WASHINGTON, Dec. 19, 2015 – In our previous article, we provided a short history of how the U.S. Federal Reserve Bank has generally dealt with inflationary and deflationary forces after its Great Mistake of 1937. Simply stated, the central bank’s policies after that point dictated easier, cheaper and more available money during hard times (recessions); while bolstering the dollar, raising borrowing costs and draining dollars from the system were employed to cool down an economy that was becoming inflationary.
While U.S. recessions after 1937 never again achieved the scale or scope of the disastrous Great Depression of the 1930s, some of these recessions were still tough to get through. But government monetary policy generally succeeded in making these cyclic economic contractions far less calamitous than the Great Depression.
But then, 2007-2009 happened.
The Great Recession: Background
Aside from the 1 percent, most working Americans today understand the Great Recession as the time when their lives changed emotionally, financially, personally and likely permanently. The days of liar loans, unlimited credit and financing upper middle-class living on lower middle-class incomes abruptly came to an end during this period. Today, for most Americans, the razzle-dazzle lifestyles of the 1990s and early 2000s seem gone for good. But the average voter remains puzzled and resentful about this debacle.
Some (like this writer) would argue that the average American worker has yet to emerge from the Great Recession. But that long-evolving, sordid tale is best dealt with in another column. For now, let’s take a brief look at the Great Recession, an event that was actually the result of gradually more reckless lending by the nation’s banks that were encouraged in this undertaking by the government itself.
Since the time of President Nixon’s resignation, it has been the tendency of Congress, particularly when a Democrat is president, to buy votes by making money—particularly in the form of real estate loans—easier and easier to borrow for more and more individuals, without much regard to their ability to pay it back.
By means of this cynical ploy, congressional Democrats could attribute the resulting “affluence” of their constituents to their own enlightened control of the government’s money spigots.
To keep the good times rolling, proclaimed congressional incumbents, you need to keep re-electing us. And that generally seemed to be the case, despite the nasty recessions of 1979-81, 1987-88, and 1999-2001. Those events were actually the harbingers of worse economic times to come. But no one paid much heed to these early warnings.
So successful was the Democrats’ redistributionist sleight-of-hand that even most Republicans got on board, evolving into “Democrat-Lites” in the process, a situation that clearly persists even today.
The reckless, relentless loosening of lending standards governing consumer real estate loans eventually got completely out of hand by the turn of the new century. Under the Clinton administration, Democrats operatives took control of Fannie Mae and lobbied banks to continue liberalizing loan writing standards–a tactic that was taken to absurd ends by independent loan organizations like the notorious Countrywide.
By 2003-2005, real estate loans could be easily obtained in many states by individuals who, in saner times, would never have remotely qualified for a housing loan in the first place. In many cases, lenders didn’t even require documentation of a borrower’s income. The term “liar loans” evolved as an apt description of this activity, and many a liar loan was granted to individuals and families clearly unqualified to carry a mortgage even under the best of circumstances. But Democrats, and Republicans as well, wanted to crow about “increasing American home ownership” at every election cycle and this was one way to do it.
Exacerbating the problems at Fannie Mae and Freddie Mac (which bought far too many substandard loans), was an increasingly accommodating Federal Reserve monetary policy. Acting in concert, these government players succeeded in creating a monstrous “bubble” in real estate prices. The cost of housing in most markets nationwide, along with the massive loans that supported housing price inflation rapidly ballooned out of control. It was a problem so immense that, when the bubble began to burst in late 2007, few realized the magnitude of the disaster that would soon to unfold.
The Great Recession erupts
As more and more lower- and lower-middle class homeowners began to default on the mortgages they never should have had in the first place, the plague of foreclosures began to spread across the country with a rapidity and shock that was the economic equivalent of the Black Death in medieval Europe.
As housing contracted, the hapless holders of liar loans were laid off their jobs, creating successive waves of new foreclosures, rapidly driving aggressive lenders toward bankruptcy.
Worse, the whole financial ecosystem began to erode, largely as a result of something no one had apparently ever heard of before, loan resale packages called “derivatives.” It seems that huge amounts of defaulting home loans had been sliced, diced and put into packages or “tranches” of bond-like instruments, which were then sold as AAA-quality loan packages to eager but often unsuspecting clients, customers and institutions. It had been going on for years. But now the problem quickly came to a head.
You know the rest. From September of 2008, the successive waves of foreclosures and the resulting relative worthlessness of the mass of mis-rated derivatives and loans that sat on the books of countless banks, insurance companies, corporations and whomever and whatever had acquired these derivatives—nearly killed the financial system.
2009-2010: The Eve of Destruction as Washington goes off the rails
For better or worse, the government and the Fed reacted swiftly and forcefully to the ongoing financial disaster once the magnitude of the issue was grasped, taking Fannie Mae and Freddie Mac and their massive pile of worthless derivatives into federal receivership; folding major financial institutions, most notably Bear Stearns and Lehman Brothers into receivership and dissolution; forcing the closure, sale or merger of banks in serious trouble for their loose lending standards; and putting other “too big to fail” financial institutions, like insurance giant AIG, on taxpayer-backed life support. Collectively, this massive bailout was known as the TARP program.
The Fed also rapidly reduced interest rates in the banking system to near zero while printing mass quantities of dollars — ultimately trillions — in the hopes of halting a deflationary disaster that threatened to equal or exceed the Great Depression.
All this was done with the new Fed policy tools we discussed in a general way in Part I. But this time, the Fed actions were running on steroids. Fortunately for the nation, the Fed’s unprecedented interventionism worked to a great extent, at least in terms of economic triage.
Government assistance–for the wealthy
Unfortunately, both Congress, which is usually a partner with the Fed in solving such disasters, as well as a new Obama administration that proved willfully ignorant of and even disdainful towards the trappings of capitalism, chose this moment to pay off their political supporters.
Worse yet, without any way to pay for it and before anything resembling economic recovery had begun to take hold, congressional and administration Democrats who were entirely in control of the government at the time, also chose to add a massive new federal “entitlement”—Obamacare—to the Great Recession’s witches’ brew. Measures to stimulate actual employment could come later if at all. “Gifts” of free medical insurance to largely Democrat constituencies would come first.
A significant percentage of the trillions of new dollars ordered up by the Fed wound up either distributed to union constituencies, sitting in bank vaults—courtesy of the massively flawed Dodd-Frank bank cure-all bill—or in the pockets of wealthy corporations and individuals who supported Democratic candidates.
Favored corporations and individuals could now obtain fresh money via cheap loans (in the case of individuals) or by selling bonds (IBM, Apple and the like) at historically low interest rates. The proceeds of many of these new bond issues were then used to buy back shares of a company’s stock, effectively inflating earnings per share and boosting share prices to above-average levels.
But at the same time that large corporations were gorging themselves on cheap money, John Q. Public—indebted to the max via previous ruinous government policies that encouraged over-borrowing and overspending—failed to qualify for any loans at all. When approaching their bank for a new housing loan or a much-needed refinancing of an existing loan, they soon ran up against draconian new lending rules that disqualified all but a few borrowers from qualifying for anything more than a high-interest rate credit card.
The result: a prolonged, unplanned buyers’ strike in both retail and real estate alike that’s only begun to life in recent years due to a loosening in auto loan standards, which, in a way takes us back to the future.
Home loans have been somewhat easier to get over the past year. But refinancing home loans still remains difficult, particularly via major lenders like Wells Fargo, which are still constrained by standards imposed courtesy of Dodd-Frank’s evolving rules. Since most consumers and homeowners not already foreclosed upon are saddled with older, high-interest loans they haven’t been able to refinance, it will take them a very long time to pay them off. That means they won’t be doing a lot of “consuming” anytime soon.
Meanwhile, the companies and institutions that could obtain essentially billions and perhaps trillions of dollars at nearly zero interest rates were using essentially free money to raise their compensation packages, snatch up huge chunks of prime corporate real estate and, not surprisingly, also buy back billions of dollars of their own company’s shares. All of this helped those still in the stock market—like themselves—enjoy outsized profits as the stock market staged a massive, taxpayer-financed recovery from its 2009 bottom.
In one sense, this was precisely the Fed’s purpose for keeping interest rates so low for so long. The Fed wanted to see the value of all assets—particularly stocks—increase again, at least back to previous, pre-recession values. On the surface at least, this would help restore the “wealth effect” that had been lost between 2007-2009. But while institutions and the wealthy benefited, no one else really did.
As it’s pump-priming money printing regime began to lose its power, it became increasingly obvious that the Fed would have to end the zero interest rate environment and start boosting interest rates back to normal levels at some point. They’d already effectively lost their standard “draining” and “injecting” strategies (Part I) in the Great Recession, leaving themselves with little on hand with which to intervene should the economy suffer another recession.
The Fed’s baffling new paradox
By the time period spanning 2013-2015, the Fed found it was trapped inside an economic dilemma they’d never anticipated or seen, at least not publicly. Having never managed, largely due to a feckless Congress and president, to get even a fraction of the cheap money they’d printed back into the hands of those who really needed it—the average U.S. taxpayer and consumer—the Fed found itself forced to start applying the kind of economic medicine heretofore only used in an inflationary environment—the hiking of interest rates and the draining of money from the system.
Unaided by either Congress or the president, they’d actually succeeded in creating the inflation they sought to counteract the deflationary effects of the Great Recession. But that inflation was limited to the stock and bond markets and, belatedly, to real estate, at least if one managed to live in New York or San Francisco or a few other cities where the wealthy once again recklessly drove up the price of local real estate. Other areas of the country weren’t nearly so lucky.
Addressing this weirdly selective inflation is truly uncharted territory for the Fed, particularly in the current environment where commodities like oil are, in fact, rapidly deflating in price. No one at this point, including the Fed knows how things will turn out for the economy as the nation’s central bank begins to hike interest rates during a weak recovery, conjuring up the ghosts of 1937.
Next: 1937 all over again?