Why Does the Economy Fall to Pieces after a Financial Crisis

The worst fi nancial crisis in the history of the United States and many other he worst fi nancial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep fi nancial collapses. have dwelt endlessly on the causes of these and other deep fi nancial collapses. Less conspicuous has been the macroeconomists’ concern about why output and Less conspicuous has been the macroeconomists’ concern about why output and employment collapse after a fi nancial crisis and remain at low levels for several or employment collapse after a fi nancial crisis and remain at low levels for several or many years after the crisis. This article pursues modern answers to that question. It many years after the crisis. This article pursues modern answers to that question. It focuses on events in the United States since 2008. focuses on events in the United States since 2008. Existing macroeconomic models account successfully for the immediate effects Existing macroeconomic models account successfully for the immediate effects of a fi nancial crisis on output and employment. I will lay out a simple macro model of a fi nancial crisis on output and employment. I will lay out a simple macro model that captures the most important features of modern models and show that realistic that captures the most important features of modern models and show that realistic increases in fi nancial frictions that occurred in the crisis of late 2008 will generate increases in fi nancial frictions that occurred in the crisis of late 2008 will generate declines in real GDP and employment of the magnitude that occurred. But this declines in real GDP and employment of the magnitude that occurred. But this model cannot explain why GDP and employment failed to recover once the fi nancial model cannot explain why GDP and employment failed to recover once the fi nancial crisis subsided—the model implies a recovery as soon as fi nancial frictions return to crisis subsided—the model implies a recovery as soon as fi nancial frictions return to normal. At the end of the article I will mention the ideas that are in play to explain normal. At the end of the article I will mention the ideas that are in play to explain the persistent adverse effects of temporary crises, but these ideas have not made their the persistent adverse effects of temporary crises, but these ideas have not made their way into the mainstream model. way into the mainstream model. This article cites only a few of the many important contributions to the mainThis article cites only a few of the many important contributions to the mainstream model. My paper Hall (2009) contains many citations and the forthcoming stream model. My paper Hall (2009) contains many citations and the forthcoming new volume of the new volume of the Handbook of Monetary Economics discusses the literature fully. discusses the literature fully.