Who and What Caused The Great Recession

There are a lot of theories on the causes of the recession of 2007-08, commonly referred to as The Great Recession. The right blames government intervention in financial markets, low interest rates, and easy credit, while the left blames free market excess, greed, and deregulation. I thought it might be worthwhile to compile a list of causes based on some of the most intelligent analysis, and see if we can’t identify the people who caused this mess.

Based on analyses from Robert Samuelson in The Wilson Quarterly (Winter 2011), the editors of National Review (January 2011), and Peter Wallison in The American Spectator (May 2011), I compiled two lists. The first is a short list of causes that have been discredited, followed by a list of four causes that are more likely.

Discredited Causes of The Great Recession

Deregulation    One explanation for The Great Recession is a lack of regulation, primarily in the financial sector. This explanation doesn’t hold up, however, because the major players in the collapse are heavily regulated and have been for many years. If there is any blame on the part of regulators, it’s that they were no smarter than the people who were being regulated and they didn’t anticipate the problems that led to the financial downturn. One could argue that this is the primary role of a regulator, so blame would rest on the government bureaucrat.

Greed and Dishonesty    Another explanation for the financial collapse is the greed and dishonesty of Wall Street. In this case, the explanation is insufficient because there has never been a shortage of greed on Wall Street, and 2007-08 were no different. Ultimately, this is just an emotional reaction – one that makes the accuser feel that they hold some moral high ground – and is not based in reality. Greed is a part of any economic activity, and there was no unusually high amount of greed and dishonesty in 2007-08.

Moral Hazard    A third cause, frequently cited by those on the right, is that the federal government introduced a moral hazard on Wall Street. In other words, the major players in the financial sector believed that they could take irrational risks knowing that they would be bailed out. Once again, this explanation is inadequate because historically most investors have not been protected from their financial losses. That means that in 2007-08, it was impossible for anyone to predict in advance who would be bailed out, so there was no moral hazard introduced ahead of the financial collapse (that isn’t to say that moral hazard has not now been introduced based on later actions by the federal government).

Reality-Based Causes of The Great Recession

Cause #1: Housing Policy (National Review, American Spectator)

As we entered the recession, as many as half of all mortgages in the U.S. were considered inferior and liable to default. This was a clear result of government housing policies to encourage home ownership, which resulted in a broad misallocation of capital, loosened mortgage standards, and created distortions in the real estate market. For example, the 1977 Community Reinvestment Act required that banks offer loans to borrowers in their service area that were at or below 80% of the area’s median income. In other words, banks were required to offer loans to people who were less able to afford a mortgage, and they weren’t allowed to use their own lending standards.

On top of this, the Department of Housing and Urban Development (HUD) had an official policy of increasing home ownership by lowering mortgage underwriting standards. This had a significant effect on the quality of mortgages in circulation prior to the recession.

So who’s to blame for the housing policies that caused the recession? HUD was created by Lyndon Johnson (a Democrat) after passage of the Department of Housing and Urban Development Act by a Democrat-controlled House and Senate in 1965. The Community Reinvestment Act was signed into law by Jimmy Carter (another Democrat) after, once again, passing through a Democrat-controlled House and Senate. It would appear that Democrats are to blame.

Cause #2: Banking Regulations (National Review, American Spectator)

Another cause of the 2007-08 recession was banking regulation that a) concentrated mortgage securities with a small number of firms, b) offered implied government insurance on bad mortgages, and c) established accounting guidelines that allowed banks to significantly reduce their capital positions. This is where Fannie Mae and Freddie Mac come in. Both entities, while technically private entities, made the federal government the implicit backers of every mortgage held. That implied guarantee was made explicit once they were bailed out following this latest recession.

Another factor that is relatively under-played is the use of mark-to-market accounting, which allowed financial institutions to over-leverage themselves as long as home prices were rising, and severely tightened credit – making it harder for the market to recover – as home prices collapsed. No less than the former FDIC chair William Isaac placed much of the blame for the mortgage crisis on the SEC’s fair-value accounting rules, which allowed banks to “mark” their assets according to their current market value instead of their real value. For example, a home loan for $300,000 could be marked up to $500,000 if home values appreciated enough. This additional $200,000 in assets allowed the bank to lend out more dollars and stay within its legally defined capital ratio. Unfortunately, when the home’s value fell to $250,000, the bank had to adjust its assets downward, even though they still received a monthly mortgage check on a $300,000 mortgage. Naturally, the fall in the housing market ensured that every bank in the country exceeded its capital ratio and became unable to lend, thanks to mark-to-market accounting.

Who’s to blame for these banking regulations? It’s probably no surprise that the progressive champion FDR signed Fannie Mae into law in 1938. In 1970, a Republican president and Democrat House and Senate authorized Fannie Mae to purchase mortgages, as well as brought Freddie Mac into existence. In 1992, a Democrat House and Senate established affordable housing goals along with the signature of George H.W. Bush (a Republican). And in 1999, Bill Clinton (a Democrat) began pressuring Fannie Mae to increase its ratio of loans to moderate- and low-income home buyers.

Blame for mark-to-market is not as easy to assign. The accounting practice has been around since the 1980s and has gone through periods of corporate abuse and subsequent clarification by the SEC, IRS, and FASB. While I’m no expert, it appears that the source of our problems began in 1993 (a Democrat era) with guidance issued in FAS 115 that defines how to value an asset or security with readily determinable fair values. As discussed above, mark-to-market accounting was not a problem as long as asset values were rising, but once the housing market began to tank, the house of cards fell fast. It was only corrected on September 30, 2008 (once again a Democrat era) when an SEC/FASB joint clarification was issued essentially lifting mark-to-market and allowing other methods of valuing assets.

Cause #3: Interest Rate Policy (National Review)

A third cause of the 2007-08 recession is the Federal Reserve’s policy on low interest rates. Extremely low rates provide cheap money and easy credit, which was obviously a contributor to the housing and lending policies described above. This low-rate policy is a relatively recent phenomenon (historical table):

• Paul Volcker (1979-1987): Low of 6% to a high of around 20%
• Alan Greenspan (1987-2006): Between 3% and 6 ½% prior to 2000, but very low following the 9/11 attacks, never rising above 5% before his departure
• Ben Bernanke (2006-present): Brought to historically low levels for historically low periods of time

For the record, Samuelson disagrees on this point and says that low interest rates are only a partial cause. His argument is that, while low rates will result in investors shifting into long-term bonds, a larger factor was the large inflow of foreign money, which the Fed could not control.

In this case, it’s not as easy to assign blame since the Fed Chairmanship is supposed to be a non-political position. Nonetheless, both Greenspan and Bernanke are registered Republicans and were originally appointed by Republican presidents. Since both were re-appointed by Democrats, we’ll have to say that both parties share the blame equally.

Cause #4: Inflation-Suppression Policy (Samuelson)

The final cause of The Great Recession is the inflation-suppression policy that our government has held since the 1980s. The argument is that taming inflation led to lower interest rates and a general feeling that the business cycle had grown less volatile. As a result, households felt richer, which led to a surge in borrowing by both households and institutions and eventually a lowering of lending standards and, most importantly, misreading of risk.

Many of us assume that interest rate policy and inflation policy are the same, but in fact interest rates are a component of inflation policy. An inflation-suppression policy will include a) managing interest rates (monetary policy), b) supply side policies like privatization and deregulation, c) managing tax rates and government spending (fiscal policy), and d) manipulation of currency exchange rates.

In order to assign blame, let’s consider each in turn. a) Interest rates were discussed above, and b) supply-side policies are very clearly a Republican economic policy. We could debate c) “managing tax rates” forever and never reach agreement on whether this means raising or lowering them, and I’ve already demonstrated on this blog that Democrats are 68% at fault for our spending problems.

The last component is d) the value of the dollar, which is important because a strong dollar keeps imports cheap while a weak dollar increases the effects of inflation. There is no good way to assign blame here since every administration, Democrat or Republican, claims that it has a strong dollar policy. If we were to base our decision on a chart of the value of a dollar over time, we would see strength in the 80s and 90s and weakness since 2001. Whether this is the result of actual policy is debatable, and both periods cross Democrat and Republican administrations, so we’ll call it a draw.

Keeping Score

	Fault of the Democrats	Fault of the Republicans
Bad Housing Policy	100%	0%
Bad Banking Regulation	66%	34%
Mark-to-Market*	100%	0%
Interest Rate Policy	50%	50%
Supply-Side Economics	0%	100%
Excessive Spending	68%	32%
Strong Dollar Policy	50%	50%
TOTAL	62%	38%

*Although the Democrats did eventually clean up their own mess

Ultimately, it appears that Democrats and their progressive policies are mostly to blame for The Great Recession of 2007-08. This is primarily attributable to their bad housing policies and banking regulation and less about support for low interest rates and inflation-suppression policies. In those instances, both parties are to blame.