Just as the 1929 stock market crash didn’t cause the Great Depression, the housing collapse didn’t cause the Great Depression. In both cases, monetary policy mistakes were the likely proximate and fundamental cause. The role of the Federal Reserve in the Great Depression was the subject of Milton Friedman and Anna Schwartz’s A Monetary History of the United States. The Fed’s role in causing the Great Recession and Financial Crisis is explained in The Great Recession: Market Failure or Policy Failure? by Robert Hetzel. The first book caused a major rethink in the economic profession, so should the second. As Hetzel puts it: “Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.”
I have written a number of blog posts on this topic. But Ramesh Ponnuru gives a great overview on the theory in his wonderful new National Review story,“Cause for Depression.” Although the housing slump began in mid-2006, the economy actually weathered the decline quite well until 2008. The following two charts show housing prices and starts vs. the unemployment rate.