Chief Economist Scott Brown reflects on the 10-year anniversary of the Great Recession.
For financial market participants, the 10-year anniversary of the financial crisis is likely to bring back a lot of bad memories.
We tend to think of the financial crisis as the bursting of the housing bubble, but it was much more than that. The country had experienced a number of regional housing bubbles over the years (defined as home prices rising faster than median household income). As the bubble burst, home prices tended to fall somewhat, but then stabilized, flattening as incomes caught up. We had never seen a housing bubble on a national scale. Alan Greenspan, the chair of the Federal Reserve at the time, likened the housing market to a glass of beer – a lot of small bubbles – and downplayed the risks.
A lot of homeowners used their homes as ATMs. At its peak, the extraction of home equity was huge, totaling more than 10% of the level of personal income. That extraction funded a wide range of consumer spending, especially motor vehicle sales, but evaporated as home prices declined.
As a rule, debt doesn’t matter until it does. High debt levels are not a catalyst for a recession, but can make an economic downturn worse. Household debt had risen sharply ahead of the financial crisis, but so had home prices, leaving household balance sheets in generally good shape – that is, until home prices began falling.
Nonfinancial businesses debt did not appear to be much of a problem ahead of the crisis. Firms were generally positioned to be able to service their debt, if the economy experienced a moderate downturn. In contrast, financial sector debt was enormous. The ensuing deleveraging generated uncertainty and boosted counterparty risks. The global financial system seized up, as the big global banks were unwilling to trade with each other. The global financial system was saved by the Federal Reserve and other central banks, which offered to exchange illiquid securities with U.S. Treasuries.
Small business relies on bank credit to regularly meet payrolls, fund inventories and so on. As the financial crisis quickly picked up steam, banks sharply curtailed credit to small businesses. Small- and medium-sized business accounts for a disproportionate share of job creation during an economic expansion. The tightening of bank credit made the downturn worse and limited the ability to recover.
The Policy Response
What set the Great Recession apart from other downturns was the magnitude of the decline. Real gross domestic product (GDP) fell more than 4%. The U.S. economy shed 8.8 million private-sector jobs (a 7.8% decline). The policy response needed to be massive.
Congress struggled to pass the Troubled Asset Relief Program (TARP), which was supposed to create a market for troubled assets over time. Within a week, we saw a simpler, more effective solution. The TARP funds were used to recapitalize banks – an absolutely necessary move that remains widely unpopular. The recession would have been a lot worse otherwise.
Fiscal policy is taxation and government spending. While tax cuts can provide incentives for work and investment over the long term, they are more likely to be saved than spent in a recession (but that never stops lawmakers from trying). Increased government spending may help offset the decrease in private demand, but it’s not always clear when support should be withdrawn.
President Obama and Congress worked to create the American Recovery and Reinvestment Act of 2009 (ARRA), which cost about $831 billion, mostly split between 2009 and 2010. Obama’s economic advisors had called for a much larger package, but the smaller size was deemed more acceptable, following the unpopular bank rescue.
A third of ARRA went to tax cuts; a third as aid to the states. About 20% was infrastructure spending. The stimulus made the recession less severe, but it would still take time for a full recovery. ARRA added to the federal budget deficit (10% of GDP in 2009), but the deficit fell as the economy recovered (2.5% of GDP in 2015).
State and local governments normally provide some base level of support in a recession. Teachers, police and firefighters still get paid. However, reduced tax receipts and balanced budget requirements led to significant cutbacks, dampening overall economic improvement in the first few years of the recovery.
The Federal Reserve (Fed) cut short-term interest rates to effectively 0% and embarked on three large-scale asset purchase programs (known as quantitative easing or QE). QE helped lower long-term interest rates and shored up the stock market. However, each round was seen as less effective. Purchases of Treasuries and mortgage-backed securities ballooned the Fed’s balance sheet, but that failed to ignite inflation as some critics had feared.
Congress passed the Dodd-Frank Act in 2010 to prevent the kind of excesses that contributed to the financial crisis, although lawmakers have worked to whittle away many of the requirements in recent years. Still, banks are much better capitalized than before.
Nine and a half years into the current expansion, there are no signs of a recession on the immediate horizon. However, there’s not much of a safety net should the economy slip and fall. The Fed lowers short-term interest rates a full five percentage points in a typical recession – we currently have about half that potential. With the economy at full employment, the federal budget deficit is surging, leaving little scope for fiscal stimulus if needed.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates, Inc., and are subject to change. Past performance may not be indicative of future results. There is no assurance the trends mentioned will continue or forecasts will occur. Economic and market conditions are subject to change. Investing involves risks including the possible loss of capital.