As election day 2012 approaches, an interesting question is: Did it matter for the economy who won the 2008 presidential election, Obama or McCain? And a more relevant question today is: Does it matter in 2012 in terms of the economy whether Obama gets reelected or Mitt Romney? A case could be made that it didn’t matter in 2008 and may not matter in 2012 for the economy anyway.
While Obama and Romney differ on many major issues, the compelling fact is that the Great Recession of 2008-2009 was caused by a financial crisis. Empirical evidence shows that recovery from a financial crisis takes not only good economic policy decisions but more importantly, time – time for the economic excesses that caused the financial crisis and recession to adjust back to some level of normalcy.
The root causes of a financial crisis don’t materialize overnight or even over a few years. It may take a decade or longer; in the case of the U.S. financial crisis, the excesses started several decades earlier. Some of you are old enough to remember the 1970s slow-growth economy and high inflation, referred to as stagflation. Treasury long-term interest rates approached 15 percent, and short-term rates 20 percent – some of the highest interest rates in U.S. history.
Paul Volcker was selected as head of the Fed in 1979 and immediately decided to wring inflation and inflationary expectations out of the U.S. economic system. In what became known as “Volcker’s Massacre,” in October 1979 he decided to tightly control the money supply and let interest rates go where they may. And they did go up further. It took a while, but by August 1982, inflationary expectations started to cool and interest rates started their secular downtrend to today’s historically low interest rates.
One consequence of lower interest rates and inflation was massive amounts of wealth created from 1982 to 2007. As interest rates came down, bond prices went up dramatically and trillions of dollars of wealth were created in the bond markets. Likewise, lower interest rates were reflected in lower mortgage rates, and home prices began to rise again – although not out of line with historical trends until 1996 when the housing bubble started. Stocks also don’t do well in high inflation environments, so stock prices were depressed in 1982. The total valuation of publicly traded U.S. stocks was only $2 trillion in mid-1982. By March 2000, they were worth $16 trillion.
The trillions of dollars of wealth created from 1982-2007 and an economy that grew and only experienced two short recessions in 1991 and 2001, resulted in a consumption bubble in the U.S. Consumption increased from 66 percent of GDP to more than 70 percent over this time period. Much of the increased consumption was funded by the increased financial wealth as well as by credit. Increasing home equity also fueled consumption as consumers used home equity like an ATM machine. The end result was a credit bubble of massive proportions. Consumer debt relative to GDP reached an all-time high in 2007.
Another consequence of the wealth creation and associated credit bubble was a financial system bubble. The repeal of the Glass-Steagall Act by the Clinton administration in 1999 allowed commercial banks to move into investment banking. There was also dramatic growth in the “shadow banking” system, which included non-commercial bank institutions such as hedge funds, private equity funds, mutual funds, money market funds and a multitude of others.
In addition to the financial system bubble, the long period of moderation in terms of steady economic growth, declining interest rates and inflation, and increasing wealth from 1982-2007 created other problems, such as aggressive risk taking by consumers, corporations (remember Enron, WorldCom and others), and financial institutions. Credit standards became lax, the complexity of the system increased – especially as the derivatives market grew from nothing in 1982 to $600 trillion in 2007 – and transparency declined as overconfidence increased.
All of this credit expansion and wealth creation began to impact home prices in 1996 when they began to increase above historical trend lines; from 1996 to 2006 median home prices more than doubled. Both the Clinton and George W. Bush administrations promoted the home ownership society. They and Congress pressured the government-sponsored agencies, Fannie Mae and Freddie Mac, to not only provide mortgage financing but also to provide financing to lower-income individuals and families. Thus the advent of the sub-prime mortgages, which grew from nothing in 1996 to more than $1 trillion by 2006.
Not even the bursting of the dot.com stock bubble and subsequent bear market from March 2000 to October 2002, when U.S. stocks lost approximately half their value ($8 trillion), could dampen the real estate enthusiasm, speculation and the increase in home prices. Home ownership increased from 64 percent to 68 percent of those eligible during this period, something most thought was stabilizing for the economy. The basis assumption was that home prices would not decline, which they had not since 1930s.
So 2007 found home prices inflated, consumers with too much debt, financial institutions that were too complex and too big to fail, and a financial system that had become not only innovative, but also complex and interrelated. Nobody knew where the risks were in the financial system. The long period of credit expansion, excess leverage, and aggressive risk taking was about to end in dramatic fashion.
The first cracks in the system came from the sub-prime mortgage market in 2007 as default rates increased and mortgage prices decreased. Most thought the problem was controllable, as the sub-prime mortgage market was less than 10 percent of the total mortgage market. But home prices in general began to decline, and problems spread to other markets and to most financial institutions – especially the large investment and commercial banks. What started out as a small credit crisis became a liquidity crisis, then a financial crisis and then the Great Recession.
Who is to blame for the financial crisis? There is plenty of blame to go around and plenty to blame. You could start with the borrower who took on too much debt, real estate speculators, mortgage lenders with lax or no credit standards, bankers who lent and then securitized mortgages, ratings agencies that gave a AAA rating to low-quality mortgages, investors in mortgage-backed securities who relied on the ratings agencies and didn’t perform due diligence, bank regulators who were clueless, the Federal Reserve for keeping interest rates too low in the latter part of the housing bubble, and two U.S. presidents and the U.S. Congress for promoting home ownership to those that couldn’t afford it. But certainly the leverage in the system exacerbated the problem once housing prices started to fall and collateral prices declined. Calls for more collateral forced margin selling, and the downward spiral began.
If the sub-prime mortgage market was the trigger that started the financial crisis, then financial innovation and derivatives also can be blamed. Sub-prime mortgages were pooled into mortgage-backed securities, which were then pooled into collateralized debt obligations (CDOs), each of which was subdivided into tranches – with the highest tranche rated AAA by the ratings agencies. In hindsight, we now know that you can’t create quality from junk. If the CDO had not existed and credit default swaps (CDSs) not available to insure CDOs, the sub-prime mortgage market would not have developed. Would this have prevented a financial crisis? Probably not, as the housing bubble was pervasive and leverage as well.
The peak of the financial crisis was probably the collapse of Lehman Brothers in September 2008. This prompted Congress to pass TARP, which bailed out the financial system as well as GM and Chrysler. In addition, Congress and the Fed threw many things against the wall. Some stuck, some didn’t.
Back to the basic question: Did it matter for the economy who was elected president in 2008? Probably not. The Fed still would have pumped massive amounts of liquidity into the system and lowered interest rates to historical lows. The U.S. Congress would have still approved of a stimulus package, and the U.S. government would still have had deficits of $5 trillion for the last four fiscal years. As Reinhart and Rogoff point out in their book, “This Time Is Different: Eight Centuries of Financial Folly,” it usually takes an economy seven to eight years to recover from a financial crisis. Consumers have to reduce debt, which they have done to the tune of $1.3 trillion since 2008. The financial system, especially the banks, has to be stabilized and recapitalized. And confidence has to be restored so consumers can spend and corporations can invest and hire. Lately U.S. consumers are spending more than U.S. corporations are investing, even though median family income in the U.S. has fallen five consecutive years.
If the U.S. economy follows the norm, it may take another three to four years to get out of the slow-growth environment and back to normal growth of 3.5 percent annually. The next president, the Fed and Congress have little ammunition left, given the magnitude of our debt and deficits. Given that world GDP growth has fallen, the problems in Europe, and the slowdown in the emerging economies (especially China), the next U.S. president faces challenging economic problems with few options. But good luck to him, whoever it may be.