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.