Did the stock market crash really cause the Great Recession?

James Pethokoukis comments on Roger Farmer´s latest:

A new study by UCLA economist Roger Farmer looks at how big stock market crashes affect the real economy, particularly the unemployment rate. By his calculations, the 50% drop in the US stock market from 2007 through 2009 should have driven the unemployment rate to 18% rather than the actual jobless rate peak of 10%. Why didn’t it? Farmer:

There are two reasons for that discrepancy. First, the stock market drop that actually occurred was not a single shock of 30%, followed by a smooth downward decline: it was a sequence of positive and negative shocks. In my view, the stock market recovered, in large part, because of the policy of Quantitative Easing pursued by the Federal Reserve. In the absence of that policy response, I conjecture that the path of unemployment depicted in the simulation is a good forecast of what might otherwise have occurred.

In Farmer´s view the Stock Market caused the Great Recession!

As in Farmer (2012b), I conclude that the stock market crash of 2008 really did cause the Great Recession.

For long he has been an advocate of the Fed targeting stock prices (here, herehere). Unfortunately his thesis does not hold sway. The charts show stock prices (S&P) and unemployment in 1987-89 and 2007-13. Although the 1987 stock market crash was deep (the largest percentage one day drop in the stock prices) unemployment kept on falling.

QE1 was likely a “life-saver”, but also indicates that the basic problem, the cause of the crash, was bad monetary policy, which allowed nominal spending to ‘crash’.

Farmers Target_1

The next charts show what was happening to aggregate demand (nominal spending or NGDP). While in 1987, when the stock market crashed, spending growth was raised, spending growth turned negative in 2008, bringing down both the stock market and the real economy (increasing unemployment).

Farmers Target_2

4 thoughts on “Did the stock market crash really cause the Great Recession?

  1. I think he is actually pretty close to an interesting research question here. The stock market is just an unreliable proxy for expected NGDP. If he would replace “stock market” with “scores from first few principal components of a big basket of U.S.-focused market prices” I’d say Dr.Farmer would be on the right track.

    • Justin, I agree but note he ‘accused’ the stock market crash of causing the GR. If I understand correctly, what you are trying to do is develop an ‘efficient’ forecasting tool.

  2. That’s a good point, he is further away from being interesting than I thought from glancing at the abstract. He’s thinking of the stock market as a pool cue hitting balls, we think of it as a weather vane picking up a shift in the economic winds.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.