Origins of the Great Recession

What caused the economic disaster of 2008? This is a question that was continually asked when the, once thriving, economy fell into a deep recession two years ago. Many blamed President George Walker Bush for the disaster; many others blamed “deregulation” and the “free market”. Others blamed the problem on greed, while some blamed it on Capitalism itself. Others like Economist Paul Krugman blamed everything on the gap between the rich and the poor and income inequality (along with the statements above).

Mortgage foreclosure rates rose to their highest levels since the Great Depression. The two largest government sponsored mortgage purchasers and repackagers, Fanny Mea and Freddie Mac both went into a bankruptcy like “conservatorship” Several major investment banks, commercial banks, and insurance companies which were heavily tied to the real estate lending market went bankrupt or were outright sold for cents on the dollar. The collapse of the investment banks, commercial banks, and insurance companies all led to the lack of confidence which led to the reluctance to lend money in other sectors of the economy. Combined with the economic shock the country faced when high gas prices damaged the economy, the financial crisis plunged us into what we know now as the Great Recession¹. The Great Recession is a recession that left us in 2008 with a 5.8% unemployment rate² which continued to climb, a stock market which went into a free fall³, a shrinking GDP⁴, a fall in consumer confidence, the collapse of many businesses, and the decline of the Median Family Income rate⁵. Along with the apparent economic problems, we were left with a national deficit of $454.8 Billion dollars in 2008⁶, which was the highest deficit in American history. Things were pretty dismal in 2008.

So what caused our once thriving economy to collapse? We were doing great; our economy was growing rapidly from 2003 to 2007. Unemployment from 2003 to 2007 fell from 6% to 4.6% in 2006 and 2007², following the second wave of the Bush tax cuts in 2003. The Median Family Income started to rise from 2003 to 2007, from $50,000 in 2003 to $53,000 in 2007⁵. The Stock Market grew throughout 2003 to 2008, when in 2008 it hit a high of 1400 points³. The GDP was also growing on average by 4% to 5% from 2003 to 2007⁴. Even the deficit was reduced from 2004 to 2007, while revenues increased from 2003 to 2007 after the second wave of Bush tax cuts⁶. The deficit hit a low in 2007 when it fell down to $160.7 Billion – the shocking part is the spending was never reduced, instead revenues from the growing economy fueled the budget and increased revenues thus reducing the deficit⁶. We were doing great! We had just came out of the Clinton business cycle recession and the 9/11 recession. Then it all went down the drain.

This entire collapse was fueled by the vast expansion of risky mortgages, or sub-prime loans, which were being given out to under qualified borrowers. Ultimately these sub-prime loans were not fully paid back. The banks lost more money than they were making, thus leading to the bankruptcies we saw in 2008. Everyone invested in Real Estate went down with the banks. Lending stopped, people lost jobs, and in short, the economy went downhill. While it may sound correct to blame “deregulation” or “unfettered capitalism” and “greed”, the truth is actually much different. In fact the entire risky mortgage business was fueled by the Federal Government, through numerous bills and acts. The origin of this sub-prime disaster began with the passing of the Community Reinvestment Act⁷ in 1977. The CRA provided that banks have “an affirmative obligation to meet the community’s needs.” The act was passed by a Democratic Congress and signed by President Carter, ultimately to address the “discrimination” by banks which would not lend loans to minorities. In truth, many minorities at the time could never afford to pay back the loans, but President Carter and the Democrats thought differently⁷.

The CRA alone could never have started this financial disaster. But the CRA was the very origin behind a line of mistakes, from the government, that led to the financial crisis that led us into the Great Recession. In 1992 the Department of Housing and Urban Development pressured two government chartered corporations, known as Fanny Mae and Freddie Mac, to buy large bundles of those sub-prime loans for the conflicting purposes of diversifying the risk and making even more money available to banks to make further sub-prime loans. Congress also passed the Federal Housing Enterprises Financial Safety and Soundness Act⁸, which mandated that those companies (Fanny and Freddie) buy 45% of all loans from people of low or moderate income¹…

In 1995 the Treasury Department under the Clinton Administration established the Community Development Financial Institutions Fund⁹, which provided banks with taxpayer money to allow the banks to give out more risky, sub-prime loans. The large amounts of risky sub-prime loans fueled the housing market’s boom and added with the credit which fueled these loans even more, the housing market and banks collapsed. Loans weren’t being paid back, which made the banks lose more money than they were making. Along with President Clinton’s strengthening of the Community Reinvestment Act in 1995⁷, it is easy to see how our Government had a big hand in the sub-prime crisis. Following the 2001 recession, Federal Chairman, Alan Greenspan, slashed the federal funds rates from 6.25% to 1.75%. In the years 2003 and 2004, the funds rate was slashed even more¹. What this created was a massive demand bubble in real-estate. Instead of keeping the money supply balanced, the Federal Reserve moved into a “Cheap-Money” policy. The large bubble or gap in the system encouraged the growth in the housing market. It also encouraged more houses to be built and for more sub-prime loans to be handed out. This action created what economist Steve Hanke called “The mother of all liquidity cycles and yet another massive demand bubble.” The expansion of the Federal credit fueled the increased encouragement to give out more sub-prime and non-prime loans and to expand on unsustainable mortgage financing.¹

Some people blame President Clinton for signing the Financial Services Modernization Act of 1999 or also known as the Gramm-Leach-Bliley Act, which allowed financial firms to diversify. It was a deregulation bill, which actually allowed greater freedom for financial firms, allowing them to own their own insurance, mutual fund, and investment subsidiaries¹. Without this extra freedom JPMorgan Chase could not have acquired Bear Sterns, nor could Goldman Sachs and Morgan Stanley have switched specialties to become bank holding companies when it was apparent they would not survive as investment banks. This extra freedom prevented further damage to our economy.

This is what led to the financial crisis. The Origin of the Great Recession came from the origin of the financial crisis. To blame one person for this mess is ludicrous. To blame greed is foolish, since greed is a constant in our economy. Blaming deregulation is foolish, since the last deregulation bill was passed in 1999 (Gramm-Leach-Bliley Act). And blaming the free markets and Capitalism is illogical, since Capitalism was not the reason for our collapse. This whole disaster was caused by poor government policies and poor monetary policies, all of which accumulated into a giant domino effect which led to the financial crisis which started our Great Recession. Just by looking at the nature of how the financial crisis began, it is obvious that our current recession had nothing to do with income inequality or also known as the gap between the rich and the poor (Something Economist Paul Krugman believes.) In the end I cannot blame a certain group of people, nor one individual, but instead a series of poor choices. The question now is can we learn from our mistakes, or are we doomed to repeat them in the future?

Sources:

1. White, Lawrence H. “How Did We Get into this Financial Mess?” CATO Institute .
N.p., 18 Nov. 2008. Web. 6 July 2010. http://www.scribd.com/doc/13673690/-How-Did-We-Get-into-This-Financial-Mess-Cato-Briefing-Paper-No-110-

2. “Annual average unemployment rate, civilian labor force 16 years and over (percent).” Bureau of Labor Statistics . United States Department of Labor, n.d. Web. 5 Feb. 2010. http://www.bls.gov/cps/prev_yrs.htm

3. “Dow Jones Industrial Average (2000-Present Day) .” Stock Charts.Com N.p., n.d. Web. 1 Feb. 2010. http://stockcharts.com/charts/historical/djia2000.html

4. “GDP and Other Major NIPA Series, 1929–2008.” Bureau of Economic Analysis. United States Department of Commerce, n.d. Web. 4 Feb. 2010. http://www.bea.gov/‌scb/‌pdf/‌2008/‌08%20August/‌0808_gdp_nipas.pdf

5. “Income, Poverty, and Health Insurance Coverage in the United States: 2008.” United States Census Bureau. N.p., Sept. 2009. Web. 5 Feb. 2010. http://www.census.gov/‌prod/‌2009pubs/‌p60-236.pdf

6. “Revenues, Outlays, Surpluses, Deficits, and Debt Held by the Public, 1969 to 2008.” Congressional Budget Office. N.p., Mar. 2009. Web. 3 Feb. 2010. http://www.cbo.gov/ftpdocs/100xx/doc10014/March2009_HistoricalTables.pdf

7. “Community Reinvestment Act.” Wikipedia. N.p., n.d. Web. 7 July 2010.
http://en.wikipedia.org/wiki/Community_Reinvestment_Act

8. “Federal Housing Enterprises Financial Safety and Soundness Act of 1992.”
Wikipedia. N.p., n.d. Web. 7 July 2010. http://en.wikipedia.org/wiki/Federal_Housing_Enterprises_Financial_Safety_and_Soundness_Act_of_1992

9. Levin, Mark R. Liberty And Tyranny: A Conservative Manifesto . New York City:
Threshold Editions , 2008. Print.

10.(Work Consulted) Le, Amy. “Did Alan Greenspan Cause the Housing Crisis?” Home Finder. N.p., 31
Jan. 2008. Web. 6 July 2010. http://www.homefinder.com/content/Blog:Did_Alan_Greenspan_Cause_the_Housing_Crisis%3F