Introduction
The recent economic crisis of 2008 has left many puzzled Americans wondering what exactly went wrong. How could a sudden collapse of our economic system happen so abruptly, so brutally, and so unexpectedly? Hadn’t we mastered our economic system, and in the words of University of Chicago Professor Robert Lucas, “solved the problem of depression-prevention economics”? (Depression economics, Paul Krugman pg. 9) Where was the market’s free hand? These and other compelling questions have vexed even the most intelligent Americans. To this day, the answers have been conflicting, inconsistent, and often contentious.
The United States has thankfully avoided a Depression, and has instead experienced the worst recession in its history. Although the recession is officially over, American citizens continue to suffer. This talk of a recession leads to a pressing question. What is a recession? Well in laymen terms, a recession is a marked decrease in economic activity over a significant period of time. Recessions are considered a normal segment of the business cycle; however, there was nothing mundane about the latest recession of 2008.
The fervent search for answers that has ensued is especially significant. Once our economic problems are fully comprehended, measures can be taken to prevent a repeat of the same mistakes. The Great Depression taught economists a great deal about the field of economics and led to the rise of macroeconomic theory. Through this they learned several lessons that prevented a repeat for 80 years. The hope is that the latest crisis will provide the correct answers so that a repeat does not occur for a significant period of time. This requires that we find the correct answers, however, and that is the purpose of this paper. To find the answers to questions that have befuddled Americans since the wake of our crisis in 2008. So, what were the reasons for the economic meltdown of 2008?
It is widely believed that the Government is to blame for our current economic problems. That conviction is true. However, it is the lack of government intervention in our economy and its perverse policies leading up to 2008 which failed to avert our grave crisis. There are of course several other reasons for the recent cataclysmic fall in the economy, but for the most part these also stemmed from a failure on the part of the government.
In this paper, the causes for the crisis will be primarily examined whereas the crisis itself and its results will largely be ignored. The crisis itself is assumed to be more or less common knowledge but its causes are what are up for rigorous debate.
The Makings of a new Economy
In the late 1970s, the United States was suffering from a bad case of stagflation that was threatening to provide a serious threat to its recent prosperity. Many Americans had grown tired of current administrations and seemed ready for a profound shift in political and economic policy. Reagan, with his avocation of a new brand of “Supply Side economics” garnered substantial popularity that was revered by many as the new way forward. Reagan and his advocates successfully convinced the American public that this new administration would not only aid the middle class but transform America.
What is “Supply side economics”? How did it transform the American economy? Lastly, how is this relevant to an event that occurred nearly 30 years later? Well, “Supply Side economics”, also referred to as “Reaganomics” was a set of ideals that Reagan imposed or at least attempted to impose during his presidency. These were namely, a reduction in taxes for the upper echelons of society, a reduction in the size of government, Deregulation of corporations and business institutions, and a reduction in inflation and unemployment. Government was perceived to be the problem and in turn its powers would need to be decapitated under Reagan’s reign. This view still constitutes a major portion of modern conservative beliefs and serves as vindication for Reagan’s lasting legacy.
The pro business rhetoric that dominated much of Reagan’s propositions eventually hampered business, with the focus on short term profits that induced a plethora of mergers. (Merger Mania, Ch. 6, The man who sold the world) The implications of these mergers caused several problems for American business. With the new mentality of short term profits, companies began to cut corners, and no longer cared about a long term outlook. Many economists attribute this as the reason why American companies no longer retained the edge they once had over recovering German and Japanese economies. The fix for short term profits which would subsequently lead to a rise in stock prices created an economy where companies were no longer investing in new technology. These businesses that successfully completed their coups of other companies did so with mostly borrowed funds. This created another problem in that the company was no sounder after the merger than it was before. The advocacy of mergers, which then led to monopolies, also contained a paradox. Reagan, the advocate of small business and entrepreneurship, in fact hampered the advance of small businesses with his disregard towards monopolies.
The American middle class and lower class were also hindered by these developments in Reagan’s powerful scheme. The level of Poverty rose each year from 1981-1992. 80% of income gains since 1980 have gone to the top 1%. Middle class income has remained relatively stagnant since 1970. The middle class has not grown since Reagan’s insistence that tax cuts for the wealthy would aid all of America. In fact, it has seen a marked decline which seriously questions the validity of Reagan’s often contentious propositions.
There is no question that Reagan was one of the most influential presidents in America’s history. His economic foundation helped drive the American economy over the past thirty years. Alan Greenspan, the Federal reserve Chairman, appointed in 1987 by Reagan himself carried out Reagan’s policies well into the 21st century. Not only did many of Reagan’s promises not come to fruition, but his influence paved way for the makings of a new economy, one that was doomed due to its flawed ideology. And that is why the comprehension of Reaganomics and its impact is of cardinal importance to any studying the Great Recession.
The not so free economy
While the United States has presided over what may closely be described as a free market, there is disconcerting evidence that points to the contrary. It is true; the Government has largely stayed out of the way of corporations. They have been provided with unprecedented freedom that was supposed to nurture competition and encourage innovation. There is one problem with free markets though. The discretion provided to the corporations and lack of regulation leads to their realization that they can maximize profits by breaching the rules. They and other companies that eventually feel obliged to partake in such malpractices eventually cause what is known as a monopoly, and if not a monopoly, at least an oligopoly. Due to the lack of regulation, the consumer suffers, because of a lack of viable options. Even the options they have are severely limited, because the goods they consume were made with profits in mind. In short, in a free system the consumer is not free. Free market proponents would argue, however, that this ushers small businesses that provide healthy alternatives. However, once a monopoly is established in the market, small businesses never get going and either fail, stay small, or get acquired.
Why Did We Have to go Through This?
The previous information has simply served as a backdrop for our current situation. Neither of these are reasons why the 2008 crisis happened. Rather they are explanations of how the recent and appalling occurrences were possible. Now, there are several reasons why the economy floundered. There is not one sole reason to blame, and in complex situations like these, there hardly ever is. However, if deconstructed, one can indeed deduce the facilitator for the problems faced. While one cannot blame the government for the crisis directly, it can be perceived as the neglecting parents who failed to discipline their children. They placed far too much trust in their child (the economy), and now their child has gotten itself into trouble.
Now this analogy, though partially true, makes the government appear much too benign. Wasn’t it the government that reduced rates for higher tax brackets that was partly the reason for such startling inequality, and dangerous deficits? Wasn’t it the Supreme Court that just recently ruled that corporations are viewed as people by the court? Wasn’t it the Federal Reserve that kept interest rates low when the economy was heating up? So in fact, the government is much like the lazy parent who provides their overweight child ice cream for lunch, because they do not want to force them into losing weight much less cook a healthy meal. So, what were the reasons for our unfortunate crisis?
1. Lack of government intervention: The first one is obvious as it is in fact the premise of this paper. However, it does deserve scrutiny for its significance. The movement towards deregulation was a mass movement initiated by several free-market economists such as Milton Friedman, F.A Hayek, Ayn Rand, and several others. This movement picked up steam and became more prevalent towards the late 1970’s. The vehement attack against regulation argued that it was holding back American institutions and stifling innovation and growth. Markets, they advocated, would work best unfettered, because the market would eventually take care of itself.
Why this new group of dissenting economists would hold this view is slightly puzzling. Not only had the economy been growing steadily since World War 2, when heavy regulation was indeed in place, but the cost of regulation had been relatively miniscule, when compared to its apparent benefits. In the words of Joseph Stiglitz, “the costs of a mistake are thousands of times greater than the extra costs of enforcement. (Freefall, pg. 179) Nevertheless, they got their way, and even the liberal Carter began to reduce Regulatory measures in the economy. When Reagan assumed the presidency, this movement had only been exacerbated. Reagan in fact helped in not only in proposing deregulatory legislation, but in appointing officials that were clearly against regulation to the Federal Reserve, and SEC and other regulatory institutions.(The Man Who Sold the World) This not only severely hindered the abilities of regulatory institutions, but in essence rendered these institutions useless.
Reagan’s successors Bush Sr., Clinton, and George Bush continued this trend in the belief that the economy is best left alone.
Now it must be understood why Deregulation has the perverse effects it has, and what infringements were committed on the part of the government.
The issue with deregulation is that it provides the wrong incentives. The nature of business is that it is conducted with profits in mind. There are several ways to maximize profits. Among these are several quite dubious methods such as cutting corners, underpaying workers, and several other malpractices. The biggest problem with deregulation is that it assumes corporations and business organizations are disciplined enough to prevent themselves from committing something unethical, which if committed would increase their profits and make their company appear more lucrative, while at the same time be completely ignored by incompetent regulatory institutions. If analyzed carefully, it is quite evident this ideology is flawed, and it is clear why it failed.
Now that the negative aspects of deregulation have been explained, examples of the impact of deregulation must also be examined.
Perhaps the most publicized effects of deregulation are attributed to the failure to regulate the financial sector. Not only were standing regulatory measures largely ignored by the Federal Reserve, but new Regulatory measures were never devised for exotic investments such as Credit Default Swaps, CDO’s, and derivatives. These so called “innovative” investments were never touched upon by regulatory measures and it is no wonder they failed miserably. The failure on the part of the government to recognize the potential danger of such assets and regulate them was a direct reason for the financial crash. If the government had kept such investments in check, they would not have grown into the colossus they were, and their impact would have been greatly reduced. In fact, many of these “innovative” methods should have been outlawed outright due to the fact that many do not even serve a purpose. They simply turned Wall Street into a high stakes casino that was getting more and more dangerous as time passed. (Deregulation and the financial crisis, Freefall)
Another regulatory failure can be found in the repeal of the Glass-Steagall act in 1999 which eroded the line between investment banks and commercial banks. This ensured that already big banks could become bigger, and that commercial banks could now take the exorbitant risks once taken exclusively by investment banks.
Rating agencies were also to blame for failing to warn investors of risky investments. These agencies are also a good example of flawed incentives because many were paid by the banks themselves. Since several of them competed for these funds the rating agency that seemed most favorable to the bankers would be the most successful. This should have been apparent to regulators but instead they insisted that the rating agencies were responsible enough to make sound decisions. (Freefall, Ch.6)
Instead of realizing that the economy was heating up and that there was a housing bubble (Alan Greenspan actually denied the existence of such a bubble up until the crash), the Federal Reserve reduced interest rates. There were many issues with this. Firstly, interest rates are used to increase or decrease liquidity in an economy. When there is a decrease in liquidity, the Fed lowers rates to spur spending, and when the economy heats up, the Fed raises rates to prevent inflation and the bursting of a bubble. To lower interest rates when the economy is heating up is paradoxical, and it is puzzling why Alan Greenspan would opt for such a measure. According to William McChesney Martin, Chairman of the Federal Reserve for 19 years, the Federal Reserve’s job was ''to take away the punch bowl just when the party gets going.'' (NY Times) Alan Greenspan provided more punch to make sure the party became even more boisterous. All that sugar leads to a crash eventually, and it is no surprise that our party crashed miserably.
It is clear that over the past thirty years Government officials had all been in cahoots in terms of regulation. Less meant more. Nothing was the best. This anti-regulatory mantra indeed led to a system with flawed incentives. We had been convinced that banks were mature enough to self regulate themselves. They would never give in to the temptation to maximize profits and do so unscathed. Not only is that an oxymoron, but it has proven to be a fallacious assumption.
2. Too big to fail: This issue is indeed partially a regulatory problem, but it deserves its own mention. There is a reason why the Economists are wary of corporations that are too big to fail. Too big to fail creates a moral hazard for the corporation, is a cause for systemic risk, and leads to a monopoly. Apart from these effects mentioned above, it must be comprehended why too big to fail is dangerous, how it pertains to the economic crisis of 2008, and why regulatory agencies refused to deal with the issue.
When a company is too big to fail, it obviously realizes that its fate has a direct impact on the fate of others. As a result, the company begins to act carelessly and erroneously to increase profits, knowing full well that the government will not allow them to fail. Since a free market begets monopolies, it is no wonder that our quasi-free market was littered with such monopolies that contained dangerously big companies. Once it is too big, not only does this company act irresponsibly, but it is too big to be challenged as well. Causing a severe problem for the little guy, workers, small businesses, consumers etc. If you are too big to fail you are too big to be challenged.
The other problem with too big to fail, is that the actions of one, or some impact the wellbeing of all. This is what happened in 2008 with the financial crisis and is why the tax payer was forced into bailing these corporations out. Their failure would lead to the failure of the rest of the country.
The sane response is for the government to recognize this and impose limitations on such problems from arising. Much like the antitrust laws of the progressive era imposed by Teddy Roosevelt and Taft. However, the government did the opposite and even allowed threatening mergers to occur. To them, it would be far much better to leave things alone as long as everything was going up, including the size of dangerously large corporations. Reducing their size would be a hassle and as long as everything was going up, there was no need to worry. However, what goes up must come down.
3. The Mortgage Debacle: Much of this was also covered by the section on deregulation, but there are some aspects that must be elucidated on. These are namely, securitization, and banking/mortgage malpractices such as predatory lending.
Securitization is the practice of consolidating groups of debt obligations, packaging them up, and selling them as investments. This popular practice is a deviation from standard banking where banks would issue a loan, and keep it. In this system, banks had the incentive to issue loans to worthy candidates, because they would ultimately be paid back. With this new method, banks were no longer concerned with the quality of a loan because they would be sold as an investment regardless. With faulty ratings from ratings companies, risky loans were classified as safe and these loans were sold all around the world.
Predatory lending practices and faulty banking practices also led to the financial crisis. Since Banks no longer cared about the whereabouts of their loans, they began to hand mortgages to anyone with a social security. Some critics blame irresponsible consumers for this. However, who should be at blame for this? Ignorant, helpless consumers or the bankers who insisted that all would be well as long as home prices rose exponentially knowing full well the risk of such lending practices. It is no wonder eventually the speculation on housing prices eventually reached a crescendo, after which home prices dropped and many Americans found themselves with an underwater home.
The reasons for the financial crash itself also involved the shady practices committed by bankers. Practices such as risky leveraging increased risk exponentially and would dully increase profits, as long as the value of everything continued to skyrocket. The banks in the small country of Ireland leveraged to such an extent that the entire country transformed from a success story into a disaster. It is this shortsightedness and obsession with short-term profits that caused bankers to behave so irrationally. These exorbitant risks taken by banks were also highlighting their inability to regulate themselves, thus calling for the existence of an overseeing authority. According to Joseph Stiglitz, “Bankers are born no greedier than the rest of us.” It is the government however, that willingly allows bankers to act upon their natural instinct, and instead of curbing it, exacerbates it.
4. Income disparity: Several economists such as Robert Reich and Raghuram Rajan have pointed to income disparity as one of the primary reasons for the Great Recession. In saying this, they are indeed correct. What they do not focus on enough however, is how the government paved the way for such levels of disparity.
As Robert Reich himself noted, the problem with income inequality is not only an issue of fairness, but it is an issue of pure economics. The reason why large concentrations of wealth are unsustainable is because rich people tend to save money. Not only do they save but even the ones who spend have so much that it would be impossible to spend it all. This is all money that is not reaching circulation and thus fails to stimulate the economy. The reason why government tax cuts to the wealthy have consistently failed to create jobs is because the wealthy save the majority of their tax cuts. (Aftershock)
As has already been noted, wages for middle class men have been stagnant since Reagan assumed the presidency. How has the economy been able to achieve sustainable growth during this period? Well, basically, Americans stopped saving and started borrowing. For the past thirty years, Americans have been living beyond their means, and eventually this reached its saturation point, hence our current economic crisis.
Since the middle class is the primary consumer of produced goods, then they must be sustained in order to consume what is produced. If the middle class is sputtering, and corporations continue to grow and increase their supply, then eventually the supply outstrips the demand, and the country enters a recession. Such an example can be found in the Great Depression with the demise of farming. In fact, one of the biggest and least acknowledged bubbles is that the American consumers no longer had the means to purchase the products that were being produced. Thus, it can be deduced that an economy is not truly healthy unless its middle class is growing in accordance with the growth of its nation.
Even the staunchest Free-market capitalists would be forced to admit that pure capitalism begets inequality. Since a healthy economy is not sustainable with widening levels of inequality, how is it that pure capitalism is the answer to what ails us?
The issue of income disparity is in fact one in which the Government’s perverse policies are directly to blame. The catering to the rich and wealthy that has transpired in Washington is appalling, and begs to question if the current government actually is for the people by the people. The plethora of tax cuts gifted to those who can full well afford to pay it is appalling, and as a result have lead to the widening chasm between the rich and the poor. Deteriorating social safety nets have been a direct result of the lower amount of revenue collected. The less taxes are collected to support these safety nets, the more inequality rises, and the more people begin to fall below the poverty line. Then, to “stimulate” the economy, more tax cuts are given to the wealthy which exacerbates the vicious cycle. The rich get richer, the poor get poorer, and our economy suffers. (Of the 1% for the 1% by the 1%, Paul Krugman)
Conclusion
The ensuing economic turmoil that was a direct result of these causes is more or less common knowledge. The housing bubble collapsed in 2007, and later in 2008 banks began to feel the pressure. Bear Stearns endured a near death experience, Lehman brothers did die, and many other financial institutions were bailed out. The resulting contagion was not necessarily anything anyone could stop at the time. The damage had been done, and the effects were finally coming to fruition. The fed moved expeditiously, and as a result the economy was put on life support, where it has been for the past 3 or so odd years. Now that the damage has been done, it is time to reminisce about what has transpired. The American people need answers just as dearly as do the economists. However, if they look closely enough, they must realize that we need to improve the function of our ailing government to improve the anemic growth of our economy. The sooner the Government is coerced into improving its policies, the sooner the Economic Crash of 2008 becomes nothing but a fleeting memory, albeit a painful one.
