Discussing the failure of modern macro to incorporate the financial system into its models, Ben asks, why did the bursting of the housing bubble spank the economy so much harder than the dot bomb crash? He sez (courtesy Brad DeLong, emphasis mine):
…the decline in wealth associated with the tech bubble bursting [in 2001] and the decline in wealth associated with the decline in house prices as of, say, late 2008 was about the same–maybe even more on the  stock [market] bubble. From a standard macro model or even one elaborated with financial factors, you would not have really thought that the housing bubble would have been more damaging than the stock bubble. Now the reason it was more damaging, of course, as we know now, is that the credit intermediation system, the financial system, the institutions, the markets, were far more vulnerable to declines in house prices and the related effects on mortgages and so on than they were to the decline in stock prices. It was essentially the destruction of the ability of the financial system to intermediate that was the reason the recession was so much deeper in the second than in the first.
This familiar (and delusional) self-serving lionization of financial-industry “intermediation” completely misses the most significant difference between the two bubbles: one briefly dinged the wealth of a small proportion of the population — those who own stocks — while the other slammed hundreds of millions of people, permanently (click for larger):
(U.S. Census Survey of Consumer Finance)
Is it hard to imagine the effects of this picture on demand for real-world goods and services that humans consume, or the incentives for producers to invest, and produce (and sell) those goods and services?
Takeaway: if we want widespread prosperity and stability, we need a financial and political system that delivers…widespread prosperity. Pace (even) Paul Krugman, you don’t get it by making (and keeping) the rich people richer, and justifying it with the old “intermediation” rationalization.
Cross-posted at Asymptosis.