“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.

Leave A Comment

Comments are moderated and generally will be posted if they are on-topic and not abusive.



View All Comments »
  1. Clancy says:

    If aggregate demand depends on wealth (sounds plausible, and seems backed up by evidence) it seems like that points to the housing bust being the most important. Most families have a lot more of their wealth tied up in their houses than in the stock market, so it seems more likely to be the driving force.

    Well-loved. Like or Dislike: Thumb up 6 Thumb down 1
  2. Eric M. Jones. says:

    Curious that Roger Farmer has no Wikipedia bio. I spent last night listening to Richard Wolff’s tale of “Capitalism Hit the Fan”. Recommended and terrifying.

    By 2008 the damage had already been done. The ship had sunk. It matters little what happened later. See:

    Thumb up 1 Thumb down 1
  3. Scott from Ohio says:

    If Event A began in December 2007, and Event B occurred in September 2008, how can Event B be the cause of Event A? Something does not compute here.

    Thumb up 4 Thumb down 1
    • Tara says:

      The housing bubble actually started to become apparent in late 2005-early 2006, as adjustable & sub-prime mortgage rates started to convert but supply was still increasing. By mid-2006 prices were noticeably softening. Foreclosures started to increase, caused by owners’ inability to pay the new rates, and the mortgage markets seized up. By the time Lehman failed in 9/2008 (directly because it held a huge position in sub-prime mortgages), as well as several other banks and mortgage companies, credit was impossible to get by almost anyone (including businesses.) Result: market crash 10/2008 lasting into early 2009.

      Thumb up 2 Thumb down 0
  4. Speed says:

    Agree with Scott from Ohio … Housing caused the stock market crash which caused the recession. Therefore Housing caused the recession.

    Terrorist dynamites dam. Dam bursts. Flood follows. Farmer would say that the dam caused the flood.

    Thumb up 4 Thumb down 1
    • David Stigant says:

      >>Terrorist dynamites dam. Dam bursts. Flood follows. Farmer would say that the dam caused the flood.

      Good point, but I think there’s a limit to the metaphor. The housing crisis could have been a contributing factor to the market crash, but not the only cause. However, if market crashes (whatever the cause of the crash) will continue to always proceed recessions then it’s not wrong to say that the market crash caused the recession. While if housing crises only sometimes lead to market crashes (and thence to recession), then we can only say that housing crises are correlated with recession.

      Thumb up 2 Thumb down 0
      • Engy says:

        We’ve exhausted the first time hmerbuyoes tax credit. This country needs to come to the realization is that it’s OK for some to rent that can’t afford to buy. Instead all our policies are toward home ownership. Why focus solely on families that can buy just 1 home when there are others with capital to put to work that can buy 5 or 6 homes? I would like to see the govt give incentives to landlords that put 25%+ down on a home in order to clear inventory. An incentive like mortgage rates being similar to primary homeowners, or property taxes being pari-passu with primary homeowners, or long-term capital gains breaks. Any of the 3 would make real estate look like a more appealing investment vs. the alternatives. People think the “leverage” is enough of a factor to make real estate a good investment. They are WRONG.

        [WORDPRESS HASHCASH] The poster sent us ‘0 which is not a hashcash value.

        Thumb up 0 Thumb down 0
  5. Roger Farmer says:

    @Scott, Tara and Speed. The point of my paper is to argue that the loss of confidence in asset values can CAUSE recessions. US tangible assets consist of housing (roughly 2 times GDP) and factories and machines (roughly 3 times GDP). Housing wealth has remained relatively stable for much of the past eighty years, with notable exceptions in the two most recent recessions. Stock market wealth has remained volatile over the entire period and is closely correlated with unemployment. The dynamic correlation between the stock market and unemployment has remained stable over the entire post-war period and data on the stock market and unemployment from the period from 1954 through 1980 can be used to forecast unemployment ion the period from 1980 through 2011. Adding housing to the equation does not help to predict unemployment. It’s for that reason that I focused on stocks rather than housing in the paper.

    Thumb up 5 Thumb down 1
    • Speed says:

      Roger Farmer, thanks for your reply.

      It may be correct to say that the stock market fall was the proximate cause of the recession while the housing crash was the ultimate cause. That idea may be extended to say that easy money and/or government policies were the real ultimate cause(s).

      Has your research uncovered a set of causes of stock market falls/crashes? Or is it just the butterfly effect?

      Thumb up 1 Thumb down 2
      • Roger Farmer says:

        @Speed My research explains how market psychology exerts an independent causal influence on economic activity. I think of confidence as a new fundamental.

        I would not blame the Fed for the Great Recession. In my view, Fed policy was responsible for the fact that business cycles have been more stable since WWII than before. During the ten previous post-war recessions, Fed policy helped to moderate the recession by lowering the interest rate. In 2008, as in the Great Depression, the interest rate hit zero and that avenue was closed.

        I see capitalism as an evolving system. The Fed was developed to help ameliorate financial crises and Fed policy makers have been learning how to do that more effectively throughout the twentieth century. Now its time to give the Fed through more effective tools to stabilize economic fluctuations. I discuss these ideas in my book “How the Economy Works: Confidence Crashes and Self-Fulfilling Prophecies”.

        Thumb up 2 Thumb down 0
  6. Holly Balcom says:

    Has the shift to defined contribution retirement plans (which are, of course, invested in the stock market) intensified this reaction?

    Thumb up 1 Thumb down 0
  7. Shotzy says:

    Wow. This guy’s foresight is 20/20!

    Thumb up 0 Thumb down 0
  8. rachel Styles says:

    Playing the stock market is very similar to gambling. You are risking your money hoping to make more money in the end. If you don’t know how the stock market works, this article gives a great explanation on it.


    Thumb up 0 Thumb down 0