"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.


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.

Eric M. Jones.

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:

Scott from Ohio

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.


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.


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.

David Stigant

>>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.


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.


Roger Farmer

@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.



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?

Roger Farmer

@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".


Holly Balcom

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


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

rachel Styles

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.



The bigger question is if we really care. The end of a bubble causes damage - does that mean we need to prolong and support the bubble as long as physically possible? And if actions are affected by beliefs about the future which are affected by market surprises, what is the impact of policy uncertainty?

It sounds like this could use a bit more detail:

"An alternative explanation of the crisis that is widely held by central bankers is that ?rms are liquidity constrained. It was the liquidity constraint explanation of the recession that caused central banks throughout the world to ?ood the ?nancial system with cheap money. As a direct consequence of Fed policy, U.S. businesses are now awash with credit and commercial banks are holding in excess of $2,000b in excess reserves with the Federal Reserve. In light of these facts, it seems unlikely that the unavailability of credit is currently constraining U.S. corporations from creating jobs"

Does this focus on the large-cap corporations that most people see as the stock market, or the small and growing businesses that often create a lot of jobs? I haven't done the research myself but people often refer to a large percentage of jobs being created by smaller businesses that might not even have public stock let alone be in the S&P 500. I believe I saw another piece recently showing it was only in the last 6 months that small businesses started to be able to borrow at anywhere close to normal levels.


Mike Fladlien

Isn't this just standard economics 101? A decline in wealth leads to a decline in aggregate demand. A decrease in AD means unemployment and declining income. I agree with Mr. Farmer.

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Interesting article.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.

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I am chilean economist and I have been following Farmer aproach to understand business cycle (BC) since his 1996 book "Macroecomics of Self-Fulfilling Prophecies" (MIT press). I also read one of his last books, and I can clonclude that the idea of beliefs driving the BC is a "sound" theory, thats is consisten with part of classical economics (the fact that wealth not income determines consumption -Friedman aproach-, that self-fulfilling beliefs are consistent with the rational expectation hypothesis, and that classical Search Theory agenda to undestand the Natural Rate of Unemploment in the labor market has been missleading -basically what he postulate is that there is not such things as the NRU). What it's impresive is the policy prescription: (i) no role for fiscal stimulus in the long run (NOT NEW!), (ii) a new instrument for monetary policy, i.e., targeting an agregate stock index (as what the Fed do with inflation now days) to pin down the unemployment rate that we want (that is "best" for society). This means sterilized direct intervention in to the stock market when is necessary (when the economy permanently face a high unemplyment rate and when we face a liquidity trap -interes rate near zero). In my personal view, this prescription has further implication for financial stability objectives, because it could prevent bubbles and burst cycles in asset prices (or in wealth) and avoid unnecessary lay offs.



All the evidence that I've seen and read suggests that the great recession was a result of the wealth effect and other arguments presented by Mr. Farmer and others. Three words that describe it best, real estate, real estate, real estate. Well, six words. It was the loose credit market that was introduced by federal government policy on the pretense that "every American has the right to own a home" that caused this, not the Federal Reserve's monetary policies. I believe historians will write that politics (and not party politics, mind you) caused the Great Recession and the Fed saved us. God save us from big government!

Hank Patric

Bigger issue than Greece now is the crisis of expiring Bush-era tax cuts. It's going to be a whopper, I think. This article has a tidy deconstruction of GDP and why things are tougher now than they in 2009, when the Obama administration kicked the proverbial can two years down the road in 2009.


B. Burch

In the twenties the government was very corrupt and would take money from government and lend to businesses for a percentage. This loss of taxpayer's money from government created a slow collapse of the US government. The idiotic credit lending of wallstreet didn't help either.