The Economic Crisis from a Neoclassical Perspective

Abstract

This paper assesses the 2007–2009 recession using neoclassical business cycle theory. I find that the 2007–2009 U.S. recession differs substantially from other postwar U.S. recessions, and also from the 2008 recession in other countries, in that lower labor input accounts for virtually all of the decline in income and output in the United States, while lower productivity accounts for much of other U.S. recessions and the 2007–2009 recession in other countries. I also find that existing classes of models, including financial market imperfections models, do not explain the U.S. recession. This is because the 2007–2009 recession is almost exclusively related to what appear to be labor market distortions that drive a wedge between the marginal product of labor and the marginal rate of substitution between consumption and leisure, a topic about which current classes of financial imperfection models are largely silent. I discuss future avenues for developing this class of models, and I consider alternative hypotheses for the recession, including the view of John Taylor and others that economic policies intended to help manage the crisis, actually deepened the recession by increasing uncertainty and distorting incentives.