Fiscal stimulus

The National Bureau of Economic Research (NBER) has decided that a recession began in December of 2007. That date means that the fiscal stimulus of the past summer was properly timed--it occurred early in the recession--which raises the question, "If fiscal policy works the way the textbooks say it does, why have things gotten so much worse?"

The current recession seems linked to two major shocks. The primary one is the bursting of the housing bubble and the mess of bad debt left in its wake. The housing bubble itself was encouraged by lending that made sense only by assuming that housing prices would continue to rise, such as zero-percent-down loans, interest-only loans, and the array of sub-prime and near sub-prime lending. Further, large banks and financial institutions thought that they were managing risk, but most of the risk management techniques assumed that the markets would function smoothly. However, when a financial panic hits, markets never function smoothly. Things that work without problems in normal times can fail to function in abnormal times. After episodes such as the stock market crash in October, 1987 and the demise of Long Term Capital Management in 1998, one would think that people running big financial institutions and the regulatory agencies would have been very aware of that problem.

The second and secondary shock was the oil-price run-up, which has now receded.

Some commentators point to the mark-to-market rules not as a source of a financial shock but as an amplifier of the downturn. I do not fully understand their argument, but it seems to be a feedback argument similar to Irving Fisher's debt-deflation theory of depression. A decline in the value of securities causes distress in some financial institutions that have to mark down the value of assets. Because their net worth is affected, they rearrange portfolios trying to flee risk, which causes a further decline in the price of securities.

Fiscal and monetary policy were designed to offset demand shocks, which is what the Keynesian economics that emerged from the Great Depression saw as the source of almost all instability. But is the source of our present recession a demand shock, or is it something else? And if it is something else, why should we expect any stimulus package, no matter how large, to fix the problem?

Addendum: Here is marginalrevolution.com on monetary policy.