Anyone awake in the 1980s should have known about the dangers in the 2000s

Lots of people were supposed to prevent the financial crisis. But while a few warned about the dangers in real time, most policymakers, risk managers, and academics failed in their responsibility to protect the rest of us.

After the fact, the common defence was that the crisis so complex and unusual that it would have been impossible to predict. How could regulators on government salaries or ivory tower professors have been able to understand CDO-squareds and the nuances of the repo market? The aggressive form of this argument is that those who were worried during the go-go years of the 2000s were simply perpetual pessimists who had gotten lucky.

Their logic collapses when faced with the most obvious parallel to the 2000s boom-bust cycle: the credit boom and subsequent balance sheet recession of 1983-1993. That was a dress rehearsal in miniature for what was to come.

(Alphaville has previously covered some of the many striking similarities between the two periods as well as how, for several large areas of the US — including Boston, Los Angeles, and New York — the late 1980s and early 1990s were actually worse than the more recent downturn.)

In a new paper, Atif Mian, Amir Sufi, and Emil Verner present additional evidence to demonstrate that anyone who was aware of what was happening in the 1980s and 1990s should have been spooked by what was happening in the 2000s.

They take advantage of differences in the timing of bank deregulation across US states in the 1980s — specifically, limits on both inter-state and intra-state branches — to measure the importance of "credit supply shocks" for employment, consumer spending, house prices, indebtedness, and inflation. States more willing to let banks from other states enter their market, such as New York, had bigger booms in the 1980s and bigger busts subsequently when compared to places less open to financial-sector competition, such as Illinois.

These booms took the form of greater household borrowing, significantly faster inflation, and a big uptick in the size of the notoriously unproductive construction sector. Rather than encouraging worthwhile investments, easier lending standards only exacerbated the amplitude of the cycle:

The simultaneous real exchange rate appreciation, growth in non-tradable employment, and stability of tradable employment is consistent with a model in which credit supply shocks boost local demand; these patterns are inconsistent with the view that deregulation operated primarily by boosting aggregate firm labor productivity…When aggregate conditions deteriorated from 1989 to 1992, the opposite pattern occurred. Early deregulation states witnessed a larger drop in house prices, residential construction, GDP, and household spending. Further, the unemployment rate increased more in early deregulation states.

The policy choices on deregulation, rather than other properties inherent in the various US states, seem to be the main driver. For one thing, "the rise in household debt from 1982 to 1989 is the strongest predictor of recession severity from 1989 to 1992". Mian et al also found that the states to deregulate first weren't more volatile than the rest of America back in the 1960s or 1970s, nor can their findings be explained by the big drop in the oil price in the mid-1980s.

Perhaps worst of all, the damage to the banking systems of the states that embraced deregulation most aggressively seems to have hit employment in manufacturing and other sectors that should have been insulated from local recessions. In other words, 'twas notbetter to have boomed and busted, rather than never to have boomed at all, since the consequences of the bust were bigger than simply reversing the earlier boom.

These results match what Mian and Sufi previously found when studying what happened in America in the 2000s. They also match what we know happened in places such as Ireland and Spain, which didn't explicitly deregulate their financial sectors in the 2000s but nevertheless experienced huge lending booms thanks to the explosion of cross-border credit flows within the euro area.

The change in credit supply had such a big impact both then and more recently because it's hard to write down debts without crushing the banking system and hard to cut wages without first firing lots of people. The big increases in debt and the big wage hikes in the boom period couldn't be reversed without significant pain.

This research is interesting and important, but the basic idea that the cycle of the 1980s and early 1990s was related to changes in credit supply is not new. The big mystery is why the Pollyannas of the 2000s didn't appreciate the lessons from their youth.