At the end of World War II, America stood virtually alone as an economic power.
The United States accounted for 50 percent of global GDP, held 80 percent of the world’s hard currency reserves, and was a net exporter of petroleum products.
During World War II, a private sector ‘welfare’ system had developed. Under wage and price controls, labor-short companies could not offer higher wages. But they could offer health care and pensions.
After the war, the combination of little international competition, rapid productivity growth, and effective bargaining by industrial unions expanded health care and pensions as well as wages.
That world changed in the 1970s.
Two oil shocks, an expansive monetary policy, and growing competition as Europe and Japan recovered from the devastation of World War II.
By the end of the decade, the country went into what came to be called
stagflation, a combination of no growth and rising inflation. In eﬀect, the country had the worst of both worlds.
President Carter’s appointment of Paul Volcker as Federal Reserve Chair started the path to change. He restricted the money supply in a war that drove up unemployment, but eventually tamed inflation.
The Reagan presidency started with cuts in spending and income taxes in what was called a ‘supply-side experiment.’
The intent was to stimulate saving, work, and investment. The emphasis that the supply-side approach put on incentives is now a more prominent part of economic thinking, but the experiment itself led to larger fiscal deficits.
President Reagan responded by raising income taxes in 1982 and social security taxes in 1983. He also worked closely with the Congress on a major tax reform in 1986, a shift that by eliminating a number of special features in the tax code allowed tax cuts without a loss of revenue.
President Reagan started his presidency in the midst of a recession, but as the economy recovered, he scored a landslide re-election victory in 1984 running on the slogan, “It’s Morning in America.”
Reagan’s successor, George H.W. Bush, was enormously successful in foreign policy, leading the world to victory in the first Iraq War and helping guide the country and the world through the years that saw the fall of the Berlin Wall and the collapse of the Soviet Union.
The presidency of George of H.W. Bush, however, also faced serious fiscal deficits. In striking a deficit reduction agreement with the Democratic controlled Congress, he violated his earlier pledge to not raise taxes. The political fallout was serious and contributed to his subsequent loss to the governor of Arkansas, William Jefferson Clinton.
After taking office, President Clinton made a serious course correction.
Having run on the promise of a middle class tax cut, he expressed surprise at the size of the budget deﬁcit. In place of tax cuts, he proposed and eventually succeeded in cutting spending and raising taxes in an effort to control and reduce the fiscal deﬁcit.
During the period between his election and his inauguration, President-elect Clinton met with a number of leading economic figures, including Alan Greenspan, the Chairman of the Board of Governors of the Federal Reserve System. Greenspan was the most influential monetary figure in the world.
At the end of their meeting, President Clinton emerged from the room say-ing, “We can do business.” At his first address to Congress, Alan Greenspan sat in the balcony between First Lady Hillary Clinton, and Second Lady Tipper Gore, the wife of the Vice President.
In an era of deﬁcit reduction, many Democrats had hoped to combine fiscal austerity with a more expansive monetary policy that would maintain growth and job creation. President Clinton thought his move to tighten fiscal policy would be met by looser monetary policy from the Federal Reserve.
At the same time, Clinton’s move to be fiscally conservative may have changed the expectations of the business community in a way that was likely to foster private sector investment.
The economy that had already begun to recover under President Bush continued to recover during the early Clinton years. Other trends favored the President as well. Oil prices were moderate. Global competition and a strong dollar both helped keep inflation in check. Rising productivity growth made a non-inflationary expansion of the money supply possible.
Finally, the internet had matured to the point that it triggered a boom in business startups and investment.
Overall growth and a surge in capital gains created a series of budget surpluses, the first in years. By the end of the Clinton presidency, Alan Greenspan was expressing concern that we might completely pay oﬀ the publicly held debt. With no federal bonds to buy, noted Greenspan, the Fed would find it difficult to conduct monetary policy.
The Roots of the Financial Crisis
As President George W. Bush took office, what became known as the “dot-com bubble” burst. The Federal Reserve responded by lowering interest rates and keeping them low. While there was a gradual economic recovery, productivity growth was moderate.
Since the tight-money recession of the early 1980s, the United States had experienced roughly two decades of stable growth and moderate inflation. Even the bursting of the dot-com bubble did little damage to the overall economy.
Long periods of stability can mask risks and make average and even sophisticated investors less cautious.
Hyman Mynsky, a professor of economics at Washington University in St. Louis, emphasized the tendency of financial markets to grow in confidence and then experience bubbles that inevitably led to crashes, a period of caution, and then a return to what we now call “irrational exuberance.”
Pressures were building throughout the 1980s, 1990s, and the 2000s.
There were several elements that contributed to the financial bubble.
Low cost, readily available credit made speculation possible and, with low re-turns on conventional assets, attractive.
The gradual erosion and eventual repeal of financial regulations that dated back to the New Deal created added opportunities for speculation.
Economic theories that emphasized ‘efficient markets’ and ‘rational expectations’ were simplified to the idea that ‘the market always gets it right.’
With easy credit, banks adopted very high levels of leverage—having as little as one dollar for every thirty dollars of investment.
The development of new forms of derivatives allowed for speculation on assets in which investors had no direct stake. It was a world in which John could bet Jane on whether Bill would actually pay Karen back.
What were called subprime mortgages (mortgages to less qualified borrowers) became widely used. Major companies bundled them together with other mortgages to form securities, sliced them into riskier and safer tranches, and sold them on to various institutional investors.
Fannie Mae and Freddie Mac, two private companies that were viewed as having a federal guarantee behind their bonds, joined in by financing and, at times, holding mortgage backed securities. One president of Fannie Mae explained his decision to participate in the sub-prime mortgage world as the need to meet the demands of the shareholder and still pursue his public mission of supporting the housing sector.
Gradually, concern about sub-prime mortgages began to appear in the major daily newspapers.
The Washington Post started to describe them as “NINJA” loans —
“no income, no job, and no assets”
The dominoes started to fall in 2007 as Bear Stearns bailed out two of its independent funds.
While not legally responsible, Bear Stearns management feared the damage to its reputation if it did not support these independent entities. Months later, they were rescued by the Federal Reserve and eventually sold to J.P. Morgan.
Near total collapse came in September 2008 with the bankruptcy of Lehman Brothers. In this case, the Treasury and the Federal Reserve sought a private sector buyer for Lehman. They failed, having failed, they also refused to take action to bail out Lehman Brothers.
The Lehman collapse triggered a near global financial panic. In Andrew Ross Sorkin’s book, Too Big to Fail, he quotes key financial leaders as seeing the entire industry heading for total collapse. In Europe, banks were reluctant to lend to each other and LIBOR (the London Interbank Offered Rate), a key short-term interest rate, shot skyward.
Under the leadership of Secretary Henry Paulson, the Treasury sought emergency funds from Congress. Initially, the House of Representatives refused to act. In response, the stock market dropped by hundreds of points.
The message from the markets had a near immediate impact on Congress.
Secretary Paulson succeeded in securing 700 billion dollars in what was called TARP, the Troubled Asset Relief Program.
At the same time, Fed Chairman Ben Bernanke became creatively active in helping to bail out American International Group Insurance and foster mergers for Merrill-Lynch (Bank of America), Wachovia (Wells Fargo), and Washington Mutual (J.P. Morgan).
While the major banks and other major financial institutions were the focus of national attention, community banks also felt the impact. Some made significant loans to support commercial real estate that had also fallen in value. The community banks are often particularly important for small business because they are closer to local conditions, often know the borrower, and can more easily monitor the progress of a local business.
The banks were not alone. Industrial firms were also shaken. General Motors and Chrysler were both heading to bankruptcy. Only early intervention by the Bush Administration gave them at least a temporary life line.
As President Obama took office, the financial crisis continued to reverberate around America and much of the world.
America was still at war in Iraq and Afghanistan. Unlike Roosevelt, Obama entered office months before the economy hit bottom.
General Motors and Chrysler were still on their way to bankruptcy. In addition to the immediate impact of throwing thousands of GM and Chrysler employees onto the unemployment rolls, there was a risk of another serious blow to national confidence.
Just as important, the entire supplier chain was at risk. Ford, having earlier secured private finance, was not seeking federal support. But being dependent on the same supplier chain as General Motors and Chrysler, Ford was an advocate of federal action to save its two rivals. As a result, thousands of small suppliers and small service businesses that depended on them were saved. (Ford did receive help via the Federal Reserve’s purchase of loans through the Term Asset Loan Facility, TALF).
The President responded. The federal government helped arrange a structured bankruptcy and ended up investing $50 billion in General Motors stock. A similar approach was taken with Chrysler with the government receiving stock in return.
In addition, the President proposed (and the Congress passed) the American Recovery and Reinvestment Act of 2009.
The Act included tax cuts, some infrastructure spending, funding for much of the Competes Act (research on physical rather than life sciences and support for science, technology, engineering and mathematics education) and the Advanced Research Projects Agency-Energy (ARPA-E).
The Act also included some added provisions for the Small Business Administration a $30 billion dollar Small Business Lending Fund (SBLF) to be administered by the U.S. Treasury Department. The focus of the SBLF was to “encourage community banks with less than $10 billion in assets to increase their lending to small business.
Despite the fiscal and monetary stimulus, the recovery has been slow and not always steady. Growth has varied between anemic to modest.
Unemployment (as of Jan. 2014) has fallen to 6.7 percent.
In many ways unemployment understates the weakness of the overall economy.
Many working part time are seeking full time work and millions have left the labor force all together. The percentage of working age Americans in the labor force has dropped back to levels not seen since the 1970s.
The recession officially ended in July 2009, but the financial damage continues to hover over the economy.
A more typical recession involves a tightening of monetary policy in response to the emergence of inflation; in effect, the Federal Reserve turns off the ﬂow of water through the financial pipes of the economy.
In a financial crisis, confidence falls, trust erodes, and entire institutions are weakened or lost altogether.
Instead of a slower flow of water, it is as if the pipes themselves were out of kilter or completely broken.
Welcome to 2014.
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Riveting Team found via Wikimedia Commons and used under the public domain; The New Chevrolet: 1957 found on Shorpy; Gas station during oil crisis accessed via Flickr, used as a public domain photo; Stock market photo by Rafael Matsunaga, used under a CC-by-2.0 license; Fannie Mae HQ photo by Flickr user futureatlas.com, used under a CC-by-2.0 license ; President Barack Obama taking his Oath of Office, used as public domain photo; Geithner and Summers meet in the West Wing Hall, used under CC-by-2.0; Sign from Occupy Wall Street by David Shankbone. Found via Flickr. Used under a Crative Commons license