastic short-run supply.

There’s an impulse to believe massive price swings must reflect market power. I said “swings.” That’s not accurate. Only massive price hikes actually get blamed on market power. Price cuts don’t get attributed to cost savings being passed through by a monopolist.

There’s also a tendency to conflate high prices with rising prices when discussing market power. A firm with market power will typically charge high prices, but that doesn’t mean price increases indicate existing market power.

Conversely, firms in perfectly competitive markets may see dramatic price increases when faced with supply disruptions or demand spikes. The egg market illustrates this perfectly; we see rapidly rising prices, but that tells us nothing definitive about market power. We need to look at price levels relative to costs, not just price changes, to draw conclusions about competition.

But economic theory suggests that swings don’t clearly suggest market power. In fact, competitive markets often show larger cost pass-through than monopolistic ones. For simplicity, let’s assume a linear demand curve and a constant marginal-cost curve. These aren’t trivial assumptions, but the point is to show the mechanism, not to prove it is always true (it isn’t).

With perfect competition and a flat marginal cost curve, you’d see complete pass-through.

But if it were a monopoly seller, you’d only see 50% pass-through.

It’s maybe more intuitive to think of a drop in marginal cost and why that isn’t passed through. Marginal revenue drops faster than price. With a linear demand curve, the monopolist’s marginal-revenue curve is twice as steep as the demand curve. A $1 decrease in price would mean marginal revenue drops by $2. The monopolist really does not want to pass through that cost saving, which makes more sense. But if the logic applies when moving from c’ to c, it applies in the exact opposite way if we move from c to c’.

The takeaway here is that, even with identical cost changes, market structure significantly affects how much of that cost increase gets passed on to consumers."