Brad DeLong: the Propagation Mechanism is Key

Brad DeLong responds to Larry White's article "What Really Happened" at CATO Unbound by arguing that an understanding of the economic shocks that started the current crisis is not as important as is understanding why the shocks have been propagated into the worst global financial crisis since the Great Depression:

Thus we have an impulse — a $2 trillion increase in the default discount from the problems in the mortgage market — but the thing deserving attention is the extraordinary financial accelerator that amplified $2 trillion in actual on-the-ground losses in terms of mortgage payments that will not be made into an extra $17 trillion of lost value because global investors now want to hold less risky portfolios than they wanted two years ago.

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Thus my dissatisfaction with Larry White’s piece: he talks only about the impulse, while it is the propagation mechanism — the financial accelerator — that is the important part of the story...

DeLong's point is a good one that could be leveled against me too, as I have spent most of my time writing about how we got here rather than why the fallout has been so pronounced. I do, though, disagree with DeLong's claim that the Fed had little influence on the housing boom. In evaluating the Fed's impact, he only looks at the dollar value of the Fed's open market purchases (OMP). The absolute dollar size of the OMP, however, is not important. What is important is whether these increases in liquidity were excessive relative to the demand for them. One only needs to look at the negative real federal funds rate that persisted over this period to see that these injections were excessive. (Read here and here for more on this view.) Still, DeLong's main point about the propagation mechanism is a good one. Probably the best analysis on this issue comes from Claudio Borio and others at the BIS. See here for a summary of some of their relevant research.

Update: Josh Hendrickson provides further thoughts on this discussion.