Faulty monetary policy and insufficient regulation helped — but old-fashioned avarice really tanked the economy RICHARD S. GROSSMAN MONDAY, OCT 14, 2013 12:43 PM
Reprinted from “WRONG: Nine Economic Policy Disasters and What We Can Learn From Them” by Richard S. Grossman with permission from Oxford University Press. Copyright © 2013 by Richard S. Grossman
If financial crises came with their own nicknames, the subprime meltdown surely would have earned the sobriquet “worst financial crisis since the Great Depression.” That mantra has been chanted over and over again, not only by leading academics and media pundits, but at the highest levels of policy making. When President Barack Obama selected Christina Romer, an economic historian from the University of California, Berkeley, as chair of his Council of Economic Advisors, some carped that the president should have selected an economist with a deeper background in policy rather than in economic history. When Romer herself later asked President Obama’s chief of staff Rahm Emanuel why she got the job, Emmanuel answered: “You’re an expert on the Great Depression, and we really thought we might need one.” Given how close the subprime crisis came to economic Armageddon, it is important to understand the series of policy mistakes behind it.
For the most part, previous chapters in this book have focused on particular policies that have had disastrous results, rather than on economic disasters and the policies that led to them. The three policy failures of the interwar period—German reparations after World War I, the interwar gold standard, and the increasing trade protectionism of the 1930s—each merited its own chapter instead of being discussed in a single chapter on the Great Depression. The approach adopted here is different. Rather than starting with a failed economic policy, this chapter starts with a disaster—the subprime crisis—and examines the policies that contributed to it.
There are good reasons for proceeding in this way. The interwar policies discussed earlier had their origins in different countries and occurred under widely differing circumstances. World War I reparations resulted from fears that an isolationist United States would not be able to counter future German aggression, the heavy burdens of inter-Allied debts, and a French desire to punish Germany. The worldwide return to the gold standard was galvanized by the British precedent, which was based on a desire to return to the monetary “normalcy” of the nineteenth century. And the rise of trade protectionism, spurred by the United States’s Smoot-Hawley tariff, was a response to the beginnings of a global economic downturn and domestic political factors. By contrast, the subprime crisis originated almost entirely in the United States, although it subsequently spread far and wide. The main culprits behind the crisis were ill-conceived and ideologically motivated fiscal and monetary policies, which were aided and abetted by inadequate regulation and a variety of other policy mistakes.
Despite the severity of both the Great Depression and the subprime crisis, neither was completely unprecedented. Banking crises were common during the nineteenth and early twentieth centuries: there were more than 60 such crises in the industrialized world during 1805–1927. Many of these crises shared a common “boom-bust” pattern. Boom-bust crises occur when business cycles—the regular, normally moderate upward and downward movements in economic activity—become exaggerated, leading to a spectacular economic expansion followed by a dramatic collapse. Boom-bust crises play a central role in formal models of financial crises dating back at least as far as Yale economist Irving Fisher, who wrote about them in the 1930s. In Fisher’s telling, economic expansion leads to a growth in the number and size of bank loans—and even the number of banks themselves—and a corresponding increase in borrowing by non-bank firms. As the expansion persists, bankers continue to seek profitable investments, even though as the boom progresses and more investment projects are funded, fewer worthwhile projects remain. The relative scarcity of sound projects does not dissuade eager lenders, however, who continue to dole out funds. Fisher laments this excessive buildup of debt during cyclical upswings: “If only the (upward) movement would stop at equilibrium!” But, of course, it doesn’t.
Continue reading Greed destroyed us all – George W. Bush and the real story of the Great Recession (Long Read)