Editors’ Note: This month economics professor Charles Ballard answers our questions about the economic fallout.
Are We in a Recession?
The official call of when a recession begins and ends is made by a committee of the National Bureau of Economic Research, a think tank headquartered in Cambridge, Massachusetts. The members of the committee pore over all sorts of economic data. They want to get it right, so they usually take a long time to call the beginning and ending dates of a recession. The current situation has not yet been officially labeled a recession. However, I (and many other economists) believe that the U.S. economy is indeed in a recession now.
How Did We Get Into This Mess?
Today’s financial crisis is the most serious since the Great Depression of the 1930s. The current crisis has its origins in the housing market and the mortgage market. Several years ago, many financial institutions relaxed their standards for issuing home mortgages. The result was an increase in “subprime” mortgages, which are mortgages issued to borrowers whose credit isn’t very strong. As more people bought homes, the prices of homes went up. In some areas of the country, home prices went up dramatically.
As home prices went up, more and more people began to think that home prices would always go up. Some people decided to buy a home, even if they couldn’t really afford it, because they expected the home price to rise. For a time, this kind of psychology can be self-reinforcing. Prices go up, so people decide to buy because they think prices will go up, so prices go up. This is called a “bubble”.
As long as the bubble was expanding, everything was OK. However, bubbles can’t go on expanding forever. Sooner or later, bubbles always burst. We started to see decreases in home prices a few years ago. When home prices stopped increasing, some borrowers found themselves in real trouble. In some cases, the only way for them to pay back the mortgage was to refinance on the basis of an increased home value. When the home values began to fall, some of these folks were unable to make their mortgage payments. In many cases, this has led people to give up on trying to make the mortgage payments, and the house has gone into foreclosure. In other words, the house is taken over by the bank or other institution that lent the money.
But financial institutions don’t want to hold onto these foreclosed properties. They want to sell them, in an effort to get at least some of their money back. But when foreclosed properties are dumped onto a market where housing prices are already decreasing, there is pressure for prices to fall even further.
On top of this, many of these mortgages were being packaged together, and resold in “mortgage-backed securities”. Many investors bought these new-fangled securities. In many cases, however, these new financial instruments are very complicated. It now appears that many people in the financial community did not fully understand how these securities would work, especially if housing prices ever were to fall.
Various government agencies are supposed to provide oversight of the financial system. These include the Federal Reserve System, the Securities and Exchange Commission, and others. It appears that these agencies did a poor job.
In the summer of 2007, we began to hear reports of financial institutions being under stress, as the value of their assets was decreasing. In March 2008, we saw the failure of Bear Stearns, a venerable Wall Street firm. As the months went by in 2008, more and more institutions were finding themselves in trouble. Indy Mac. Fannie Mae. Freddie Mac. AIG. The federal government reluctantly provided funds to help shore up these institutions, and the Federal Reserve lowered interest rates and tried to inject cash into the system.
On Sept. 15, another famous old Wall Street firm, Lehman Brothers, went down. This time, Treasury Secretary Henry Paulson would not go along with a bailout. Executives at Lehman Brothers had engaged in very risky strategies, and the firm would pay for those mistakes by being allowed to go under. On the same day, Merrill Lynch was sold at a bargain-basement price.
Confidence in the credit markets had already been weakened. The collapse of Lehman Brothers appears to have dealt another very serious blow to those markets. Banks and other financial institutions became more and more reluctant to lend. If Lehman Brothers isn’t safe, who is safe? The credit markets came very close to freezing up. Many borrowers couldn’t get credit at all, even though they had a good credit history. Those who could get credit saw huge increases in interest rates.
The tightness in credit markets has had effects all through the economy. Small businesses have had to put off plans to expand, because they could not get credit. State and local governments have had to delay investment projects, because of the increase in borrowing costs.
Many of the financial institutions that got into trouble were now desperately trying to shore up their balance sheets. The mortgage-backed securities were turning out not to be worth as much as had been thought, and so the firms had to sell stock to raise cash. But these sales of stock contributed to big declines in the stock market. Trillions of dollars of stock value were wiped out.
On Sept. 19, Secretary Paulson made a dramatic reversal. Only days after letting Lehman Brothers go down, he and other authorities now saw that the entire financial system was in danger of a meltdown. A $700 billion government rescue plan was announced.
Ten days later, however, the bailout plan failed in the House of Representatives. It was caught in a cross-fire between some Democrats, who did not want to be seen as bailing out Wall Street fat cats, and some Republicans, who were unwilling to support such a large government intervention in the private economy. But the Senate passed a modified version of the plan, and the House of Representatives ultimately went along.
However, the details of the bailout have been changing. The precise combination of policies is still evolving. Ultimately, the bailout will involve three main components.
1. Secretary Paulson’s original plan was for the Treasury to buy some of the toxic assets from financial institutions, so that those institutions could get the assets off their balance sheets. The problem with this is that it takes time to set up the auctions that are necessary to make the purchases.
2. In October, British and other European authorities began to inject funds directly into the troubled institutions, by taking a direct ownership stake in them. The United States soon followed suit.
3. At the root of the problem are the home mortgages and the foreclosures. Some portion of the bailout money will be used on providing relief to some borrowers, so that they may stay in their homes.
Will the Bailout Work?
I think it will, although it will take time. Some damage has already been done to the economy, and the economy will probably have several more very weak months, at least. We are in fairly uncharted waters, and so it is difficult to know exactly how long it will take for the economy to right itself. However, I am pretty certain that we will not have another Great Depression.
For one thing, the United States economy is tremendously stronger and larger than it was in the 1930s. From the peak of the economy in 1929, to its trough in 1933, per-capita income (adjusted for inflation) decreased by almost 30% in the United States. Even if we were to suffer a decline that large (and I don’t believe we will), we would still have inflation-adjusted per-capita incomes that are about five times as great as they were during those dark days of the Great Depression. In the 1930s, people didn’t have air conditioning, or cell phones, or microwave ovens, or televisions. Our economy is vastly more productive than it was in the 1930s.
Thus, even though this is the most serious financial crisis since the Great Depression, we are very unlikely to witness the kinds of deprivation that we saw back then.
One reason why we should be able to avoid another Great Depression is that we have learned some lessons from the policy failures of the 1930s. Clearly, we have made plenty of mistakes. But we have avoided some of the mistakes that were made then. This time around, the Treasury and the Federal Reserve have acted boldly, in an attempt to take some steam out of the crisis. In the 1930s, too often the reaction of the authorities was to do nothing. That kind of inaction is what made the Great Depression great. That is why I supported the bailout, even though I did not believe that every detail of it was correct. In my view, it is far better to do something (even if imperfectly) than to do nothing.
What Does This Mean For the Job Market in the Next Year or So?
Clearly, this is not the greatest time to be approaching the job market for the first time. For many students who are earning a Bachelor’s degree this year, the job hunt will be more difficult than it otherwise would have been. However, it is important to remember a couple of things. First, the precise field in which you are looking for a job will make a difference. If your degree is in engineering or business or the natural sciences, your prospects will probably be better than those of some of your classmates in the arts and letters.
The second point is even more important: Regardless of your major, you will be in much better shape with a college degree in hand. Over the last 30 years, the labor-market earnings of college graduates have gone up dramatically, whereas the earnings of high-school graduates have stagnated, and the earnings of high-school dropouts have done very poorly.
What About the Longer-Term Future?
One of the lessons of this mess is that it is risky to take on too much debt. If you borrow heavily, things may go smoothly on the way up. However, on the way down, those who are up to their eyeballs in debt can have a very rough time of it.
Over the last 40 years or so, America has been on a debt-fueled spending binge. Since 1969, the federal government has only balanced its budget in four years. (Those four years came during Bill Clinton’s second term in the White House.) Private households have increased the percentage of income that is spent, and they have decreased the percentage of income that is saved. Thus, when the government issues its debt, private U.S. citizens often haven’t saved anything, and are thus unable to buy the government bonds. That means that much of this spending binge has been financed by other countries.
This pattern is unsustainable. I hope that the current financial crisis will convince people that the go-go days are over. It will be good if people return to some of the fundamentals of sounds financial management. You won’t die if you don’t buy. It really is possible to live a very good life, while still saving money. Saving can provide a cushion. Moreover, saving early in life can lead to a big payoff later. A dollar saved at age 25 will be worth far more at retirement than a dollar saved at age 45.
If you save, you will have to invest. In view of the recent poor performance of the stock market, some people may be tempted to stay away from stocks. That is probably a bad strategy. Stock prices do gyrate up and down, and the ups and downs can be difficult for some investors to take. Over the long haul, however, stocks have always been a good investment.
This does not mean that it is necessarily smart to put every single dollar into stocks. However, stocks should be an important part of the investment portfolio of any young person starting out. A stock market mutual fund is an especially good way to go. When you buy a share of a mutual fund, you are effectively buying a little bit of stock in each of a large number of companies. In this way, a mutual fund allows the investor to diversify his or her risk.