Recession: causes, impacts, and economic recovery

¶ … credit crisis and recession of 2008-2009: Overview and lessons (not) learned

The official, accepted definition of an economic recession is "two successive quarters of negative growth" (Sparrow 2009). However, far from received wisdom from 'on high,' this commonly-cited definition was actually created during the Johnson White House to allow Johnson, "to claim that the economy was in good shape" and was "entirely spin, according to Peter Jay, who was in the room at the time when the definition was created on the back of an envelope" (Sparrow 2009). A more serious, reliable indication of the economic downturn of 2007-2009 may have been afforded the National Activity Index of the Federal Reserve Bank of Chicago "which in the past has nearly always signaled the beginning of a recession when it fell to a certain level, shown as negative 0.7 in the accompanying chart. It hit that level last December of 2007" (Norris, "More evidence," 2008). Consumer spending, confidence, employment, and inventory stockpiles are some of the indicators evaluated by the index. However, for many historians, the failure of Lehman Brothers is likely to be cited as the epoch-defining event that symbolized the credit crisis and recession of 2007-2009.

Although it remains uncertain as to how the current historical situation will be viewed by economists in retrospect, critics have placed at least part of the blame on diffuse and weak oversight of government agencies, who were tacitly or explicitly encouraged to look the other way as banks across the nation engaged in fiscally irresponsible lending practices to consumers who could ill-afford mortgages on over-priced homes. This "business-friendly approach to regulation, allowed banks, insurers, and Wall Street firms to engage in reckless mortgage lending and trading - ultimately requiring a taxpayer-financed bailout of $700 billion to prevent the U.S. economy from sliding into a depression" (Wirzbicki 2009).

Even economists have been accused of sleeping 'on the job.' Although the recession has been dated as beginning 2007, it was not until September of 2008 that many economists admitted that the economy was contracting. "A major reason for that delayed acceptance of the downturn was that the government initially reported the economy grew at an annual rate of more than 3% in the second quarter" of 2009 (Norris, "More evidence," 2008). Also, there is often a tacit reluctance on the part of economists to admit the existence of a recession, for fear of creating consumer panic. According to a The New York Times special feature on the credit crisis, the roots of the recession stretch back to the efforts of the Federal Reserve to bolster the economy with historically low interest rates at the beginning of the decade. "Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up," creating a bubble ("Credit Crisis," The New York Times, 2009).

Homeowners refinanced their mortgages, and people, who had never owned homes before, who often with little understanding of different types of mortgages, began to seek out homes to take advantage of 'teaser' interest rates. Interest in investment properties also increased. As rates of leverage skyrocketed, so did default and delinquency rates. In 2006, despite increased delinquency rates, "the pace of lending did not slow. Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks -- or so they thought" ("Credit Crisis," The New York Times, 2009). "The first shoe to drop was the collapse in June 2007 of two hedge funds owned by Bear Stearns that had invested heavily in the subprime market" ("Credit Crisis," The New York Times, 2009). The federal government was also forced to take over two of the major home loan companies, Freddie Mac and Fannie Mae, and to bail out the insurance group AIG, which had insured many of the subprime loans.

The panic that ensued upon the news of the likely failure of Lehman Brothers, the boutique Wall Street investment firm, proved to be far more seismic in nature. As early as the summer of 2007 questions began to be raised about the value of its and other firms heavily invested in subprime mortgages, and "the overnight lenders began getting increasingly nervous. Eventually, they decided the risks of lending to these firms far outweighed the rewards, and they pulled the plug. The firms then simply ran out of cash, as everyone lost confidence in them at once and wanted their money back at the same time" (Cohan 2009, p.1). Of course, it could be argued that Wall Street is always motivated by the profit-making impulse -- that is the essence of capitalism -- but in this case, the thirst for profits outweighed any prudence or sensible capacity for assessing risk. Even Alan Greenspan, free enterprise guru and former Federal Reserve Bank chairmen, admitted that he had over-estimated the capacity of the market to correct itself and under-estimated the limits of human greed and hubris in the banking industry.

Soon, Lehman's collapse and the federal government's surprise failure to 'bail out' Lehman after throwing a lifeline to AIG and Bear Stearns "coincided with and contributed to a classic panic, breeding such distrust among banks that they were reluctant to lend even to each other. In the weeks that followed, the Fed and Treasury leapt to keep insurance titan American International Group Inc. from following Lehman into bankruptcy proceedings" (Wessell 2009). Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke were forced to ask for $700 billion from the Congress. While they initially said the intention of the money was to buy bad assets, they eventually opted to inject the cash directly into bank's coffers. The U.S. government then guaranteed all of newly issued debt of all of the troubled banks: "to shield money-market mutual funds from what resembled a 19th-century bank run, and the Fed bypassed banks and markets by giving loans to credit-starved industrial companies…Money-market funds had become a parallel banking system, taking household savings and lending to corporate borrowers -- but without any of the shock absorbers that conventional banks had" possessed (Wessell 2009). By insuring such funds, and pumping cash into the system, according to Bernanke, the Fed's efforts "succeeded in achieving the vital, but narrow, objective of preventing a catastrophic systemic meltdown" (Wessell 2009).

Today, most analysts believe this was the right move. But, as the crisis was in its nascent stages the government initially believed the softening of the market to solely be a case of illiquidity "a temporary inability to raise cash -- rather than insolvency -- the issue when a financial institution is broke. The assumption was that the banks really would be fine when worries went away, and they had to be helped over that temporary hump. The Federal Reserve expanded both the amount it was willing to lend and the collateral it would take to back up loans" (Norris, "Plan B," 2008). Yet the root of the crisis was one of solvency, not merely liquidity -- there was a widespread mistrust of the banking industry, even between member banks. Lowering the interest rate to zero did little to encourage lending, much to the initial surprise of the Fed -- distrust was simply too great, of both consumers and member banks.

Many expressed outrage that the major credit rating agencies had done little to flag the Wall Street behemoth's risky practices. Yet the Securities and Exchange Commission has been "historically been slow to act in regulating the nation's credit rating agencies" of both consumers and banks (Sanati 2009). Outrage also continues to simmer, as Wall Street stocks have rebounded, thanks to the government's lifeline yet job growth been slow. While the rate of jobs 'shedded' by the economy is in decline, for individuals out of work, the picture is still dismal. "There are about 6.3 unemployed workers competing, on average, for each job opening, a Labor Department report shows. That's the most since the department began tracking job openings nine years ago, and up from only 1.7 workers when the recession began in December 2007" ( Rugaber 2009). Thus, today, a worker is less likely to lose his or her job than in 2007 or 2008, but for individuals out of work, it is just as hard to find new employment.

According to Larry Summers, speaking on behalf of the Obama Administration: "The good news is that this deep and long recession appears to be over, and with improving credit markets, the U.S. economy can return to solid growth next year without worry about inflation" (Pulizzi 2009). More than 80% of the 44 forecasters surveyed by the National Association of Business Economics (NABE) "believe the economic recovery has begun, but they anticipate modest growth -- a 2.9% pace in the second half of 2009 and a 3% rate next year. They predict the Federal Reserve won't begin raising interest from the current zero-0.25% range until late next spring and won't lift its key short-term interest rate above 1% before 2011" (Pulizzi 2009).

But amid the celebration, crucial opportunities have been lost: In September 2009, the "inspector general for the Troubled Asset Relief Program, a k a, the bank bailout fund, released his report on the 2008 rescue of the American International Group, the insurer. The gist of the report is that government officials made no serious attempt to extract concessions from bankers, even though these bankers received huge benefits from the rescue. And more than money was lost. By making what was in effect a multibillion-dollar gift to Wall Street, policy makers undermined their own credibility -- and put the broader economy at risk" (Krugman 2009). Many banks have given back their TARP funds, in exchange for the ability to once again engage in risky activities, to pay traders the bonuses they desire, and to pay executives what seems to be overinflated compensation. In June ten of the largest recipients of aid, including J.P. Morgan Chase, Goldman Sachs and American Express "paid back a total of $68 billion, a move that allowed them to stand without taxpayer dollars and operate without increased government scrutiny" ("Credit Crisis," The New York Times, 2009).