Americans are nervous. Their investments and homes have been losing value. Good jobs are hard to find. Each day the news brings more troubling reports about a mounting debt crisis in the USA, credit downgrades by a rating agency, and the vulnerabilities of Greece, Spain, and Italy. Americans wonder: How did we get in this mess?
Historian Alan Brinkley observed that “economists and historians still have not reached anything close to agreement” when trying to explain the Great Depression, and disputes about causes of the Great Recession are likely to remain as lively. Nevertheless, history provides some useful clues for tracing causes and effects.
Two perspectives are especially helpful. One draws attention to international factors. The other focuses on actions (and mistakes) made by leaders in Washington.
Americans are in the habit of focusing almost exclusively on domestic events when explaining their economic problems. Yet U.S. businesses are closely integrated with the global economy. One of the principal reasons that federal authorities rushed to save the mortgage giants, Fannie Mae and Freddie Mac back in 2008, was that foreign investors from Japan, Russia, China and other nations had more than $1 trillion in debt issued by those agencies.
Bond and stock markets move roughly in tandem these days. When Greece sneezes, the United States catches a cold. When stocks crash on Wall Street, often markets drop in Tokyo a few hours later.
This is not a new phenomenon. Back in the nineteenth century, financial experts did not speak about “globalization” as we do today, but finances were, in fact, closely connected.
When U.S. historians discuss the depression of 1873, for instance, they tend to focus on the events in America such as frenzied railroad building and the failure of a bank, Jay Cooke and Company. But the crisis of 1873, like many others, started abroad (in a decision to cease the minting of silver coins in Germany and bank failures in Vienna).
Currently, bankers and political leaders in Europe are trying to stop their region’s economic hemorrhaging by creating a large bailout program for the eurozone. They want to restore market confidence and prevent “contagion.”
To a degree, though, contagion is already affecting markets in America. Trading on the New York Stock Exchange has been volatile for months, in large part because of serious debt problems affecting Europe’s southern nations.
Politics in Washington are not, then, solely to blame for our economic woes. Global weaknesses have brought hard times to Wall Street and Main Street. But it is not appropriate, either, to attribute the bulk of our economic ills to foreign troubles, as President Herbert Hoover tried to do in the early 1930s. To a considerable extent, our difficulties are home-grown.
Investor and author George Soros astutely links American troubles to excessive confidence in “market fundamentalism”—a belief that private markets are highly efficient and can generally regulate themselves. Proponents of this viewpoint believe government bureaucrats are not in good positions to understand business affairs. Their fumbling interventions often block enterprise and innovation. Market fundamentalists subscribe to Ronald Reagan’s judgment: “Government is not the solution to our problem. It is the problem.”
Conservatives often tout the benefits of “free” markets, but in practice, market fundamentalism has produced a troubled history. Rapid deregulation of savings and loan institutions in the 1980s contributed to a smashup of the “thrifts” that cost more than $100 billion to repair. In 1998 risky trading in derivatives by managers at Long-Term Capital Management threatened the U.S. financial system (the Federal Reserve came to the rescue and limited the damage). Lax regulation of mortgage underwriting led to abuses involving sub-prime loans and various obscure real estate contracts.
Particularly troublesome was a little-noticed decision by the Securities and Exchange Commission in 2004, which allowed investment bankers to stretch their firms’ capital-to-debt leverage from 12-1 to 30-1 and in some cases 40-1. The exemption gave bankers opportunities to expand their trading in mortgage securities. That activity put the companies at risk when real estate collapsed in 2007-2008. Bear Stearns was about to go under when JPMorgan Chase grabbed it at a fire sale price. Lehman Brothers crashed in September, 2008, which led stock markets to drop precipitously around the world. Merrill Lynch averted bankruptcy by selling itself to Bank of America. Morgan Stanley and Goldman Sachs survived through reorganization and assistance from bailout funds.
In these and many other instances, largely unfettered markets produced both impressive booms and frightening busts.
From the 1980s to the Great Recession, American finance lost its stability, which had been fostered by the New Deal’s reforms of the 1930s. Regulations created at the time of Franklin D. Roosevelt’s presidency helped to keep banking and securities businesses from engaging in highly risky activities. During the Great Prosperity of the post-World War II decades, American bankers joked about a 3-6-3 arrangement in their industry. Bank managers borrowed money at 3%, loaned it out at 6%, and began play on the golf course by 3 PM. Economists identify this period as the era of “boring banking.”