The Big Short got it exactly backwards

I saw The Big Short on Friday. It’s pretty good! But… The economics of The Big Short are all messed up. They got the story exactly backwards.

I saw The Big Short on Friday. It’s pretty good!

I’m a sucker for Michael Lewis stories and The Big Short is a good one, and it’s a fun adaptation. It looks like they had a laugh making it.

But…

The economics of The Big Short are all messed up. They got the story exactly backwards.

I don’t even blame Michael Lewis for this. The Big Short tells the official story of the financial crisis, the one everyone accepts, the one that’s gone unchallenged for eight years.

Well I’m here to say that everyone’s wrong! All of them! Krugman and Michael Lewis and the Austrians and Peter Schiff and the old men down the pub!

So here it is, exclusively for Risk and Reward readers: the real story of what happened in 2008.

The official history of the Great Recession

Here’s The Big Short version of events:

Easy credit fuels a huge housing bubble in America  greedy banks get rich selling mortgage backed securities → the housing bubble bursts → the banks are all loaded up with mortgage backed securities and they go bust → a “credit crunch” occurs → the economy crashes.

That’s wrong. It’s wrong because it implies the housing crash caused the banking crisis and the banking crisis caused the recession.

But there was “a third man”. An independent factor which caused a) the financial crisis and b) the recession.

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Perfect crime

Okay, enough build-up. The Fed is to blame.

What do I mean? Well, everyone can agree what happens when the Fed runs monetary policy too loosely (in other words, if it lets the money supply get too big). That causes inflation. Simple.

On the other hand, when the Fed messes up in the opposite direction by running monetary policy too tightly (i.e., lets the money supply get too small)… There isn’t much agreement about what happens. Most pundits don’t really think it’s possible to run monetary policy too tightly. Or they don’t bother thinking about it at all.

But if you look at economic history, it’s happened a few times before. In places like the USA in the 1930s and Japan in the 1990s. There’s a clear pattern.

The first thing that happens is that the stock market collapses. The stock market is hyper-sensitive to tight monetary policy. It’s always on the lookout for it. That’s the first sign of trouble.

Next up, your currency gets a lot stronger. When a country’s money supply shrinks its value goes up, relative to other currencies. Not good.

Next you get a financial crisis. You get a financial crisis because banks are in the business of borrowing lots of money. They decide how much to borrow based on the existing conditions in the economy. If the money supply collapses unexpectedly the banks are stuck with huge debts and no means to service them. So lots of banks go bust.

The next thing you see is a big recession (or a depression) in the real economy. When the money supply shrinks people don’t have the cash to pay their workers, or to spend in the shops. So lots of people lose their jobs and output goes down. It’s like a game of musical chairs: when you take away a chair, someone has to sit on the ground (stole that one from Scott Sumner).

At this point, the value of property goes down and the value of bonds goes up (because bonds give a fixed stream of money – useful when there’s expected to be less money to go around in future).

And finally, after a few years of recession and chaos, the central bank decides to try increasing the money supply. And that solves the problem.

The tight money checklist

So anyway, back to 2008.

The tight-money checklist I just described – stock market crash, soaring currency, financial crisis, recession, relief by money printing – all happened in 2008-2009. Just like in the 1930s and the 1990s. A few economists tried their hardest to bring everyone’s attention to it. But the “housing bubble” story had taken over.

Nobody seemed to notice that the housing “bubble” burst back in 2006, two years before the mess hit the fan in September 2008. Millions of construction workers had already lost their jobs by then, but money wasn’t too tight (the musical chairs hadn’t been removed!) so they just found work in other jobs. Overall unemployment didn’t go up until the Fed messed up, years later.

Go to The Big Short for a good yarn about the financial industry and a star turn from Christian Bale. Just don’t expect to learn why lots of people lost their jobs in late 2008.

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