Causes and Solutions of the 2008 Recession

The 2008 Recession: What was the right thing to do?

In 2006 the housing bubble burst, sending the United States and soon the rest of the world close to economic collapse. A few years later, the 2008 financial crisis hit the U.S. with worldwide effects. The causes of this financial recession are rooted in deregulation of the banking industry back under the administrations of Clinton and George H.W. Bush and the malpractices of the banking industry concerning loans, specifically mortgages. When it came to stopping the economic crisis from having a horrid and lasting effect on the world economy, forces from the public and private sector came together to try and work out a solution that wouldn’t necessarily fix the problem as the damage had been done, but to prevent the collapse of the financial system one at a time. The main argument, continuing into today is how involved should the government have been and when it comes to future economic crisis…what is the government’s role?

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While the effectiveness of what the government and private firms did to help save the economy is debatable, the root causes of the financial crisis in 2008 are well sanctioned into two main causes, although there is a bit of argument with these too, but that will be delved into later. What is seemingly the most recognized cause of the financial crisis is the poor discretion of the mortgage banks or just blatant denial of them when it came to loans and mortgages. In 2005 life seemed good, housing prices were rising; people were making money, construction projects were in the midst around the nation. It seemed everyone had a home. But a storm was brewing, could all of these people actually afford a home? In 2008, the country found out the real answer, no. Before that is addressed, let’s back track a bit. Under Clinton the U.S. economy was doing really well, so feeling confident; the United States government deregulated the banking industry slightly. The video of Clinton signing the bill into law was shows that it was a law met with a room full of applause. What awaited the nation in the next decade would have all of those applauders thinking long and hard. The new bill allowed for investment banks to merge with larger banks, creating these massive super banks that seemed “too big to fail” and they were right and wrong about that. In HBO’s “Too Big to Fail” the aftermath of the crisis is shown from the perspective of the US Treasurer Paulson and the financial institutions he had to interact with to try and unfreeze the economy after the worst financial shock the U.S. had seen since the Great Depression. These new banks reduced the qualifications needed to apply for a loan, so now people who wouldn’t be able to afford a loan just two months prior would be able to apply for a loan. Banks seemed confident these people would pay them back, but they never did. When the housing market crashed, people began defaulting on their mortgages. At first it was controllable, but eventually these mortgage companies weren’t getting their money back. With no money, they stopped lending and credit froze. They weren’t able to pay their expenses. An example would be the Lehman Brothers. They were the fourth largest investment firm in the nation when they went under. In the movie they tried to get other companies to buy them out, but none would take such a risk and many asked the Secretary of the Treasury if he would “bail” the out but he was hesitant to as it would be very hard to get Congress to approve of such a move, so he tried to find a private market solution, which ended up failing. These banks were literally too big to fail because if they did, they would take the nation’s entire financial system with them.

How An Economy Grows and Why It Crashes by the Schiff brothers provides some insight into the 2008 financial crisis by showing a step by step process of exactly what the title states. Now with an economy already established, the Schiffs focus on how the government overspends, raising taxes, which ultimately causes more problems, mainly distress among citizens. Now the root of the problem regarding the financial crisis was in government spending according to Schiff, “Wall Street leaders were also irresponsible. The profits made by the big banks during the boom year were obscene. After the crash they should have paid far more dearly than they have. But the bankers were playing the distorted hand dealt them by the government.” When the government stepped in with stimulus packages it prevented the big firms from collapsing, which might have been a good idea for them to do so, according to Schiff. This would allow the markets to “learn a lesson” per say for the future, to prevent these from happening. The main problem with this view, contradicted by the beliefs of The Fed chairman Bernanke and the Secretary of the Treasury, was that these banks were so large that if they went under, they would have brought the entire financial system down with them, and possibly the world economy. This poses an interesting divide. The war between academic theory and what actually works. What sounds great as an idea becomes much more complicated when put into a real life situation like a financial system in extreme distress.

The first solutions taken to try and slow an economic meltdown were through the private market. Paulson organized and stayed in touch with world investment banks to try and save Lehman brothers before they went under. If they went under, it would scare the populace even more and they would lose even more faith in the banking system of the U.S. the Brits were looking promising until their regulators killed the deal as they thought it would bring down the British financial system, which it would affect just six months later as the repercussions of the crisis went global. Eventually Lehman Brothers files for bankruptcy, restoring temporary confidence until it’s seen that AIG is faltering. AIG faltered because one the mortgage companies realized they weren’t getting their money; they all rushed to make their claims as AIG is a mortgage insurance company, a massive one at that. No one wanted to regulate the mortgage market because they were making too much money. Before stimulus packages were introduced, Geithner wanted to make the investment banks even bigger, hoping this would grow their access to the Discount Window and easy access to Fed money to stabilize. The main issue was trying to get the money back into banks so they could unfreeze credit and loaning again. Since people had lost all this confidence in the banking system, they held their money back and didn’t spend, driving aggregate demand down, causing firms like GE to cut costs, increasing unemployment. With private market solutions seemingly hopeless, they tuned their focus to a last resort option, a cash injection.

Initially a capital injection seemed almost taboo, as it would require a level of nationalization of the nation’s largest investment banks, but it was their last hope. This hope was to get these banks to use this money to loan out, to unfreeze credit, and restore some level in confidence in the economy. This TARP bailout was several hundred billion dollars, and Bernanke was sure it would work, but the banks never went through with it, and the effects were mass foreclosures continuing and an unemployment rate of 10%. The effectiveness of these policies is very arguable among politicians and economists to this day. The divide in Washington seems to be anchored in the government’s role in the economy. On one hand the democrats say the stimulus packages have worked, saving the nation from the collapse of the financial system, which is true, but several questions remain. Would there have been a financial collapse if the banks were left to work it out themselves? Most republicans would agree. But was it worth the risk of economic collapse to see if that was really the case? Some say yes, while others heavily disagree. In an article from The Seattle Times it says, “..The stimulus law succeeded because it ‘helped avert what might have become the second Great Depression.’” This has a ring of truth to it. In theory, the stimulus should jump start the economy through a multiplier effect, but with TAR this didn’t happen. Overall consensus points that the stimulus packages were good enough at fending off a total economic collapse, but for not helping the economy to grow.

The financial recession of 2008 was caused by irresponsibility on the fault of the government and the private sector, and a lot can be learned from that event in our nation’s history. Banks should be more careful about who they give loans too, and make sure the can pay them back. Sometimes the government can be a savior in these extreme cases, fending off economic recessions. It all boils down to what ideology one approaches a crisis with, and how they combine that with pragmatism to really save and economy.

Bibliography

Schiff, Peter D., and Andrew Schiff. How an economy grows and why it crashes a tale. Hoboken, N.J.: John Wiley, 2010. Print.

Suderman, Peter. “Why It’s So Hard to Figure Out What the Stimulus Did.” Reason (): n. pag. Print.

Too big to fail. Dir. Curtis Hanson. HBO Home Entertainment ;, 2012. DVD.

“White House defends stimulus laws, but GOP says it hasn’t worked.” The Seattle Times (): n. pag. Print.