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Summary Article: FINANCIAL CRISIS OF 2008 from Encyclopedia of U.S. Political History

The Financial Crisis of 2008 thrust the federal government into a more active role in economic policy making. Beginning with losses in the market for subprime mortgage securities, banks and nonbank financial institutions experienced substantial losses, which reduced their capital available to lend and forced the financial firms to reduce their debt. Ultimately, economies worldwide contracted. As companies reduced investment spending and consumers increased savings in response to economic uncertainties, the Nobel prize-winning economist Paul Krugman noted that this situation required the government to provide substantial fiscal stimulus if the economy was to recover. Responses to the crisis—including government spending, corporate bailouts, and interventions in the financial markets—created a deep political divide, however. Critics of the growing government role worried that the United States might be on the road to socialism and that such expansion of the government would reward the irresponsible behavior of wealthy financial professionals and greedy mortgage borrowers.

Events of the Financial Crisis

The financial crisis began in August 2007, when concerns about losses in subprime mortgage securities led to fears of counterparty risk (the risk that the other party to a financial arrangement will be unable to meet its obligations) and the freezing of financial markets around the world. The Dow Jones Industrial Index weathered that shock and peaked in October 2007—and then lost about 54 percent of its value by March 2009. In March 2008, the Bear Stearns investment bank collapsed, and the government helped arrange for it to be bought at a fraction of its previous value by JP Morgan Chase. In September 2008, the Lehman Brothers investment bank declared bankruptcy; the government engineered a takeover of "Fannie Mae" (Federal National Mortgage Association) and "Freddie Mac" (Federal Home Mortgage Corporation), the nation's two largest mortgage finance lenders; the Federal Reserve provided a bailout of the American International Group; Merrill Lynch was sold to Bank of America; and Morgan Stanley and Goldman Sachs both transformed themselves into traditional bank holding companies, thus making them more subject to federal regulation but also giving them access to federal support. This transformation ended the era of independent investment banks in the United States. In December 2008, stock broker and financial advisor Bernie Madoff was implicated in the world's largest Ponzi scheme scandal to date. Throughout this period, climbing unemployment as well as troubles in the automotive industry and other companies outside of the financial system ensured that the financial crisis affected almost every aspect of the wider economy.

Politics and Causes of the Financial Crisis

Many factors have been cited as a cause of the 2008 financial crisis, including the growth of complex and opaque financial derivatives, a glut of savings from developing countries that reduced the returns from taking risks and thus led financial actors to seek greater risk to achieve desired returns, and the low interest rate policy of the Federal Reserve while Alan Greenspan was chairman (1987-2006). One factor in particular, though, is closely related to American politics—the role of regulation. An important political divide exists over if the crisis was caused by too little or too much regulation. The argument of those who blamed deregulation was that it allowed banks and other nonbank financial entities to take excessive risks because bank officials believed that the government would come to the rescue if things went wrong. Financial analysts spoke of the "Greenspan put"—the idea that the Federal Reserve would act quickly to prevent economic downturns—and also of "too big to fail"—the idea that the government would not let large financial companies fail, as the costs to the overall economy would be too high. Since the 1970s, deregulation in the banking sector had included allowing banks to merge into larger units with more total assets, to pay interest on checking deposits, to remove the ceilings on interest rates that could be paid on other types of deposits, and, in 1999, even eliminated the separation between commercial banks and investment banks.

Deregulation expanded as new financial innovations and products grew outside the scope of existing regulations. Paul Krugman characterized this as the "shadow banking system." Since the 1970s, the growth of private equity firms, hedge funds, financial derivatives, and nonbank financial actors had occurred outside the scope of existing regulations. In the words of author and former banker Charles Morris, "The relentless deregulation drive that started during the Reagan administration steadily shifted lending activities to the purview of nonregulated entities, until by 2006, only about a quarter of all lending occurred in regulated sectors, down from about 80 percent twenty years before." (54) Because regulations are meant to limit the actions of financial institutions, these companies had and have strong incentives to find loopholes or other ways to legally avoid regulations. Because of the antiregulatory environment of the past three decades, many of these financial innovations were left unregulated. The growth of securitization, the holding of assets off a bank's balance sheet, and the lack of a centralized location for trading financial derivatives all contributed to the financial crisis.

The antigovernment side of the political spectrum, however, laid the blame for the financial crisis more squarely on government regulations such as the Community Reinvestment Act of 1977. While the intentions of the act were noble—it required banks to avoid discriminating against low-income members of the community when deciding about loans—critics charged that this requirement forced banks to lend money to those who were poor credit risks. Specifically, with the goal of increasing home ownership and reducing discrimination, the Clinton administration was blamed for strengthening the act by requiring Fannie Mae and Freddie Mac to purchase and securitize housing loans made to poor individuals with low credit ratings. By taking such action, these government-sponsored enterprises allowed the subprime mortgage market to grow more than it would have otherwise, though the specific degree of blame to be placed is a source of controversy as Pres. George W. Bush also supported similar policies. In addition, many subprime mortgage lenders operated outside of this system as a part of the shadow banking system, and these institutions were less concerned about credit quality because they sold the loans—packaged as securities—to other financial actors.

The Role of Politics in Formulating the Government's Policy Response

Regardless of the causes, clearly a strong policy-making response was needed to end the crisis and to avoid a prolonged economic downturn. These responses include providing fiscal stimulus through increased government spending or through tax reductions, using government funds to buy the troubled assets of financial institutions or to otherwise inject further capital into financial institutions, bailing out companies viewed as "too big to fail," and providing a coordinated international response to avoid both beggar-thy-neighbor policies and countries falling into protectionism.

As for fiscal stimulus, President Bush signed a $150 billion economic stimulus plan in January 2008; it provided $100 billion worth of tax rebates for businesses and individuals; President Barack Obama signed the much larger $787 billion American Recovery and Reinvestment Act of 2009 in February 2009. This bill included tax relief, greater unemployment benefits, and more government spending on infrastructure, education, and health care.

Using government funds to assist failing financial companies has more generally been the task of the Department of Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation. The Federal Reserve, in particular, dramatically expanded its role by printing money to inject into financial markets in various ways; as a result, the assets on its balance sheet grew from less than $1 trillion to more than $2 trillion in 2008. The Troubled Asset Relief Program (TARP), passed by Congress in October 2008, allowed the Treasury and Federal Reserve to spend $700 billion to help some financial institutions stay solvent.

Politics, however, often constrains the necessary actions. Although most economists argued that ending the crisis required the government to aid in restoring the health of banks' balance sheets so that they could resume extending credit to the wider economy, the American public tended to view such actions with suspicion—either because they see this as rewarding irresponsible bankers or because they believe government action is the first step on the road to socialism. For example, in March 2009, the public and politicians were outraged by the revelations that officials at the American International Group (AIG) received $165 million in bonuses despite receiving a bailout of $173 billion of taxpayer monies. Politicians discussed creating special provisions for a 100 percent tax on such bonuses; AIG's actions also further threatened plans to provide financial assistance to similar firms. Economists were also concerned about and outraged by such cavalier actions; economists also maintained that this type of government intervention was the only way to normalize conditions in the financial sector and resume the growth of credit and lending in the economy. Treasury official turned academic Phillip Swagel has argued that political constraints have severely limited the role of government actors; for example, the Federal Reserve and Treasury desired a TARP-style program in March 2008 but knew such request to Congress was politically unfeasible. They had to wait until the financial crisis further escalated in September of 2008.

Economics and politics collided in the arena of protectionism. In their desire to take action and to garner votes, some politicians urged protectionist measures popular with the public but that will do long-term damage to the country after inevitable retaliation from other countries reduces global trade and further damages the American export industry. For example, in the debate over the Obama administration's stimulus package, much time was spent discussing "Buy American" provisions that would require stimulus funds only be used to purchase American-made products. Politicians also discussed whether banks receiving TARP funds only be allowed to make loans in the United States or to hire only American workers.

The Financial Crisis and Long-term Reforms

As a long-term response to the crisis, many reforms have been considered. For instance, rating agencies experienced conflicts of interest—they were paid by the organizations for which they were providing ratings and some consideration had been given to put regulations in place to prevent this behavior. In addition, financial actors initiating mortgage loans could be required to keep a stake in the mortgages they create so that they will pay more heed to credit risk. Complex financial derivatives might be regulated and sold through exchanges rather than in over-the-counter markets; such arrangement would help reduce counterparty risk and make the industry more transparent. Regulation in the future may also be designed to keep pace with new financial instruments and innovations and ensure that all financial actors are adequately regulated—admittedly a difficult task as the finance industry constantly develops new products and techniques to bypass regulations and also lobbies extensively for favorable treatment. The United States may, in the future, consolidate its many regulatory bodies and expand regulation to any financial entity that behaves like a bank or is "too big to fail." Economists have also discussed developing countercyclical capital requirements that force institutions behaving like banks to develop a larger capital cushion during boom times.

The financial crisis and very deep recession that began in 2007 thrust the federal government into an activist role unseen in the United States since the 1930s. In the coming years, the experience of the financial crisis of 2008 will certainly have important implications for economic policy. The enormous bailout provided to the financial sector greatly expanded the size and role of government in economic policy. This growing government activism raises important questions about the role of the government in the economy; President Obama can be expected to push for a more active government role and less reliance on free market outcomes, reversing the Reagan-era goal of limiting government.

Bibliography and Further Reading
  • Barbera, Robert J. The Cost of Capitalism: Understanding Market Mayhem and Stabilizing Our Economic Future New York: McGraw-Hill, 2009.
  • Carr, Edward. "Greed—and Fear: A Special Report on the Future of Finance.". Economist, January 24, 2009, 1-24.
  • Foster, John B., and Fred, Magdoff. The Great Financial Crisis: Causes and Consequences New York: Monthly Review Press, 2009.
  • Krugman, Paul. The Return of Depression Economics and the Crisis of 2008 New York: W. W. Norton, 2009.
  • Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets, 8th edition. Boston: Pearson Addison-Wesley, 2007.
  • Morris, Charles R. The Trillion Dollar Meltdown New York: Public Affairs, 2008.
  • Swagel, Phillip. "The Financial Crisis: An Inside View." Brookings Papers on Economic Activity Spring 2009 Conference, April 2009. (accessed May 28, 2009).
  • Wallison, Peter J. "The True Origins of This Financial Crisis.". The American Spectator, February 2009. the-true-origins-of-this-finan (accessed May 13, 2009).
Wade Donald Pfau
© 2010 CQ Press, A Division of SAGE

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