A Short History of American Panics, Recessions, Depressions: PART II: 1973 - 2009 (1-14-2014) [143*13]
PART II - This is a continuation of part one which simply became too lengthy to contain in one hub. I am surprised the hub editors didn't say something. Anyway, enjoy.
RICHARD MILHOUS NIXON
RECESSION OF 1973
EVERYTHING CONSIDERED, THIS RECESSION was the worst since 1937, until 2008. At one year four months in length, it was three months longer than one in 1937, but only two month shorter than 2008. Unemployment, however, hit 9%, far less than the 19% seen in 1937 as well as the 25% in 1933, but, nevertheless it was the highest until the 1981 and 2008 recessions, both of which surpassed a 10% unemployment rate. You should also begin to be able to understand how different recessions were between the pre- and post-Keynesian economic periods by comparing declines in GDP. In 1933, GDP fell 26.7% and in 1937 it fell 18.7%. Compare this to 1958 and 1973, when GDP only fell 3.7% and 3.2%, respectively; these remained the low points until 2008, when GDP declined 5.1%.
What led to the “worst” downturn since 1937? Many events, the Vietnam War and the 1973 OPEC-inspired oil crisis being the primary ones. One of the main factors leading to recovery was a page President Nixon took from President Franklin Roosevelt; he unilaterally (something Roosevelt didn't do) took America off the gold standard for the final time. Unlike many recessions, the 1973 recession was a rather complex one, with many internal and external factors all coming to a head in 1973, which precipitated a major stock market crash; heralding the beginning of the recession.
LYNDON B. JOHNSON WAR WITH THE GREAT SOCIETY
GUNS AND BUTTER
ONE FACTOR LEADING TO THE RECESSION was the cost of the Vietnam War. That cost, in and of itself might have been bearable, if it were not for the compounding effect which was starting to be felt from the effects of President Johnson's Great New Society program. Like President George W. Bush in the beginning of the twenty-first century, President Johnson refused to raise taxes to pay for the cost of the Great Society and Vietnam War; instead, he started to borrow money to pay for both and began running a larger and larger budget deficit (printing money) and increasing the national debt.
Everything else being equal, printing money leads to inflation in normal times and the late 1960s was no exception since the economy was still booming. Generally, inflation in one country leads to larger and larger trade deficits, which is what began happening in America. The effect of this is to weaken the dollar which, because of the restrictions of the 1944 Bretton Woods monetary system, established to keep the international monetary system stable, increased the depletion of America's gold reserves. (The reasons for this are rather intricate and were complicated by the advent of currency speculation among nations and huge banks.) The Bretton Woods agreement, among other things, had two requirements, 1) the dollar would be pegged to gold at $35/ounce and 2) the U.S. guaranteed that it would convert dollars into gold upon demand. This worked fine while the private market for gold remained near $35/ounce, but by the late 1960s it had increased to $40/ounce and as it headed even higher, the weaker the dollar got.
Various patches were tried to repair the collapsing system, such as letting the price of gold float, while still keeping the dollar pegged to gold, but nothing really worked. The situation kept deteriorating; inflation kept rising; and so did the unemployment rate; enter Richard Nixon - stage right.
INFLATION RATES (%) 1966 - 1987
RICHARD NIXON HAD A MESS on his hands when he took office in January 1969. The Vietnam War was not going well and the world economy he inherited was structurally coming apart at the seams, given the tug-of-war going on between currency and gold speculators on the one hand, and the restrictions caused by trying to maintain the gold standard on the other. Eleven months after taking office, Nixon had to endure a small, short recession; a precursor to what was to come.
To combat the rising the inflation, in 1971, Nixon implemented his famous wage and price freeze. At the same time, he unilaterally took America, and therefore the world, off the gold standard, thereby totally dismantling the Bretton Wood agreement; this was known as the Nixon Shock. As you can see in Chart 1, inflation had already peaked in 1969 and had already fallen significantly by the time these two actions occurred, but they probably did help to continue the slide until mid-1972. Nevertheless, these moves set the stage for problems later, especially the fall-out from the wage-price freeze policy
THE 1973 OIL CRISIS AND 1973 RECESSION
ON OCTOBER 6, 1973, SYRIA AND EGYPT ATTACKED ISRAEL, and the Yom Kipper War was on. On October 12, 1973, President Nixon authorized Operation Nickel Grass, an overt strategic airlift to deliver weapons and supplies to Israel, after the Soviet Union began sending arms to Syria and Egypt. On October 16, 1973, the Organization of Petroleum Exporting Countries (OPEC) declared a 70% increase in oil prices and on October 20, 1973, the Arab exporting countries began an oil embargo on the West. In November 1973, the 1973 recession began
UNEMPLOYMENT RATES (%) 1966 - 1987
RECESSIONS AREN’T ALWAYS CAUSED by internal economic or financial conditions or policies, they are sometimes caused by external events, such as the Civil War. The 1970s recession was a poster child of such an event and Presidents Nixon, Carter, and Reagan were standing in the way of an economic avalanche. This is not to say that governmental monetary and fiscal policies didn't aggravate the situation on occasion (on other occasions, of course, they helped), but the economic events in America in the 1970s and early 1980s were largely driven by what was happening in the Middle East and Southeast Asia.
The 1970s was beset by three major external events, the Vietnam War, the 1973 Oil Crisis, and the 1979 Oil Crisis, see Chart 2. It is said the "good times can't last" and that is certainly true here. After one of the longest periods of economic expansion in the 1960s, the economy was ready for a change and these outside events provided the catalyst.
The economic pressure brought on by the Vietnam War began raising deficits in the early 1970s which, along with a crisis developing around the divergence of the private price of gold compared to "pegged" rate, created the first ripple, the 1970s recession with the accompanying rise in unemployment and interest rates. President Nixon's reaction to that in taking America off the gold standard, coupled with the fed tightening the money supply and Nixon's wage and price controls, helped bring things under control, or so it seemed for both inflation and unemployment started coming down. Unlike the 1960s, the 1970s was a volatile time relative to world politics and events which left confidence in the economy weak.
Then the huge shock of having oil prices increase 70% almost overnight was too much; the stock market crashed and the economy tanked as the gas lines grew; unemployment and inflation skyrocketed, even though the fed did all it could to stop it from happening; all they could do was mitigate it, the result was the infamous "stagflation", unusual for a recession.
Government countermeasures kept the recession from spiraling out of control until it had run its course. The recession ended in May 1975 but unemployment kept rising until it hit 9% before sliding back down until the next oil crisis drove it, and inflation, up to its all time high in the early 1980s since the Great Depression period.
CLASSIC U-SHAPED RECESSION
The recession of 1973 was the worst overall recession since 1937 when you consider length, unemployment, inflation, and decline in business activity. This recession lasted one year, four months, a characteristic of the 'U'-shaped recession seen in Chart 3; as reported, unemployment hit a recent record of 9%; inflation rose to 12%, second highest ever except for the 15.1% reached in 1981; and business activity (GDP) fell 3.2%; only the latter metric was less than previous recessions in the last 30 years, but only by .5%.
When compared to the Great Depression or the 1937 recession, 1973 was a drop in the bucket, hardly a blip, but then that was the point of all the structural protections built into the Progressive version of economic policy, but more on that later.
SHAW OF IRAN
RECESSION OF 1980
The Carter-Reagan Recession started with a short downturn from Jan - Jul 1980, but began in earnest in 1981. It was a major recession primarily brought on by the confluence of three world-wide events. Most people now call it, perhaps unfairly, the Reagan recession because he was in power when it was officially announced and, coincidentally, my second attempt at entrepreneurship went down the tubes. (Of course, I could thank him as well because I ended up with a pretty interesting career as a civil servant.)
The kick-off event was the 1979 overthrow of the not so nice Shaw of Iran, Mohammad Reza Pahlavi, Mohammad Reza Pahlavi, by the order of magnitude worse religious tyranny the world has seen since the Catholic Inquisition in the 1400s. Oil production fell off considerably and this destabilized world oil prices considerably which then led to a quick, huge run up in oil prices to their highest levels to that point in history.
The next factor that led to the 1980 Recession was the run-up in the Federal Reserves Prime Interest rate which is their main monetary policy weapon used to battle inflation. As you can see from the Chart 1 above, as a general rule, as the price of a barrel of increased so did inflation. This results from the fact that the price of oil wasn't being driven up by market forces, in other words not by supply and demand, but by external events, speculation, and greed. Because so much production and transportation relies on oil and oil products, their prices were forced to increase for non-economic reasons. That, by definition, is inflation. You can also see that the Fed kept raising the prime (discount) rate in an effort to battle inflation.
Now look at the Chart 2 below. It shows the change in the Gross Domestic Product The GDP reflects the cumulative effect of the titanic struggle between the inflationary forces of ever increasing oil prices and the resulting run-up in inflation and the Fed's effort to curb inflation by turning down the fire underpinning economic activity. The Fed ultimately won ... as you can see from the upper chart, in a BIG way.
The period between 1977 and 1981 was called "stagflation". It is the worst of all possible worlds as it is when you have flat or falling economic growth coupled with high inflation. It is what some people call a death spiral, a situation that is very hard to break-out of. This is why Paul Volcker, the current Fed Chief, went to such drastic measures to break the spiral.
ANNUAL % GDP DURING THE NIXON AND CARTER ADMINISTRATIONS AND THE FIRST PART OF THE REAGAN ADMINISTRATION
The third factor that led to the 1981 Recession was the Oil Embargoes of 1967-1968 and 1973-1974. You can easily see one Charts 1 and 2 that both brought on economic chaos followed by negative growth and two recessions. These were like the before shocks that strike just ahead of the Big One. This may also be one reason why the unemployment rates for the 1981 recession aren't remembered as vividly as they should be. This earlier recession led to higher unemployment rates (10.8%) that stayed above 10% much longer than the same rates did this time around. Our current unemployment problems have a long way to go before they break the longevity record of the 1981 recession as well. For example, unemployment hit its low point of 5.9% two years before the 1981 recession started and didn't get back to that level until 6 years after the recession was over. I don't remember anyone complaining about how terrible a job President Reagan was doing getting people back to work, do you? Under his Presidency he had unemployment rates above 8% from from the end of 1981 to the beginning of 1984! It didn't get below 7% until 1986! Do you think today's Right-wing Conservatives who are in power now said one word of complaint against Reagan back then? I think not. (Darn these soapboxes, they keep jumping in front of me.) Anyway, unemployment was at 4.2% only 6 months before the official start of the 2007 recession. We don't know if will ever get that low again since 5-6% is normal.
Notice how I have not brought up either President Carter or President Reagan as being associated with the cause of this recession? That is because I personally don't think they are. From the discussion above that the real culprits were the Arab oil moguls and Paul Volcker's necessary reaction to the calamity they caused, don't you see.
President Carter is out of the picture because the stage was set for the big fall when he took office in 1977. He had no control over the rapid increase in oil prices and the reaction by Paul Volcker. The 1981 recession was a done deal and just needed to happen.
I do think President Reagan's fiscal policies set the stage for future problems, mainly America's first runaway deficit, but not this recession. He was just the unlucky fellow who happened to be President when it landed in his lap.
ANNUAL % GDP DURING BUSH 43 ADMINISTRATION
THE ARCHITECTS OF DOOM AND SAVIORS, ALL BUT ONE WERE BOTH
The Great Recession of 2007 - 2009
The Great Recession of 2007 officially started, according to the NBER, in December 2007. It officially ended in June 2010, again according to the NBER. Official or not and whether the American economy is actually expanding again or not is a bit mute if the American People feel we are not; and right now they still don't!
[Let me digress a moment and hop on one of my favorite soapboxes. One reason the people don't is jobs. Unemployment is hovering a little under 10%. I want to talk about why it is staying at that number in the face of twelve months of private sector job growth! Count them Twelve Months!! President Obama's stimulus policies have added more than 1,000,000 private sector jobs since Jan 1, 2010! Granted, it is not the 6 million jobs that the Republicans and their policies caused to be lost in the first place but it isn't a bad start in trying to stop the boulder they started rolling downhill.
The reason the unemployment number hasn't come down is because of the stupid way we count unemployment. Get this! If a person stops looking for work, we stop counting them!! So, in an extreme and unrealistic example, if, for one week, everybody who had been looking for work the previous week, quit looking and simply gave up ... the unemployment rate would drop to zero; go figure, lol. Now, of course, this would never happen, but what is happening is that when people start going back to work, then those who had previously given up looking, start looking again and we start counting them again; ergo the unemployment numbers don't change. They won't change until the number of people who get hired exceed the number of people begin looking for work again. In addition, the number of new people joining the workforce keeps growing also adding upward pressure on the unemployment numbers. So long as major corporations want to sit on the billions of dollars of cash they have accumulated and not invest and hire, those altruistic son-of-a-guns, then unemployment has to remain high.
In the mean time, those who want to do damage to President Obama's domestic and economic policy get to make hay by loudly (but stupidly) proclaiming that Obama is failing because all they need to do is point to those terrible unemployment numbers and ipso facto, Obama just doesn't have a clue, don't you see, on how to bring those unemployment numbers down ... rubbish. In fact, of course, he is doing what needs to be done, it is the Republicans and Corporate America who are not.]
OK, back on message. The recession lasted one year and six months which makes it the twelfth longest recession or depression that has been estimated by the NBER. The downturn in the GDP was -4.1% which is minuscule when compared to the double digit downturns from 1867 to 1938 which ranged anywhere from 26% to 37%! (and we thought we had it tough!!) Likewise, unemployment while high at the peak of 10.2% which lasted only one or two months, doesn't begin to compare with the Depression of 1929, 24.6%, and the Recession of 1937, 26.7%. Even the Carter-Reagan recession of 1980 had higher and longer unemployment rate at 10.8% than does the current recession.
Who gets the blame for the Great Recession of 2007? President Bush, of course. Everyone knows that the president in power always gets the credit or the blame. Well, I don't work that way. I try to find the real cause. In this case, it really is President Bush and the Republican fiscal policy philosophy. Although, I have to admit, they had more than a little help from the Democrats, mainly Presidents Carter and Clinton. But, nevertheless, when you dig down deep, the real culprit in my opinion is the proven failure of the Republican fiscal philosophy regarding the relationship between business and government (my first foray into this arena was via my first hub "Thoughts on the "New World Order And 2012") and, as I pointed out in the section on the 1873 Depression, the American citizen's and, more importantly, our politician's unforgivable and plain stupid inability to learn from past mistakes.
The prima fascia cause of the 2008 recession was the collapse of the Sub-Prime mortgage loan market from 2007 to 2009. For brevity and clarity I want to reproduce a section from Wikipedia's opening on this subject:
"The US sub-prime mortgage crisis was a set of events and conditions that led up to the late-2000s financial crisis, characterized by a rise in sub-prime mortgage delinquencies and foreclosures, and the resulting decline of securities backing said mortgages.
The percentage of new lower-quality subprime mortgages rose from the historical 8% or lower range to approximately 20% from 2003 to 2006, with much higher ratios in some parts of the U.S. A high percentage of these subprime mortgages, over 90% in 2006 for example, were adjustable-rate mortgages. These two changes were part of a broader trend of lowered lending standards and higher-risk mortgage products. Further, U.S. households had become increasingly indebted, with the ratio of debt to disposable personal income rising from 77% in 1990 to 127% at the end of 2007, much of this increase mortgage-related.
After U.S. house prices peaked in mid-2006 and began their steep decline thereafter, refinancing became more difficult. As adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities backed with mortgages, including sub-prime mortgages, widely held by financial firms, lost most of their value. Global investors also drastically reduced purchases of mortgage-backed debt and other securities. In addition to causing increased delinquencies and foreclosures in sub-prime mortgages (along with all other types of mortgages including Alt-A and conforming), the 2007-2010 financial crisis caused a decline in the capacity and willingness of the private financial system to support lending, tightening credit around the world and slowing economic growth in the U.S. and Europe."
But what allowed this to happen? Why now and not some other time earlier during Clinton, Reagan, Carter, or Kennedy-Johnson administrations? The simple answer is the repeal of the Glass-Steagall act of 1933; this might be characterized as the straw that broke the camel’s back. This repeal was signed into law in 1999 by President Clinton as a compromise with the right-wing conservative Congress both had forgotten the lessons of history.
Part of the reason for the depth of the Great Depression of 1929 was a lack of regulations regarding the relationship between commercial lending banks and investment banks; they could be one in the same and as a result a lot of risk taking and speculation was done in the name of making a profit. It got out of hand (sound familiar?) and ergo, the Great Depression (not quite that simple of course, but you get the idea). Obviously, this wasn't the sole cause to the Great Depression, but it was a major constituent. Consequently, over the painful howls of the conservatives, both Democrat and Republican, the Glass-Steagall Act was passed in 1933. It separated commercial banks, who were allowed to make mortgages, but also assume all of the risk associated with those same mortgages, and the investment banks who could not participate in the mortgage market at all. There was a firm wall between the two. The conservative fiscal ideology does not like walls, however, and deregulation became the name of the game.
Over time, the protective wall began crumbling here and there. In the late1980s enough holes were poked through it and new ways of financing not covered by existing laws were created to allow the Savings and Loan crisis to happen. As a consequence of the havoc created by this financial scandal, which was very similar to what happened in 2002 – 2006, new, powerful oversight commissions were created with new authority granted by Congress to ensure a repeat would not happen.
It was these regulations, among others, that were under attack by conservatives. What grew out of this conflict was something called the shadow banking industry which began in 200; it had really been around much longer but had been dormant. Nevertheless, the growing housing bubble coupled with the inability of the normal banking institutions as well as Fannie Mae and Freddie Mac, the massive mortgage loan guarantee organizations, to provide flexibility in mortgage loans, provided a ready market of people wanting to cash in on the rising prices of real estate and speculators for these shadow financial institutions. They were able to make little secured, low interest loans where other, normal banks couldn’t because they were lightly regulated and where they were regulated the SEC and FED chose not to regulate them because it was “bad for business”.
With emergence of “derivatives”, “bundling”, “swap-backs”, and other strange sounding financial transactions, which these new mortgages might find themselves subject to, took all of the risk of loan making out of the hands of the loan-maker and put it in the hands of the investors; the loan-maker no longer had any “skin-in-the-game” on the mortgage loans they made and simply did not care if they were good loans or not!
In response, the normal banking industry, Fannie Mae, and Freddie Mac lobbied Congress for relief; they got it in a very big way. The Glass-Steagall Act was repealed by the Gramm-Leach-Bliley (GLB) Act of 1999. The GLB Act allowed the investment bank’s financial firms to own sub-prime adjustable rate mortgages, while the commercial bank (who may now be one-in-the-same) no longer must assume any risk associated with the loan which they made and therefore really do not care if they make a good loan or not!! What this meant, of course, was that now NOBODY was regulated and greed was in the air, the brakes were off, the locomotive was running down the tracks on the mountainside and the bridge was out; it was 1857, 1873, 1882, 1893, and 1929 all over again. Each one was a classic Boom-Bust depression brought on fundamentally by unregulated financial markets, a runaway real estate market, a lack of or inactive Fed, greed, and the Austrian school of economics … every one.
What is worse, is that in the financial world of 2001you can make a bet with this investment, a mortgage in this case, like at no other time in history. You can bet the value of the mortgage will go up or, amazingly, you can bet the value of the mortgage will go down!. Previously, real banks could not do this, only shadow banks could. Once Glass-Steagall Act had been repealed, everybody could and nobody cared whether the borrower could pay their loan, not the people making the loan, too some degree Freddie Mac and Fannie Mae, not the SEC, not the Fed, and not the federal government (many state governments started taking notice early on but were rebuffed by the SEC, the Fed, and Congress)
After the repeal of the Glass-Steagall Act and when George W. Bush became president, the Republicans set about dismantling the rest of the barriers that protected society from the excesses of business. The result was predictable, the Almost Depression of 2008.
A CHAIN-REACTION LEADING TO WHAT SHOULD HAVE BEEN A DEPRESSION
In all other periods of history prior to 1933, what was happening from 2006 to 2008 would have ended up in the worst world-wide depression the world had ever known. I say this without a doubt in my mind. It wouldn’t have been a Panic, because of the laws in place to protect against bank runs, but overlaying what was happening in the financial, business, and industrial sectors with those of previous depressions, this was setting up to dwarf them because of the interconnectedness of businesses and financial institutions around the world and the speed of today’s technology, it doesn’t take a rocket scientist or a degree in economics to understand this; I think rocket science is easier nowadays, by the way.
I will by-pass the rest of the politics and mismanagement by the Fed and federal government from 2000 to 2005 and begin with the peak of the housing bubble in April 2006 and follow it through to the implosion which started later in 2006 and continued through June 2009; an amazing three year long economic decline of which only one year, six months of it was the actual recession.
All through 2002 – 2005, regular people, regular investors, and speculators were snapping up houses and real estate of every description, up scaling their living standards, becoming instant millionaires by flipping property which seemed to double in price overnight. People took huge amounts of new found equity out of their homes using low-doc and no-doc loans when no real proof of income or solid collateral were commonly available; just like they were in the 1800s. You could almost blink your eyes and have a loan from a shadow bank; to get a loan from a bank backed by Freddie Mac or Fannie Mae,, you had to try a bit harder for they actually required proof of employment and income, which[S1] accounts for their lower default rates, but their loan-to-value and equity requirements were still pretty lax.
Many attempts were made by various states and other organizations who understood what was happening to convince Alan Greenspan, Chairman of the Federal Reserve, and of many members of Congress of the disaster that was coming; all of the signals were there, but nobody in control believed the nay-sayers, what was happening fit the conservative economic model to a “T”, they said, “stay-the-course” President Bush said, so we did.
Beginning in late 2006, as knowledge that housing starts had slowed down began to spread, prices first stopped rising at such stupendous rates, then flattened out and finally began to decline in a few parts of the country. Most of the mortgage loans made over the preceding six or seven years were based on a “wing and a prayer”, meaning people prayed that home prices would keep going up indefinitely; I actually heard supposedly smart pundits say such idiocies back then, I could only shake my head, because I read and remembered my history. When people believe this nonsense they buy adjustable rate mortgages without thinking about it or doing any analysis as to whether it makes any sense and most mortgages made during this time where adjustable rate mortgages. If they weren’t adjustable rate, they were sub-prime, fixed rate, meaning poor credit history, or worst of all, sub-prime, adjustable rate. Only a minority of loans were made to credit worthy customers with a fixed term.
As in all the other financially-based recessions/depressions of the 1800s and early 1900s which we have studied, the stage for a major depression sometime between 2007 and 2009 was set.
- Greed was rampant through-out the financial sector
- Speculation was everywhere in the real estate market
- The population was going crazy trying to cash in on a stupendous, once-in-a-lifetime housing bubble
- Most government regulation of the financial sector had been repealed and what regulation that was left was not being enforced, on purpose.
- The regulators were asleep at the switch
- Those in a position who could have done something lent a deaf ear to those who were screaming a warning.
- New, exotic investment instruments were invented to place bets with the mortgages made to secure the real estate loans which were accomplished in such a way that relieved the lender of ANY risk from having made the loan in the first place with the consequential result of removing any incentive to properly vet the borrower for ability to repay. With no incentive and no government regulations in place or any oversight if there were, these financial institutions were free to do as they pleased, and they did, a lot as you will see in the next bullet.
- Over $300 billion was invested in mortgages annually by shadow, non-agency lending institutions between 2003 and 2006, most of it sub-prime. Another $100 - $200 billion was made annually by normal institutions, including those backed by Freddie Mac and Fannie Mae.
Picture, if you will, a tall mountain, say in Aspin, CO or Lake Tahoe, CA with snow piling up on it for the last five years, no melting during the summer. It has reached an enormous depth by April 2006; that is when housing prices began turning down and construction starts began reversing three months earlier. It was in 2006 as well when the most sub-prime mortgages were sold, even the tell-tale signs of a flattening housing market were becoming evident in 2005.
What were these sub-prime mortgages based on? Most of them … nothing; just like in the 1800s, do you notice how I keep going back to that? No proof of income was required;; no collateral was required; the original lender had no risk in the loan, in fact, nobody knew where the actual mortgage actually was, only where the payment was going; and the bulk of the loans were of an adjustable-rate type The ONLY thing holding the system afloat was that the ever increasing prices of housing and the belief that it would stop; in April 2006 it did stop and the house of cards, this public-private sponsored Ponzi scheme of sorts, collapsed in on itself and the Recession of 2008 was just two years away. The question was whether will it be a depression, a great recession, or a run-of-the-mill recession America had become use to. President Bush began promising no worse than the later, if even that. Which one it would be would depend entirely on what action the government took, if any, between 2006 and when the downturn hits full-throtle.
The collapse didn’t come quickly, it came in stages instead. As I mentioned earlier, even though housing starts peaked in late 2005, and housing prices peaked in early 2006, mortgage loans of all types, but especially adjustable-rate, sub-primes still were being made at record rates, at total of $340 billion, by financial institutions other than Fannie Mae and Freddie Mac, who began reducing their exposure in 2005. These same institutions lent $210 and $320 billion in 2004 and 2005, respectively[ii]. Add in 2003 and they lent over one trillion dollars in what were generally questionable loans, especially those made in the last two years. Oh yeah, Freddie Mac and Fannie Mae contributed another $460 billion to the sub-prime woes, bringing the total up to an unprecedented $1,460,000,000,000 in mortgage loans over just four years! And that was just in America.
THE OFFICIAL REPORT ON WHY THE GREAT RECESSION OF 2008 HAPPENED!
ANOTHER HOUSE OF CARDS COME TUMBLING DOWN
WHAT HAPPENED WITH THIS TRILLION AND A HALF worth of mortgages, a significant portion of which was bound to fail, that was placed in the financial institutions of America. It was bundled, then sliced and diced then bought and sold by other financial institutions, including your and my local banks and insurance companies, if they so chose, because all of those nasty regulations that hampered American enterprise so terribly had been repealed in the last 30 years, but mainly in the last 10.
Not to worry though, so the thinking went by economists such as Alan Greenspan, the Chairman of the Federal Reserve, and Henry Paulson, the Secretary of the Treasury. The risk, according to conservative economic theory, is so diversified over so many strong institutions that even if many of these loans in the portfolios these banks and insurance companies and the like were making bets with defaulted, none would be so large for any one institution as to cause a problem for the whole. What their theory forgot to account for, and more progressive economists, who were out of power, were unable to convince them of, was that if the “whole” was based on a false assumption, in this case, that housing prices would keep going up. If that assumption proved very wrong, then the “whole” would suffer the same consequence because all of their investments were based on the same risk, there was, in fact, no diversification at all, don’t you see.
If you recall back to some of the other histories in this book of similar types of financially-based economic failures, you might recall there is normally an event or two that gets the ball rolling, to start the avalanche headed downhill, to use the metaphor I began in the last section.
In early 2007, the first snowballs began their long slide to the bottom. Even though business was still strong as evidenced by a historically low 4.5% unemployment rate[i], pressure was starting to mount on the economy with rising oil prices and home prices had now fallen 4% nationally[ii]. Further, smaller sub-prime lenders started failing and larger ones stopped lending. In April 2007, one of the mid-sized sub-prime lenders in California filed for bankruptcy. Nevertheless, those in the know were publicly preaching confidence including President Bush; but, the snow was definitely starting to slip.
As the middle of 2007 approached, the credit market saw the first signs of the long winter coming on as money started getting scarce to those making loans. As strange as it may seem, the beginning of the end, the thing that started the avalanche on its course downhill, in my estimation, as a Congressional Act passed back in 2002 to protect America and Americans, one of those nasty regulations, from Corporate corruption called the Sarbanes–Oxley Act of 2002. The Act was the result of the horrendous scandals by such infamous companies as Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. Their crimes were so terrible that they managed to bring together an overwhelming bipartisan vote the likes of which modern American can only dream about. Among other things, this Act contained one arcane requirement that went into effect November 2007, and that was for publicly-held companies to report assets “mark-to-market”, in other words, to give their true value as best they can.
Consequently, from early Spring 2007 onward, some companies jumped the gun, reports started appearing across the nation painting an astounding portait of ill-health in the financial industry. Bit by bit, the real picture slowly developed and by the time 2007 was over, three things had happened, 1) the sub-prime market had nearly dried up, only a total of $200 billion in loans were made that year; mostly in the early part of 2007, 2) the recession of 2008 officially started in December 2007, and 3) our snow slide had just turned into a minor avalanche, but, it was only going to get worse, much worse.
In 2007 and early 2008 companies like Goldman Sachs, Bear Stearns, Citibank, Bank of America, Merrill Lynch, AIG, and all of the other big names you have heard of were in an internal panic, but publicly were lying their whatever’s off. All of those esoteric financial arrangements like CDOs and CDO-squared, credit swaps, and the many other unregulated transactions which were designed to move bad loans off of their books onto some, most often unsuspecting, other investor became buzzwords bandied about in the newspapers and talking-heads on cable who didn’t have a clue what they were talking about. Most of the time these “deals” were fabricated out of thin air (paraphrasing from the testimony contained in “The Financial Crisis Inquiry Report of the United States of America”, authorized edition), without really understanding what the final result would be; these were accomplished by the best and the brightest of our financial gurus on Wall Street, the ones nobody wants to bring to justice, by the way.
By mid-2008, lenders like J.P. Morgan began calling in their margin loans they made to companies like Bear, Stearns, a major hedge-fund manager. A major motivator for these actions was the very belated downgrading by the credit rating agencies of the creditworthiness of these huge financial firms who had bet the farm on mortgage-backed securities. Initially, during 2004 – 2006, these credit rating agencies were part of the problem because they did not give honest ratings to the holders of these securities once they became so overburdened with sub-prime mortgages. Then, in 2008, these credit rating agencies continued being part of the problem by creating a panic in the market with drastic and frequent downgrades that, while initially only affected a very small percentage of the market, emotionally put it a tailspin because everybody knew what was coming next. Finally, in mid-2008, people like Ben Bernanke and Alan Greenspan, Chairman and former Chairman of the Federal Reserve; Henry Paulson, Secretary of the Treasury, and other conservative economists understood the fundamental flaws in their prior decisions; the conservative politicians, on the other hand, did not; they still don’t.
The stock market understood what was happening as well[S1] . Chart xx tracks the Dow 30 Industrial Index through something called an Exchange Traded Fund (ETF) with the exchange symbol of DIA; I trade options in trying to guess whether it will go up or down each month. What you are see here is a very close reproduction of actual Dow numbers you hear every day in the news, you know, the one that keeps trying to top 15,000 but doesn’t quite do it. On the chart are several significant dates with reference numbers attached which you can find in the table below to see their meaning. I present it at this point so that you can see what is happening in the stock market as the Great Recession of 2008 unfolds.
The lines at the top of the chart are technical analysis lines know as Support-Resistance lines. Looking at this “formation”, which computers would have identified for them as a “head-and-shoulders” pattern would have told the very savvy investor (I wasn’t one of them, I am still not) to start getting his or her portfolio ready to sell because the market might have reached its top; only might have. More later.
Let me take a moment to catch you up on what you are looking at in terms of history, both American and financial. Coming out of the Clinton administration and a record 10 years of growth, not boom growth like under the Austrian economics of the 1800s but sustainable growth as we had under Kennedy-Johnson, an expected recession occurred in 2001. It was precipitated by the “rich-man’s” market crash known as the tech-bubble in 2000; neither were very large and are not covered in this book.
The crash left the economy unstable, but the kick-off event however was the terrorist attack on New York City on September 11, 2001, which, along with bringing the twin towers down, it brought America’s economic engine to a halt for a moment and slowed down the airline and financial industry for much longer. Adding to the panic was the anthrax attack by a lone, misguided scientist not too long afterwards.
As terrible as the 9/11 attack was, America’s economy and fiscal situation was so robust going into 2001, even with the cost of the Wars in Afghanistan and on Terror, which necessarily had to follow the attack on the U.S, America could well have survived economically. What it could not survive, however, was the additional expense of the War in Iraq; the subsequent skyrocketing of oil prices; and the loss of government revenue resulting from the Bush tax cuts in the face of reduced economic growth. The combined effect of this is reflected in the two-year long bear-market and crash between May 2001 and May 2003.
It was also in 2003 that America began to see the first incipient signs of the housing bubble, and the market, with the quick “victory” in Iraq, was recovering quickly. By 2004, the market had recovered most of its loss and was back to Jan 2002 levels. America soon became aware though that the “victory” in Iraq was hollow and that America was in trouble there. Partly in reaction to this and other world events, the market went into a year-long retreat and GDP stopped growing at a sustainable rate and slipped to a 2.5% range for awhile before finally falling into the massive 2008 recession.
While economic growth was moving toward the precipice, the market was initially following along. In 2005 the market and the economy was basically flat as GDP varied between a low of 1.8% quarterly growth to 4.2% quarterly growth. It is in 2006 when the situation started changing quickly. The market began to take-off while the GDP struggled to keep aloft and then fails; housing starts, then housing prices peak followed by a reversal.
SIGNS OF IMPENDING DOOMClick thumbnail to view full-size
Let’s assess where we were as the country moves into the Summer of 2006.
- CHART 1: Sales of homes in the South and West rose rapidly from 2000 until early 2005, when they peaked and began just as rapid decline three years before the actual recession
- CHART 2: Housing starts continued to rise for another year, based only on speculation and flipping, peaking in January 2006.· CHART 3, Not coincidentally, housing prices, which had been skyrocketing to historic levels based on nothing but the belief the increases will never stop, also stopped in early 2006; plummeting faster than they rose.
· CHART 4, Historically, since 1937 anyway, real estate has always been funded by traditional banks, often backed by government sponsored enterprises (GSE) like Freddie Mac. It was not illegal to purchase real estate through other means, just much more difficult. However, with deregulation of the financial industry, those protective barriers came down so as real estate prices skyrocket, the share of total loans from unregulated, non-GSE backed shadow banks dramatically increased while the initially more secure loans from traditional banks and GSE (Fannie Mae and Freddie Mac) declined (they always remained more secure, they just became less secure). That trend began to reverse in 2005.
- CHART 5: While the share trend for all mortgages may have begun reversing in 2005, the amount of money going into subprime mortgages did not, as can be seen by this chart. Non-GSE and traditional banks started pulling back on subprime lending at the beginning of 2005 when homes sales began to decline, but shadow banks and other speculative institutions created from deregulation doubled down on subprimes for another one and half years until the bubble imploded and the worst recession in 60 years was assured.
- CHART 6: With this chart, we see the increase in the price of gas kept pace with housing price increases, going up 50% in period 2002 - 2006 when bubble burst. The problem is, it kept going, increasing about 80% by the time of the recession. The point, of course, is gas is taking more and more of a bite out of consumer's budgets just at the time they are going to be squeezed by increased mortgage costs.· CHART 7, GDP was also a problem. Except for 2003, the economy leading up to the recession was weak. If it had been robust, the outcome might have been different
- CHART 8: The stock market is often prescient ... not this time, however. After recovering from the 2001 recession in 2003, it stabilized, largely ignoring the run-up in housing prices and the subsequent activity; probably in reaction to the soft business climate reflected in the GDP numbers. It isn't until the bubble bursts in 2006 that the stock market ironically surges to historic heights. is is a result of the happy face put on by government and the financial industry as well as a flurry of merger activity through part of 2008.
- CHART 9: The end result of the bursting of the real estate bubble is this unemployment chart. The die was cast in 2006, and the evidence can be seen in the increase in the unemployment rate beginning in mid-2007.
- CHART 10: This is just a continuation of Chart 8 depicting the recovery.
It is a very contradictory picture, in my mind. On the one hand, we see the stock market going crazy, along with the home loan industry; billions were being make in the financial industry … but being lost elsewhere (with nobody noticing just yet). On the other, the GDP is faltering, housing starts and prices have reversed, median family income was going down, the War in Iraq was in trouble as was the War against Terror, and America was becoming isolated from its allies.
August 1, 2006 was D-day of sorts. That was the day Goldman Sachs and AIG (the giant insurance company) had a watershed conference call where Goldman was wanting more collateral for its margin loans given to AIG, like it did to Bear Stearns earlier, to cover all of the complicated mortgage-backed security bets they had made; this is the “mark-to-market” debate that became so famous. Goldman Sachs didn’t believe the portfolios held by AIG (and Bear Stearns) were worth what AIG said they were because the housing market was collapsing. AIG would not, could not, acknowledged that reality without starting a crash on its securities. Goldman and AIG would not come to an agreement that day and AIG’s securities investment arm began the 14-month process of bringing its giant parent company, and America along with it, to its knees with it; of course AIG had a lot of help along the way.
While this titanic struggle was taking place, the Federal Reserve Chairman and President Bush were telling America everything was just fine, thank you, only a little hiccup, not to worry; and the stock market kept surging, housing prices kept falling, the number of normal mortgage loans slowed down, but not subprime loans, not quite yet; thus ended 2006.
After the landing on the beaches along the Normandy coast in France during WW II on D-Day, it took many months for the Allies to gain ground on the Axis forces; but the outcome was inevitable. So it was after the call was finished between Goldman Sachs and AIG, it would take many months for the forces of the slowing moving avalanche that started eight months earlier to gather enough momentum as to become an unstoppable force. In August 2006, they were probably already there, but nobody really said so out loud for fear of it sounding like an artillery battery going off straight into the snow-covered mountain side.
It took another 12 months of dancing, pushing and shoving, and dodging and weaving by the monolithic financial giants who had the world’s fate in, dare I say, their greedy little hands before humpty-dumpty finally fell off the wall and broke. From August 2006 to August 2007, Wall Street tried everything it knew how to do to hold back five years of accumulated snow that had already started slipping downhill and they failed. Cumulatively, financial institutions globally had accumulated more than ten trillion of dollars of asset-backed securities, a significant percentage of which were subprime grade mortgages. They had bet the farm, as it were, that real estate values would keep increasing, but, now they were falling, and at an increasing rate; these institutions were desperately trying to get rid of these bad securities they owned.
These mega-financial institutions were looking for lesser institutions to pawn there bad bets off on to; and they were finding them, such as Germany’s IKB Duetsche Industriebank AG. To quote a section from “The Financial Crises Inquiry Report”
“In early 2007 … an employee of Paulson & Co., the hedge company taking the short side of the deal, bluntly said that “real money” investors [ones using real cash, not borrowed money] such as IKB were outgunned, ‘The market is not pricing the sub-price [residential mortgaged-backed securities] wipeout scenario,’ the Paulson employee wrote in an e-mail. ‘In my opinion this is due to the fact that the rating agencies, CDO managers, and underwriters have all the incentives to keep the game going while the “real money” investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate [on] the ‘news’ available everywhere are actually realized.
Between August 2006 and August 2007, IKB and many other companies like inside and outside the United States ended up on the wrong side of many of these “deals” from the financial giants on Wall Street trying to dig themselves out the hole they were in. Saying they are giants is an understatement and is the reason why the recession did not occur sooner. Each company individually, and we are talking about such well known names as Bank of America, Merrill Lynch, Wachovia, Countrywide, Citibank, Goldman Sachs, AIG, Wells Fargo, Lehman Bros, and Morgan Stanley to name a few, had very deep reserves, political power, and wherewithal to survive for a significant, but not indefinite period. Again from The Financial Crisis Report:
“Countrywide Home Loans (the largest in its field), saw the handwriting on the wall on August 2, 2007 when, after realizing his company could no longer roll its commercial paper or borrow on the repo market. It’s CEO, Angelo Mozillo said, “When we talked about [August 2] at Countrywide, that’s our 9/11. We worked seven days a week trying to figure this thing out and trying to work with the banks … Our repurchase lines were coming due, billions and billions of dollars”
ASIDE - For stock market aficionado’s, let me explain a little about Chart 8 and the meaning of time around August 2, 2007. It is actually important to our discussion on recessions for as we move along, it might start noticing some similarities with the precursors to the 1929 depression. About a month before, July 7 to be precise, the market hit a local high point. The news of the problems that Countrywide and others were having began leaking out which began the slide toward a local low around August 2 when Countrywide realized it was in very deep trouble. (BTW, that sharp downturn at the beginning of March 2007 was attributed to some strange “glitch” and the pundits predicted 18 more months of wonderful growth ahead.)
Now, there isn't anybody who could have known at the time, but that local high followed by the local low was the left-shoulder of a Top Head-and-Shoulder formation pattern that is recognized as a rather bad sign in technical stock market analysis. Keep that in the back of your mind for there will be more in a little bit.
BACK TO POINT – As I said, July 7, 2007 was a local high for the Dow 30, The Dow Average as most of us know it, and 21 days later you see it take a huge nosedive on July 28. On that day, proof of the housing market’s problems emerged with quarterly losses from the two largest home builders in the U.S., D.R. Horton and Beazer Homes; Exxon-Mobile happened to take big loss that day as well, it lost $16 billion in market value alone! New York Reuters reported the following the next day,
“Financial shares took a beating on growing evidence that problems in the subprime mortgage market are spreading, making financing the corporate buyouts that drove the market's spring rally more difficult. ‘It was easy credit that helped fuel stock prices,’ said Peter Boockvar, equity strategist at Miller Tabak & Co. in New York. Worsening credit conditions means ‘less liquidity for private equity, stock buybacks, business expansion, consumer spending, global growth.’ “
On August 2, the same day Countrywide’s Mozilo e-mailed the former Fed governor his famous 9/11 comment, he told the public that,
“Countrywide had ‘significant short-term funding liquidity cushions’ and ’ample liquidity sources of our bank… It is important to note that the company has experienced no disruption in financing its ongoing daily operations, including commercial paper.”
Credit rating agency Moody’s confirmed this by reaffirming it's A3 ratings and stable outlook on Countrywide. [Author’s note – I actually remember when the above statement and Moody’s assurances were put out.]. The stock market rose accordingly the next few days until August 6 when word began leaking out that both Countrywide and Moody’s were rethinking their position. On August 14th, Countrywide, the largest subprime lender in the country, released its July 2007 operating report which said that “foreclosures and delinquencies were up and that loan productions were down by 14% during the preceding month.” A company spokesman said layoffs would be considered, 10 million more would follow in the next 29 months, before America would see its first positive jobs report.
On September 18, 2007 the Federal Reserve finally made its first move, they lowered interest rates, to try to stave off the impending recession they saw coming. They did not yet, however, appreciate the full extent of catastrophe that was only 14 months away for as late as August 6 or 7th, the Fed’s Open Market Committee members noted, during discussions, that “the considerable financial turbulence” in the subprime market, while showing some strain, did not “indicate a collapse of the housing market was imminent …” but, to be fair, they also expressed concern that “effects of subprime developments could spread to other sectors … ‘ and that they have been repeated ‘surprised’ by the depth and duration of these markets.
It was this announcement by the Fed and reports from Bear Stern and Goldman Sachs of beating earnings estimates that pushed the Dow Jones to its final high on October 10, 2007, 78 years and 36 days after the market reached its peak in 1929. Fourteen days later, on the 78th anniversary of Black Thursday, October 24, 1929, the beginning of the Great Depression, the Dow Jones hit its first of seven consecutive new lows before finding its final low point on March 9, 2009; 1 year, 5 months after the seeing its historic high and 20 days after the passage of the American Recovery and Reinvestment Act (ARRA), President Obama’s signature and controversial stimulus program.
ASIDE: Following the low reached on Oct 24, 2007, resulting from lowering home prices and spiking oil prices, the end of October saw good earnings reports from America’s businesses AND another rate cut from the Federal Reserve, that drove the market up to a local high on Oct 31, 2007 given it fell back sharply the next trading day. Note, from Chart 8, this high was not as high as the market high on Oct 10, and, in fact, is about as high as what I identified as the Left Shoulder in the previous Aside. As you might guess, we are now looking at the Right Shoulder of the Head-and-Shoulder formation known in technical analysis as a bad omen. However, because this happened so close in time to the market high, technicians will be looking for a confirmation, although they will now be taking precautionary steps to exit the stock market should things start to go south.
Back On Point: There is no good news any more other than corporate earnings, they still seem to be strong, except in the financial sector; only because the full impact of rising oil prices have not been felt yet. On Nov 1, 2007, the bears took back over with news of surging oil prices, the emerging crisis in the credit market, and the housing sector collapsing growing. The short-lived upswings you see on Chart 8 in this period are brief profit-taking episodes. The economy is now all about the housing market, the stock market, and the credit market; it is clear to all now the former has collapsed, it is just dawning on those in the know that the latter is going to collapse, and the stock market is finally acknowledging that fact. America has been hung out to dry.
On Nov 27, 2007, the stock market reverses on 1) news that the Fed might cut rates again, 2) Citigroup got a $7.5 billion loan from Abu Dhabi, 3) oil prices start falling as the economic crises starts sinking in with the speculators, 4) a freeze in sub-prime interest rates, 5) the last of good unemployment statistics, and 6) good business sector earnings reports. All of these factors conspire to push the stock market, and America’s hopes along with it, up for the next 15 days, until Dec 15, 2007 when the inflation report came out that wiped out all of the good feelings and sent the market crashing down again.
ASIDE: That was the confirmation market technicians were looking for to solidify their belief that a strong Head-and-Shoulders formation had actually formed, and those who believe in technical analysis began making hurried preparations to exit the market or actually began doing do so. (I wasn't a technical analyst back in those days so I was just sitting there, fat, dumb, and happy with my 401k retirement plan rolling toward a cliff.)
POINT: The pressure on the credit market kept increasing as defaults kept rising and bank failures began to rise among the weaker institutions; the largest firms still had enough assets and power to find wiggle room to stay afloat or find buyers, like Countrywide seemed to be doing. Nevertheless, between Dec 15, 2007 and Jan 24, 2008, America officially entered a recessionary period, although that wouldn't be announced for some time yet. Also, on Jan 24, the Fed cut interest rates yet again and that, along with more good earnings reports, stopped the market from tumbling even further. From this point until May 2008, the stock market, and America moved sideways, waiting for something to happen.
In April 2008, America, especially those invested in the stock market are looking for any good news, and when they hear it, stock prices soar. During April there was a mixture of good and bad earnings reports, oil price and inventory reports, employment reports, and the like. On the whole, the market reacted more positively than it did negatively, even though there was a huge cancer eating away at America’s underbelly. By May 19, 2008, it was all over but the shouting for the stock market, and America as it turns out.
ASIDE: A combination of financing for companies like Lehman Bros and Bear Stearns as well as other good news here and there kept the market up in early May 2008, but by May 19, the drumbeat of higher oil prices and the release of core inflation indices show substantial increases was all it took to send the stock market plummeting again, permanently this time. Even when a solid Head-and-Shoulders formation is established, all it indicates is a strong likelihood of a moderate, medium-term downturn in the market. We are seeing that now, and in May 2008, it could have been over. But, when, in May, the rally peaked out where the high did not reach (or even come close) to the Right Shoulder high, and, in fact, only got as high as some previous major low points, that established something called a Neckline. When technical analysts worth their salt saw this, any who were still in the market, exited in a hurry, because this formation is a sign that the market is in the midst of a Major correction; a significant, long-term bear market. (You know what I was doing of course, hiding my head in the sand.)
POINT: The last snowflake holding the avalanche from going over the cliff melted at 1:45 AM on September 15, 2008, when Lehman Brothers Holding Inc, filed for Chapter 11 bankruptcy protection. As the well-worn statement goes, it was as if the “air had been let out of the balloon.” (and that is when I finally moved my retirement savings.) You can see from Chart 9, Job Growth, that while job losses had been steadily increasing since Feb 2008, they accelerated at an alarming rate after September. Although you can’t see it in Chart 7, GDP Growth, the end of Sept 2008, was the first of two consecutive quarters of the negative growth needed for the official declaration of a recession. Unfortunately, the end of Sep 2008 data is the only information soon-to-be President Obama would have available to base is economic plan on for the first term of his Presidency, something his political opponents have taken great advantage of because it barely told how bad things were going to get; President Obama didn't have that information available to him until well after his plans had already been made.
The fall of Lehman Bros, was the Knickerbocker Trust Company of the Panic of 1907, or the Philadelphia and Reading Railroad of the Depression of 1893, or the Vienna stock market crash of the Long Depression of 1873. It was the final shock needed to unhinge everything and send the avalanche of five years of accumulated snow crashing down on an unaware and fooled American public and on a newly elected president who was to face the most uncooperative and vitriolic opposition party the nation has seen in modern American political history.
STEMMING THE TIDE AND RECOVERY
TO SUMMARIZE BRIEFLY how we came to this sad state of affairs.
- From 2003 to 2006, America saw an unprecedented and unsustainable growth in housing prices and construction based only on greed; there was no fundamental reason in the real estate marketplace to have caused the type of growth that was experienced.
- In late 2005, housing construction finally crested and in early 2006, housing prices did the same
- Fueling this unparalleled growth were, beginning in the early 1980s and accelerating in the 2000s, a loosening, the then near elimination of regulations governing the financial markets, returning regulatory oversight to pre-1937 days
- As a consequence, a shadow banking system developed completely outside regulatory control and the firewalls that separated mortgage banks from investment banks disappeared; credit became as simple and easy to get as it was throughout the 1800s
- Historic numbers and amounts of mortgage loans were made to satisfy the rampant greed occurring within the financial and housing markets, a significant percentage of which were made with risky sub-prime mortgages
- These risky mortgages were spread throughout the investment sector was part of various and sundry portfolios, putting the whole financial industry at risk if these loans go bad
- When real estate prices began to retreat in 2006, the sub-prime mortgages began to lose value, and therefore so did the investment instruments that contain them, making the companies who own them shaky
- The stock market ignored most of this for awhile because it was in a merger mania period and business earnings were still strong; it kept on climbing
- From Fall 2006 to Summer 2007, the credit market began to realize the predicament it was in and started looking for a way out and not finding any
- In September 2007, the Federal Reserve finally entered the marketplace by lowering interest rates and in October 2007, the stock market itself peaked. After that, the credit market and oil price news kept getting more dismal
- From Oct 2007 to May 2008, the Fed kept trying to keep a lid on the problem by lowering interest rates, the stock market kept trying to right itself, but deepening credit woes and rising oil prices kept the market either falling or moving sideways
- In May 2008, after one final attempt to make a break-out, all of the interest rate lowering efforts had a predictable effect, increased inflation and the market gave up the ghost
- In Sep 2008, when Lehman Bros filed for bankruptcy, so did the credit market.
Once Lehman Bros failed, it was like dominos stacked on edge each one close enough to the other to knock the next one over when it fell, it was a chain-reaction. This was so because the sub-prime mortgages were so ubiquitous throughout all of the investment instruments in the marketplace, that anybody that owned them, had a potentially worthless investment on their hands. And, if those investments made up a significant portion of that company’s assets, then they were as vulnerable to failure as Lehman Bros was; that was most of the big financial institutions on Wall Street.
So, when Lehman Bros. collapsed, because they were the first large institution to actually value their portfolio to market and thereby reduce their asset value well below their liabilities, the cat was finally out of the bag and all eyes turned toward the rest of Wall Street, who, in turn, could not stand the scrutiny. When the Fed saw the market reaction to its letting Lehman Bros. fail, it changed its policy and began bailing out troubled banks and insurance companies, starting with AIG, in Sep 2008. By the end of September, the Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson finally understood what had happened and what was wrong with their conservative economic theory they cherished so much. Together, they set about trying to convince President Bush of the same thing and get him to abandon his long held conservative fiscal principals and approve the $700 billion Troubled Asset Relief Program (TARP).
In a radio interview I heard in 2011, President Bush talked about his conversations with Bernanke and Paulson. He said they spent quite awhile educating about economics, what had happened and why. In the end, he knew he had a choice to make 1) go against all that he believed in and approve the TARP program and fight with his own Party to get it through Congress or 2) risk an actual depression, which the two conservative economists had convinced him was a distinct possibility. History now tells us, President Bush chose the TARP program, one of the two major reasons America did not end up in a depression; the other reason was President Obama’s stimulus initiative.
There is a process in many fields of social and physical sciences called positive feedback. It means that the output of a process influences the input in such a way as to increase the output even more in the next iteration. For example, suppose you invest in a stock (input) and it goes up (output); your friend notices this and invests as well (positive feedback); the stock goes out some more; you, your friend, and now his friend invest (more positive feedback) invest, wanting to cash in on the trend, etc. Now everybody notices this stock is increasing and lots of people start buying the stock (lots of positive feedback) and the price skyrockets. Unless there is something to slow this down, it will grow exponentially and that is the effect of positive feedback. Positive feedback works in reverse as well, leading to rapid collapse, the “bursting of the bubble”, in other words. All throughout the 1800s and up until 1929, America experienced this phenomenon, sometimes known as the “boom-bust cycle”, in the financial and real estate market every 5 to 6 years; it experienced again from 2003 to 2009.
The “boom” for the Great Recession of 2008 was from 2003 to 2006 as the “housing bubble” was created. The “bust” was from 2007 to 2009, as the bubble burst and the economy collapsed in upon itself, with the effects of positive feedback taking over in the down direction around Sep 2008, if not sooner. After Lehman Bros announced its bankruptcy, it was like you buying your first share of stock in my positive feedback example, except now you are selling it. People, other institutions, AND the government began to notice and the equivalent of your friends and his friends and their friends selling their stock started taking place on Wall Street until by mid-September you had a Panic going on. This might have been known as the Panic of 2008, except that we had FDIC and there was no run on banks per se by the people, even though many were beginning to fail, but the run of Wall Street firms was just beginning, and job losses were picking up steam as businesses were finally feeling the effects tightening credit (all positive feedback mechanisms leading to the famous “death spiral”).
Amidst all of this you have the 2008 presidential contest going on between Senators Obama and McCain. This was an amazing sight to behold! In the mix you have moderate and liberal Democrats and Republicans, conservative Democrats and Republicans, conservative President Bush, progressive Senator Obama, conservative-to-moderate Senator McCain. At issue was the need to bail out Wall Street, something virtually all economists, conservative and progressive agreed was needed. (If you recall, or refer back to the recession of 1907, this is exactly what J.P. Morgan and the consortium of financiers he put together to mitigate that economic crisis, given governments inability and unwillingness to do so.) But, to accomplish this, first President Bush and then Congress, with a Democratic majority but still with a strong conservative presence, must agree.
· President Bush was conservative to the core and bailing out Wall Street was something government simply did not do! But, as previously mentioned, it was either this or risk the very real probability of a full-blown 1929-style depression. Consequently, Bush favored a bail-out.
· Senator Obama, being a progressive, favored a bail-out to begin with as did moderate and liberal politicians on both sides of aisle.
· Senator McCain proved to be lukewarm for the bail-out but ended up supporting the idea as well.
· It was the conservatives of both parties that made everything problematic
The bail-out took the form of the $700 billion Troubled Asset Relief Program (TARP) where the government would, in essence, protect those companies holding portfolios containing assets which have lost their value from going bankrupt. Conservatives believed these companies should simple take their lumps and let what happens, happen, not believing the doomsday scenarios laid out by economists; they resisted strongly in the legislative and media battle to pass this legislation.
It was an amazing sight watching all of this unfold on TV, the radio, and in the newspaper; the talking heads went crazy with speculation. The battle was intense with President Bush and Senators Obama and McCain seemly joining forces, but trying hard not to appear to, in trying to convince recalcitrant conservatives to support TARP. In the end, I don’t believe it was their arm-twisting, which must have been fierce, but the stock market itself, and maybe behind the scenes business interests, for after the first vote on TARP, Sep 29, 2008, the Act didn’t pass. In response, the stock market nose-dived 778 points, the one-day loss in its history.
That was enough for Congress, the measure passed four days later on Oct 3, but the damage had been done, the market fell another 157 points on news that 157,000 jobs had been lost in September; a drop in the bucket for things to come. As the bad news kept coming in, the market kept falling sharply for a week or so before profit-taking, more interest rate cuts by the Fed, and oil price decreases pushed stock prices back up … for a moment at the end of October
But only for a moment, for more bad job loss numbers and now very poor retail sales turned the market back down sharply again only to level out for the rest of Dec 2008.
So ended the 4th quarter of 2008, which was an extremely dismal quarter whose impact was yet to be determined and wouldn’t be known to President-elect Obama until well after his plans for recovery had been made. While many people on the left-side of the political spectrum already knew this fact, as did many people in main street America, until the beginning of the 4th quarter, conservatives were downplaying an economic downturn which had become a recession almost a year earlier. It wasn’t until November with the first of the great waves of layoffs did reality finally sink in on just how bad things might possibly get, and even then, conservative and liberal economic experts were still underestimating the ultimate outcome while many on the Right kept saying it will never get that bad, just let the economy fail, America has always survived (like in 1929, 1893, 1883, 1874, …)
Several things happened in March 2009.
- By the end of that month American’s had lost approximately 5.6 million jobs from the official beginning of the Great Recession of 2008
- President Obama initiated the American Recovery and Reinvestment Act (ARRA), aka, the Stimulus
o March saw a reversal in job losses
o March saw a reversal in the stock market
o March saw a reversal in first time jobless claims
o March saw a reversal in declining GDP
It is not happenstance that all of those reversals in a collapsing economy occurred in March. It is highly likely they were a result of two things, 1) the real effect of TARP and 2) the psychological impact on the business sector and investing community of ARRA. Those two sectors were begging for government to get its collective act together and with the supermajority the Democrats won in 2008 in Congress and the actions that President Obama took in 2009, gave business the necessary confidence to start investing in America again; for a short while, anyway. By the summer of 2009, the Great Recession of 2009 was officially over.
Having said that, however, there was much left to do and the recovery faltered. It faltered for two reasons, in my estimation. One was the Democrats squandered away the best opportunity they will have until the next great recession or depression by in-fighting and by spending an extraordinarily amount of time in passing Obamacare, rather than passing job creating measures while they had the chance. The other was the fierce media campaign mounted by the conservatives. It started immediately after the stimulus was announced and never stopped.
In fact, it increased over time to an ear-shattering, mind-numbing roar; the Democrats seemed powerless to put up a counter-offensive, they were, in a word, inept. As a result, they, and the country paid dearly for their ineptness in the 2010 mid-term elections when the conservatives swept to power in the House and took effective control of Senate, at least in terms of what could pass the Senate. With that, the conservatives brought government to a standstill for the next two years and left the business community wondering what was going to what was going to happen next.
Senate Minority Leader Mitch McConnell set the stage in December 2010 when he proclaimed that the Republican agenda for the next two years was to make President Obama a one-term president and he, along with House Leader John Boehner were in a position to make a determined effort to do so. The conservatives wasted no time starting their obstructionist activities.
This propaganda campaign was not lost on business, especially after the conservatives launched their offensive against President Obama and the Democrats. Their response was to be expected; business reduced their expectations about how serious government really was regarding taking the necessary actions needed to pull the country out of the sinkhole in which it had fallen. As the squabbling between the Democrats and the conservatives turned into all out war when the conservatives drove the country to the brink of defaulting on its international debt in August 2011, and causing an actual downgrade of the United States’ credit rating in the process of their fight to balance the budget without a tax increase of any kind. It was an unbelievable spectacle, a shameless one, really, quickly followed by another.
As part of the “compromise”, the conservatives never did get anything substantive of what they wanted beyond what the President Obama had already proposed before they upped the ante, was to form a “super- Congressional committee” composed of Senators and Representatives from both Parties sworn to get to a compromise or else have the government face a sequestration unacceptable to both sides --- they failed! That was in November 2011. As of this writing, July 2012, three months before the next election, each side is still in the middle of a huge fight over sequestration, the economy is marginally improving, unemployment is stagnant, although not declining; in other words, business is waiting for America to make a decision.
ANALYSIS AND CONCLUSIONS
HOPEFULLY, I WON'T HAVE TO ADD any more depressions and recessions to this book, and I haven't even included them all! In total, I covered 25 of the worst economic downturns in the 215 years since 1757. Missing are another 19 recessions, to wit: 1812, 1828, 1833, 1845, 1847*, 1853*, 1860, 1865, 1867, 1887, 1890, 1899, 1902*, 1923*, 1926, 1949, 1953, 1990, and 2001. That is one downturn every 4.9 years and one major depression every 8.6 years; America's economy has been anything but stable!!
Most of the recessions I did not cover were generally short and not too severe, except for those labeled with an '*'. In those cases, the loss of business activity were generally the same as those I classified as "major", but their impact was mitigated by their short duration.
A VERY TURBULENT ECONOMIC HISTORYClick thumbnail to view full-size
As you might have noticed in the previous sections, the reasons for recessions and depressions arise out of two fundamentally different set of circumstances; 1) turbulence from external and internal non-financially related events such as wars and 2) internal (and sometimes externally initiated) asset bubbles. The charts are intended to provide you an idea of the relative make-up of each.
- Chart 1 depicts all economic downturns as listed by the National Bureau of Economic Research (NBER). The width of the triangles represent the length of the event and the height, the severity.
- Chart 2 removes all of those whose reasons were external leaving only those caused as a result of the governmental economic monetary and fiscal policies, or lack thereof, that provided the environment in which the economic activity took place. The severity measures are more directly related to those policies while the width measure indicates the amount of governmental involvement in recovery efforts and/or mitigation of the downturn once it began.
These are extremely powerful charts which sum up my hypothesis that there is a striking difference between the Conservative's Classical/Austrian system of economics and the various variants of the Keynesian economics promoted by non-Conservatives. If you focus on Chart 2 and read it from left to right, you should notice a multitude of tall spikes occurring every few years; these represent large recessions or depressions. Then, a little more than halfway across, they almost stop! Just a few small spikes much more widely spaced ... little until you get to the last one; that was the Great Recession of 2008. Compare it to the 1937 recession, the one following the last really major spike; they look the same, don't they.
The economic theory in play prior to the change was Classical economics. Afterwards, it was Keynesian, until 2000. Now, I could present a ton of numbers proving that the two sides are statistically different from each other to a significance level of at 5%, and judging from the obvious disparity, probably to an alpha of 1%. I, however, will not bore with you that since you have eyes like I do.
ADDING POLITICS TO THE EQUATION
I let Chart 3 grow in size to make the details clearer. This is an important chart in that it relates political economic philosophy in play at the time and what was happening in the economy. For most of our history, America has been governed by a moderately Conservative to a very Conservative President and Congress. Because this political spectrum kept getting elected speaks strongly toward the natural inclination of America's electorate. The only times they were booted from power was after a particularly nasty depression.********** After a term or two, Conservatives were put back into power ... until 1933, that is. After that date, because of the Great Depression, America did not revert back to its Conservative roots, but, instead made a fundamental change toward moderation and even Progressivism. The Conservative Austrian school of economic theory was replaced with various forms of the adaptable Keynesian economic theory. This change held until 2001, when the Conservative movement that began in 1981 finally came to fruition with the reinstallation of a largely Austrian economic school again; at least to the extent of the remaining laws still on the books that hadn't been rescinded in the 20 years, would allow. Eight years later America experienced its worst recession since the 1937 recession and the ruling Conservatives were removed and replaced with Progressives who began the job of switching back to a more Keynesian economic school of thought.
AUSTRIAN SCHOOL OF ECONOMIC THEORY
U.S. Representative Ron Paul, a presidential contender in the 2012 Republican Presidential Primary race, is the loudest vocal proponent for returning to the Austrian School; he mentions it in several of his speeches. The remainder of the candidates, while not referring to it so directly, tick off its characteristics when talking about what their economic policies will be. So, what is the Austrian School exactly?
According to Wikipedia The Austrian School of economics is a school of economic thought which advocates methodological individualism and a deductive approach to economics called praxeology; whew! What is "methodological individualism"? Again, turning to Wikipedia, Methodological individualism is the theory that social phenomena can only be accurately explained by showing how they result from the intentionalstates that motivate the individual actors. And, what is "praxeology"? It is"Praxeology is the deductive study of human action based on the action-axiom"; sheesh, another strange phrase, "action-axiom".
With a definition of this final term, we can start walking our way backward to actually understanding the Austrian School of economics that Conservatives love so much. So, here we go: "Action axioms are of the form "IF a condition holds, THEN the following should be done." Decision theory and, hence, decision analysis are based on the maximum expected utility (MEU) action axiom" [Wikipedia]. What these rather imposing string of words are trying to say, is that people base the choices they make on logical, rather than emotional reasons and that their choices are biased toward those things they think will provide the most benefit. To put it more bluntly, people always make cold, calculating choices that benefit them the most.
This idea forms the foundation of the Austrian School, of the economic system Ron Paul and the other Republican presidential hopefuls believe is best for our country. It is the same economic theory followed by American governments for virtually all of the 1800s and the first two decades of the 1900s. What are the ramifications this idea?
The ramifications are that essentially only the actions of the "individual actors" within the economy make a difference on the economy. The theory of supply and demand was developed to explain what takes place in this environment as well as the whole theory of microeconomics.
Those who accept the Austrian School, along with buying into the precepts of that theory, also deny the applicability of other possible influences on the economy, more specifically macro influences, which is the interaction of major economic sectors like output, unemployment, and inflation. In other words, microeconomics is all you need to predict economic behavior and balancing the forces that are at work at that level is all that is needed to make the economy function properly. Macroeconomists disagree, of course.
KEYNESIAN ECONOMIC THEORY
Complementing microeconomics is macroeconomic. It should be patently obvious from Charts 1, 2, or 3, that the period prior to 1940 was very unstable. John Maynard Keynes and several others searched for reasons for this seeming inability of the prevailing economic theory to account for obvious discrepancies, such as goods being left unsold while workers are left unemployed or what lead to such a long, frequent stream of sometimes violent boom-bust cycles. As a consequence of his research, in 1937, Keynes published General Theory of Employment, Interest and Money.It was a seminal work that changed history.
What Keynes brought to the table was the idea that not only did individual decisions play a role in determining the activity within the economy, but so did unemployment, inflation, and interest rates and how they interacted with one another. Conservatives reject this latter idea, which is the basis of macroeconomics. One reason they reject it is because an outgrowth of Keynesian economics is that it requires the government to intervene in the economy by modifying fiscal and monetary policies in order to keep unemployment, inflation, and interest rates in balance. Keynes maintains these factors, and the relationship between them, have a significant impact on supply and demand, in addition to individual decisions.
As I said, prior to 1940, and Keynesian economics, the country went through over 100 years of major boom-bust cycles with the economy spiraling out of control roughly once every 5 years. After 1940, the economy settled down significantly and continued without a major downturn until 2008, 8 years after Conservatives re-instated their version of economics. That, in and of itself, should be a clear indictment of the Austrian School and a confirmation of Keynesian economics.
Both systems clearly work when the economy is stable, supply and demand follow the dictates of individual decisions. Even small perturbations end up correcting themselves with price variations, i.e. 1) demand goes up, 2) supply goes up, but lags, 3) price goes up, 4) demand peaks once price gets too high, 5) supply continues up, 6) price goes up to cover increasing inventories, 7) demand goes down, 8) supply goes down, but leading, 9) price goes down and so on until equilibrium is found. There is no pressure on employment, inflation or interest rates in this scenario.
However, consider the case of an overheated economy, such as what happened in 1825, 1837, 1857, 1873, 1893, 1929, and 2008. I found that overheating results from almost the sequence of events and in the same financial environment in each case, including the Great Recession of 2008.
1) First, there is some economic event that is spurring the economy, in the 1800s that was often the expansion of the railroad.
2) Second, there was investment of some sort in real estate.
3) Third, the investment led to speculation
4) Speculation could flourish because banks were unregulated and credit flowed freely at extremely low interest rates with little or no collateral or showing ability to repay.
5) In the case of the the recessions/depressions in the 1800s, there was no Federal Reserve to control the money supply and the States, and therefore the state banks, were more or less free to do what they please. The result was a huge increase in money supply.
6) Fourth, the speculation drove prices beyond the value of the commodities being bought and sold, therefore driving up inflation.
7) Fifth, this series of events spiraled up, out of control until it was unsustainable when it finally crashed.
8) Sixth, loans were called, people and businesses couldn't pay and went bankrupt; this in turned forced banks to fail.
9) Seventh, people are fired in masses, unemployment skyrockets; and the death spiral continues on down.
Keynes theory says that in this situation, the Austrian School's theory fails, because individual decisions led to the overheated economy; they fed it and there was no counterweight to offset the effect. The more people speculated, the higher inflation and the money supply rose; there was nothing to stop it ... except its own weight. When the crash inevitably comes, it is like a large boulder rolling downhill, it keeps gaining momentum and speed; no amount of individual decisions are going to stop the bolder until it reaches the valley floor.
Kaynes also says that none of this needed to happen, or at least as bad as it did. By using fiscal and monetary tools, money supply, inflation, and the rate of growth can be somewhat controlled mitigating the overheating pressures of speculation. Likewise, when the economy contracts, those same tools can be used to stimulate the economy, thereby mitigating the effects of the downturn. Looking at the before and after views of the American economy seems to substantiate Keynes' theory.
Why has the Conservative's Austrian School of economics failed so badly in crisis situations?
It has been my long standing observation as a professional cost analyst that "one-size fits all" models rarely, if ever, work in all circumstances and at its core, the Conservative's model is "one-size fits all". To understand this, you need to go back and relook at what the basic foundational theory is behind the Austrian School - it "advocates methodological individualism and a deductive approach to economics."
To work, it requires that most individuals make rational decisions that maximize their personal needs or wants based on an analytical thought process, rather than an emotional one. That is it; sounds like we are all Mr. Spock of Star Trek fame, doesn't it. With this one fundamental notion, the whole theory and practice of microeconomics was built; which is all one needs, according to the Austrian School's way of thinking. What is more, it works! ... so long as the economy stays within normal bounds.
The reason this theory fails in abnormal times is because humans are not like Mr. Spock, we, as a group, don't always think rationally in large numbers at all times, and because we don't, the theory ultimately fails. The greed and "follow-the-herd" mentality individuals assume, en mass, in great times, overcomes the normal control mechanisms that is part of the Austrian School's theory and we end up with overheated economies and the "bubbles" we are all so familiar with now. Having one major financially-based recession or depression every 5 years, on average, attests loudly to this fact.
The by-products, as we have seen from the above series of vignettes, of an overheated economy generaly are 1) inflation, 2) a large increase in money supply, 3) easy credit resulting in very large debt with little collateral, and 4) often an inability to repay the loan at the time of the making. You see most, if not all of these traits in every single downturn that measures 4 or more in Chart 3. Please note, the only item from this list not experienced in the Great Recession of 2008 was inflation.
Even before Keynesian economics, it was understood that a way of affecting the money supply and the need for a "lender of last resort" was required; both ideas encompassed in Keynesian economics. In fact, because America was tied to the gold standard, its effect on money supply amplified any overheating and deepened the predictable downward spirals. To act as a counterweight, a Federal Reserve was chartered for the third time in 1913 and given the authority, over time, to combat each of the maladies listed above; in 1929 and 2002-2007, the Fed as basically asleep at the switch, mainly because believers in the Austrian School were manning the switch.
In 1929, the Fed either did nothing to dampen the Roaring 20's and let that period be known as the Blazing 20s, or something, and when the crash occurred, if effected policies that made it worse. In 2002 - 2007, the Fed forgot the lessons of history and refused to use its regulatory powers to reign in the shadow and regular banking systems, including the Government Supported Enterprises, and prevent the kind of credit lending practices that led to the housing bubble and its bursting. In both cases, the Fed had the power to, if not prevent a downturn, to certainly mitigate the terrible personal tragedies resulting from "big" economic collapses.
After Keynesian economics, the Federal Reserve, and the federal government, had a formal theoritical framework to help guide their decision making. And it paid off! From 1940 to 2008, there were no major economic, or any other kind, based recessions and for those that did occur, it was, on average, once every 9 or 10 years, half the rate of the Austrian School. It was only when Keynes was abandoned and the country moved more toward an Austrian system did we have our first major recession in 61 years!
I think the phrase, "the proof is in the pudding" is applicable here. I hope I have made a clear and convincing case that 1) there are substantial differences between how Conservatives believe the economy should be run and how non-Conservatives do, 2) the Conservative economic system is inherently unstable because it only considers one part of the economic equation, microeconomic, and 3) the non-Conservative system is much, much more stable because it takes into account other variables that are included in macroeconomics. Further, I pray you received some sort of understanding of the horrible personal price citizens pay when the wrong system is chosen to be implemented.
I thank you for making your way through this long, and potentially boring saga of American economic woes and hope it has been worth your trouble.
WHAT DO YOU THINK NOW?
Which economic philosophy do you believe is mostly responsible for America's Economic Based Recessions and Depressions
I HAVE TURNED THIS HUB INTO A BOOK and it is currently has been editing by the publisher, who has sent it back to me to fix ... big mistake, that was a year ago now (it is Jan 2014); read my hubs on Meyers-Briggs and you will see why. The book will include additional content such as a Political Landscape prologes to each Panic, Depression, or Recession. It will also have a Demographic summary at the end of each downturn. I understand I can't promote this work on my hubs but you will see it here in the Amazon ads.
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