THE FINANCIAL CRISIS OF 2008: AN ESSAY
It is impossible to denote a single culprit for the financial crisis of 2008. Instead, it was due to multiple unpredictable factors, the sins of many institutions, and the shortcomings of countless individuals. That being said, the financial crisis can be attributed to the inadequacies of five entities—the risk-loving lenders, the irresponsible debtors, the blind-sided government officials (e.g. the Fed, the President, the Treasury, and Congress), the credit-reliant banks, and the imperfect financial regulatory system. Once the actions of each one of these is analyzed utilizing the aggregate supply and demand model, monetary policy, and national income accounts, it will be easier to see why each piece fits into the financial crisis culpability puzzle of 2008.
The most notable game-player of the financial crisis was the Federal Reserve. The Fed caused economic stress far before Bernanke was elected as chairman in 2006. It began with chairman Alan Greenspan’s Fed (Wessel 2009, 59). Interest rates were extremely low for a long period of time, which caused risky behavior in lenders and debtors (Wessel 2009, 56). This can be explained using aggregate demand and supply. First, low interest rates set by the Fed made it easier for people to borrow for home ownership, which caused housing prices to rise. These prices then declined rapidly, causing two complications—homeowners stopped paying back loans and struggling financial institutions suffered deep financial losses. Thus, aggregate demand shifts left, shifting short run aggregate supply left, and then shifting long run aggregate supply left as well. A decrease in consumption and investment in national accounts arose and quantity and price decreased (Mankiw 2012, 348). The Fed’s low interest rate target was merely the catalyst for the cycle.
Loaners and debtors also inflated the financial crisis of 2008. Loaners were culpable because of the trade-off between risk and return (Mankiw 2012, 183)—the higher the risk, the greater the return. Here, some financial institutions partook in what was deemed “predatory lending,”—lending to the poor in order to gain a major profit (Wessel 2009, 62). Then there’s the debtor. Analysts thought that the debtors were at fault for taking out loans they could not repay (Wessel 2009, 127). The debtors and loaners bit the hand that fed them, the low interest rates, and ran with it, not expecting what was to come: the lowering of prices and quantity, resulting in a recession.
The last player was the government. Governments may improve market incomes (Mankiw 2009, 11) but it failed to do so in 2008. Bernanke attributed much of the unchecked lending and borrowing to the faults of the financial regulatory system. He also noted that no legal framework existed for dealing with bank failures, further exasperating the problem (Wessel 2009, 272). These two failings did not cause the entirety of the crisis, but necessary and not excessive, regulation would’ve been satisfactory to prevent risky lending-loaning behavior.
The Fed, the President, Congress, and the Treasury all responded to the crisis. First, the Fed took to conventional monetary policy and cut the federal funds rate to 0% – 0.25%, flooding the markets with liquidity in the hope that banks could again make loans, businesses could expand, and unemployment would fall (Wessel 2009, 271). Then Bernanke realized that the Fed could bring the Fed Funds rate no lower and found the problem to be fiscal (Wessel 2009, 189). He endorsed untraditional tools: buying assets (Mankiw 2012, 345) and lending directly into the markets (Wessel 2009, 253). President Bush was passive at first (Wessel 2009, 194), however, President Obama was sworn in and followed the Keynesian way by releasing a major stimulus package with increased federal spending and tax cuts, altering the national accounts (Wessel 2009, 278). The Fed was relieved. Lastly, the Treasury succeeded in asking Congress for $700 billion to save the banks (Wessel 2009, 208). Unfortunately, the request came too late and the money was not sufficient to bring the economy back to where it was during the boom.
Historical events cannot truly be analyzed until time has passed, and this is true for the financial crisis of 2008. The main takeaway is that though many actors responded to the crisis, it was much too late. Unemployment is still an issue and the economy has not returned to its pre-recession level. The prevention of the crisis would have been plausible had the measures that were taken in 2008 been taken earlier. Had the Fed seen the underlying problems during the boom (Wessel 2009, 272), the interest rates could’ve been lowered during the Greenspan era, aggregate demand wouldn’t have shifted in such a major way, and the responses by government officials wouldn’t have to have been so large to shift the curve back. That being said, had the Fed judged the crisis correctly after the fact, action could’ve been taken to remedy it much earlier, lessening the shift of aggregate demand (Wessel 2009, 115). Had the Fed utilized traditional monetary policy and untraditional fiscal policy much earlier, the crisis wouldn’t have been so dire. This also applies for Congress’ $700 billion dollar rescue program and President Obama’s stimulus package. But that’s the thing about economics; it’s easy to play the “what if” game (Wessel 2009, 275). What if everything had been done earlier? There is no clear answer, but what can be said is that had these actions not been taken whatsoever, the economy would be in a much worse place than it currently is. The best thing we can say is that our economy must be built to be flexible.
ALL OR NOTHING: THE FISCAL AUTHORITY PROBLEM IN THE EU
What originally seemed like a good idea is now weighing on the heads of many European leaders[i]. Deeper integration of the European Union has slowly become an increasing problem and less of a real possibility. The recent crisis created a rift that now exists between countries pushing for further integration and those hoping to go as far as to divest the EU of some of its current monetary powers. Europeans do understand that something needs to be done to improve the EU economic situation. What this paper will argue is that the decision will have to be an all-out move to either create a full monetary and fiscal union or completely dismantle its monetary authority—the following analysis will be used to support a position encouraging the EU to add fiscal unity[ii].
The first implicit issue raised by Walker and Steinhauser is whether Europe is an Optimal Currency Area[iii]. The basic criteria for an OCA are as follows: high labor and capital mobility, price and wage flexibility, and the ability of the government to use fiscal controls[iv]. Put simply, it is the capability of the government in question to internally handle asymmetric shocks[v]. As it stands, language and culture barriers make it difficult for labor to move in the event of a negative shock to a country’s economy. Wages are also strongly affected by labor unions and wage protection policy within the EU rather than by market forces. Most importantly, the EU lacks the fiscal authority to use taxes or unemployment insurance to mitigate for unresponsive monetary policy[vi][vii]. It is difficult to label the EU as an OCA. However, is it truly so important that the EU be an OCA before becoming a fiscal union? Not necessarily, given that the U.S. also was not an OCA before unification but progressively became more so over the years[viii].
In order to become an OCA, the EU does need to incorporate elements of federalism into its government, but it need not be of the American breed. Proponents of EU federalism suggest that the government needs to utilize “budgets, bonds, financial oversight and depositor protection at the national level” to improve economically[ix]. If we follow the OCA theory above, this component is crucial to maintaining internal stability. Olivier Blanchard wrote in 2004, “Europe may be converging to a more efficient European model rather than to the US model.”[x] Perhaps the European economy has become its own economic identity, like Blanchard suggests, but “efficient” cannot be used to describe it after the crisis of 2008. If the EU does decide to pursue stronger supranationality, it does not have to mimic the American model, but it will need to adopt some fundamentally federalist ideals[xi].
Unfortunately, decision-making is further complicated by what President Hollande describes as a lack of “social cohesion.” Hollande also stated that true European integration could only be achieved in the long run, which may be difficult for such a culturally diverse group of nations[xii]. Presently, each country determines its needs based upon its individual macroeconomic circumstances. If each EU nation has differing opinions in regards to fiscal and monetary union, the collaborative action fails. According to Mancur Olson, this is the reason that the European economy decelerated in the 1970s[xiii]. Recent news suggests that the EU is now in a similar situation. Each country has taken to leveraging the European economy for its own benefit, rather than cooperating to improve the supranational body. Countries on both sides of the integration argument are guilty of this. Germany prefers to refrain from fiscal unity so as not to support the Southern European countries. By the same token, indebted countries like Italy and Greece hope to integrate further to obtain a monetary escape route[xiv]. Regardless, the EU countries must eventually collaborate to determine a definitive solution in response to the present integration problem.
The final consideration is whether dissolving the monetary union and reverting to a simple political union would be optimal for the EU. Prime minister Angela Merkel is the primary advocate for dismantling the EU monetary union[xv]. As stated above, she does not want Germany to use its money supply to save faltering EU economies. A counterargument by the pro-fiscal authority camp is that the US became a fiscal union once it had an “Alexander Hamilton” moment and the national government took over states’ debt[xvi]. The EU can only mirror this action if countries like Germany, Denmark, and Finland agree to fiscally combine with less economically stable countries, which seems unlikely given their opinions. Another argument against fiscal integration stems from the fact that a common interest rate governing countries with very different rates of inflation or employment rates can be detrimental in the event of a negative shock. If the EU were to become only a political union, labor and interest rates can adjust with labor and capital movements[xvii].
Ultimately, the EU needs to decide whether it should be a fiscal and monetary union or devolve into a political union. The EU is caught in a dangerous middle stage that amplifies its vulnerabilities. Fiscal union would provide the tools that the supranational government needs to mitigate for asymmetric shocks. True, cultural differences do exist, the area does not fit the OCA theory, and “social cohesion” may only happen in the long run, but the benefits of fiscal integration seem to outweigh the costs. Genuine integration may take a while but it can only happen if the EU makes a conscious policy decision to begin the process.
[i] Analysis based on Walker, M. & Steinhauser, G. (2013). Control Issues: Plans for Political Union Unravel in Europe. The Wall Street Journal, A1
[ii] The following analysis does not represent the opinions of the Wall Street Journal or any parties represented in the paper. The opinions presented are those of the author alone.
[iii] This theory was first introduced by Robert A. Mundell in 1961 to discuss the creation of a common currency among sovereign countries
[iv] Mongelli, F. P. (2002). “New” Views on the Optimum Currency Area Theory: What is EMU Telling US? 2-4
[v] For example: A country experiences negative consumer perception, which brings down prices and wages. Internal stability is maintained if unemployed workers may move to other regions in the union where employment is abundant. Demand and supply are more likely to reach equilibrium in this circumstance
[vi] Reference Euro Economics. (2009). Retrieved November 21, 2013, fromhttp://www.unc.edu/depts/europe/euroeconomics/about.php
[vii] An example of unresponsive monetary policy would be a situation in which an individual country’s rise in inflation has no bearing on the national monetary policy. This is not uncommon in the EU, where the responses are based upon aggregate measures
[viii] Adams, W.J. (2013). Economics 453. The European Economy
[ix] Walker, Steinhauser
[x] Blanchard, O. (2004). The Economic Future of Europe. Journal of Economic Perspectives, Vol. 18, Number 4, 3-26
[xi] From Encylopedia Brittanica. Retrieved November 21, 2013, fromhttp://www.britannica.com/EBchecked/topic/203491/federalism: “Federalism, mode of political organization that unites separate states or other polities within an overarching political system in such a way as to allow each to maintain its own fundamental political integrity.”
[xii] Walker, Steinhauser
[xiii] Olson, Mancur. (1996). The varieties of Eurosclerosis: the rise and decline of nations since 1982. 73-93
[xiv] Walker, Steinhauser
[xv] Walker, Steinhauser
[xvi] Walker, Steinhauser
[xvii] Adams
Although most of my recent coursework has involved economics, I chose it as a major quite late in my college career. After finding a strong interest in macroeconomics and appreciating the relevancy that it has in the careers that I would enjoy, I finally decided to concentrate in economics. These writings are quite different from the rest of my samples in this portfolio given that they are deeply rooted in economic theory. The first piece was written for my introduction to macroeconomics course as a response to the book, "In Fed we Trust," by David Wessel. The second essay was written for my European Economics course as an analysis and expansion upon the article, "Control Issues: Plans for the Political Union Unravel in Europe", which originally appeared in the Wall Street Journal.