September 15, 2008. I remember waking up to see the news of the beginning of what would become the worst financial crash in decades. Lehman Brothers investment bank filed for bankruptcy (1). This news would set off a downward spiral of the financial markets. Banks were going belly side up. Investors were losing thousands of dollars. Millions of homeowners could no longer afford their mortgages. Something had to be done to stop the free fall.
Before, we analyze the steps the government took to reverse the economic demise, it is wise to dissect how exactly this collapse occurred so that we know how to prevent such calamities in the future. One major theme I have learned from being a student of economics is that no matter how much one learns about the economy, it can never be fully understood. There are far too many working variables to be able to pin down exactly what caused which effect. However, we know macroeconomic trends and what causes such economic recessions in general. We can compare this to weather and climate. Meteorologists have a difficult time predicting the next two weeks of weather since there are so many little variables that have the power to affect day-to-day weather. However, climate scientists do know what affects the climate in general over time. It is in this mindset that we can examine what led to the worst economic recession since the Great Depression.
In the years leading up to 2008, there existed a housing boom. A home became one of the safest and smartest assets in which to invest. This was due to the fact that there was a firm expectation that housing prices would keep soaring upward. When someone purchases a mortgage to buy a home, they agree to borrow a given amount of money from a bank under the condition that the bank will be repaid in a set period of time with a certain amount of interest. In those all-important years, banks wanted to keep pushing up the demand for homes. Therefore, these commercial banks began to lower the criteria for who qualified for a mortgage. They began to accept mortgages with conditions, such as $0 money down. This would entice even more Americans to purchase a home. This sounds great; more Americans can move from rentals to home ownership.
However, banks did not want to put themselves on the line entirely for these risky mortgages, so they were sold often as adjustable-rate mortgages, which means that the interest rate on a homeowner’s bill could change from month to month. This is in contrast to a fixed-rate mortgage, which maintains the same interest rate every month. Therefore, during the first months homeowners might be able to afford the payments on big, new homes. However, once the banks began to alter the interest rates, many homeowners found themselves unable to pay anymore.
Now, some analysts will blame homeowners for entering into risky mortgages when they should have known better. These people argue that these Americans should have seen that they could not realistically afford a house worth hundreds of thousands of dollars. However, the goal of some commercial banks was to sell as many mortgages as possible, which would in turn lead to large short-run profit. The banks were making tons of money. They were enticed to continue giving out these sub-prime mortgages while convincing Americans that they could afford it.
Once these homeowners realized that they could no longer pay, they began to file for foreclosure. This began to bring the value of all homes drastically downward. Many homeowners now found themselves owing more on their mortgages than their homes were worth, a state known as being underwater. Many people found themselves unable to sell their homes, which led to even more foreclosures. This reality materialized for three million homes across America (1). From these foreclosures, we would expect these banks to file insurance claims for loss on risky bets to their own insurance company. That insurance company for most of these mortgages was AIG. Due to the onslaught of so many foreclosures, AIG could not afford to support all the banks filing losses (3). Therefore, the insurance for these banks had dried up.
An important layer to add onto this collapse is the repeal of the Glass-Steagall law, which was originally enacted after the Great Depression to prohibit the combination of commercial banks (which control mortgages and Americans’ bank accounts) and investment banks (which control Americans’ investment accounts on the stock market). The bill sought to protect Americans’ assets and money from becoming too vulnerable to loss by belonging to an investment bank that could be hit greater by a financial collapse. Congress repealed this safeguard in 1999 leaving banks to combine and leaving Americans’ savings at risk of falling with the financial markets (4). This happening likely did not cause the eventual financial crash, yet it put a greater swath of the financial world at risk.
With this combination, banks started doing lucrative practices with all the mortgages leading up to the stock market collapse. A bank could now package multiple mortgages into bundles called a mortgage-backed securities and collateralized debt obligations, which could be sold to investors on the stock market. These investors would in theory make money on the payments made by the homeowners of these mortgages. Some investors then speculated on the value of these securities expecting them to continue rising as they had been for years already. If a mortgage were to go under foreclosure, the purchaser of the mortgage-backed security could perform a credit-default swap with the investment bank, which sounds like a great idea if the investment bank were to handle only a small number of foreclosures. That investor would get a payout for holding the security even when it defaulted. You can see how this additional layer of moneymaking in theory led to a whole mess of financial ruin in reality. So quickly the United States found itself with its biggest banks failing to stay afloat from the immense foreclosures and unable to pay back investors for the credit-default swaps. Investment insurance companies, banks, and investors were all out of luck. No one had the money to handle the hit of this enormous housing bubble bust. America’s financial sector was collapsing fast.
Due to the stock market collapse, companies across the country started to feel the hurt. They no longer had great value on the stock market. Companies had to start contracting. On top of this, with so many Americans in foreclosure, consumers could no longer afford to spend willingly within the economy. Without demand for products, companies were losing money quickly and had to begin laying off millions of workers. On top of this, Americans’ 401(k)’s were suddenly worth much less since those retirement accounts ride the stock market. Everyone was being hit from all sides.
In all, the damage was unfathomable. The number of jobs lost totaled 8.7 million raising the unemployment rate from 6.1% in September 2008 to 10% in October 2009, the worst unemployment rate of the recession (5,6). One in ten Americans were out of a job, and work was not easy to come by. The median amount of time without a job rose to 25.2 weeks at its highest point in June 2010 (6). It took over half a year to find work again for most Americans. If people were not working, they certainly could not afford to boost the economy by consuming. America’s economy was stuck on rock bottom.
When the private sector cannot save itself, an outside force with the ability to take on debt must take action. The government is the only force able to effectively stimulate an economy that has lost its lifeblood. Without investment and consumer demand, the economy would not budge from its sorry state. The government could use its power to reboot the investment industry and also put people back to work. Those workers would then get money back in their pockets to then spend and restart the cycle of a moving economy.
The first plan of action was undertaken by President George W. Bush to save the biggest banks from all-out collapse. This program became known as TARP, the Troubled Asset Relief Program–better known to Americans as the bailout of the banks. President Bush authorized $700 billion to purchase debts from the biggest banks in order to free up their cash flow and get the markets moving once again. Such moves of buying up bad assets from the financial sector is known as quantitative easing–an effort to give more liberty to banks so that they begin lending again.
Some critics thought that the banks should have been punished for their risky behaviors rather than saved, but that retribution may have damaged the rest of the economy even further. Nevertheless, many of the banks were later hit with billions-of-dollar fines for their behavior, yet no one went to jail.
Punishment aside, TARP caught the banks while they were in the midst of utter turmoil. The program in reality invested $426.4 billion into the financial sector rather than the initial authorization of $700 billion. Because the banks were able to recuperate over the following years, all the assisted institutions had paid back the money to the government in full with surplus. TARP ended with a revenue of $441.7 billion for the government. Therefore, government action recovered the financial sector while actually making money in the end (7).
President Bush implemented this plan in October just months before he would hand over the presidency to Barack Obama. Therefore, it then became President Obama’s task to reboot the economy of the private sector. The banks were saved from complete demise by President Bush, but the American people were still out of work and strapped for cash. Therefore, immediately upon becoming President, Obama took major steps to reboot the economy. He and the new Congress passed the stimulus package, formally known as the American Recovery and Reinvestment Act (ARRA). “The Act included direct spending in infrastructure, education, health, and energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions.” The bill actually set up recovery.gov in order to be fully transparent with the American people on how the $787 billion (later adjusted to $830) would be spent on rebooting the economy. 35% of the entire bill was authorized solely for tax cuts. The other 65% of the bill was authorized for spending in order to encourage consumers to spend again and employers to hire again (8).
The big question all people will ask is: was all the spending effective? Did the government stepping in when the private sector could not have a positive effect on the economy? Did the benefits outweigh the costs? We will measure the quality of the recovery via many different metrics in order to gain the clearest picture of reality.
First off, the investment of the ARRA has largely ended and, therefore, its impact can now be measured. The non-partisan Congressional Budget Office, which analyzes the expected costs and benefits of Congress’s actions found that the ARRA saved or created up to 3.3 million jobs (9). It is difficult to pin it down to an exact number as jobs are not labeled as existent due to the stimulus package or not. They could have been created regardless of the stimulus, because of it, or as a later product of the overall recovery. Therefore, this number sounds great, but we can push further into more comprehensive metrics to determine the health of the current economy compared to 2008.
First, we can examine the amount of jobs created in total since the rock bottom of the recession.
We can see that after January 2009, jobs began climbing out of the hole. Since the end of 2010, we have never again experienced a month of net job losses. That is truly impressive data. 70 months of straight job growth puts this economic recovery as one of the longest between recessions ever.
Another common data set to examine, which is closely related to jobs created, is the unemployment rate. This rate is known as the U-3 rate; it includes all people that are actively searching for work but have not found it yet.
Now, some critics argue that this “official” unemployment rate does not tell the entire story on economic health. There are many different ways that the government slices unemployment to determine the state of the economy. One metric often touted as more realistic is what is known as U-5 unemployment, which includes workers who want employment but have given up actively searching for some reason. They either have given up searching for work because they cannot find a job or because they are attending school or have family responsibilities. This group is known as the unemployed who are marginally attached to the workforce.
We can also examine another sliver of employment numbers. If there are workers who are working part time when they wish they could be working full time but are not due to economic reasons, this can be a sign of economic struggle. When we add this set of workers to the marginally attached workers of U-5, we obtain the unemployment rate known as U-6, which some argue is the most realistic metric on unemployment.
Before the recession at economic peak:
At the peak of the recession:
As we analyze these three data sets at once, we can analyze the improvement of one over the other (10).
When we examine the official unemployment rate U-3, we see that at the peak of economic expansion in March 2007 prior to the recession, it was 4.4%. Then it rose to 10.1% at its highest. It has now dropped to 5.0%, essentially full employment–just 0.6% from the last economic peak and a 5.1% decrease from rock bottom.
This “full employment” notion seems counter-intuitive since there is technically still 5% of people not working; however, there will always be a certain percent of unemployment due to people willingly changing jobs, foregoing employment for some time, etc.
When we examine the “marginally attached” unemployment rate U-5, we see that at the peak of economic expansion prior to the recession, it was 5.2%. Then it rose to 11.5% at its highest. It has now dropped to 6.1%. This is just 0.9% from the last economic peak and a 5.4% decrease from rock bottom.
When we examine the “marginally attached/part-time” unemployment rate U-6, we see that at the peak of economic expansion prior to the recession, it was 8.0%. Then it rose to 17.4% at its highest. It has now dropped to 9.9%. This is still 1.9% from the last economic peak, so there is still room for improvement. However, this is a 7.5% decrease from rock bottom. Therefore, the recession drove many workers into part-time work, and we have made great progress digging out of that problem.
Now, workers may be out of work less, but it is also important to monitor for how long the people who are out of work have to wait before finding a job.
As I mentioned earlier, the median amount of weeks unemployed at the height of the recession was 25.2 weeks in June 2010. That numbers stands at 10.5 currently–it takes about 2.5 months to find work again. This level is virtually equal to the median in September 2007 (10.2 weeks) right before the recession hit. If we again take March 2007 as the peak of the last economic expansion, that median was 9.1 weeks (6). Therefore, Americans are currently waiting about one week longer to find work. Overall, these data are great news. We have largely returned to the same amount of waiting periods between employment as before the recession hit.
Another telling economic metric is the Labor Force Participation Rate (LPR). These data measure how many able people are actively in the work force compared to the national population. Therefore, we can determine how many people have simply chosen to leave the workforce, even though they are within the able age range to work (above 16 years old).
Some critics will look at the trend on a small scale of just the last few years claiming that the economic recovery has been weak since the LPR is declining year after year (6). However, when looked at on a larger time scale, we see that the downward trend really began at the turn of the millennium. Therefore, this cannot really be related to the economic recession of 2008. What makes more sense as an explanation for the decline is that we see a gradual rise for decades starting in the 1960’s. It seems as though our largest generation–the Baby Boomers–came of working age. Now that they are reaching retirement age, they are leaving the workforce. Additionally, many college-age Americans may be choosing to stay in school rather than start working immediately. Therefore, this is not a trend that is at least not wholly due to economic policy.
Aside from employment, it is necessary to analyze whether workers’ compensation (wages plus benefits) are growing over time, especially compared to inflation.
If we again take the peak of the economy prior to the recession as March 2007, compensation growth was at 3.5% year-over-year. The end of 2015 rate was 2.0%. Therefore, workers’ compensation are growing and luckily beating inflation, which is currently around 1% (6). However, workers’ compensation is not growing as quickly as it was prior to the recession. Possibly there are some more economic steps that the government can take to ensure that employers share their economic profits with their workers. Furthermore, studies have shown that a great share of the jobs created during the recovery have been high-paying jobs, namely 44% pay over $53,000 (11). Additionally, “the last six months were the best extended period for employee paychecks since the recovery began six-and-a-half years ago (12).”
Lastly, Gross Domestic Product is an overall telling measure of economic growth. This metric determines the value of all goods and services being produced within the country. A strong U.S. economy typically grows at 3-4%.
We can see that GDP growth has varied much over the past few years (13). The economy has hit a few quarters of 3-4% growth, which is a great sign. Important to note is that the one quarter of contraction was due to weather-related factors rather than economic weakness (14). Overall, we can see that the GDP is growing. We would like more robust growth, but we are indeed steadily improving. Some people actually argue that steady growth is overall safer than rapid recovery. That may sound counter-intuitive as when we are in a recession we would want everything to return to normal as soon as possible. However, rapid growth can result in an economic phenomenon known as overheating. This means that when GDP grows so fast, it can outgrow the ability to manufacture products to meet the rise in consumer demand and also outgrow the ability to higher enough people compared to the rate at which new workers are entering the workforce. This potential shortage in workers and supply results in rapid inflation of prices; rapid inflation would send a demand shock to the economy and cause consumers to stop buying products. That fixes the shortage problems but can send the economy back into recession. Therefore, slower and steady growth is arguably more desirable overall for economic health as the economy will be less likely to overheat.
The above graph demonstrates that too quick of GDP growth can result in exponential price rising (inflation) (15). In order to prevent that from occurring, the Fed has the ability to raise interest rates and prevent the economy from overheating. Therefore, GDP may not grow as quickly but at the same time inflation will be stable, which allows the economy enough time to manufacture more products to meet consumer demand and allows enough time for more Americans to enter the workforce, which allows producers to hire them. Overall, the main goal of the Fed is to keep the economy in a stable balance.
The amazing news is that the U.S. is actually growing stronger and more dependably than many of our developed counterparts right now. “The most direct comparisons to the United States are probably the other six members of the elite Group of 7 economies — the United Kingdom, France, Germany, Italy, Canada and Japan. And all of them rank below the United States when measured by projected growth for 2016 and 2017” (16). “Economists also said that…the American economy is holding up well despite a slowdown in China, growing risks in emerging markets and turmoil in the stock market” (12).
It is important to note that in addition to the fiscal policy of the government, the Federal Reserve, which is an autonomous agency of the government with a chairperson who is appointed by the President of the United States, monitors monetary policy. The Fed determines the interest rates (formally the Federal Funds Rate) that we Americans pay on loans like mortgages via controlling the supply of money in the economy through the sale and purchase of government bonds. Understanding how money supply regulation and bonds work is not necessary to understand the effect of changing interest rates. In order to stimulate economic growth, the Fed set the FFR to 0% for years during the recession. In December 2015, the Fed decided to finally raise the FFR to 0.25%–a sign of economic health. The Fed would not raise the rate unless the economy was in a stable and strong enough position to face the possible slowdown in desire to borrow due to a higher interest rate. Americans would be less likely to borrow if they had to pay more in interest. However, this raising of the FFR allows banks to make more money of loans now. Therefore, the Federal Reserve sees this economy as stable enough to do such an action. Furthermore, the Fed raises rates to keep inflation in balance. As mentioned before, if GDP grows too quickly, it can set off hyper-inflation shocking demand negatively. Since the economy is at virtually full employment, the Fed sees it as necessary to rase the FFR minutely in order to prevent the economy from overheating.
Lastly, an important index to which economists pay close attention is the consumer confidence index (CCI). This represent consumers’ confidence in the economy and, therefore, their willingness to make purchases in the future hoping that the economy stays strong.
We can see that the CCI has largely returned to exactly the same place it was at the peak of the last economic expansion in March 2007 (17). Therefore, consumers expect this economy to continue growing. This is great news for businesses that choose whether to invest and hire based on these data.
You may ask what it took out of the government to reach this progress. Admittedly, billions of dollars were spent on pulling the nation out of this rut. The government had to invest when no one else could. Luckily, President Obama has rightfully brought that spending back to normal levels now that the economy has recovered.
The worst of the budget deficits came in 2009 with a $1.4 trillion hole. Once the government used this spending to stimulate the economy, Congress and the President were able to cut back spending to levels identical to times during the Bush Administration. This kind of economic stimulation through spending is necessary when the private sector is frozen at rock bottom. That is why arguments for a constitutional amendment that bans budget deficits is short sighted. Of course, we need to aim for budget surpluses where revenues are greater than expenditures. However, the government must retain the ability to enter a deficit as an emergency procedure to stimulate the economy when the private sector cannot. Now that the economy is growing steadily, there are budget battles to be had in order to finally regain the surpluses that we achieved during the Clinton Administration. For now, we have at least dug ourselves out of the huge deficit hole by cutting that spending by 60% (18).
You may say this is all great news; the economy has left behind the worst hit in seventy years, but how have we ensured that this financial collapse will not occur again in the future? President Obama and Congress took many major steps to safeguard Americans from the risky behaviors of Wall Street. Some of those laws included the Dodd-Frank Wall Street Reform Act and the Credit Card Act. One of the effects of these laws was the creation of a Consumer Financial Protection Bureau (CFPB) that monitors Wall Street to prevent it from putting the entire economy at risk again and from exploiting Americans. Additionally, banks are no longer allowed to gamble with mortgages. Banks are also now subject to checks by the Federal Reserve known as stress tests, which analyze if a bank could handle an economic downturn without going bankrupt. These banks are pressed to act safer through a stipulation in Dodd-Frank that mandates that banks keep a higher percentage of cash in their reserves so that they could cover the cost of potential future losses–effectively lowering the need for the government to ever bail out the banks again (18).
Overall, it seems that by almost every metric the economy has drastically improved to near or at the levels that were experienced right before the Great Recession. The policies of the Obama Administration seem to have pulled this country out of the worst economic downturn since the Great Depression. Growth is steady and stable just as we desire. The recession is over.