Economic recessions are caused by a decline in GDP growth,
which is itself caused by a slowdown in manufacturing orders, falling housing
prices and sales, and a drop-off in business investment. The result of this
slowdown is falling employment, and rising unemployment, which causes a
slowdown in retail sales.
Irrational exuberance in the housing market led many people
to buy houses they couldn't afford, because everyone thought housing prices
could only go up. In 2006, the bubble burst as housing prices started to
decline. This caught many homeowners off guard, who had taken loans with little
money down. As they realized they would lose money by selling the house for
less than their mortgage, they foreclosed. An escalating foreclosure rate
panicked many banks and hedge funds, who had bought mortgage-backed securities
on the secondary market and now realized they were facing huge losses.
By August 2007, banks became afraid to lend to each other
because they didn't want these toxic loans as collateral. This led to the $700
billion bailout, and bankruptcies or government nationalization of Bear
Stearns, AIG, Fannie Mae, Freddie Mac, IndyMac Bank, and Washington Mutual. By
December 2008, employment was declining faster than in the 2001 recession.
In 2009, the government launched the economic stimulus plan.
It was designed to spend $185 billion in 2009. And in fact, it halted a
four-quarter decline in GDP by Q3 of that year, thus ending the recession.
However, unemployment continued to rise to 10%, and many business leaders still
expected a W-shaped recession by the end of 2010. High unemployment rates still
persisted into 2011.
In 2007, the housing bubble burst, leading to a high rate of
defaults on subprime mortgages. Exposure to bad mortgages doomed Bear Stearns
in March 2008, then led to a banking crisis that fall. A global recession
became inevitable once the government decided not to rescue Lehman Bros. from
default in September 2008. Lehman's was the biggest bankruptcy in history, and
it led promptly to a powerful economic contraction. Somewhere around here,
agreement ends.
Most analysts find former Fed Chairman Alan Greenspan at
fault, though for a variety of reasons. Conservative economists—ever worried
about inflation—tend to fault Greenspan for keeping interest rates too low
between 2003 and 2005 as the real estate and credit bubbles inflated. This is
the view, for instance, of Stanford economist and former Reagan adviser John
Taylor, who argues that the Fed's easy money policies spurred a frenzy of
irresponsible borrowing on the part of banks and consumers alike.
The pithiest explanation I've seen comes from New York Times
columnist and Nobel Laureate Paul Krugman, who noted in one interview:
"Regulation didn't keep up with the system." In this view, the
emergence of an unsupervised market in more and more exotic
derivatives—credit-default swaps (CDSs), collateralized debt obligations
(CDOs), CDSs on CDOs (the esoteric instruments that wrecked AIG)—allowed
heedless financial institutions to put the whole financial system at risk. "Financial
innovation + inadequate regulation = recipe for disaster is also the favored
explanation of Greenspan's successor, Ben Bernanke, who downplays low interest
rates as a cause (perhaps because he supported them at the time) and attributes
the crisis to regulatory failure.
Though the economic recession seemed to hit the nation with
a sudden fury in 2008, the storm had been gathering force for years.
Deregulation and stability had afforded Wall Street traders a self-confidence
that encouraged them to take significant risks, many centered on America’s
growing number of homeowners, who took advantage of relaxed credit restrictions
and a market wide open to lending. Subprime mortgages (high-risk home loans)
began to take their toll on the economy as homeowners defaulted or fell behind
on payments. When Henry Paulson reluctantly accepted the position of secretary
of the treasury in 2006, he immediately began to reach out for economic reform.
Paulson initially focused on Fannie Mae (Federal National Mortgage Association)
and Freddie Mac (Federal Home Loan Mortgage Corporation), two
government-sponsored mortgage institutions responsible, either directly or
indirectly, for nearly one-half of the nation’s $12 trillion in mortgages.
Facing a war of economic ideology between a Democratic congress and a
conservative white house, Paulson failed to achieve a compromise to address
concerns about fannie mae and Freddie mac’s continued viability and, more
broadly, the volatility of subprime mortgages.
In the summer of
2008, both institutions were on the verge of collapse. A $300 billion credit
line was extended to stabilize Fannie Mae and Freddie Mac, but ten days later
Lehman Brothers, an international financing firm, declared bankruptcy, the
largest in U.S. history. The next day, the federal government authorized an $85
billion buyout of A.I.G. Financial Products, an insurance group closely related
to Goldman Sachs, another financial behemoth specializing in investments.
Citigroup, Merrill Lynch, and other companies teetered on the brink of
bankruptcy and were forced to radically restructure. A general alarm sounded as
the healthy financial institutions shut down credit lines and less-fortunate
companies scrambled for economic security through mergers, buyouts, and federal
bailouts. By late September, the Bush administration began lobbying for a
massive bailout of Wall Street firms. The crisis hijacked the 2008 presidential
election as both candidates, Republican senator John McCain and Democratic
senator Barack Obama, flew back to Washington, D.C., to attend an emergency
meeting at the White House. Despite the hysteria of bipartisan fights, with
Republicans blocking legislation and McCain suspending his campaign, Bush
signed the Troubled Asset Relief Program (TARP) on 3 October, authorizing $700
billion in rescue funds to beleaguered banking firms. More than $17 billion was
carved out to save the auto industry.
The political fallout was immediate, but the recession
continued to deepen, provoking further federal action. While fiscal
conservatives condemned the bailouts for using taxpayer money to rescue corrupt
or incompetent companies, the newly elected Obama administration stepped in
with a federal stimulus package to save failing state governments that were
struggling to meet payrolls and to continue welfare and unemployment programs.
In February 2009, the American Recovery and Reinvestment Act offered $787
billion in federal funds for domestic spending to help struggling homeowners
and state and local governments. A month later, news reports revealed that
parting CEOs from Wall Street firms that had benefited from bailouts received shocking
severance packages. These “golden parachutes,” as they were labeled in the
media, along with Obama’s stimulus package, elicited a mammoth response from
conservatives and liberals alike. In particular, a new group of activists, the
Tea Party, organized against federal spending. A series of conservative
governors tried to block their states’ access to the stimulus. By early 2010
the economy had stabilized, but unemployment remained high. The Tea Party
widened its platform to become the anti-government party, distancing itself
from earlier attacks on CEOs and even endorsing golden-parachute recipient
Carly Fiorina, former CEO of Hewlett-Packard, in the Senate race in California
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