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Why Does the Economy Fall to Pieces after a Financial Crisis?

  • Robert E. Hall

The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses. This article pursues modern answers to a different question: why does output and employment collapse after a financial crisis and remain at low levels for several or many years after the crisis. It focuses on events in the United States since 2008. Existing macroeconomic models account successfully for the immediate effects of a financial crisis on output and employment. I will lay out a simple macro model that captures the most important features of modern models and show that realistic increases in financial frictions that occurred in the crisis of late 2008 will generate declines in real GDP and employment of the magnitude that occurred. But this model cannot explain why GDP and employment failed to recover once the financial crisis subsided—the model implies a recovery as soon as financial frictions return to normal. At the end of the article, I will mention some ideas that are in play to explain the persistent adverse effects of temporary crises, but have yet to be incorporated into the mainstream model.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.24.4.3
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Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 24 (2010)
Issue (Month): 4 (Fall)
Pages: 3-20

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Handle: RePEc:aea:jecper:v:24:y:2010:i:4:p:3-20
Note: DOI: 10.1257/jep.24.4.3
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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  2. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
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