A calamity that shaped the past decade, the Great Recession marked an end to the Great Moderation, three decades of prosperity. The root causes behind the Financial Crisis and the subsequent Great Recession are complex. A speculative shadow banking sector was supported by reckless Central Banks, bailing out financial institutions and promoting the culture of ‘Too Big to Fail.’ More crucially, the Great Recession didn’t need to be so severe; a meltdown in the financial system could’ve had a short-lived impact on Western economies had it not been for imprudent monetary policy.
Bailouts
Bailout culture promoted the risk aversion and credit centralisation that created the pre-conditions for a financial meltdown; in 1974, the Federal Reserve bailout Franklin National Bank – for $1.7 billion. A bank of moderate capital size, the 20th largest bank, excessive high-risk loans and ill-advised forex activities culminated in significant losses and inevitably insolvency. The regulators decided on bailing the bank out, citing a ‘domino effect’ in which widespread financial panic would threaten the economy. Sound familiar?
In the 1980s, bank bailouts continued. The First Pennsylvania bank became the first national bank to be bailout by the Federal Reserve in 1980. The continual bailout of banks engaging in increasingly risky behaviour was unsurprising to many. An initial bailout of a medium-sized bank in Franklin National indicated that the Federal Reserve wouldn’t be prepared to see a large bank face insolvency, creating a financial safety net. Banks engaging in risky behaviour would be rewarded with high rewards; the losses would be paid for by Central Bank bailouts.
Without the free market punishing risky behaviour, commercial and investment banks became inclined to engage in riskier lending – culminating with the birth of NINJA loans in the 2000s to aspiring homeowners. The eventual rise in mortgage defaults in 2006 and house prices provoked the collapse of the financial system. Mortgage-backed securities tranched with toxic assets became worthless, leaving insurance companies picking up the slack with credit default swaps – sinking the likes of AIG into insolvency. The underlying cause behind the collapse of the financial system was intervention from bureaucrats. Had Franklin National been allowed to fail, financial systems would’ve allocated credit more efficiently; instead, the incentive structure from a financial safety net promoted risky, irresponsible behaviour that wouldn’t have taken place under a free market.
Bernanke’s Backwards Tightening
He criticised the Bank of Japan for restrictive monetary policy in 2001, yet, repeated the same mistakes as chairman of the Federal Reserve following his appointment in 2006.
Replacing Alan Greenspan would be no easy feat. Overseeing decades of price stability and growth, monetary stability promoted the efficient allocation of resources through the price mechanism, leading to unbridled economic growth across Western economies. Bernanke’s appointment initially proved promising. Recognising the failure of the Bank of Japan’s tight monetary policies in the 1990s that failed to produce nominal output growth, Bernanke seemed committed to keeping the federal reserve rate in line with the market, natural rate that promoted full employment.
However, Bernanke continued the misguided approach of raising interest rates throughout 2006 and for parts of 2007. As oil prices rose, consumer price inflation climbed, reaching 3% in 2005. Despite inflation falling in 2006, Bernanke remained resistant – holding interest rates at 5%.
The inability to distinguish between aggregate-demand induced and supply-side inflation would hurt the Federal Reserve’s credibility in the long run. As the Federal Reserve can do little to tame inflationary shocks from global oil prices rising, contractionary monetary measures were ill-placed. Core inflation (the inflation rate excluding food and energy) still hovered at around 2% between 2005 and 2007. As house prices started to fall and mortgage defaults sharply rose, the appropriate Federal Reserve response would have been to ease money; instead, Central Banks across the West continued tightening – in the battle against external inflationary shocks outside their control.
This created a considerable slump in aggregate demand. As the Federal Reserve’s fed funds rate rose above the market rate, contractionary monetary measures were in full force – producing a sharp fall in nominal income. As businesses and consumers rely on nominal GDP, fluctuations destabilise the economy. Inflation expectations sharply collapsed, undermining the price mechanism’s ability to allocate resources efficiently. The spread between five-year inflation-linked government bonds and regular bonds fell to 1.31% in mid-2008, months prior to the collapse of Lehman Brothers. Even following the collapse of the investment bank, the Federal Reserve remained resistant to rate cuts, citing inflationary fears from commodity price shocks – despite the collapse in market inflation expectations.
The slowest recovery from a recession since the Great Depression soon followed; economists largely agree the 1930s Depression had resulted from the Federal Reserve’s tight monetary policies. The Federal Reserve would repeat that mistake, focusing on credit allocation in the aftermath of the financial crisis. Financial sector turmoil didn’t need to produce a sluggish recovery. Had Central Banks acted decisively and with confidence from the markets in their actions, a mild recession from the uncertainty of the financial sector would’ve followed. Black Monday in 1987, a record 20% fall in most stock indices, didn’t produce a financial crisis and severe recession globally. Restrictive money conditions let nominal output fall behind its pre-crisis trend across Western economies, with more stringent Central Banks facing worse economic downturns. The Eurozone didn’t face a financial crisis as severe as the US; yet, due to the ECB’s tight policies, raising rates in 2010 amidst more inflationary fears, the Eurozone faced a double-dip recession while the US economy gradually recovered.
Ultimately, poor monetary policies created both the long and short-run pre-conditions for the Great Recession. The financial crisis’ excessive risk and speculation were due to the emergence of a financial safety net as decades of bailouts incentivised speculation; bureaucrats distorted the free market’s natural risk regulation. Similarly, overly restrictive monetary policies leading to and following the financial crisis created a slump in aggregate demand across the US and Eurozone economies. Central Banks’ failure to sufficiently ease monetary conditions to the market interest rate led to the sluggish economic recovery of over half a century. Politicians laid the groundwork for the emergence of populism by failing to promote price stability and with the departure of the economic prosperity of the Great Moderation.
Free Marketeer 