Recessionary Causes

The current US economic recession is one for which we are long overdue.  Its roots lay decades ago, and cannot be simply blamed on the recent housing bubble and subprime mortgage crisis. Looking back can help us prevent another financial breakdown, and hopefully diagnose the problem and produce an answer to the question everyone is asking: how much longer will it last? As we look back we find danger in lack of transparency—especially in reference to financial innovation and deregulation. Though the future looks grim the recession will end eventually. Only, this time around we must try to act as the catalysts for change instead of as the cause for the problem.

President Ford's final days in office were marked not only be his party's inability to control inflation, but also as the final years for Keynesian economics.  The Carter administration marked by the energy crisis and mounting foreign policy woes only helped to usher in the "Reagan Revolution" which changed the American economic policy drastically to fit his supply-side ideals. His tax cuts and reductions in government spending contracted the size of the government, as tight monetary policy tamed inflation, restoring confidence as well as national growth.  Reagan is also credited with deregulating the financial sector, believing in less government oversight, trusting the private sector to be transparent and regulate itself. He also promised something arithmetically impossible: to increase military spending, cut taxes, and balance the budget. He was tremendously successful at the first two, though his economic policies caused huge budget deficits, quadrupling the United States national debt, making the US and its presidents all too comfortable in deficit spending and starting wars. During this period, approximately between 1973 and 1985, the U.S. financial sector accounted for about 16% of domestic corporate profits. Later, we will see that in the 1990s, it grew from 21% to 30%, and this past decade, it has soared to 41%.

The 1990s and early 2000s have been marked by radical deregulation of the financial sector. Not only were the walls between investment banks and commercial banks eliminated, but the ratio of a firms debt to its capital base was drastically increased. The deregulation caused one thing for sure: greed. With the US economy essentially artificially growing, large financial institutions pushed their workers to get on board. The result, of course, is technology. What could be wrong with this as grater productivity? It only pushes our Productions Possibility Curve out. These financial innovations such as sub-prime, alt-A, and option ARM mortgages were moneymakers in theory. This coupled with bankers operating with the false sense of safety; the Gaussian Copula function, gave financers the illusion that they could accurately calculate risks. Federal Reserve policy of keeping interest rates at 1% during the 2002-2004 period was similarly a catalyst for the housing bubble. Banks were quick to loan, figuring the housing market's exponential growth was sustainable. If a loan was defaulted on, the bank could still make money--simply resell the house for a higher price. Soon, however the housing bubble and subprime mortgage crisis emerge leaving banks with toxic assets. Suddenly Franny Mae and Freddy Mac (which held at one point over half the mortgage market with 12 trillion (with a "T") dollars) found itself on the verge of bankruptcy. Much of this was comprised of asset-backed securities--the bundled loans banks sold to these institutions while FM and FM were seemingly unaware that these loans came from people trying to live beyond their means.

Going along with this, there was a 238.5% National increase in housing prices between the 1980s and the mid 2000s with a meager 1% to 5% raise in income over the same period of time. What, then, was rising if income wasn’t? Capitol gains, of course. The people who held the dangerously innovative loans were relying on the stock market’s rapid growth (NASDAQ grew from under 400 points to over 5000 at its peak in 2001) as a large part of their income. When the market became less hospitable, banks jacked up the rates on their ARMs to compensate, while people had even less pay. Ironically, it was the banks who suffered, and were forced to either go out of business or call on the government for bailout money.

In the end, who are we to not allow companies to try to make as much money as possible? Moving foreword, is the only answer to put a cap on growth? As long as there is a set of rules, there will always be innovation that tests its diction and exploits its loopholes. The main role of the government is to lessen the extremes of the business cycle, keep our inflation around 1%, reach the natural rate of unemployment, and keep the economy and GDP growing at a sustainable rate, one which matches our ever-growing LRAS curve. From my research, it would seem that government as a whole has failed to implement contractionary policy when it was needed most (semi-excluding Clinton). Certainly, a tax hike is not a wise political move, so maybe the answer lies in greater power to the Fed. Granted, a number of factors such as September 11, and the grand entrance of China into US markets caused worry among Congress and the Fed, and they acted blindly in hopes of a good turnout. Regrettably, however, the opposite happened. Undoubtedly greed and ignorance played and integral part in the private sector, though transparency seems one possible solution that could have helped prevent much of the shady dealings among financial giants. Living within your means must be a main focus, and the government may not be relied upon on the future for bailout money. These are all things to be implemented once we are out of the recession but what can we do now to increase growth? Is it consumption? Some people aren’t sure…

Household consumption as a percentage of GDP has rapidly grown in the past decades: in the 1970s it was about 62% whereas in 2006 it was up to almost 72%. Compared to four other countries with advanced economies, UK, France, Japan, and Germany, this growth and flat-out percentage rate is unprecedented. It would be expected for a country with a stable growth rate to have this ratio be fairly constant, though ours has grown rapidly, especially in the past decade. For this number to go up, a combination of things must have happened: 1. Lower taxes (current or future) that increase disposable income 2. Expectations of larger future income (through faster productivity growth)/ expectations of more productive investment which reduces the need to save and invest to generate the same amount of future income 3. A demographic transition that makes the future (income or wealth) look better than the present. An aging population and a growing government debt make the future look worse than the present. If any, there is the need to increase savings. Now however, in the midst of a recession, would be a bad time to address this imbalance as increasing V in MV=PQ is a necessity in getting out of our recession. Once it is over, we must correct this going foreword, and use this ratio as a recessionary sign.