"The Stock Market Crash of 2008 Caused the Great Recession"

Photo: AZRainman

That is the title of a new working paper by UCLA economist Roger Farmer (abstract here; PDF here).

Note that Farmer doesn’t argue that the crash “contributed to” the recession, or “was a leading indicator” of the recession — but, rather, that the crash “caused” the recession. It’s worth acknowledging that a) Farmer attributes the housing-market crash as the direct trigger of the stock-market crash; and that b) he does this in service of the larger question: how to beat back unemployment.

From the abstract:

This paper argues that the stock market crash of 2008, triggered by a collapse in house prices, caused the Great Recession. The paper has three parts. First, it provides evidence of a high correlation between the value of the stock market and the unemployment rate in U.S. data since 1929. Second, it compares a new model of the economy developed in recent papers and books by Farmer, with a classical model and with a textbook Keynesian approach. Third, it provides evidence that fiscal stimulus will not permanently restore full employment. In Farmer’s model, as in the Keynesian model, employment is demand determined. But aggregate demand depends on wealth, not on income.

As measured as Farmer’s language is throughout, it is still a fairly incendiary argument — that the stock market itself causes the recession. I have nowhere near the requisite expertise to assess this argument but one part of it does resonate: unlike decades past, the stock market today is followed so closely and widely that it may have come to function as a signal to the general public of economic distress with an intensity that didn’t exist in the past.

Here’s a related Q&A with Farmer, from March of 2010 but still quite relevant. In fact, take a look at what he said about Greece:

How vulnerable are we to another big financial crisis?

People often talk about contagion in financial markets. When a small event occurs in one market, it causes a loss of confidence in other markets as people panic. They all jump out the window together. One situation to look out for is default on Greek debt. Although Greece is a small country, if it defaults, there’s a real concern that some other larger countries particularly Spain could follow. If that happens, it could easily feed into contagion and panic in U.S. markets. Confidence matters independently of fundamentals!

It’s well worth considering if indeed the stock market has assumed even greater prominence in the U.S. economy than previously felt. Which might mean, of course, that another meltdown (for whatever reason) might lead to another recession — or (he wrote brightly) that another market spike might lead to a quicker real recovery.