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Tuesday, June 30, 2009

Understanding the Great Recession

Unlike the Great Depression, which occurred over 75 years ago, the global recession is a mystery to most. It’s understandable, as the Great Recession is happening now, taking away the hindsight the Great Depression now provides us. Even still, many people falsely blame ideology for these financial crises, when it is many reasons that all tie into each other, none of which lay claim to any particular ideology.

Some reasons are “conservative” or even libertarian, while others are “liberal” and left-leaning. In the end however, one can only blame humanity and accept -– and learn -– from this event.

The first point we need to understand is the housing bubble and it’s inevitable burst. From that comes mortgage securitization and the complexity of large insurance firms that fooled the banks and subsequently the world. Finally, the lack of regulations surrounding foolish financial activity was the green light for the Great Recession. In a darkly hilarious manner, even the U.S. government, for better or for worse, helped speed up the Great Recession. Clearly it was for the worst.

Putting it all together, one will see how the term “bad” in macroeconomics is not very subjective, and that it’s that way for a reason. Macroeconomics is not about theory or ideological origin –- it’s about using history and our amazing capability of reason to our advantage to predict the future of the worldwide economy and to educate how it works. Why is this fact overlooked in most aspects of every day human life? In the end, it’s not about who to blame but how it really happened and why we must fix it. Never creating a severe recession would be a bonus, but humanity is far too short-sighted for that.

In the past, the main cause of housing crises has been reduced demand due to declining domestic investment in the housing market. This time, while that effect is still there, it’s a minor issue compared to the latest housing market collapse, which kick-started the Great Recession. Congressman Ron Paul (R-TX), among others, has been warning against and predicting this exact crisis for several years, perhaps even for more than a decade. Of course, the media payed little attention and so the public knew little of the matter. The short recession of 2001 in the U.S. was triggered by a sharp decline in domestic investment, mainly in telecommunications infrastructure. As a fall-out, the stock market assets of households declined, but housing assets held up, cushioning the normal decline in consumption that comes with recessions. This event isn’t that well known compared to what’s happening now, perhaps because it happened to be minor or that it worked itself out. Unfortunately, it’s not the case with the Great Recession.

A popular metaphor for crises of this nature is to call it the “bubble bursting”, and for good reason. In this case however, the balloon works much better. Consider the imaginary balloon represents the housing market, and sub-prime mortgages to be the air inflating the balloon. Sub-prime mortgages occur when banks lend to un-credit-worthy customers –- that is, handing out loans to people who want to buy a house that they can’t actually afford. This may seem obvious to us all now, but at the time people of all types -– bankers, potential home owners -– were disillusioned by the notion of housing prices continuing to go up.

The idea was that although it wouldn’t pay off now, since houses and property are long-term assets, when they are ready to turn the home over to new owners, the supposed increase in the value of the home would compensate for the lack of income in the household. As one can imagine, the idea was popular for both bakers and for eager to-be homeowners. Bankers lend more (which means more return for them in the long-run if the market goes well), and average folks get a better house than they could have otherwise -– a win-win situation, right? So the inflation of the balloon begins, filling up with lending amounts close to and exceeding equity (what one owes compared to what one owns), and eventually the rubber wears thin enough to burst.

So now you’re wondering “Where did the banks get all this capital that they’re lending out from?” The answer is one that’s overlooked but played a crucial role in the development of this recession. Simply put, many mortgages during this time of ballooning credit were packaged and sold as financial security instruments by banks to other institutions in exchange for additional capital the banks could then lend out (to those with bad credit, no doubt). The institutions that bought these packages benefited by being guaranteed a repayment. If they don’t receive the repayment, they have the legal right to take back their capital or assets worth an equivalent amount, hence the use of the word “security”. Since security is rarely seen as bad in any context, it seemed like yet another win-win situation. The fact that the American currency was the global common currency helped it make sense financially as well. As icing on the cake, the two institutions that were the lead buyers were Fannie Mae and Freddie Mac, created in 1938 and 1970 respectively, were government created.

These institutions weren’t the only thing the government created in the 1900s. In the early 1980s the government deliberately created a severe (relatively speaking) recession to control inflation using contractionary monetary policy. In other words, the money supply was reduced and interest rates were increased in order to reduce aggregate demand in the economy. A decline in demand means a decline in prices. At a time when inflation was on the run, the result was prices staying more or less the same while the nation’s output and income dropped. It’s bad, but the fear of hyper-inflation, which was a legitimate fear, would have been worse.

An economy that as a whole is generally strong, for example the U.S. economy, is able to recover from the recession along with slowly lowering interest rates speeding the recovery up. Although not necessary, increased government spending and tax cuts (expansionary fiscal policy) could have also sped it up –- which it probably did considering in 1986 the deficit rose to be well over five per cent of national GDP. Believe it or not, that was considered a huge deficit at the time. Currently, the U.S. deficit created to end the Great Recession is about 12 per cent of national GDP. and don’t think for a moment that it’s going to stop growing any time soon. Either way, the “severe” recession of the 1980s focused on expansionary monetary policy.

This time, strong expansionary fiscal policy is being used worldwide as it is much faster and more effective than the monetary policy used in the 80s. It leads to staggering deficits which are never good, but it does lead to an a strong enough increase in aggregate demand to ride of the recession without the world coming to a screeching halt. Milton Friedman is probably turning in his grave, especially with the mass amounts of bailouts to major insurance companies and banks –- many of which created this mess in the first place.

The bailouts were accepted by policy makers much easier than in the Great Depression of the 1930s. They let the banks fail and the money supply contract. At a time when 100 per cent free markets was extremely popular amongst major economists, it’s understandable why the government let them fail. In an ideal world, the free market should have corrected it all itself, but in a world full of foolish people, it just didn’t happen.

This is not a defense of government bailouts, especially to the culprits of the Great Recession, but simply an explanation of why they were done. It’s interesting when people pay attention to certain aspects of history and ignore others –- selective attention anyone It must also be said that the wrong monetary policy was used during the Great Depression. Unlike in the 1980s where contractionary monetary policy worked, in the 1930s it was a total failure by the Federal Reserve. Milton Friedman named this decline in income, prices, and employment the “Great Contraction”, as much of this was caused in the tight contraction of the money supply. Like the 1980s recession however, the government at least partially created this recession as well. At the very least the government ensured that the recession turned into a depression. Interesting enough, current Federal Reserve chairman Ben Bernanke has been quoted as saying:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton [Friedman] and Anna Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Back to the present, one might now be wondering “Well, why didn’t the banks know of the huge risks of securitization”. Great question! Complexity is the culprit; whether intentional or simply the result of mass bureaucracy, it’s often been at the root of many people’s problems skimming over the fine-print. Those pesky security instruments were further packaged in complex ways as derivative security instruments and sold again to other financial institutions, including back to the banks themselves. In simpler terms, these are bought for lower levels of risks such as interest rates or to help determine whether underlying prices will increase or decrease. This occurred because of foreigners trying to exchange cash for American securities (negotiable items that represent financial value), allowing banks and other buyers to increase returns. That was what was thought any way, but some large insurance companies such as AIG insured the packages without capital backing them up, calling them “credit default swaps”. As expected, the packages ended up being worthless. When this creates a ripple throughout the entire world in terms of mass amounts of assets going bad, we know this isn’t a normal old recession that’s expected to occur every once and a while. Although weak regulation in general was not the cause, the lack of regulation surrounding banks’ mortgage lending, banks’ capital requirements, and insurance “swaps” secured the collapse of the financial system, and can now be looked back upon when creating new policies regarding lending and capital requirements so that a crisis such as this cannot happen again.

Of course, not all of this happened spontaneously. Recall that foreigners bought up a lot of those security instruments because the U.S. dollar was so stable and strong. When the mortgages went bad, the security instruments that were held globally also went bad. The huge amount of bad assets in the bank’s financial books ceased the credit market, resulting in an unusually large recession that was and still is felt worldwide. From here, it can be said that asset prices normally decline in a recession as a result of the wealth effect (less household income, less consumption, and vice versa). This fact certainly doesn’t help fix the problem – if anything, it makes it worse. The real reasons -– sub-prime mortgages, securitization, complexity, and the lack of regulation –- pulled the world down into a sever recession. The government policies used to curb recessions (and those that help create them) differ from the past, mostly because of the sheer severity of this problem. Hopefully the world will learn from its many mistakes and get past this human flaw of over doing things; hopefully we understand more, look at the long-term more, and listen more. As Edmund Burke wrote over two centuries ago, “[e]very thing human and divine sacrificed to the idol of public credit, and national bankruptcy the consequence”.

[Cross-posted at the The Right Coast and the Campus Free Press]

Posted by Dane Richard on June 30, 2009 in Economic freedom | Permalink


“Where did the banks get all this capital that they’re lending out from”.

You never really answered that question. They got it from the FED. The FED caused the bubble and is entirely responsible for the disaster we are currently facing.

"In an ideal world, the free market should have corrected it all itself, but in a world full of foolish people, it just didn’t happen."

Yes it would have, but Herbert Hoover did everything he could to impede the free market. The Great Depression is not a failure of the markets, but of the Government and the FED.

Posted by: Charles | 2009-06-30 7:44:12 AM

I agree with Charles' comment above.

It would also be nice if you paid some attention to the clarity of your prose. It's not a pleasant task to wade through a blog post containing sentences like this:
"Macroeconomics is not about theory or ideological origin –- it’s about using history and our amazing capability of reason to our advantage to predict the future of the worldwide economy and to educate how it works."

Educate "who" about how "what" works?

Posted by: Craig | 2009-06-30 6:35:39 PM

Charles: I never said it was a failure of the markets. It was a failure of the whole financial system. As I point out, there were several reasons for this failure. I also point out which parts were speeded up by the government and the banks, and the Fed is a bank believe it or not (the American central bank).

Craig: I'll try and pay attention to this in the future, and I will change that sentence. Any ideas? I'm honestly curious, constructive criticism is rare these days. If there are any other similar sentences that are unclear, let me know. Sometimes one just needs a fresh set of eyes to spot these things.

Posted by: Dane Richard | 2009-06-30 9:37:41 PM

Fed is a bank believe it or not (the American central bank).
Posted by: Dane Richard | 2009-06-30 9:37:41 PM

My understanding is that the Fed is privately owned...who owns it?

Posted by: The original JC | 2009-07-01 4:31:56 AM

The fed is the acting central bank in the U.S., just like the Bank of Canada is ours. Both do the same thing: they control they money supply and adjust the interest rates depending on what`s going on financially at the time. The notion that the Fed is privately owned the same way the corner store down the street is, is ridiculous if you ask me. Point me to another firm that controls money supply and interest rates and I`ll change my mind.

Posted by: Dane Richard | 2009-07-01 5:42:23 AM

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