Government Fault in the 2008 Financial Recession

Since the beginning of the financial crisis, many have attempted to find a singular and most prominent cause for the recession. In general, the American public prefers to point their fingers at the wall street banks and their executives whom they feel were greedy and made risky investments that put the entire country at risk.

However, their behavior was fueled by actions by the Federal Reserve and lack for government regulation. In the early 2000s, there was a housing boom that caused the demand of homes to skyrocket along with their prices. “Mortgage lenders seeking to capitalize on rising home prices were less restrictive in terms of the types of borrowers they approved for loans [1]. This resulted in many people, who would otherwise not be able to afford a home, purchasing homes which further fueled the housing boom contributed to a housing bubble that was slowly growing during that time.

Many Wall Street banks poured their money into buying these mortgages. However, the homeowners were soon hit with higher payments causing many of them to default on their loans. The banks attempted to sell these homes causing a huge supply of homes. However, there was no demand for these homes, “and therefore no way to sell them to recoup their initial investment [2].” “Millions of homeowners and their mortgage lenders were suddenly “underwater,” meaning their homes were valued less than their total loan amounts [3].” The investment banks, who were some of the biggest in the world and were publicly traded, had poured their money into these risky mortgages and suddenly collapsed. Their stock prices fell to single digits and caused the Dow to “lose more than half its value, falling to 6,547 points” which wiped out the savings of many Americans who put their money into the market believing they would get a good return on their investment [4].

All of this could have been prevented if the government was smarter about regulation and was diligent about regulating the market and preventing the rise of these risky subprime mortgages. Even after the crisis began, the government could have slowed the crisis by rescuing the firms and banks who were about to fail. As best stated by the government-sponsored Financial Crisis Inquiry Report, “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire [5].” The government was at fault in the financial crisis of 2008 due to the lack of regulation in the years leading up to the recession, inconsistent predictions and decisions made by the Federal Reserve, and a lack of understanding by the Federal Reserve about how bad the crisis was due to their disconnect from Wall Street.

In the years leading up to the recession, the US Government did not properly regulate the economy and the Federal Reserve was not responsible with its interest rates. In the early 2000’s “The Federal Reserve kept interest rates artificially low [6].” At times, there were “negative real federal funds rates” which drastically incentivized the banking sector to issue more loans to consumers, especially ones who would otherwise not qualify for them [7]. It is known that “large disruptions to economic activity occur only when policy mistakes work against the price system [8].”

These large changes in the rate caused drastic boom and bust cycles that often cause confusion and often destabilize the economy and work against the traditional systems. Additionally, for more than thirty years there was “deregulation and reliance on self-regulation by financial institutions” as several administrations and former Federal Reserve Chairs, such as Alan Greenspan, who served from 1987 to 2006, had helped strip “away key safeguards, which could have helped avoid catastrophe [9].”

These government regulations would have prevented the creation of the many risky subprime mortgages that were offered by these institutions. These regulations would have made sure that the banks would not be able to take on such dangerous and risky assets. The Federal Reserve at several points could have stepped in and stemmed “the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards [10].”

However, the Fed’s leadership chose not to interfere as at the time, the housing market was booming and stock prices were hitting all-time highs. The Fed did not see the ever-increasing risks that were plaguing the American market and did not see the housing bubble growing. The then Federal Reserve chairman, Ben Bernanke later admitted that “he missed the systemic risks” in the system [11]. If the Federal Reserve had been more diligent and more willing to step in, the housing bubble would have stopped growing and the government would be able to contain any damage it did to the country. However, by the time the Fed had realized how bad the situation had gotten, it was already too late as banks were going out of business and people were losing their homes. The Fed had not planned for the fall of such large banks and were often caught off guard when they did. They had not taken the time to “limit the risks posed by the failure of any individual company” to the entire economy [12].

When these banks and other companies fell, they brought down the entire economy with them as there was no plan of action by the federal government of what to do in the case that a bank or other important institution that the economy depends on failed. This is what happened during the actual crisis as when Bear Stearns and Lehman Brothers fell, the stock prices fell and the entire market began to meltdown. These show how a lack of regulation and irresponsible interests rates set by the government helped cause the Great Recession.

The Federal Reserve was disconnected from Wall Street and failed to understand the severity of the crisis, and struggled to understand when they needed to intervene. As the crisis was just beginning, the Federal Reserve Board met to discuss possible actions to be taken on the crisis at hand. The Fed officials showed little worry about the state of the economy and at the time they “still believed that the American economy would keep growing despite the metastasizing financial crisis [13].”

However, on Wall Street, fear of a recession was increasing and few believed that the economy would continue to grow. This period of not intervening and staying out of the market eventually led to the bankruptcy of the global Investment Banking Company, Lehman Brothers. However, even after Lehman filed for bankruptcy, the Fed officials “showed little recognition that a serious economic downturn was underway [14].” The officials at the Fed believed that they could stay out of the market and that at the time, the best plan of action was to be “vigilant monitoring of developments but nothing more [15].”

The main reason that they believed that they did not need to intervene was due to their educational backgrounds. “Most of the committee members had PhDs in Economics, and therefore shared a set of assumptions about how the economy works and relied on common tools to monitor and regulate market anomalies [16].” Many believed in the self-correcting nature of the economy and did not believe that there was any reason to get involved. However, as echoed by many on Wall Street, it was not the time for the Fed to be academics.

Prominent television personality and financial commentator pointed out how members of the Fed and especially the Chairman, Bernanke was “being an academic” but due to his and many others on Wall Street’s fears he made the point that is was “no time to be an academic” and that Bernanke needed to listen to Wall Street [17]. The Fed did not listen and continued on the same path which caused the crisis to worsen. Jim Cramer begged for the Federal Reserve to cut the rates saying “Cut the darn discount window. Cut the rate. Open the discount window. Cut the rate. Relieve the pressure” on live television hoping to see actions from the Fed.

However, nothing happened and soon after, companies and banks began declaring bankruptcy and there was nothing the Fed could do to stop it. This shows how the Federal Reserve was disconnected from the Wall Street Banks and did not understand the severity of the crisis and when they needed to intervene.

Throughout the financial crisis, the federal government made inconsistent predictions and decisions that decreased investor confidence and caused confusion on Wall Street. The financial crisis of 2008 was most precipitated by the fall of the investment bank Lehman Brothers, the fourth largest investment bank in the world. The bankruptcy of Lehman Brothers was the biggest in United States history and still is today. When Lehman filed for bankruptcy, the government did not step in to help them as they did with competing firm, Bear Stearns, and the housing giant AIG.

These decisions caused chaos in the markets and many were confused by the government’s plan of action as they saved certain firms and let others go. The decision to let go of Lehman was one of the most unpredictable but was likely a result of them consulting the heads of other firms. “Fed officials asked the heads of competing major banks if they could survive a Lehman bankruptcy, they replied yes [18].” Soon after however, many of these firms fell apart due to the market reaction to Lehman’s chapter 11 bankruptcy and received “the same kind of government assistance denied to Lehman [19].” Such decisions increased the uncertainty and panic in the market causing stock prices to plummet.

Additionally, many of the predictions made by the Federal Reserve were inaccurate and harmful to the economy such as their failure to “recognize that a bursting of the bubble could threaten the entire financial system [20].” They also, to the dismay of investors, the Fed “voted unanimously against bolstering the economy by cutting interest rates [21].” They believed that there were still other investors who would re-enter the market and re-stimulate it. Fed transcripts show how members came to the consensus that there were “traditional investors…still out there with substantial liquidity, and they are just temporarily on the sidelines [22].” They also did not foresee how the fall of banks like Lehman Brothers would have such catastrophic effects on the entire economy. This shows how the Federal Reserve’s predictions and decisions led to the fall of some of the largest banks in the country which precipitated an overall economic meltdown.

Overall, the Government and the Federal Reserve had many opportunities to stop or prevent a financial crisis, but they made several mistakes in the years leading up to the recession and did not respond properly to the crisis when it began and as it worsened. The government was unprepared for such a crisis as there were many “gaps in the government’s crisis-response toolkit [23].”

Government agencies and those who were supposed to be monitoring the markets were off their guard and let the market fill with toxic mortgages and loans that many investment banks bought. These banks’ assets were often concentrated in these mortgages and due to the lack of transparency, the federal government had no idea how much damage these subprime mortgages could do. The government did not understand “the system’s vulnerabilities [24].” Due to this, they made many bad decisions that caused investment banks or mortgage companies to fall into bankruptcy.

The fault for the crisis was in the people involved and the systems they created. As put by the Financial Crisis Inquiry Report, “To paraphrase Shakespeare, the fault lies not in the stars, but in us [25].” However, that fault lies more in some of us than the rest. The fault lies mostly in the government regulators who failed to regulate the economy and the members of the Federal Reserve who failed to be responsible about interest rates and made unpredictable decisions that had detrimental effects on the economy.

Notes

1. Editors, History.com. “Great Recession.” History.com. December 04, 2017. Accessed June 09, 2019. https://www.history.com/topics/21st-century/recession.
2. Ibid
3. Ibid
4. Ibid
5. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. New York, NY: Public Affairs, 2011.
6. “The Great Recession and Government Failure.” Hoover Institution. Accessed June 09, 2019. https://www.hoover.org/research/great-recession-and-government-failure.
7. Perry, Mark. “How Government Failure Caused the Great Recession”. http://www.aei.org/publication/how-government-failure-caused-the-great-recession/.
8. Ireland, Peter. “Government Policy Mistakes Led to the Great Recession | Economics21”, April 9, 2019. https://economics21.org/html/government-policy-mistakes-led-great-recession-3023.html.
9. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States.
10. Ibid
11. Ibid
12. Ibid
13. Appelbaum, Binyamin. “Fed Misread Crisis in 2008, Records Show.” The New York Times. February 21, 2014. Accessed June 09, 2019. https://www.nytimes.com/2014/02/22/business/federal-reserve-2008-transcripts.html.
14. “Jim Cramer Got The Ultimate Vindication This Week.” Business Insider. January 20, 2013. Accessed June 09, 2019. https://www.businessinsider.in/Jim-Cramer-Got-The-Ultimate-Vindication-This-Week/articleshow/21437007.cms.
15. Ibid
16. Coghlan, Erin. “What Really Caused the Great Recession?”. http://irle.berkeley.edu/what-really-caused-the-great-recession/.
17. Cramer, Jim. They Know Nothing.
18. Cohen, Patricia. “Lehman Brothers, a Family Saga, as Viewed by Some Who Lived It.” The New York Times. April 17, 2019. Accessed June 09, 2019. https://www.nytimes.com/2019/04/17/business/lehman-brothers-theater.html.
19. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States.
20. Ibid
21. Cohen, “Lehman Brothers, a Family Saga, as Viewed by Some Who Lived It.”
22. “Jim Cramer Got The Ultimate Vindication This Week.” Business Insider
23. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. New York
24. Ibid
25. Ibid