How Did America Recover from the Great Recession?
Part III: Yes, Now is the Perfect Time to Talk Economic Recovery in America
Note: This post is one part of my series, Yes, Now is the Perfect Time to Talk Economic Recovery in America, which provides an in-depth look at the current economic crisis and how the United States will climb out of it. Click the link or scroll to the bottom to check out the other posts in the series.
The Great Recession, which began in December 2007 and ended in June 2009, was one of the most devastating economic collapses in American history. At its peak, the national unemployment rate hit 10% and long-term unemployment more than quadrupled in a two-year span. It would take about a decade for employment to reach its pre-recession level.
The Great Recession did not happen in a vacuum. According to Ben Bernanke, who was the Chair of the Federal Reserve during the crisis, there were early indicators of a housing bubble. It was vastly underestimated by Wall Street and Washington.
Once it failed, the housing market sparked a chain reaction which plunged the greater economy. The mortgage market and housing prices declined, a massive panic ensued and stressed American financial institutions in a previously unfathomable way.
Quickly, it became clear that many of these financial institutions were not as liquid as they appeared. Instead, they were propped up by a system of extremely risky investments and credit practices.
The Great Recession experienced a digital run on cash.
Instead of physically pulling money out of local banks, Americans sold investments and defaulted on loans. Banks then dumped credit and stopped making new loans. Almost overnight, large commercial banks, investment banks, and entire industries were in a death spiral. As Lehman Brothers went bankrupt and with other financial institutions on the brink, America held its breath.
The economy tanked. The federal response primarily focused on stabilizing these financial institutions and protecting the broader economy. The Federal Reserve, in conjunction with the Bush and Obama Administrations, determined it was critical to keep these businesses capitalized and Americans spending. The response wasn’t perfect, and the shockwaves would reverberate for quite some time. In the end however, the economy held and averted an even worse scenario.
Monetary Policy Response
To combat the crisis, the Federal Reserve utilized new tools. Bernanke, whose research background was in financial crises, had previously argued that the Federal Reserve could combat an economic calamity with a measure it had never taken before: drop the federal funds rate to the “zero bound” and communicate expectations for its gradual increase. With the Great Recession, he put his thesis into practice.
The Federal Reserve lowered short-term interest rates from 5.25% to 0%. This was a mechanism to eliminate any additional costs for banks to lend to one another. Normally, banks need to pay one another interest so that their reserves never dip below a mandated threshold. By effectively waiving this requirement, the Federal Reserve created optimal conditions for lending and borrowing. Money would now freely circulate and discourage the instinctual reaction to save during a recession.
Swimming in uncharted waters, the Federal Reserve avoided dipping below the zero bound. Even as conditions looked bleak, he discouraged setting a negative interest rate. The Japanese central bank had tested this approach in the late 1990s, but it caused massive currency devaluation.
Instead, the Federal Reserve held firm with zero bound interest rates and consistently messaged that rates would not move “for some time”.
Interest rates were merely one component of the recovery. The Federal Reserve would also need to work in cooperation with Congress, the President, and the Treasury to perform quantitative easing. In short, the government needed to directly inject money into the economy.
Fiscal Policy Response
The Federal government, led by the Treasury Department, took drastic measures. After an excruciating month of negotiations on Capitol Hill, the Emergency Economic Stabilization Act (EESA) was passed in early October 2008. It was chiefly passed by the Bush Administration and functionally executed by both the Bush and Obama Administrations. Most notably, this law contained the Troubled Asset Relief Program (TARP) which is colloquially dubbed the “Bank Bailout”.
In total, TARP was a $475 billion government bailout which would fund five industries: automotive, banking, credit, housing, and insurance. Collectively, the federal government would spend $643 billion on this rescue package.
In his bestseller on the 2008 financial crisis, Too Big to Fail, Andrew Ross Sorkin described a dramatic scene right after TARP was signed into law. Convened by Treasury Secretary Hank Paulson, the CEOs of the “Big 9” Wall Street banks were summoned to Washington and presented an ultimatum:
“The Treasury will purchase up to $250 billion of preferred stock of banks and thrifts prior to year end, the system needs more money, and all of you will be better off if there’s more capital in the system. That’s why we’re planning to announce that all nine of you will participate in the program…but let me be clear: If you don’t take it and you aren’t able to raise the capital that they say you need in the market, then I’m going to give you a second helping and you’re not going to like the terms on that. This is the right thing to do for the country.”
In essence, Paulson used TARP funding to buy a large stake in each firm. The banks were now “nationalized” because their leading shareholder was the United States Treasury. If the banks didn’t accept this offer, Paulson’s veiled threat was to essentially take complete ownership.
All nine banks obliged: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, State Street, and Wells Fargo.
Similar offers were made and accepted by General Motors (GM), Chrysler, the American International Group (AIG), and more local and subsidiary banks.
In the end, the American taxpayer didn’t lose money because the “Bank Bailout” was effectively a multi-industry loan. According to ProPublica, which is an independent nonprofit news agency, TARP has churned a $110 billion profit in terms of net outflows and inflows.
As structured, the Treasury was able to make a profit because it bought stock in many of these firms which would then pay out a dividend — basically an interest payment.
Over time, the percent of the dividend owed by these firms to the Treasury would sizably increase. For this reason, the companies had an incentive to buy this stock back from the Treasury because the price would be less than the dividend. The United States government could then sell the stock back to the company or auction it off and amass a significant profit.
It’s important to note that this only encapsulates the bailout’s nominal value. If the Treasury did not step in and instead let even some of these firms fail, the total job loss would have been enormous. The automotive industry alone accounted for over a million jobs and the “cost of doing nothing” would have been staggeringly higher.
Criticisms of the Recovery
To many, the Great Recession recovery fell short because it didn’t do enough for individual homeowners impacted by the mortgage crisis. At the same time, it picked sides and saved the Big Banks but not the “little guy”.
This frustration can be traced to a few particular events.
In terms of the housing crisis, the federal government created the Home Affordable Modification Program (HAMP) and Home Affordable Refinance Program (HARP). These programs, HAMP and HARP, were designed to guarantee mortgage loans by the federal government. They would prevent foreclosures and stabilize homeowners teetering on default.
Unfortunately, these programs turned out to be widely ineffective. The banks still had the right to provide loans to lower income individuals and many simply refused — even though the mortgage payments were fully-guaranteed by the federal government. The banks still viewed HAMP and HARP as risky and confusing. Therefore, these programs only aided a fraction of the people in need.
In terms of the broader economy, the American Recovery and Reinvestment Act of 2009 was the main form of stimulus spending injected into the country. Signed into law by President Obama, the stimulus was a series of tax cuts, direct payments, spending incentives, and federal government investments. While it did create growth, the pace to the recovery was anemic. It would take the better part of a decade for the economy and consumer confidence to revitalize.
Lastly, many felt Wall Street did not face justice. From a legislative perspective, The Dodd-Frank Wall Street Reform and Consumer Protection Act implemented more oversight and protection measures. It created important agencies like the Consumer Financial Protection Bureau.
Some felt that these reforms were too little too late. The government pursued a forward-looking approach and chose not to enforce accountability. It looked the other way on moral hazard where banks took extreme risks without fear of a penalty. In the end, the Department of Justice only convicted a single banker from the whole crisis.
Conversely, financial institutions and another large segment of the public, felt that some of these reforms were overly reactionary. With a plethora of new restrictions, business was stunted and therefore perpetuated a slow growth atmosphere. Financial institutions didn’t like it for business purposes and many consumers felt like they were being punished for no fault of their own.
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