by Richard M. Ebeling
What we now know was one of the worst post-World War II economic and financial crises began about ten years ago in 2007. Various retrospective commentaries have focused on the severity of the economic downturn, its impact on different markets and segments of the population, and the lessons from it. An especially important lesson to be learned is that this was a crisis caused by government policy, and not something inherent in a free market economy.
The recession has its origin in years of monetary mismanagement and misguided interventionist policies emanating from the Federal Reserve System and Washington, D.C.
Between 2003 and 2008, the Federal Reserve flooded the financial markets with a huge amount of money. The Federal Reserve’s M-2 measurement of the money supply (cash, checking accounts and various small denomination savings and investment accounts) increased by nearly 40 percent during those five years. The Federal Reserve’s MZM money measurement (M-2 plus a variety money market accounts minus some time deposits) expanded by almost 50 percent over that half-decade.
The St. Louis Federal Reserve Bank tracks the impact of monetary expansion on nominal and real interest rates. For most of those years, key market rates of interest, when adjusted for inflation, were either zero or even negative.
Between late 2002 to the end of 2005, the Federal Funds Rate (the rate at which banks lend funds to each for short periods of time) and the one-year Treasury security yield were between zero and minus two percent, when adjusted for price inflation (as measured by the Consumer Price Index).
They rose into positive territory in 2006 and 2007, but then they tumbled back into the negative range in early 2008. And ever since then, except for a brief period in 2009, they have remained in the real interest rate negative range, sometimes a negative two to even four percent.
Interest Rate Manipulation
What does that actually mean? Suppose that I agree to lend you $100 for a year, with your promise to pay me back the principle of $100 plus $2, representing a two percent interest on the money, at the end of the twelve months. But suppose that at the end of that year you hand me not the $100 that I lent you, but only $98? Not only have I not gotten back my original $100 with the promised $2 of interest payment, I’m short $2 of what you originally borrowed.
Now, once more, suppose I lend you $100 with your promise to pay me $102 a year from now. And suppose that, in fact, at the end of the twelve months you do pay me back $102. But also suppose that during that year prices have increased by two percent. A basket of goods that I might have been able to purchase with that $100 before I lent you the money now costs $102 to buy. In real buying terms, the $102 I received from you is only enough to buy the same basket of goods that $100 bought a year earlier. In real buying terms, as the lender, I’ve received no positive interest income from my lending to you.
Banks not only lowered the cost of borrowing, they also lowered their standards for creditworthiness.
But suppose that prices have risen, by more than two percent, so that basket of goods increases in cost to, say, $104 dollars. Then the $102 you return to me is not even enough to buy the same basket of goods from a year earlier. That represents a “negative” rate of interest on my lending.
Of course, from the borrower’s point-of-view the lenders’ loss is his gain. He returns principle and interest that has depreciated in market buying power over the period of the loan, thus obtaining investable funds at a lower cost than if prices, in general, had remained relatively stable or if the nominal interest of interest had been higher relative to the rate of price inflation during that time.
The Housing Bubble and Crash
Due to Federal Reserve monetary policy during 2003-2008, the banking system was awash in money to lend to all types of borrowers. To attract people to take out loans, banks not only lowered nominal interest rates (and therefore the cost of borrowing), they also lowered their standards for creditworthiness.
To get the money out the door, financial institutions found “creative” ways to bundle mortgage loans into tradable packages that they could then pass onto other investors. It seemed to minimize the risk from issuing all those subprime home loans that were really the housing market’s version of high-risk junk bonds. The fears were soothed by the fact that housing prices kept climbing as home buyers pushed them higher and higher with all of that newly created Federal Reserve money.
With interest rates so low, there was little incentive to save for tomorrow and big incentives to borrow today.
At the same time, government-created home-insurance agencies like Fannie Mae and Freddie Mac were guaranteeing a growing number of high-risk mortgages, with the assurance that the “full faith and credit” of Uncle Sam stood behind them. By the time the Federal government took over complete control of Fannie and Freddie in 2008-2009, they were holding the guarantees for half of the $10 trillion American housing market. (See my article, “A Collapse Made in Washington,” p. 4).
Low-interest rates and reduced credit standards were also feeding a huge consumer-spending boom that resulted in a 25 percent increase in consumer debt between 2003 and 2008, from $2 trillion to over $2.5 trillion. With interest rates so low, there was little incentive to save for tomorrow and big incentives to borrow and consume today. But, according to the U.S. Census Bureau, during this five-year period average real income only increased by 2 percent at the most. People’s’ debt burdens, therefore, rose dramatically.
The Federal Reserve’s easy money and U.S. government’s guaranteed mortgage house of cards all started to come tumbling down in 2008, and then with a huge market crash in 2008-2009. The monetary-induced low interest rates and creative credit methods resulted in a significant misuse and misallocation of resources: Too many houses that too many people could not afford; too many investment projects that were unsustainable in the post-bubble environment; and too much consumer debt for what people could realistically afford out of their recession-adjusted wealth and income.
Post-Crash Monetary Expansion and Interest Rate Manipulations
The same Federal Reserve System that produced the monetary excesses that generated the bubble and its eventual burst then got busy flooding the financial markets with even more newly created money.
Between 2009 and 2016, America’s central bank increased the Monetary Base (cash and reserves in the banking system) by more than $3 trillion by purchasing U.S. government securities and buying a huge amount of “toxic” mortgage-backed securities, adding to its own portfolio of “assets” by the equivalent amount. During this time, the Federal Reserve’s M-2 and MZM measurements of the money supply each increased by almost 85 percent from what they were in 2008, a near doubling of the money supply being utilized by people in the marketplace.
Even a small differential adds up to a lot of money.
But with such a huge $3 trillion increase in the amount of available lending reserves due to the Federal Reserve’s buying of U.S. Treasuries and mortgages, many expected much larger growth in M-2 and MZM and a more significant increase in general price inflation over time. Instead, prices in general only increased by about 16 percent between 2008 and 2016.
The reason for this was a new twist to the Federal Reserve’s manipulation of money in the banking system. Since 2008, the central bank has been paying banks not to lend. To the extent that individual member banks find the rate of interest offered to them on excess (unlent) reserves more attractive (given risk, credit worthiness of potential borrowers, etc.) more potentially profitable than lending all the reserves at their disposal to you and me, they have left over $2 trillion of those reserves “parked” on the books with the Federal Reserve.
The actual interest differential that has made it attractive for banks to hold large excess reserves may be small in absolute terms but when we’re talking about hundreds of millions of dollars at a bank’s discretion, even a small differential adds up to a lot of money.
Government Intervention Hindered Market Rebalance
The U.S. economy and the American citizenry could not escape a correction process after 2008. Housing prices were pushed far too high and had to settle down to more realistic levels. And some people just could not afford the homes they purchased during the bubble period; they would not have gotten into this financially distressful situation if artificially low-interest rates and loan guarantee programs had not put them in those houses to begin with.
Companies that were overextended had to dramatically downsize, and in some cases go out of business. Workers, who were drawn into unsustainable jobs and wages due to all of that Federal Reserve money sloshing around the economy, found themselves unemployed.
Implementation of ObamaCare exacerbated economic recovery difficulties.
In spite of the politicians’ promises and Keynesian-style delusions, the trillion-dollar Federal bailouts and “stimulus” packages only prolonged the agony and delayed any real economic recovery. This began with the forced infusion of capital into the banking system during the last months of the George W. Bush Administration through partial “nationalization” in the form of compulsory government acquisition of bank stock, that took years to finally unwind.
What the Bush Administration began in its last year in office, the Barack Obama Administration continued in 2009. Due to uncertainty of its costs and impacts, the agonizing implementation of ObamaCare exacerbated economic recovery difficulties. (See my article, “For Healthcare, the Best Government Plan is No Plan”.)
At the same time, regulatory control over the market strangled the capacity for faster recovery. In 2016, the Federal Register of federal regulations came to almost 100,000 pages of bureaucratic rules, restrictions and commands, a 20 percent increase from 2008 when the regulatory rules covered a “mere” about 80,000-printed pages in the last year of the Bush Administration.
It is estimated that it costs around $2 trillion in compliance expenses for businesses to report and meet the demands of government regulatory agencies; this was more than 10 percent of the U.S. Gross Domestic Product in 2016.
Lagging Labor Markets
Another factor in the sluggish economic recovery has been the labor market participation rate. In 2007, the number of people in the labor force was 66.4 percent of the working age population. In 2017, the labor force participation rate fell to 62.9 percent of the working age population, a more than 8 percent decline. Over this decade the working age population in the United States grew by around 10 percent, but the number of people entering the labor force was only 4 percent, according to the Bureau of Labor Statistics.
Where did those working age members of the population go if not into the workplace? The Obama Administration significantly reduced the eligibility requirements for receiving disability benefits from the Social Security Administration, regardless of age. The number of people meeting lower eligibility standards, who in turn stayed out of the workplace, increased from 6.8 million to over 8.8 million over 10 years, a near 30 percent increase.
Meanwhile, Social Security Disability spending increased from $90 billion in 2005 over $150 billion in 2016, a 60 percent increase.
While the government’s official unemployment rate may have come in at a low of 4.3 percent of the labor force in July 2017, the general youth unemployment rate was 11.4 percent and the African-American youth unemployment rate came in at 25.4 percent.
In other words, government grabs more than 1 out of every $3 of output in the economy.
In addition, the Bureau of Labor Statistics estimates that part-time workers who would gladly accept full-time employment and discouraged workers who wish they could find work and have stopped trying, if added to the official measure, would bring July 2017 unemployment in the US to 8.9 percent.
This is hardly an example of a successful employment outlook, especially since some people who can’t find desired full-time employment are stuck in part-time work due to the ObamaCare employer mandate.
Government Spending and Growing National Debt
A fuller recovery from the 2008-2009 recession has also been burdened by taxation at all levels of government – federal, state and local – which currently comes to around 35 percent of U.S. Gross Domestic Product. In other words, government grabs more than one out of every three dollars of market-valued output in the economy. In absolute numbers, out of a projected $19 trillion GDP in 2017, all levels of government are forecast to absorb about $7 trillion this year in government spending.
But not all that government spends comes from taxes. Borrowing, especially at the federal level, covers a large part. This has been dramatically increasing the overall federal debt.
There is no end in sight for continued growth in government debt.
The competitive process of supply and demand brings the productive activities of tens of thousands of businesses into balance with the demands of all of us as consumers.
When George W. Bush entered the White House, the U.S. federal debt stood at $5 trillion. It doubled under his administration to $10 trillion. During the eight years of the Barack Obama administration, the national debt doubled once more, to nearly $20 trillion when he left office in January of 2017.
There is no end in sight for continued growth in government debt as the annual budget deficits continue and are expected to grow over the next decade due to distributive “entitlement” programs. (See my article, “Trump’s Budgetary Blueprint Retains America’s Welfare State”.)
No wonder that it has taken a decade for the U.S. economy to have some semblance of an economic recovery, though far from what a free market would have been able to do, and could be doing.
Capitalism Is the Solution, Government Is the Stumbling Block
The capitalist system is a great engine of human prosperity. It creates the profit incentives for industry and innovation that have literally raised hundreds of millions of people out of poverty around the world over the last half century. The competitive process of supply and demand brings the productive activities of tens of thousands of businesses into balance with the demands of all of us as consumers, both here in America and around the globe.
There is no economic system in history that has had the same ability to do so much material and cultural good.
There is no economic system in all of history that has had the same ability to do so much material and cultural good as the open, competitive free market. But the capitalist system cannot do its job if the government interferes with its operation. Burdensome government taxes, heavy-handed government regulation, misguided government spending, and mismanagement of the monetary system only succeed in gumming up the works like so much sand in the machine. (See my article, “The Free Market vs. the Interventionist State”.)
The best pro-active policy the Federal government and the Federal Reserve could have taken following the beginning of the 2008-2009 recession would have been to admit that its own past policies caused the economic crisis, and then leave the market alone to rebalance itself and re-establish the basis for sustainable growth and employment.
But, of course, this would have required the reversal of the premises, presumptions and political plundering of the modern interventionist-welfare state, and its accompanying system of monetary central planning. It would require a rejection of the collectivist ideological and policy perspectives that continue to dominate and direct all the governments around the world, including in the United States.
It would also clarify the fact that everything the American economy has gone through over the last decade is not a “crisis of capitalism,” understood as a truly free market, but the crisis of the government-managed and manipulated system of economic control, command, and accompanying corruption. Alas, we are not likely to see either any such admission or rejection in the immediate or foreseeable future.
Richard M. Ebeling is BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel in Charleston, South Carolina. He was president of the Foundation for Economic Education (FEE) from 2003 to 2008.