A Comparison of Economic Crises | Gwayne Gautreaux
Gwayne Gautreaux | Policy Brief 140
Gwayne Gautreaux — Guest Analyst | February 20, 2021 | Policy Brief 140
I. ABSTRACT / INTRODUCTION
According to Albert Einstein, the definition of insanity is repeatedly doing the same thing over and over and expecting different results. Recognizing the causes, conditions, and similarities of past economic crises allows policymakers to be able to provide solutions conducive to the betterment of the overall economy. The complications that underscore the dilemma of policymaking within a financial crisis illustrate clearly, the tradeoff between minimizing moral hazard and preventing widespread economic failure. Government must ensure that, while sometimes necessary to capitulate to unintended consequences of maintaining balance, the treatment cannot be worse than the disease. Yet, despite the symptomatic similarities that underscored the two most significant economic events to affect the U.S. economy, the federal government appeared to facilitate the actions that precipitated both anomalies.
II. COMMON DENOMINATORS OF ANALYSIS
The overall impact of financial crises, both of which the Great Depression and the Great Recession had on the business sector, was indicative of structural stagnation, which required legislation that attempted to minimize the risks that led to unfavorable economic conditions. Additionally, both events were encouraged by expansionary monetary policy, which triggered over-inflated asset prices, exacerbated by a financial system incentivized to make risky investments, indicative of a network of conglomerates seemingly too big to fail. As a result, the financial industry was inundated with the economic phenomenon known as principal agent and moral hazard (Luck & Zimmerman, 2018).
a. Principal Agent & Moral Hazard
In general, failure to mitigate unnecessary risks in an economy can potentially weaken institutional foundations. For the federal government and by extension, an agency like the Federal Reserve, it is important to fully recognize anomalies like the principal-agent problem, in addition to the dangers that moral hazard presents, for the health and safety of the overall economy.
When circumstances dictate the necessity of the (primary) principal appointing a (secondary) agent to act and perform on behalf of the principal, the potential exists for the agent to be motivated by self-interest as opposed to the interest of the principal. In other words, the agent has been hired and tasked with the responsibility of making decisions for the betterment of the principal. Yet, because the agent can potentially benefit apart and separate from the principal, agents are incentivized to maximize individual gains, in ways that are contrary to the principal. Moreover, when the principal inadvertently hedges the agent from risk, the situation can transition into another economic phenomenon which further incentivizes the agent to act in self-interest, leading to a condition called moral hazard (Quinn, 2011).
Similar to the principal-agent problem, moral hazard can exist within any relationship but mostly visible in an economic or political environment. Moral hazard occurs when one party haphazardly exposes itself to risk with the belief that the other party will protect them from the ill-effects of their own behavior. A classic example of moral hazard is the way financial institutions have been incentivized to engage in risky lending practices by government, which gives them the assurance they will not have to bear the potential danger of borrowers defaulting. Of course, moral hazard can exist within the purview of the principal-agent problem or as a standalone anomaly (Quinn, 2011).
Therefore, counteracting the commercial effects of the principal-agent phenomenon in business requires aligning the interest of both the shareholder and the manager by shifting agent incentives in a mutually beneficial way. If the manager is undercompensated, management may pursue goals more aligned to their own interest rather than the interest of the very shareholders they were hired by in the first place. In an attempt to resolve the distortion of incentives between management and shareholders, valuable executive compensation and incentive rewards are offered as packages to upper-level managers and CEOs to get them to make decisions and structure business models strictly to serve the best interest of the company (Quinn, 2011). Individual owners or corporate shareholders have developed several incentive mechanisms that address the ‘agent-problem’ for management. Companies have offered generous annual performance bonuses that are tied to an increase in net or retained earnings, in that each bonus is associated with a specific parameter of gains (Quinn, 2011). Base salaries go through periodic performance assessments, increasing proportionately to the increase in profit. Managers are offered valuable stock options that unite their interest to the interest of the firm. Some are given access to luxurious company assets in the form of jets, boats, cars, and suites as a way to raise their comfort levels to enhance their performance.
It is important to understand that sometimes an agent’s incentives aren’t always motivated by economic or financial gains but sometimes through the influence of social or political forces that are important to certain people.
b. Moral Hazard in Crisis
In the case of financial crises, the Federal Reserve considers moral hazard to exists when mitigating adverse effects of risks promotes risky behavior in and of itself. For example, when the Federal Reserve absorbs the impacts of risk posed by financial institutions deemed too big to fail, it unintentionally creates a subsequent condition that encourages risky behavior (Rosenblum, DiMartino, Reiner, & Alm, 2008). Since the Federal Reserve is tasked with maintaining stable prices, full employment, and sustainable economic growth, the fed, on both occasions, have found itself with the difficulty of balancing the required mandates, all while minimizing risky behavior and ensuring institutional stability. In other words, if the Fed seeks to overcautiously reinforce the mechanisms to protect the banking system, a degree of moral hazard would exist by setting a precedence of bailouts, like in the 2008 crisis (Rosenblum et al, 2008). This would perhaps encourage banks to engage in risky loans and investments, believing that the Fed would protect them from the ill-effects of their own behavior; yet an under-emphasized response, which ignored the potential collapse of the banking system could have effectively put the entire foundation of financial institutions in jeopardy, ultimately putting the U.S. economy in the crosshairs of danger as well. Either way, a failure within the financial sector makes it impossible for the Federal Reserve to achieve the objectives of its mandate (Rosenblum et al, 2008).
III. THE GREAT DEPRESSION
a. Background
The Great Depression was preceded by almost a decade of rapid economic expansion throughout the 1920’s. At the turn of the 20th century, there were massive improvements in productivity, innovation, and industrialization within the manufacturing sectors of steel, agriculture, energy, and electrification, boosting output and personal income substantially. As a result, consumers began seeking durable goods, which improved the standard of living, as people began to feel much more prosperous. Because there was a greater shift from consumable goods to more expensive luxury items, banks used credit installment loans to meet the increased demand for financing high-dollar investments, like automobiles and major appliances, which was a relatively new concept at the time. Therefore, banks began facilitating credit to customers who were using borrowed money to invest in company stocks, while also borrowing and investing in stocks themselves with deposits and borrowed money (Samuelson, 1976).
Stock prices were continuously rising because of speculators seeking out inflated assets, significantly increasing the likelihood of overvaluation. Whereas a more conservative investor’s strategy is to traditionally buy low and sell high, speculators buy high with the hopes of maximizing and compounding profits while prices elevate even more. This continued until the later part of the decade when consumer spending began to level off. At the same time, investors began to speculate the over-valuation of asset prices and stocks. Alternatively, in the same way asset prices had trekked aggressively upward, it now began to reverse course, inevitably resulting in the stock market crash of 1929. Because commercial and investment banks were vertically integrated, the fall in stock prices had a direct adverse impact on financial institutions. With stock prices plummeting, investors, who had bought stocks on borrowed money, were unable to earn the necessary returns that would allow them to fully repay bank loans. With borrowers unable to pay off loan balances in full, banks did not have the liquidity to pay off depositors to whom they had borrowed from, leaving a cash shortage among financial institutions, ultimately setting off a series of bank deposit runs and panic. Therefore, one of the factors blamed on the Great Depression was the collective failure between the mechanism of the Federal Reserve and banking institutions. In the first place, it was believed that because banks had assumed the unitary control of both commercial and investment functions, they were more susceptible to catastrophic loss. The real seeds of the ‘too big to fail’ mantra were planted back in this time. Because there was no separation between investment and commercial responsibilities, banks were subject to the classic principal agent problem, in that they were motivated to act in their own self-interest rather than the interest of their customers (Samuelson, 1976).
In the second place, rather than the Federal Reserve challenging the causes of economic contraction, it chose to confront the issue of speculation by tightening lending terms making it harder for speculators to borrow. Unfortunately, what the economy needed at the time was for the Fed to provide much needed liquidity to the banking system, for the purpose of satisfying the increasing deposit withdrawals. After years of analyzing the after-effects of the Great Depression, it has been the consensus of most mainstream economist that, had the Fed chosen to exercise expansionary policy by increasing the money supply, lowering interest rates, and acting as lender of last resort to failing financial institutions, they could have staved off the contagion of bank runs, and otherwise prevented a depression. Analyst do not deny that the country would have still experienced a recession of some type, but only mild in comparison to the depression that was induced by the lack of liquidity in the banking system (Samuelson, 1976).
IV. EFFECTS OF THE GREAT DEPRESSION
The lack of liquidity provided to the banking system caused massive economic contraction. Economists attributed the severity and depth of the depression on four factors: easy money policies that induced the artificial asset boom, President Hoover’s interventionist policies that contributed to the length of contraction, and most importantly the Fed’s decision to tighten policy to prevent speculators from borrowing rather than expanding the money supply, which allowed aggregate demand to fall precipitously to unsustainable levels. When all was said and done, the money supply shrank by 30%. One-third of all banks in American had closed, while people’s savings disappeared. According to the CBO (2013), this was the drop in money supply for the Great Depression as opposed to the Great Recession.
Additionally, unemployment had climbed to 25%, while being 1.6% just a few years before in 1926. After the crash, for those who remained employed, wages had also declined aggressively as well. During the first five years of the depression, the economy shrank 50%. In 1929, GDP was $105 billion, $1 trillion dollars by today’s standards (Samuelson, 1976). The first year of the depression, more than 600 banks around the nation had failed, predominantly in the Midwest. By 1933, 4 years since the stock market crash, the economy had lost 50% of its value, while GDP was only $56.4 billion dollars (Samuelson, 1976). As more banks closed, the money supply continued to decline, causing spending to fall, which in turn made prices fall, leading to a production glut. The deflationary effect was extremely visible, as the consumer price index fell over 27% from 1929 to 1933 (Samuelson, 1976).
a. Government Legislation
One of the ways in which the Great Depression lingered into slow structural stagnation was the response undertaken by the Hoover Administration. Hoover, who claimed to be a proponent of free markets, took an aggressive interventionist approach that induced the Revenue Act of 1932 and the Smoot Hawley Tariffs (Samuelson, 1976).
While the economy needed expansionary fiscal policy to stimulate aggregate demand, the Revenue Act of 1932 doubled income taxes, which ended up contributing to the largest peacetime tax increase ever (Samuelson, 1976).
Furthermore, in an attempt to protect domestic industries from foreign competition, the Smoot-Hawley was passed, as tariffs were levied against foreign producers looking to break into the U.S. market. This led to unintended consequences, actually making U.S. companies less competitive in the global markets by forcing them to bear artificially higher input costs, not to mention reciprocated tariffs in the markets that they were attempting to gain access to. As a result, trade contracted globally, as American producers attempting to access foreign markets experienced a $4 billion drop in exports from 1929 to 1932, causing industrial production to fall close to 46%. When international commerce was disrupted, U.S. foreign trade fell by 70%; the agriculture industry collapsed, and the world on the verge of global recession (Samuelson, 1976).
b. Schools of Thought
In response to what he perceived as market failure, Economist John Maynard Keynes published several works on the causes and solutions of the Great Depression. Rejecting classicalist theory that the economy would return to natural state of equilibrium, Keynes suggested that rather than waiting for the market to self-correct, government should induce aggregate demand by running deficits, when the private sector cannot sustain the necessary amount of spending during recession, either by injecting money into the economy, cutting taxes, or a combination of both. Keynes believed that the economy was driven by demand and spending was the factor that would ensure full employment and potential output. Whereas classicalists believed that because prices and wages adjust similarly, Keynes believed that because wages are sticky, demand side policies can have a positive effect on economic growth, not just affecting prices. The school of Keynesian Economics was subsequently adopted by mainstream economists, especially since the narrative blamed market failures as the engine that caused the Great Depression.
In 1933, under the new leadership of Franklin D. Roosevelt, U.S. policymakers adopted Keynesianism as the main strategy that set forth the New Deal, to correct the moral hazard and risks caused by the Great Depression. The New Deal was a huge piece of legislation that ultimately addressed labor practices, provided tighter oversight over the banking system and relief for the unemployed. Some of the components of the New Deal that was set up directly to prevent the most important contributory factors of the Great Depression was part of the Banking Act of 1933, which set up two barriers to prevent another banking collapse. First, the Federal Deposit Insurance Corporation was set up insuring bank deposits to customers in the case of financial collapse and deposit run. Although this does protect the consumer, it doesn’t come without enabling some degree of moral hazard for banks who would now be incentivized to make risky investments with depositor money.
Secondly, Glass Steagall was legislation that was instrumental in separating commercial from investment banks, one of the main factors blamed on the Great Depression, which minimized widespread loss in the event of bank failures (Barth & Wilhborg, 2016). It was believed that because banks had assumed the control of both commercial and investment functions, they would be an easier target for catastrophic loss, in the case of an economic downturn. Because there was no separation of investment and commercial responsibilities, banks were subject to the classic principal agent problem, in that they were motivated to act in their own self-interest rather than the interest of their customers. The main responsibility of a commercial bank was to match lenders with borrowers. The main responsibility of an investment bank is to underwrite securities for investors. By merging both functions, banks could easily mismanage deposits on risky investments for the purpose of generating higher returns. During the Great Depression, banks began to fail, which began a series of bank runs, ultimately ending with thousands of banks closing. Without any liquidity, banks could not remain in existence and since the banking institutions unified the functions of both investments and deposits, there were no separations. Therefore, those who had money invested and deposited in the same institution were both subject to billions of dollars of losses. *Note: In 1999, Glass Steagall was repealed by the Clinton Administration.
It could be argued that the lingering effects of the Great Depression remained until the automatic stabilizers brought about by World War II steered the country back to pre-depression levels. Despite the years of studying the dangers that asset bubbles and speculators can pose to the financial sector and the overall economy, in 2007–2008, another financial crash reared its ugly head, one that appeared to resurrect the ‘ghosts’ of the Great Depression.
V. THE GREAT RECESSION
a. Background Information
Like the conditions and timespan surrounding the Great Depression, the Great Recession was borne by the combination of policies initiated by the federal government, over-inflated asset prices, easy-money monetary policy, and risky investments. In the decade prior to the housing crisis, the federal government, under President Clinton, began pushing homeownership aggressively. Government housing policies began promoting minimal down payments, as well as well as relaxed credit checks and income verifications, essentially guaranteeing home mortgages. Additionally, the Federal Reserve began a series of interest rate cuts, dropping the federal funds rate target from 6.5% to 1% between 2000 and 2003 as a way of remedying the effects of the dot com recession and the 9/11 terrorist attacks. With the combination of expansionary monetary policy and relaxed lending standards, it was clear that the housing market was driving the economy. The industry witnessed the typical American home rising in price by 124% within a three year span. The national median price of homes went from approximately 3 to 4 times average household income during the same period. With housing appreciating at such an expansive rate, consumer spending was driven with home equity loans for several years prior to the housing bubble bursting (Luck & Zimmerman, 2018).
Financial institutions recognized the investment returns capable of being made by expanding mortgage lending to potential homeowners and real-estate investors. By relaxing mortgage loan prerequisites, borrowers with a wide spectrum of risks, continued putting upward pressure on demand, inflating housing asset values even more. The share of sub-prime lending increased by over 20% of total homebuyer mortgages, which meant 1 out of 5 borrowers were high risk. [Refer to the table below by the Joint Center for Housing Studies at Harvard University]
Banks understood that bundling the mortgages into securities and selling to a secondary market yielded greater returns than waiting 30 years for amortized interest payments to be made. By reselling the debt, banks could forego any concern about any factors of risk. Selling mortgages to Fannie Mae and Freddie Mac had also contributed to the unintended consequences of moral hazard and principal-agent problem due to these government sponsored enterprises guaranteeing mortgages, once they in turn sell them to other large investment institutions, ensuring investment banks reap all of the rewards without absorbing any of the potential costs of default. As a result, bundles of mortgage-backed securities were built with a mixture of both secure and risky investments, and since a good investment is only as strong as its weakest link, this was a major factor in the collapse of housing prices. In summarizing, economist attribute several factors to the Great Recession: (1) years of government policies that artificially encouraged home ownership, regardless of affordability, (2) expansionary monetary policy to encourage easy credit, (3) relaxed lending standards that ultimately mixed high-risk subprime mortgages into the securities, and (4) speculators who made risky investments, which drove the economy to be steered by overinflated homes. Consequently, similar to the way the asset bubble busted during the Great Depression, once investors suspected homes had become over-valued, prices began trekking downward on a major deflationary course (Fligstein & Goldstein, 2014).
VI. EFFECTS OF THE GREAT RECESSION
The Great Recession is the longest on record since World War II. Not only was widespread, but the magnitude of severity was unmatched. The one element that exacerbated the intensity of the Great Recession, not as persistent during the Great Depression was the interconnectedness of the global community. Globalization has been the paradigm of specialization, encouraging peace, prosperity, and cooperation. Yet, in much the same way the world has collectively come together, economic hardship of one nation usually becomes incorporated into another.
According to the Bureau of Economic Analysis, real GDP 4.3% from the peak in 2007 to 2009. Unemployment went from 5% in 2007 to 10% in October of 2009. Overvalued home prices fell over 30% from the peak of 2006 to 2009, while the S&P index fell almost 60% during that same period. During the first quarter of 2009, at the lowest point of the recession, over 230,000 U.S businesses closed. From 2007 to 2012, more than 450 banks failed across the country. Between 2006 and 2014, 16 million homeowners faced foreclosure, averaging approximately 3 million foreclosures per year (Luck & Zimmerman, 2018).
a. Government Legislation
Legislation enacted by the Bush Administration and by extension the Obama Administration, both catching each end of the recession, echoed the classic Keynesian response similar to Roosevelt. Effectively trying to spend its way into recovery, the federal government legislated a series of policies in an attempt to stimulate aggregate demand. Originally proposed by the Bush Administration, but adopted and modified somewhat by the Obama Administration, there were 2 significant pieces of a legislative package that subsequently injected $787 billion in the form of stimulus, plus a $700 billion relief package labelled TARP, which facilitated the bailout and purchase of failing financial conglomerates entitled too big to fail. The Fed also extended loans that circumvented using the discount window for longer term loans accepting a broader range of collateral. A $30 billion dollar line of credit was facilitated to JP Morgan Chase to purchase the mortgage-backed securities that the investment bank of Bear Stearns had acquired. An $85 billion loan was made on behalf of AIG Insurance in exchange for 79.9% of the company’s equity, including a $22 million interest payment toward the bailout (Cecchetti, 2008). The potential collapse of Bear Stearns and AIG could have ultimately set off a chain reaction of unfavorable conditions, distorting the savings and investment mechanism that allows the free flow of capital, effecting retirement accounts, leading to a contraction of aggregate demand, eventually having adverse effects on the overall economy (Rosenblum et al, 2008).
Additionally, Dodd Frank, like Glass Steagall from years ago, sought to break up collective functions of ‘too big to fail’ financial institutions. The tenets of Dodd Frank were aimed at preventing banks from engaging in risky behavior by forcing them to have the necessary ‘skin in the game’ rather than rely on the subsidization of government (Barth & Wihlborg, 2016). Banks were able to enjoy gains, without necessarily having to worry about absorbing the losses, indicative of the unintended consequences produced by moral hazard. The outcome from these concerns culminated into the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010. The law eliminated many speculative behaviors that were believed to lead to the collapse of the housing market. To ensure that banks would maintain some solvency in the case of financial institutional failure, they were forced to raise reserve requirements, keeping more money on hand. The law prevented predatory mortgage lending, which meant banks had to reasonably ensure consumers understand all terms of loans before agreeing to the conditions. The Volker Rule was established, which limited speculative trading. It eliminated proprietary trading on behalf of banks seeking to maximize their own returns rather than working for commission, similar to the principal agent problem solved by Glass Stegall. In 2018, the Trump Administration repealed some of the components of Dodd-Frank citing that overregulating the financial sector made American banks less competitive in global markets due to international banks operating with less restrictions (Barth & Wilhborg, 2016).
Therefore, both Glass Steagall and Dodd Frank were two pieces of legislation borne out of economic downturns, which sought to improve the deficiencies of the financial sectors.
Finally, in 2008, the Federal Reserve decided to follow ‘extraordinary’ measures in promoting the very best outcome for the U.S. economy. The Fed decided to do in 2008, what was neglected in 1929, which is truly fulfill its role as lender of last resort. Proper monetary policy cannot be conducted when credit is disabled through lack of capital. By doubling the assets on their balance sheet, the Federal Reserve injected an unprecedented amount of liquidity to the financial sector, incentivizing consumers to borrow and banks to loan, which would ensure confidence remained sustainable, unlike the lessons learned in the Great Depression. (Rosenblum et al, 2008).
Commonly referred to as credit or quantitative easing, the Fed began aggressively expanding lending operations to other markets outside the reach of the more conventional banking institutions, such as the mutual funds and asset backed securities market. After dropping interest rates down to zero without the economy experiencing the economic objectives it was supposed to, the Federal Reserve turned to the more unconventional policy of QE, which expanded their balance sheet by purchasing, not only treasury bonds but other sources of private and public debt. The Fed also began purchasing agency debt from Freddie Mac and Fannie Mae, as well as guaranteed student loan debt, auto loans, and credit card debt as well (Cecchetti, 2008). The objective was to lower the cost of credit in targeted troubled markets as a way to jump-start it and increase availability. The federal funds target rate, typically the most important monetary tool of the Federal Reserve, was drastically lowered by approximately 500 percentage points from 5.25% to between 0 and .25%, which, at the time, was unprecedented policy (Cecchetti, 2008).
With 4 rounds of quantitative easing from 2008 to 2014, the Fed injected trillions of dollars into the financial systems by purchasing bonds, expanding the money supply, lowering federal funds rates, creating instantaneously credit, which was aimed at encouraging more consumption and investment, indirectly lowering rates for durable interest sensitive merchandise like automobiles, appliances, or just about any other consumer driven debt, also making it more affordable for businesses to expand operations (Luck & Zimmerman, 2018).
After examining some empirical studies, the success of quantitative easing is still debatable. While QE1 and QE2 did show signs of increasing commercial banks’ mortgage refinancing activity, there were some positive effects on local consumption and employment in non-tradable goods without any affect on overall employment. QE3 was associated with more commercial and industrial lending translating into some overall employment gains. Ultimately data does show that large scale asset purchases can affect real economic outcomes through the vessels of bank lending (Luck & Zimmerman, 2018).
VII. CLOSING STATEMENT
Thus, after examining the data of the underlying conditions within the periods that span the economic crises of the Great Depression and Great Recession, it is clear that impact of both bound the business sector to slow recovery of structural stagnation. Both crises required legislation that was passed in an attempt to restrict behaviors that minimize the risks that cause unfavorable economic conditions. Ultimately, both Glass Steagall and Dodd Frank were rooted in disincentivizing ‘too big to fail’ banks from extending risky loans to companies of vested interest. Economists will always try to draw correlation between economic anomalies and financial crises like the Great Recession and Great Depression in an attempt to prevent the very same mistakes that led to adverse risk indicative of these events.
Sources:
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