What caused the Great Recession? (or recessions in general)

This is kinda an important question, with a lot of different theories to answer it. Some theories offer a solution, but one in particular offers none. Years ago Paul Krugman called it the “hangover theory”. It's the idea that a boom must inevitably cause a bust, and any attempt to alleviate it will only delay the inevitable recalculation. As Krugman puts it himself in a piece you should read in its entirety (from 1998):

“In the beginning, an investment boom gets out of hand. . .Whatever the reason, all that investment leads to the creation of too much capacity—of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes—investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover. . .this is not a bad story about investment cycles. . . But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole?”

Krugman goes on to point out that the fact that they are highly correlated is not a theory; a theory is causal. It's disturbing how little this question is asked among economists. I've taken numerous classes that take it as a given that if investment demand falls so does the economy as a whole, without ever explaining why. When an explanation is offered, it is usually that there is some friction in the transfer of workers out of one sector to another, such as out of housing construction and into whatever. But that doesn't answer the question of how a housing bust, which started in 2007, led to a world-wide crisis in late 2008. And if that's true, Krugman asks, why doesn't the boom cause frictional unemployment as workers transition from one sector to another? Then comes one of the best comments in the theory of recessions I've read:

“As is so often the case in economics, the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.”

The housing bust caused that increase in private demand for money, the failure to adjust the money supply to the change in demand caused nominal GDP growth to crash causing the crisis that started the Great Recession. I kinda like the part about “only after an epic intellectual journey”. I felt like I was grasping at this conclusion for a while but with only partial understanding and somewhat recently have come towards the end of that journey. Sure the trend rate of real GDP growth can't be affected by the money supply in the long run: one is a nominal variable and the other real. But recessions are short run deviations of lower than trend growth, and those can be made less severe by adjusting the supply of money to movements in demand. Generally, the determinants of the trend for long run real growth are real, the determinants of short run fluctuations from that trend are nominal.

Remittances to Somalia

A few years ago the United States put stricter regulations on the sending of money abroad in a process known as remittances, out of concern that money may end up in the hands of extremist groups. Remittances are money that immigrants in a rich country send back home to their families. The flow of remittances worldwide is huge; the World Bank estimates they will be about $500 billion in 2015. Around $1.6 billion of that annual total goes to Somalia, a larger amount than foreign aid and investment. According to the UN, nearly 40% of Somalis receive remittances, in a country where GDP per capita is around $1000. Remittances are an economic lifeline for families who have relatives working in rich countries, and are an important factor in the positive benefits of migration.

In February, the last US bank handling transfers to Somalia stopped providing the service, citing US bank regulations, effectively cutting off every Somali who receives money from relatives in the US. This is a huge blow to the Somali economy, and will put millions further into poverty. The reason for the regulations is to prevent transfers to terrorist groups, such as Al-Shabab. But such groups have illicit sources of financing, and some degree of networks in multiple countries. The average Somali has no other options. It is unknown to what extent if any terrorist groups in Somalia are financed this way, making the benefits, if any, highly uncertain against high and certain costs.

Not to mention that increased poverty is a threat to well-being itself. Without resources, more Somalis may be pushed into the arms of extremist groups or militias that can provide them with some level of income or resources. Poverty is fertile ground for violent extremism. The intent of the regulations was to make people safer by defunding terrorist groups. The effect is to increase poverty, and reduce safety. It is a cautionary tale about judging regulation by its intent rather than effect.

Fortunately Somali-American groups in the US, and their representatives, have been pressuring the US to revise the relevant banking regulations. Supposedly remittance services will become available again to Somali-Americans this month; it can’t happen too soon.