Novel Policy Approaches Reduced Impact of Great Recession and Produced Speedier Recovery
By Norton Reamer and Jesse Downing
The actions taken by the U.S. Federal Reserve (the Fed) and U.S. Department of the Treasury following the 2007 – 2008 U.S. stock market crash were, in the end, a brilliant response to a truly frightening financial crisis and incipient major economic collapse. The economic impact of the crisis, while severe, was clearly contained. America experienced the gravest economic setback in 80 years, but one whose duration and magnitude fell far short of the country’s experience in the 1930s.
No other country can claim as brilliant a use of the economic toolkit as what was brought to bear in the United States. The historical record clearly shows the superiority of the response to the Great Recession versus the Great Depression. Every day now, one can look at the world around us and see the efficacy of the novel and successful response by U.S. policymakers, in contrast with less successful methods employed by other governments, particularly in Europe.
The successful U.S. response validated the role of activist monetary and fiscal policy in the face of severe economic crises. Moreover, the primary focus of activist policies undertaken by the Fed, and both the Bush and Obama Administrations, was democratic in nature: focused on stabilizing employment, consumption levels and broad economic performance, and benefiting the broadest possible segment of the population.
While some of the “bailouts” did help large financial institutions, the primary focus of government’s Olympian efforts was not on saving bankers, CEOs, and tycoons. Instead, what we saw was “democratization” at work. Government leaders took an active hands-on approach to making sure that middle-class and working-class Americans were not devastated by unemployment the way they were in the Great Depression. Their activist approach and laudable results stand in stark contrast to the approach advocated by many free-market thinkers, who believe that a hands-off approach by government is the optimal response to cyclical economic crises.
We devote a chapter in our book Investment: A History to two cataclysmic economic events: the Great Depression and the Great Recession. The contrasts between the policy responses to these two crises illustrate important progress in economic theory and increased effectiveness of remedial measures. Policymakers today better understand the importance of staving off deflation and drops in aggregate demand and supply, and activist monetary and fiscal policies help democratize the national response to crises.
Looking at these two crises side by side reveals that the U.S. has become more proactive and more effective in addressing cyclical economic problems. Government has also brought a more broadly democratic focus to national economic policy.
Analysis of these two crises reveals the critical role played by radical, innovative central bankers – Benjamin Strong (in the lead-up to the Great Depression) and Ben Bernanke (in managing the fallout of the Great Recession). Both central bankers took calculated but bold steps to maintain order in the economy and the market, and in doing so, often took no shortage of political heat. Sadly, Strong did not live to see the critical moments of the earlier crisis and his skills were not available after 1928.
Some people rail against what the Fed did during and after 2008, but U.S. economic management was based on decades and decades of understanding how economics works. Their detractors claimed at best that their policies would not succeed and at worst that they would wreak irreparable havoc upon the financial system. As history is likely to see it, these detractors were shortsighted.
Today, due to financial innovation, virtually all parts of the real economy are dependent to some degree upon the financial markets. As a result, risk is socialized and spread from the balance sheets of a few to the balance sheets of many.
Socializing risk through financial markets has created a common source of risk for many more economic agents than would otherwise be involved. This is perfectly fine as long as the potential risk is properly understood beforehand. But if the nature of the risk is not correctly understood, many economic agents can become distressed all at once, because they are all exposed to this common source of risk. At the same time, human behavior has not changed, and is not likely to change. Policymakers today have shifted their focus toward employment and consumption management, and are disinclined to accept dramatic dislocation as a natural and healthy purging of economic excess. Yet there is little evidence of public restraint or caution once confidence in economic success has built up in the system: so future meltdowns are still highly probable.
Once an economic cycle has delivered notable financial rewards to the business community and the general population, we still see excessive confidence, excessive greed, excessive speculation and excessive carelessness by many market participants. This human frailty doesn’t ever seem to change, and the tendency for the system to become more permissive during periods of prosperity has not changed either. This proclivity shows in both legislation and regulation, as rules are often pared back once a boom is underway.
In the end, thanks to the use of modern fiscal and monetary tools, the Great Recession was quite different from the Great Depression. The fiscal stimulus may have been a little too small, too short lived and too oriented towards tax cuts. But it still helped, and the monetary response was robust enough to aid the economy in moving out of the recession. We learned many important lessons from the Great Depression, which helped us through the recent crisis. From the Great Recession we learned that informed activist efforts work, and often we are not hampered by the modest use of fiscal tools as much as a lack of political will, which can stand in the way of a faster and more robust recovery.