Introduction and Overview

Our overriding objective in this book has been to show that unusual credit flows frequently produce asset bubbles; when those assets are highly leveraged, immobile, and illiquid, borrowers and the financial system often suffer severe balance sheet deterioration in a collapse. Moreover, the economy is left saturated with an excess of produced assets, so that output is reduced. We have described the Great Recession as the result of a balance sheet crisis. In this chapter, we examine several even more severe downturns and show that all resulted from a collapse in the production of fixed assets. The opening quotes for this chapter argue for the view that the source of severe economic downturns lies in reductions to inputs of labor and capital and a reduction in the efficiency of these factors of production. Although this view is not “the only game in town,” it is arguably the dominant view in macroeconomics. In this book, we have sought to present evidence that supports an alternative view. Our argument is that when a bubble has pushed asset prices above fundamental value, production of those assets grows rapidly, but when asset prices become noticeably disconnected from fundamentals, financing for purchases of those assets collapses, asset prices collapse, and their production collapses too. When that happens, the economic downturn can be severe. The economic collapse does have noticeable effects on inputs of labor and capital and their efficiency, but changes to those factors are not causal.