The Great Recession brings into empirical focus much of the overall message of these Muddy Water Macro pages. Details of the events leading up to the recession are complex, but taken as a whole, this history confirms the critical role of demand as a driving force of modern economies over long sweeps of time. That is, the Great Recession and the stagnant recovery that has followed resurrect a more fundamental perspective on Keynesian economics that had been largely overshadowed in mainstream economic analysis since at least the 1970s. Demand matters for the performance of modern economies beyond just short-run business cycles, and policy cannot afford to take for granted that demand generation will be adequate to maintain full employment, even over decade-long horizons. Furthermore, in this recent historical era, the key engines of demand have been historic shifts of income distribution coupled with the dynamics of financial instability, along the lines proposed by the theory developed by Hyman Minsky.

The central pieces of our understanding of the Great Recession are:

  • Consumer spending was the most important engine of demand growth in the U.S. from the middle 1980s until the Great Recession.
  • The importance of overall consumer spending was not particularly unique (real personal consumption spending actually grew somewhat faster from 1960 to 1980 than it did from 1980 to 2007). But the way in which consumer demand was financed with an unprecedented amount of debt was both historically unique and ultimately unsustainable.
  • The ability of middle-class households to borrow at excessive rates was necessary for these events to unfold. A wide variety of structural-institutional changes facilitated greatly expanded consumer credit. These include financial deregulation, tax changes that favored mortgage borrowing, financial innovation that spread risks of consumer lending (such as securitization and the development of the mortgage-backed securities markets), falling interest rates that encouraged refinancing, and incentives for the financial industry to push what now look like predatory loans onto households that did not fully understand the risks they were taking on.
  • As mortgage lending boomed, home prices rose faster and faster, a classic asset-price bubble that further encouraged borrowing and an created unjustified complacency with the increasingly fragile foundation of demand growth, because high house prices seemed to provide collateral for all the debt.
  • When the house price bubble burst, lending collapsed, and the engine of demand crashed. The economy experienced the most severe Keynesian demand crisis since the early 1930s.
  • Rising income inequality was a key factor behind these dynamics. The rise in debt coincided with a decline in the share of income earned by the bottom 95%.  The excessive debt build-up was concentrated almost exclusively in the bottom 95% prior to the Great Recession. When the crisis hit, it was consumption relative to income of the bottom 95% that suffered a historic collapse and has not recovered, while the pattern for the top 5% in the recession and its immediate aftermath was more or less normal.
  • The recovery of consumption demand in the aftermath of the Great Recession is far behind the profile of any recessions in the past 70 years. The cut off of household credit, along with the continued stagnation of wages for all but the top of the income distribution, lead to concerns that the U.S. economy does not have any feasible way to generate the demand necessary to again approach full employment in the current environment. Fiscal policy could help, especially since attaining full employment may be the most effective policy to restore middle-class wage growth. But fiscal policy is hamstrung by concerns about government debt. Policies to address the stagnation of low- and middle-class incomes are also critical to reviving demand growth.

Yes, craziness on Wall Street, facilitated by financial deregulation and low interest rates set by a Federal Reserve that faced a growing challenge to maintain full employment, contributed in important ways to the imbalances that triggered the Great Recession. Yes, many households with stagnating wage growth lived beyond their means and financed their excesses with unsustainable mortgage debt. But our analysis reveals a deeper problem. The U.S. needed all the demand it got prior to 2008 just to approximate full employment, even if that demand was generated in unsustainable ways. Without the Consumer Age housing and consumer spending bubbles, secular stagnation would have likely been upon us earlier. Now that the Great Recession destroyed that unsustainable path of household spending, we must face the challenge of finding a way to generate demand growth to keep up with our rising productivity in different ways. To meet this goal, we believe that changes in the institutional and policy structure of the economy are needed to assure growth of wages across the income distribution that keep up with productivity growth. Only in that situation can we get the consumption demand growth needed for full employment without unsustainable debt bubbles or a large rise in the share of the government sector.