by Dr. Scott Brown, Chief Economist, Raymond James
September 20 – October 1, 2010
The financial crisis began more than three years ago and it’s been two years since the failure of Lehman Brothers kicked off a broad financial panic. It’s well known that recessions that are caused by financial crises tend to be more severe and longer-lasting, and the recovery process is typically lengthy. Believe it or not, the U.S. economy is getting better, but the pace of improvement will be slow-going for some time.
We all know that the housing bubble was the main cause of the economic downturn, but there were many factors that combined to set off the financial crisis.
Subprime lending occupied a small, but important, niche in the mortgage market. Those without a good credit history could get a mortgage, at a higher rate, and lenders, accounting for the greater risk, could make a good return. However, subprime lending got way out of hand in the middle of the last decade. Mortgage lending supervision was lacking and most of the excesses occurred outside of the banking system. The “shadow” banking system was not subject to the regulatory rules put in place after the Great Depression (rules designed to prevent a financial implosion). Subprime loans, offering higher returns (and higher risks), were then securitized and sold around the world to investors who were willing to stretch for yield.
Some blame the Fed for keeping interest rates too low amid the bubble. However, a global savings glut, a consequence of America’s large trade deficit, helped push long-term interest rates lower, helping to fuel the bubble.
In past recessions, business leverage often led to debt service problems once the economy slowed. However, outside of the financial sector, leverage in business was relatively low heading into the recession. The leverage problems were concentrated in the financial sector.
There was a huge degree of complacency. Investors spoke of the “Greenspan put” (later, the “Bernanke put”) – no matter what happens, the Fed was there to lower short-term interest rates and make everything okay again (that complacency has now been flipped 180 degrees).
Another factor, in the summer of 2008, was $4 gasoline, which broke the back of the consumer. Higher oil prices have been associated with recessions in the past. However, that has usually been because the Fed raises interest rates to choke off inflation. The late Rudi Dornbusch once quipped that economic expansions never die of old age, asleep in their beds. “The Fed kills them,” he said. However, the recent recession has been a lot different than usual. Tight bank credit certainly magnified the downturn, but that was a consequence of credit concerns in general, not a function of tighter monetary policy.
