Steven Horwitz
Charles A. Dana Professor of Economics
Department of Economics
St. Lawrence University
Canton NY 13617
sghorwitz@stlawu.edu
(315) 229 5731
March 2009
Version 1.0
Prepared for “Symposium on the Economy in Crisis: Causes and Cures” at the Jean Beer Blumenfeld Center for Ethics at Georgia State University, Atlanta, GA, March 18, 2009
Introduction
Good afternoon, and thanks for inviting me. As I have joked with numerous friends over the last few months, this crisis has done wonders for the demand for economists, myself included!
In my short time today, I hope to accomplish two tasks. First, I will offer a narrative about how we got into this mess and how our response to it has, largely, made matters worse. As a side note, I still think we need a name for “this mess.” I am consciously refusing to use the word “crisis,” as politicians of all stripes have made it clear that they will use the language of crisis to augment their power regardless of whether the supposed crisis is real and whether the acquired powers are effective solutions. My own preferred name is the “Great Recession,” (not mine originally), because of the ways in which this mess and our reaction to it do indeed parallel that of the early 1930s. Which brings me to my second goal today: arguing that the roots of the “Great Recession” can be found in the Great Depression. By “roots,” I mean both several institutional changes that took place in the 1930s which had the unintended consequence of causing the current recession and changes in ideology and perceptions about economic policy that came with the Great Depression, which have informed much of the policy response since last fall, and only worsened matters in the process. My argument is that our misunderstanding of the Great Depression led to both institutional and ideological changes that were mistakes, and the Great Recession is, to use a phrase much invoked in a “crisis” from not so long ago, those chickens coming home to roost.
How we got here
Before talking about how we did get here, let me say a quick word about what didn’t cause this mess. Those who wish to blame greed for the crisis need to explain how and why it is that greed seems to causes crises only at specific times, despite the fact that it is omnipresent as a feature of human nature and market economies. As the economist Larry White has noted, if we saw a bunch of planes crash all on the same day, we wouldn’t blame gravity. It’s always there. Something else must be at work. I would argue that the key is the set of institutions through which greed or self-interest is channeled. That is, good institutions can cause self-interest to generate desirable unintended consequences, and bad ones can cause undesirable ones. So perhaps we should be looking at institutions and policy.
Those who wish to blame deregulation or the supposed “laissez-faire” philosophy of the Bush Administration are going to have to identify the deregulation in question, which will be a challenge given that the last deregulatory legislation in the financial industry was in 1999 under Clinton. These folks will also have to explain how the enormous growth in the Federal Register and domestic spending over Bush’s two terms reconciles with his supposed belief in laissez-faire. Answer: it doesn’t.
The two key causes of this crisis are expansionary monetary policy on the part of the Fed and a series of regulatory and institutional interventions that channeled that excess credit into the housing market, creating a bubble that eventually had to burst. In other words, the boom (and the inevitable bust) are the product of misguided government policy, not unbridled capitalism.
The Fed drove up the money supply and drove down interest rates very consistently since 9/11. When central banks do so, they make long-term investments relatively cheaper than short-term ones, thus the excess funds flow toward such goods. Historically, these were producer goods in capital industries, but in this particular case, a set of other government interventions and policies pushed those funds toward housing.
A state-sponsored push for more affordable housing has been a staple of several prior administrations. Fannie Mae and Freddie Mac are key players here. Although they did not orginate the questionable mortgages, they did develop a number of the low down-payment instruments that came into vogue during the boom. More important, they were primarily responsible for the secondary mortgage market as they promoted the mortgage-backed securities that became the investment vehicle du jour during the boom. Both Fannie and Freddie are, we must remember, not “free-market” firms. They are “government-sponsored entities,” at one time nominally privately owned, but granted a number of government privileges, in addition to carrying an implicit promise of government support should they ever get into trouble. With such a promise in place, the market for mortgage-backed securities was able to tolerate a level of risk that truly free markets would not. As we now know, that turned out to be a big problem.
Other regulatory elements played into this story. Fannie and Freddie were under significant political pressure to keep housing increasingly affordable (while at the same time promoting instruments that depending on the constantly rising price of housing) and extending opportunities to historically “under-served” minority groups. Many of the new no/low down-payment mortgages (especially those associated with Countrywide) were designed as reponses to this pressure. Throw in the marginal effects of the Community Investment Act and zoning laws that crowded residential development into less and less space in many large cities, not to mention the bully pulpit arguing for more affordable housing of at least the last two presidents, and you have the ingredients of a credit-fueled and regulatory-directed housing boom and bust. And all of this was happening with the enthusiastic support of much of the private sector, who benefitted from the wealth generated by the government-induced boom.
How We Have Responded
The response by both the Bush and Obama Administrations over the last six months or so has been a series of government programs, few of which seem to have been very helpful. Let me start this discussion with a challenge laid down by economist Bryan Caplan: “Suppose for the last six months both administrations had responded to the crisis by adopting a strong laissez-faire position. On 9/3/08, the Dow stood at 11,533. Monday it was around 7300. Unemployment has gone up by 2 percentage points. Does anyone think that laissez-faire as a policy would not have been absolutely savaged by the media and others given the economy’s performance since then? If not, then why haven’t we rejected the activism as vigorously, given that performance?”
As the scale of the bust became clear, in particular the dangers to several large investment banks, the reaction from Washington was to declare a crisis of epic proportions and to develop a plan to bail out various investment firms and banks. It’s not at all clear whether the bailouts were needed nor whether they have been effective. The crisis, we were told, was that credit markets had frozen. However, later research by several different sources indicate that while the major investment houses and other Wall Street firms were having some trouble borrowing, consumer credit and more traditional forms of producer credit were flowing just fine. Bush and Paulson looked around at the firms they knew and saw them in trouble and decided that their situation was a proxy for all credit markets. One need not assume some sort of intentional conspiracy here, but rather just a sort of “I see what I see” effect that also happened to help a number of Paulson’s friends.
As we’ve also seen, the original TARP plan has not done much good, especially as it has evolved every couple of months as the various players try to figure out exactly what they thought they were trying to do. All of this ignores the question of whether it is government’s responsibility to maintain the value of private investors’ assets, including homes, and whether doing so is even a good idea. The tension between trying to prevent housing prices from falling and the complaints that housing prices have been too high for too long is an interesting one. The bottom line is that prices of inflated assets need to fall and much of the policy response has been to prevent precisely the needed corrections from taking place.
The stimulus legislation was premised on the belief that government spending would bolster the demand for labor through public works jobs, reducing unemployment and possibly increasing wages. More generally, it was believed that only government could step in and “make up for” the declines in private expenditures argued to be resulting from the credit crisis and more general recession. Economists differ on how effective such plans are, or can be. The Japanese experience of the 1990s suggests they don’t do much, as they tried six different stimulus packages, spending hundreds of trillions of Yen in the process, and the Japanese economy stayed in the doldrums for the decade. The question of how government spending can add to growth when government can only get resources through a reduction of private spending remains unanswered. The $1 that government spends would have been used by the private sector in some fashion, not to mention the more “microeconomic” question of whether private or public expenditures will be more efficient and growth-enhancing.
Too much of the discussion about the stimulus and recovery has been focused on the “macroeconomics” of GDP and overall rates of unemployment, and not nearly enough on the required microeconomic adjustments that are necessary. Part of the curative process of the recession is not just an overall retrenchment from inflation, but a sectoral reallocation of resources away from the artificially large longer-term asset sectors toward where real consumer demands lie. Unfortunately, no one person or group knows what those are, which is why we need to rely on the competitive discovery process of the market to figure it out, rather than government allocators who both lack the necessary knowledge and have, as we’ve seen, every reason to use such resources to serve their political self-interest.
The Obama Administration’s 2009 budget is also connected to the current mess. According to the president, the reason we got into this mess is that we apparently spent too much on housing, the financial sector, and debt in general and not enough on the core issues of the environment, health care, and education. For the life of me, I cannot see how such a theory can explain anything of what’s happened the last six months, but it does serve to create a rationale for a budget that contains a whole bunch of new initiatives that don’t obviously seem to be related to the Great Recession. At a time when the US government has taken on a whole bunch of new debt with the bailouts and the stimulus, one would think that the next year’s budget should show more restraint and focus on issues central to economic recovery. As many commentators have noted, it’s hard to both argue that too much debt got us into this mess and that more will get us out.
Instead, as several members of the administration have said quite explicitly, they see this crisis as an “opportunity” to promote a variety of long-standing economic reforms. Again, at a time when the federal government is already deeply in debt, planning to spend hundreds of billions on new initiatives having nothing to do with recovery seems a bit strange. It’s especially ironic in light of the accusations make by the likes of Naomi Klein that it was the Bush Administration and conservatives in general who manufactured or jumped on crises as a way to push through their long-standing free market policies. Even the most cursory study of American history would show that crises grow the state and destroy the market, and now we have the explicit evidence in front of us from Rahm Emmanuel and Hilary Clinton. In any case, whatever the merits of this spending on its own, none of it will do anything to promote recovery.
The Causes of the Great Recession as Institutional Residues
In arguing that the current mess is to a significant degree a product of the institutional and ideological changes brought on by the Great Depression, I will focus first on the former and point to three different institutional/regulatory changes that emerged during the New Deal that are relevant for our current experience.
The most important of these is the set of powers granted to the Fed to conduct centralized open market operations by the Banking Act of 1935. The main tool the Fed historically had for adjusting the money supply was lending reserves to banks via the “discount window.” Sometimes a few of the individual reserve banks would buy and sell government securities as a way to tinker with the money supply, but this was never a formal power, nor was it a power granted to the System as a whole. After the great contraction of 1930-33, where the Fed did not aggressively respond to a collapsing supply of money, Congress centralized more of the Fed’s powers in the Reserve Board in Washington and gave them the power to buy and sell government securities in order to adjust the money supply and interest rates. It is this power that the Fed uses today. It is also the power it had to create the credit expansion of the post-9/11 period that caused the boom that has ended in the current bust. Those powers that have come back to haunt us were an institutional response to the Great Depression.
The same can be said of another major player in the current debacle: Fannie Mae was chartered in 1938, in the heat of the Great Depression and New Deal. Much like today, one of the effects of the Great Depression was a significant rise in foreclosures and a large number of families who were unable to own a home any longer. Fannie Mae, along with other smaller programs, were created in part to address the that problem and help struggling families get homes again. It was the first time in American history that there was a serious attempt to use systematic policy to artificially support the housing market (other than some of the emergency relief under Hoover and FDR). Fannie was central to the current mess, which is to that extent an unintended consequence of the Great Depression’s institutional legacy.
A third example is the role played by the Securities and Exchange Commission. The SEC was created in 1933 and 34 in a pair of laws that emerged out of concerns that the stock market crash and Great Depression were caused by a lack of regulatory oversight in the stock market. The SEC has a small role in the current crisis through the various bond rating agencies. For many years, there were a large number of these agencies who provided information to investors about the quality of various bonds and other investments. In the late 1960s, after some investment scandals, the SEC created a cartel by authorizing only a limited number of these agencies to be officially-designated raters. With that government-created cartel in place, the agencies slowly shifted from serving investors to serving the issuers of bonds. Many purveyors of mortgage-backed securities ended up “ratings shopping” to find a rater who would give their securities the highest rating. It’s worth asking what might have happened had there been real competition, rather than the cartel, in place. In any case, this too is an unintended consequence of the Great Depression.
The Policy Reaction as an Ideological Residue of the Great Depression
As my discussion this far has suggested, many of the responses of the last few months are also “residues” of the Great Depression. Many of the same errors of interpretation of both the causes of the recession and the appropriate cures that were prevalent in the 1930s are back today in one form or another. Let me briefly discuss a few.
The public conversation about the recession has been reflective of the earlier, and mistaken, interpretations of the Great Depression. As I noted at the outset, the attempts to blame things on “laissez-faire” and “greed” were also common in the 1930s. The response to the “greed” argument was the same then as today, as was the response to the “laissez-faire” argument. In fact, the 1920s were hardly a time of laissez-faire, particularly in the crucially important financial sector. Not only did we have the Fed, hardly an example of laissez-faire, but we had a whole stack of regulations on banks that made them less diversified and stable than they could have been, which was a major contributor to the banking failures and monetary collapse. The comparison to Canada is interesting, where it lacked a number of those same limits on banks and saw only one bank failure in the 20s and none after 1929.
This raises another parallel: the near-absence of discussion of the role of the Fed. In all of the mainstream analyses of the current recession, especially the dialogue in Washington, precious little is being said about the role of the Fed in stoking the boom that led to the current bust. Professional economists, of course, are talking about the Fed, but nowhere in the political discussions of how to prevent a repeat or what to do now is there any real discussion of the problems the Fed might have caused and how to reform monetary institutions in a way that ensures it won’t happen again. Interestingly, this parallels many popular discussions of the Great Depression, in which blame is laid everywhere but on the Fed. Even the Banking Act of 1935 came about not because people thought the Fed was responsible for making matters so bad, but because it claimed that it didn’t have the powers it needed to fight the collapsing economy after the stock market crash. Economists today argue that the Fed had the required powers in 1930, but it just failed to use them, thus it is fair to blame it. Even Ben Bernanke in a 2002 speech honoring Milton Friedman admitted as much as he apologized to Friedman for the Fed’s mistakes, saying “you were right, we messed up.”
Few discussions outside economics today ask serious questions about the role of the Fed and monetary policy, preferring more simplistic attempts to blame greed, laissez-faire, deregulation, or specific individuals or companies. No serious understanding of the current recession can afford to ignore the role of the Fed and we should be trying to save ourselves the mistakes made for decades after the Great Depression because we ignored the role played by the Fed in that disaster.
Finally, the parallels between Obama’s new budget and the first 100 days of FDR’s administration are worth noting. In both cases, the agenda was clearly one of reform rather than recovery. Whatever the merits of Obama’s empahsis on health care, the environment, and education, those aren’t about recovery. They are long-standing policy preferences of his party which he has attempted to spin as related to solving the long-term problems that supposedly caused the recession. And FDR’s first 100 days included things like the National Industrial Recovery Act and the Agriculural Adjustment Act, of which exactly the same could be said. These were long-standing reforms of capitalism that people like Raymond Moley and Rex Tugwell and others wanted to enact. The depression and FDR’s decisive win provided them the opportunity to do so, even as there was no accepted economic theory that saw those dramatic makeovers of industry and agriculture as ways out of the depression. The aforementioned comments about not wasting a good crisis are not new. FDR and his brain trust reacted the same way, if not as explicitly. Both the NIRA and AAA were eventually declared unconstitutional and history has not judged them well as contributing to recovery. In fact, the consensus seems to be that programs like those exacerbated the distortions of the 1920s and prevented necessary corrections and reallocations of resources.
Conclusion
There are indeed parallels between this recession and the Great Depression, but they are not what much of the public commentary would lead you to believe. What we are living through today is a recession whose causes are significantly the unintended result of institutional changes made during the Great Depression and whose proposed solutions reflect the same failed understanding of the causes that motivated Great Depression “solutions” that largely ended up doing more harm than good. History is indeed repeating itself, and not in a good way.
A final thought: recent work in economic history attributes the slow recovery in the 1930s to, among other things, what Robert Higgs has called “regime uncertainty.” The constant experimentation of FDR along with his frequent anti-business rhetoric caused a high degree of uncertainty about future policy and the security of the property rights of members of the private sector. As a result, they held off on investing until they were more certain of what was going to happen. That slowing of private investment due to uncertain policy needlessly extended the Great Depression. As we watch the Obama Administration struggle to find direction and apparently changing policies on the fly, it would be understandable if private investors wanted to “sit it out” for awhile. Perhaps that is what we are seeing as the Dow and other indicators continue to flounder. If so, this parallel does not bode well for recovery. Once again, the lessons of the Great Depression need to be learned as we try to extract ourselves from the Great Recession.