Presupuesto y Gasto Pblico 59/2010: 7-21

Secretara General de Presupuestos y Gastos

2010, Instituto de Estudios Fiscales

The U.S. Great Recession. Its Genesis. (And a regeneration?) 1

UGO SACCHETTI
Former Controller of the Inter-American Development Bank
Recibido: Marzo 2010
Aceptado: Mayo 2010

Abstract
The recent, and ongoing, Great Recession can be tracked back to multiple phenomena which took place during the
latter part of the 1990s and most of the 2000s. These phenomena can be related to a systemic malfunction of the financial markets resulting from: an ill advised legislative step that permitted banks and financial institutions to undertake excessively risky investments; the pursuance of an overly accomodating monetary policy; and an, apparently
deliberate, laxity on the part of various components of the regulatory system. This permitted the creation of numerous financial innovations, particularly a large variety of derivatives some of which were of such complexity
that their consequences were beyond perception even of professional appraisers. It also allowed imprudent conducts
on the part of large groups of private institutions and individuals in the housing and commercial markets; notably
lenders, rating agencies, borrowers, appraisers, and realtors; all of whom were motivated by the desire of quick profits, at times, at any cost. The perceived danger that a repetition of the Great Depression of the 1930s was a distinct
possibility induced the U.S. Government to take courageous steps to save financial institutions in grave danger, and
to reactivate a fast declining economy. Notable were the program called TARP, initiated by the Treasury Department; massive purchases of bonds backed by mortgage loans of a dubious value (the Toxic Assets), and other large
injection of liquidity by the Federal Reserve System. In a second stage there was the adoption of a stimulus program
of massive proportions, and the introduction of various measures to assist home owners in difficulty and unemployed persons. While it is not possible, by any means, to be sure that these programs will restore healthy growth in the
economy and financial sector; the U.S. Government is in the process of undertaking a set of reforms of the financial
system to prevent the repetition of the phenomena that led to the Great Recession. Considering the conflicts of interest involved, it is too early to judge whether the measures under consideration will become fully effective.
Key words: Great Recession, Glass-Steagall Act, Federal Reserve System, Derivatives.

Resumen
Los orgenes de la reciente y vigente Gran Recesin se remontan a mltiples fenmenos que tuvieron lugar a finales
de los noventa y durante gran parte de la primera dcada de este siglo. Estos fenmenos se pueden relacionar con un
mal funcionamiento sistemtico de los mercados financieros que ha resultado de: una mal aconsejada iniciativa legislativa que permiti que bancos e instituciones financieras asumieran inversiones excesivamente arriesgadas, la
prosecucin de una poltica monetaria ampliamente acomodaticia y una, aparentemente deliberada, laxitud por parte
de varios elementos del sistema de regulacin. Esto permiti la creacin de numerosas innovaciones financieras,
en particular una amplia variedad de derivados, algunos de los cuales eran de tal complejidad que sus consecuencias iban ms all de la percepcin misma de evaluadores profesionales. Tambin permiti conductas imprudentes
por parte de grandes grupos de instituciones privadas e individuos en los mercados residenciales y comerciales; especialmente prestamistas, empresas de calificacin (rating), prestatarios, evaluadores y agentes inmobiliarios; todos
los cuales estuvieron motivados por el deseo de beneficios rpidos, a veces a cualquier precio. El peligro que se per-

Ugo Sacchetti

ciba de que una repeticin de la Gran Depresin de los aos treinta no era una posibilidad desdeable, indujo al Gobierno de Estados Unidos a tomar medidas valientes para salvar instituciones financieras en grave riesgo y para reactivar una economa en rpido declive. Destacaron el programa llamado TARP, iniciado por el Departamento del
Tesoro; compras masivas de bonos respaldados por crditos hipotecarios de valor dudoso (los activos txicos), y otra
gran inyeccin de liquidez por parte del Sistema de la Reserva Federal. En un segundo momento se adopt un programa de estmulo de proporciones masivas, y la introduccin de varias medidas para asistir a los propietarios de viviendas en dificultades y a los desempleados. Si bien no es posible, en manera alguna, asegurar que estos programas
restablecern un crecimiento sano en la economa y en el sector financiero, el Gobierno de los Estados Unidos est
inmerso en el proceso de adopcin de una serie de reformas del sistema financiero para impedir la repeticin de los
fenmenos que llevaron a la Gran Recesin. Considerando los conflictos de intereses en juego, todava es demasiado
pronto para juzgar si las medidas consideradas sern plenamente efectivas.
Clasificacin JEL: E42, E44, E52, E62, E63.

The calamitous path to the debacle

1. The Great Recession, of which the 2007-2009 Credit Crisis is a major component, is a politico-societal multifaceted phenomenon which future historians will examine in
all its aspects. They include, but are not confined to, political orientations, monetary and fiscal policies and developments, regulatory prices, all of which, no doubt, played a very important role.
Economists may try to place the Great Recession within one or another theory of Business Cycles; or, some followers of the long waves hypothesis, of which Professor
Kondratieff was a major proponent, may consider it a secular phenomenon, occurring every
fifty or sixty years. It is true that the Great Depression of the 1930.s occurred about sixty
years after the great depression of the 1870.s; but, unless one is prepared to maintain that the
stock market crash of 1987 would have been the next great depression if the Federal Reserve
had not massively intervened, the 2007-2009 Great Recession falls outside the above mentioned time range. While this hypothesis is worth mentioning for its historical value, it is of
limited use in the present context, as it lacks clear determinants. In fact, Professor
Kondratieff himself, in his concluding paragraph, stated: In asserting the existence of long
waves and in denying that they arise out of random causes, we are also of the opinion that the
long waves arise out of causes which are inherent in the capitalistic economy. This naturally
leads to the question as to the nature of these causes. We are fully aware of the difficulty and
great importance of this question; but in the preceding sketch we had no intention of laying
the foundation of an appropriate theory of long waves (Kondratieff, pp. 41-42 of the
reprint).
While it may not be possible to identify the recent phenomenon with one or another
theory of Business Cycles, it appears appropriate to observe that economists and commentators seem to be prisoners of the Keynesian-Monetarist dichotomy, ignoring some of the cited
as pertinent to the case: horizontal maladjustment in the structure of production; magnification of derived demand (alias acceleration principle la J.M. Clark); over indebtedness
(I. Fisher); and psychological theories combined with physical theories.

The U.S. Great Recession. Its Genesis. (And a regeneration?)

In accordance with our thesis that we are confronted with a multifaceted dynamic
event, it is proposed to take into consideration elements of some of the above mentioned
theories, particularly indebtedness and psychological theories. In doing so we will be guided
by the dictum of an old master, even though it related to a somewhat different issue, in his
following concluding remarks: Thus the introduction of the element of time does away with
the strict (i.e., simultaneous) interdependence of economic quantities..., and substitutes for it
a consistent scheme that may be taken as a basis for the general theory of economic change.
According to this scheme the economy is not a stable system which reacts to random changes
by cancelling them instantaneously or after a while. It is a loosely bound congeries of social
institutions, which in response to random changes goes through a series of fluctuations, a
congeries which has to be studied in its main aspects of the distinguishable elements, if any
understanding of change is to be obtained (italics are mine) (Kuznets, p. 30).
2. One distinguishable element to adopt Kuznetss language was a major legislative step taken in the United States in 1999. To understand the importance of this step one
has to go back in history, to the beginning of the Great Depression. Following the 1929 stock
market crash there was a large number of bank failures. In the succeeding three years 5102
banks failed (1352 in 1930, 2294 in 1931, and 1456 in 1932), with combined deposits of
about $3.7 billion (a very large sum at that time). To avoid a repetition of those events, two
major pieces of legislation were adopted under the New Deal, in 1933. They were the
creation of the Federal Deposit Insurance Corporation, which aimed at avoiding, or reducing
within limits, runs on banks, and, thus the banks failures; and the Glass-Steagall Act: The
latter separated the deposit taking business from investment activities, since it was recognized that one of the major causes of the massive bank failures was the fact that banks, in
addition to their typical banking functions, had engaged in financial and other types of
investments.
That Act lasted, and served the economy well, until 1999 when it was repealed. This
opened the door to investments by banks in various types of instruments, in particular home
financing loans and commercial loans. Equally important, it gave rise to various types of derivatives which in later years affected adversely the institutions 2. The following is a list of
the main derivatives: Collateralized Mortgage Obligations (CMO); Commercial Mortgage-backed Securities (CMBS); Asset-backed Securities (ABS); Auction rate Securities
(ARS); Residential Mortgage-backed Securities (RMBS); and Government-sponsored Enterprise Mortgage-backed Securities (GSE MBS). A practice that is worth mentioning is that
under some of the above derivatives loans are bundled into a mortgage-backed security in
which payments from mortgages are split into slices, and each slice is sold as a separate security (see a later paragraph for an example of this practice).
Another practice that acquires importance after 1999 consisted of resales of loans by
the originators; at times a chain of resales. This practice permitted the original lender to shift
the risk of non-repayment by the borrower; and this encouraged carelessness in lending.
Moreover, in a large number of cases the ultimate purchaser of the loans were one of two
Government-sponsored Enterprises; i.e., the Federal National Mortgage Association (commonly known as Fannie Mae), and the Federal Home Loan Mortgage Corporation
(commonly known as Freddie Mac). In order to obtain the funds to purchase the loans, these

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institutions issued bonds on the financial markets, bonds which had the backing of the
Federal Government. Another creation was a derivative which became widely used with
serious adverse consequences for certain institutions; i.e., the Credit Default Swap. This is,
in essence, an insurance instrument under which a security is guaranteed against the payment
of a premium. As of December 2009, there were $30 trillion of CDSs outstanding. All of the
above took place in a new atmosphere in which regulatory institutions prominent among
them the Security Exchange Commission, which was also created after the 1929 stock market crash followed what can be called a laissez faire policy.
Two indications of the attitude at high official policy level, which explains the deficient
performance of the regulatory system, are a recent statement by Mr. Alan Greenspan that he
had placed an excessive faith in the market self-discipline; and a statement reportedly
made in 1999 by Mr. Lawrence Summers: America has honest corporate accounting; this
lets investors make good decisions, and also force management to behave responsibly; and
this results in a stable, well-functioning financial system. This statement was made when
Mr. Summers was deputy Treasury Secretary, in the same year when the Glass-Steagall Act
was repealed. At this time Mr. Summers is the head of the National Economic Council.
3. While the repeal of the Glass-Steagall Act made possible the above mentioned
practices, and others which, after the fact, can be considered as one of the main features of
the genesis of the Great Recession another important distinguishable element after 1999
was the conduct of monetary policy; or, from an institutional point of view, the performance
of the Federal Reserve System (Fed). This performance, and particularly its principal actor
Mr. Alan Greenspan have been, of late, the target of severe criticisms. It must be said from
the outset, however, that these criticisms are not universally shared.
One of the most unforgiving critics of Mr. Greenspan, as Chairman of the Fed and the
promoter of its philosophy, is Mr. William A. Fleckenstein. In a recent book, he has diligently detailed many pronouncements of the Chairman, and has highlighted contradictions
and biases. In the book, which bears the subtitle The age of ignorance of the Federal Reserve (Fleckenstein, 2008) 3 the author places emphasis on Mr. Greenspans repetition of
his belief that it is impossible to detect a bubble before it bursts (a laissez faire attitude)
and on the use of this belief to justify policy inaction. The second major line of attack is
on Mr. Greenspans other belief that productivity was fast rising, which led to an optimistic
attitude about the future of the countrys economy. Such a belief is shown to be without
foundation. A major part of the criticism is directed at the Feds policy to permit, or even
encourage, the Tech bubble which burst in 2000 and which caused the Nasdaq index to fall
by 7 percent between its peak in 2000 and the bottom at the end of 2002. Furthermore, that
policy is alleged to be the precursor of a policy, started in the early 2000s, which permitted
the development of the Real Estate Bubble.
Another evaluation of the Feds policy can be based on its sole reliance on the interest
rate as a restraining factor. Scholars of monetary policy in general may reflect on the correlation between changes in the federal funds rate and the development of bubbles. During the
Tech Bubble that rate was raised a number of times from September 1998 to 6,75 percent in
2000; and during the Real Estate bubble it was raised from 1 percent in mid-2004 to 5.25

The U.S. Great Recession. Its Genesis. (And a regeneration?)

11

percent in June 2006. It is clear that, contrary to prevailing theoretical doctrine, the correlation between increases in the federal funds rate and increases in prices and economic activity
was decidedly positive. Given the fact that the bubbles lasted a relatively long period of time,
it is legitimate to raise the question as to why the Fed did not increase the margin requirements for lending in general, and for bank mortgage loans in particular. Mr. Greenspan was
questioned about this point in Senate hearings, but he declined to explain why he did not use
that additional tool.
Two considerations may mitigate the criticism of the behaviour of the Federal Reserve
System. One is that the federal funds rate has only limited influence on the rate for mortgage
loans; and the other is that interest rate, as a policy tool, is effective only on short term investments, such as stock market transactions and foreign exchange transactions. Moreover,
over the past decades, the opinion among economists about the importance of the interest
rate has gone trough pendular movement. It went into a disrepute in the 1930s, especially after the publication of Keyness General Theory. Empirical surveys of entrepreneurs, both in
England and in the United States, purported to show that businessmen did not consider the
interest rate as important for their investment decisions. This body of opinions made highly
regarded British economist lament that putting him (the rate) in chains and leading him
about has become a popular sport.
4. The faith in the effectiveness of the markets appears to have been pervasive in
the whole U.S. institutional set-up, besides the Federal Reserve System. The current
ex-post-facto recognition of the need to reform the financial regulatory system results also
from the careless behaviour of other U.S. agencies. Among them, the Office of Thrift Supervision is considered to have been most negligent; but the following are also deemed to have
been at fault, in their respective spheres of supervision: the Security and Exchange Commission, the Comptroller of Currency, and the Federal Deposit Insurance Corporation. They all
had their share of responsibility 4. At the time of writing, however, the subject of regulatory
reforms is still under discussion in the United States and in other developed countries.
In considering the genesis of the Great Recession one has to analyze the behaviour of
the counterpart of the regulatory official set-up; i.e., of those who were to be regulated.
5. Before reviewing the conduct of the various actors in the developments under
discussion, it is appropriate to point out how an exogenous element has acted as a major contributor to the real estate bubble. As stated in an earlier paragraph, the interest rate for real estate mortgage loans is, and has been, correlated with the yield of the 10-year Treasury notes,
rather than the Federal funds rate. On this aspect, an important role, though an invisible one,
was played by the combination of the large U.S. trade deficit and the investment policy, at
that time, of the trade surplus countries. Prominent among the latter were China, Japan and
the Middle East oil exporting countries. The latest available estimate of Chinas holdings of
U.S. securities is about $1.0 trillion, of which about $800 billion in Treasury bonds and
notes.
The most simplified description of the influence of those countries policies on the U.S.
real estate bubble runs as follows. Exporters of goods to the United States sell the dollar proceeds of their exports to local banks which, in turn, sell them to the Central Bank. This pro-

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duces: (a) a simple bookkeeping transfer of funds from the account of the U.S. importer to
the account of the Central Bank, or one of its subsidiaries, and (b) a corresponding capital inflow to the United States. In the past and to a lesser extent at present a portion of these
funds has been invested in Treasurys 10-year notes. These purchases had an important impact on the yields of those notes whereby maintaining them at levels which were lower than
they otherwise would have been. As a result, the interest rates on mortgage loans for housing
and other real estate were maintained at a relatively low level.
Another result which affected the U.S. economy as a whole was the depressing effect
on the general price level of the low prices of goods imported from China and from other
countries. This dispensed the Federal Reserve System from pursuing counter-inflationary
policies, particularly through short term interest rates which were maintained at levels lower
than they would otherwise have been. In turn, this contributed to the maintenance of interest
rates on instalment consumer loans (credit cards, auto purchases, etc.) which encouraged
consumers purchases financed by debt.
6. While the factors mentioned above, concerning public institutions and foreign financing were important contributors to the Great Recession, they could not, by themselves,
have produced the bubbles and the credit crisis without the behaviour of actors in different
areas of the private economy. A prominent American public servant, David Walker, who,
until recently was the head of the independent Government Accountability Office, alerted his
fellow citizens about the danger of the country following the path of the Roman Empire. In
an address in August 2007 he identified four factors which, in his opinion, led to the decline
and fall of that Empire; and which he believed to be present in the United States. One of
those factors was declining moral values (Walker, p. 11). There is no doubt that this social
phenomenon could be detected in various attitudes or behaviours during the genesis period,
as will be described below. It is possible that the various manifestations of the phenomenon
under discussion were made easier, if not downright encouraged, by a variety of innovations in the real estate financing area. They included: (temporarily) variable interest rate
loans; negative amortization loans; No Doc loans (i.e., loans for which no documentation
of borrowers financial situation was required); and home equity lines of credit. The latter innovation permitted home owners to borrow, and receive cash, against the home equity;
that is, the amount by which the estimated value of the house exceeded the face value of the
outstanding mortgage loans (first mortgage and, at times, a second mortgage loan). Since
until the end of 2006 the market prices of homes were increasing (the bubble) in part due to
the easiness to obtain loans through the traditional instruments and the innovations the
home equities continued to rise. The same expectations as to home prices led, at times, to
lenders granting mortgage loans of up to 125 percent of the estimated house value (at times
with the help of benevolent appraisers).
7. The principal actors in the drama known as the credit crisis were: bankers at all
levels and other financial institutions; rating agencies; borrowers, appraisers; and real estate
agents. It should be clear that the statements and characterizations which will be made in the
following paragraphs refer to prevailing behaviours; but they should not be understood as
applying to each single member of the business, professional groups, or single individuals.

The U.S. Great Recession. Its Genesis. (And a regeneration?)

13

(a) Lenders. The orientation of the lending community with respect to all loans, and
not only to housing loans, is fairly well described in the following paragraph
(Fleckenstein 2008, p. 154): Lenders face fierce competition from other lenders.
Rather than make prudent, sound lending decisions, they rely on automated underwriting, and are often greatly influenced by the threat of losing market share.
Lenders also rely on the upward slope of the average housing price in America.
They assume that deals that go bad will eventually find a buyer without too much
damage to principal. Lenders are intent on growing, no matter what the costs.
Besides engaging in the innovative practices mentioned in paragraph 6 above,
lenders in general were not fully informative in their dealings with customers.
When borrowers opted for variable interest rates, lenders so it was alleged did
not warn them about the possible risk involved; a risk due to the fact that rates were
based on the federal funds rate, or on the prime rate, both of which fluctuated
within broad ranges, in correspondence with the two bubbles. The federal funds
rate fell gradually from 6.50 percent in 2000 to 1.0 percent in 2004, and then rose,
step by step, to 5.25 percent in 2005, where it remained until mid-2007.
Besides loans for housing, lenders extended loans to the commercial sector with
equal abandon. An analyst on this subject wrote recently: So keen were the banks
to give speculators cash as well as debt, sometimes on structured terms that
guaranteed an upside for investors with only the thinnest skins in the game, 5-10
percent of their own equity perhaps.
In their motivation and eagerness to increase profits, and to maintain or increase
their market shares, lenders felt encouraged by pronouncements by the Federal Reserve System, and by the knowledge that their loans could be packed and ultimately resold to Fannie Mae and Freddie Mac. As pointed out by Mr. Fleckenstein
(pp. 155-156), Mr. Greenspan stated in a speech in February 2004 that the traditional fixed-rate mortgage may be an expensive way to finance a home; and that
American consumers might benefit if lenders provided great mortgage product alternatives to the traditional fixed-rate mortgages. And in April 2005, in a speech
on Consumer Finance he stated, inter alia, that technological advances resulted in
higher efficiency and scale in the financial service industry, with a multitude
of new products, such as sub-prime loans, and that these improvements have led
to a rapid growth in subprime mortgage lending... (i.e. lending to higher risk
borrowers).
Between 2000 and 2007 (the end of the bubble) non-farm mortgage loans by all
lenders rose by 136 percent, or by $8.36 trillion, compared with an increase of 49
percent between 1993 and 2000. The share of subprime lending in the total rose
from about 5 percent in 2000 to close to 25 percent in 2006. The available data
offer some clear indications of the consequences of the repeal of the Glass-Steagall
Act, in 1999. From 1989 to 1998 mortgage loans by commercial banks rose from
$770.1 billion to $1,337 billion, or by 73 percent; whereas they rose by 173 percent
(from $1,337 billion to $3,646 billion) between 1998 and 2007.

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(b) Ratings. Recently there has been widespread criticism of the three main rating
agencies; i.e., Moodys, Standard & Poors and Fitch. The criticism covers
different areas of finance, but there is scant documentation available, official and
unofficial. A tentative explanation of the performance of the rating industry is that,
generally speaking, there have been two major developments in the recent past
which have interfered with the traditional operation of the rating institutions. One
was the complexity of the instruments which the financial sector created. The other
was a certain co-dependency between raters and rated, to use a euphemism,
which falls under the general phenomenon of declining moral values. A pertinent comment can be found in the 2009 Annual Report of the Bank for International Settlements (BIS).
Referring to the rating companies, the Report stated These organizations are
designed to mitigate the information problems that plague debt financing by
providing third-party evaluation of the likelihood that the borrower will repay a
loan or bond. There are a number of problems with this system. Ratings are expensive, difficult to produce and impossible to keep secret. Once information becomes
public, its reproduction is costless. Knowing that, the rating agencies charge those
who need the ratings most, the bond issuers. Although neither new or unique
rating agencies have charged bond issuers for decades, and auditors are paid by
those they audit this arrangement helped to distort incentives. Moreover, the complexity of the financial instruments and the pace of the issues the flood of
asset-backed securities and structured finance products issued over the past
decade made the rating business both more difficult and more profitable....In the
end, the rating agencies assigned the task of assessing the risk of fixed income securities and thus guarding collective safety became overwhelmed and by issuing
unrealistic high ratings, inadvertently contributed to the build-up of systemic risk
(BIS pp. 8 and 9) 5.
Much of the information on this matter is anecdotal. For example, in an article in
Fortune Magazine Alan Sloan and Doris Burke (Fortune, December 21st, 2009)
related on a case of rating by Moodys which is not reassuring. It refers to a sale in
April 2006 of $494 million of securities by Goldman Sachs to institutional investors. These securities were backed by second mortgage loans which normally
are guaranteed by the residual 20 percent of home value (the first 80 percent
being covered by the first mortgage loan). In this case, however, the equity in the
borrowers homes was, on average, 0.71 percent of the total. In the words of the
authors: Despite these problems, the formula used by Moodys and S&P allowed
Goldman to market the top three slices of the security cleverly called A-1, A-2
and A-3 as AAA rated. That meant they were supposedly as safe as U.S. Treasury
securities.
(c) Borrowers, Appraisers, Realtors. These categories are grouped together because
they are, at the same time, parties to each single transaction. A general comment on
borrowers behavior can be found in the official document called The Economic
Report of the President (to the United States Congress). The 2009 issue includes

The U.S. Great Recession. Its Genesis. (And a regeneration?)

15

the following statement: The very competitive lending environment encouraged

and intensified myopia among lenders and borrowers both of whom took on too
much risks (Economic Report, p. 65) (italics are mine).
Insofar as the pressure by realtors on individuals to purchase homes, the common
knowledge at that time was that it existed and that it was widespread; but no
documented information is available. As to appraisers, the fact that they were quite
generous in attributing high values to the properties to be bought, was also
commonly known at the time; but in this case also the practice is not officially or
unofficially documented. There is, however, an abundance of anecdotal evidence.
For instance, in Mr. Fleckensteins book reference is made to an article in the Wall
Street Journal of August 20, 2002. In this article it was emphasized the extent to
which people were now pressing their appraisers to maximize the amount of
money they could borrow against the value of their homes. A common characterization of the behaviour of home buyers, or of home owners, was that they
treated their homes as an ATM machine. In other words, home owners tended to
finance their conspicuous consumption by banking on their homes in the same
fashion as when they drew money from an Automatic Teller Machine (ATM). The
figures on total consumers borrowing are eloquent: in the decade ending in 1999
that borrowing rose by $737.8 billion, or by 73.7 billion per year, whereas in the
eight years between 1999 and 2007 it rose by $986.6 billion, or $123.3 billion per
year. This represents an increase in total consumers borrowings of 67 percent per
annum between the two periods mentioned above.
8. In the preceding paragraphs the genesis of the Great Recession was traced back to
the behaviour of public institutions, and of professional and non-professional groups in the
private sector. The almost daily reports during the recent 12-18 months suggest that, before
the crisis came out in the open, a number of large companies in the financial sector had been
following risky and financially unsound practices which, at the time, went undetected by
regulators and by analysts. So-called toxic assets were hidden from the public view for the
reason that they were off balance sheet; others were invisible due to packaging of
subprime loans; others consisted of derivatives (such as the credit default swaps) which
eluded supervision. Much has been written about the failure of Lehman Brothers; about the
rescue by public authorities of AIG and others; and the promoted acquisition of major
companies on the brink of bankruptcy, such as Merrill Lynch, Bear Sterns, Wachovia Bank,
and others.
In a broad sense, the activities mentioned above in the financial sector were part of the
genesis of the Great Recession; but the publicly available information on them is scanty; and,
at any rate, even if sufficient information were available, the phenomena were too intricate
and complex to allow an accurate description in a short article. They are mentioned here only
for the record, as part of the whole picture. Their unprecedented dimension will partially and
indirectly become apparent in the following chapter.

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The aftermath
9. To conclude this article, the following paragraphs are added to summarize the steps
taken, and those planned, by the United States Government as a consequence of the developments described in the preceding sections.
Since it is somewhat inevitable to compare the events of the last two years, or so, with
those of the Great Depression, it is appropriate to highlight briefly the major differences in
the political background between the two periods.
One of them is the difference in the underlying economic policy philosophy. In the
early 1930.s there was an inhibition to deliberately intervene through fiscal policy and to use
deficit financing. That, as well is known, no longer exists. The balance the budget imperative has long disappeared.
The second major difference is that an international coordination, however loose, to
solve the problems in various developed countries has been established and put into effect.
This compares with the failure of the 1933 London Monetary Conference, which had similar
purposes.
10. An appropriate preface to description of the actions taken in the United States to
avoid another Great Depression is a brief paragraph taken from a recent article by the Secretary of the Treasury at the onset of the crisis, Mr. Henry M. Paulson, Jr. (Paulson 2010):
Sixteen months ago, Americas financial system teetered on the brink of collapse. The
Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation took actions
that were unpopular and previously unthinkable - but absolutely necessary to stave off an
economic catastrophe in which unemployment could have exceeded the 25 percent level of
the Great Depression.
The actions referred to above were followed by many others, and still others are in the
process of being taken. All of them can be grouped under three categories 6:
(a) Measures aimed at preventing the aggravation of the initial situation from occurring (to paraphrase Mr. Paulson, a collapse of the financial system).
(b) Measures taken to reactivate the economy and to alleviate the adverse consequences of the credit crisis for various groups, particularly home owners and
unemployed persons; and
(c) Measures still under discussion within different branches of the Government
aimed at preventing in the future the recurrence of mismanagement, excesses,
errors of the past decade, or so.

A.

The Initial Steps

The government actions in this phase can be divided into defensive measures and active
measures.

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When the problem started appearing in 2007, i.e., the bursting of the housing bubble,
the first assessment was that those problems were confined to the housing sector, and to the
lenders which had granted sub-prime loans. This, however, proved to be optimistic. In a relatively short time serious problems arose in the whole financial sector (eventually, there
was what can be called the first stage of the propagation, which involved the totality of the
economy).
One of the first stop-gaps was the creation of a new program for the Federal Housing
Administration (FHA) under which home owners with delinquent adjustable mortgages were
offered the possibility of refinancing their loans with fixed rate mortgages insured by the
FHA.
The Fed, for its part, started lowering the federal funds rate and expanded its lending
through the discount window. In addition it started a coordination with the Central Banks of
four other currency areas so as to reduce pressure in the short-term credit markets, including
the establishment of reciprocal swap lines of credit.
When the problem with sub-prime loans started affecting the solidity of many banks,
due to the decline in the value of their assets, the fear of bank failures prompted the FDIC
to act. To avoid the events of the early 1930.s; i.e., the massive withdrawal of deposits and
the consequent collapse of thousands of banks, the FDIC increased the limit of the deposit
insurance from $100,000 to $250,000. The U.S. Treasury, for its part, decided to guaranty
temporarily money market funds.
The above measures were the equivalent of plugging holes in a dike; and it soon appeared that they were not sufficient, and that more vigorous and wide-ranging measures were
needed.
As a steep fall in value of the MBS affected the viability of Fannie Mae and Freddie
Mac (the ultimate buyers of mortgage loans, and packaged loans) the Government purchased
the stock of these agencies; and shortly thereafter took them under its direct control 7. This,
however, took care of only one segment of the financial markets. A more comprehensive
program was prepared by the Treasury to relieve the financial institutions of their toxic assets of any nature, whether or not they originated in the housing sector. In fact, massive
losses accumulated in those institutions which had engaged in dealing with credit default
swaps. It was calculated that the task required an additional appropriation of $700 billion.
The program, called Troubled Asset Relief Program (TARP) was approved by Congress in
October 2008.
Parallel to this major measure, the Federal Reserve System started purchasing both
public sector bonds and mortgage backed securities (the so-called quantitative easing) which
eventually increased its portfolio to more than $2.1 trillion. In addition, it continued to lower
the federal funds rate, by small and large steps; and at the end of 2008 the rate was brought
down to zero.

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B.

Ugo Sacchetti

Reactivating the Economy

Rescuing major financial institutions in distress, and injecting massive amounts of liquidity was not sufficient to halt the downward trend in the economy, which in 2008 had
fallen into a deep recession. A more comprehensive program was necessary, which would
also cover the human side of the recession i.e., the loss of homes and large unemployment.
The new administration adopted important measures covering a large number of activities. The most important was the Stimulus Package, formally known as the American Recovery and Reinvestment Act (ARRA), which was signed by the President on February 17,
2009. The estimated expenditures under this Act were $787 billion, over a two year period.
The overall objective of the Stimulus Package was the reactivation of total demand
both by direct spending in infrastructures and by increasing the spending capacity of businesses and individuals. More specifically, individuals were granted tax rebates, and middle
income persons received tax cuts; and unemployment compensation was extended. Small
businesses were to receive tax cuts as well as credit facilities from the Small Business Administration. They also were scheduled to receive fiscal benefits in the form of accelerated
depreciation of certain investments.
Specific sectors were also assisted. The housing sector, which was the major factor in
the recession, was targeted for special benefits. The main provisions were as follows. First
time home buyers could deduct from their income tax dues $8,000 for the purchase of a
home (until December 2009, but later extended). A separate program (Making Home Affordable) provided assistance to homeowners in financial difficulties through refinancing of
mortgage loans at low interest rates. Another assisted sector was the automobile industry
which benefited from the Car Allowance Rebate System, popularly known as cash for
clunkers (which was also extended at expiration). Other facilities, of a financial nature,
were granted to the automobile industry, particularly to two of the three major car producers.
Finally, the Governments of various States of the Union received assistance under
ARRA. States (and local communities) were greatly affected by the recession because of the
reduced tax revenue (income tax, property taxes, sales taxes), and because of their limited
access to the capital markets. Major States, particularly California and New York, encountered (and still face) grave difficulties.
The importance of the problems in State Budgets can be understood when one considers the functions which States and local communities perform; since these functions are
not under the jurisdiction of the Federal Government. Prominent among them are: infrastructures, such as the road networks, and the water and sewer systems; education; and public
security (i.e., police). The reduction of these and other services, besides adversely affecting
the standard of living, entails loss of employment and personal income, which, in turn,
means loss of revenue for the State and local authorities.
Outside of ARRA, and even before its inception, the Treasury introduced the Financial
Stability Plan, which, in a sense, supplemented the TARP. Under this Plan a Public-Private
Investment Program (PPIP) was created, jointly with the Federal Reserve System and
the Federal Deposit Insurance Corporation. Like TARP, this Program aimed at restoring the

The U.S. Great Recession. Its Genesis. (And a regeneration?)

19

health of financial institutions through the removal from their balance sheets of toxic assets,
so that they could resume their normal lending activities.
In addition, pursuant to the Plan, the Fed activated the previously announced Term
Asset-backing Security Loan Facility (TALF) which had the purpose of reactivating the
moribund securitized lending in difficult sectors, at low interest rates. The sectors included
automobile, student, and small business loans.

C.

Measures under consideration

Having learned from the past, the United States, and other developed countries, have
under consideration a number of measures which, if put into effect, may contribute (but not
assure) to avoiding re-occurrence of the major causes of the Great Recession. Before focussing on the United States our main task a brief mention should be made of activities at the
international level.
One of the main items in the agenda of the recent G-20 meetings was the reform of the
regulatory system in the financial area. Active discussions have taken place in that forum as
well as in other international fora although no agreement has been reached. At the same
time, improved rules have been worked out in what is called Basel III, and they are expected to become effective late this year.
In the United States a reform of the regulatory system is under active consideration
within the Administration and in Committees of the U.S. Senate. As can be expected, the
subjects are contentious, since the to-be-regulated, and those philosophically and politically associated with them are opposed to any change which, from their point of view, would
constitute an undue intrusion into the free functioning of the capitalistic system.
A re-enactment of the Glass-Steagall Act, which was proposed, not long ago, has been
sidestepped; but its principles are very much alive 8. Mr Paul Volker, a former Chairman of
the Federal Reserve System, and at present an Advisor to the President, is very active. He has
proposed to the Congress that action be taken in three major areas a modified and enlarged
Glass-Steagall. The first is the separation of commercial banking from proprietary trading.
This would protect the banks capital as well as depositors from the risks of investment activities undertaken by financial institutions. Mr. Volker was specific in a recent article: The
specific points at issue are the ownership or sponsorship of hedge funds and private equity
funds, and property trading, that is, placing capital at risk in the search of speculative profits
rather than in response to customer needs. Those activities are actively engaged in by only a
handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be
significant internationally (Volker, 2010).
The second area is the size of the institutions. On the basis of the recent experience,
where very large companies were rescued by the Government (notably AIG) because of the
fear that their failure would have had serious repercussions for the whole system, the proposed action is to prevent institutions from becoming too-big-to-fail.

20

Ugo Sacchetti

The third area covers the whole of the derivatives operations. In a nutshell, it is
proposed to create a central clearing of credit derivatives. It is not clear yet what the precise powers of this agency would be, nor which regulator would be assigned these tasks (the
Federal Reserve System? or an enlarged Commodity Futures Trading Commission?). In
general, the objective would be to keep those activities under control in such a manner that
they would not endanger the solidity of the system.
A broader suggestion, not related to specific activities, is to vest into a government
agency (existing or to be created) the power to impose an orderly liquidation of institutions
in serious financial difficulties, so as to protect the rest of the system.
The above brief description of proposed major reforms of the regulatory system in the
financial area, implies that certain behaviors, which are highlighted in the sections dealing
with the genesis of the problems, are not covered (and almost certainly cannot be regulated).
This refers to two major categories of performance. The first is the observed laxity in the implementation of existing powers, particularly in the case of the Security and Exchange Commission, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation.
The second category is the behavior of individuals and private institutions; i.e., rating agencies, lenders of all kinds, appraisers, realtors, and, last but not least, the borrowers themselves.
To regulate these categories is tantamount to regulating human nature; and this is
beyond the scope of any legislative system. It is to be hoped, therefore, that, especially
for future generations, the main thrust of the regulatory proposals becomes reality, and
that, above all, the seeds of a regeneration of moral values will emerge from the ongoing
catharsis.

Notes
1.

The author wishes to express appreciation for valuable assistance received from the staff of the Library of the
Universit della Svizzera Italiana.

2.

An indication of the importance of the consequences of the decision to repeal the Glass-Steagall Act is that recently two Senators have introduced a bill to re-instate that Act.

3.

This can be viewed within the framework of contemporary American culture, which is lamented by many writers: Susan Jacoby, in her The age of American unreason (2008); Lee Siegel in Against the machine being
human in the age of electronic mob (2008), and Eric G. Wilson, Against happiness.

4.

Nobel laureate Paul Krugman recently wrote: ...in the years before the crisis, the rules were relaxed and, even
more important, regulators failed to expand the rules to cover the growing shadow banking system, consisting
of institutions like Lehman Brothers that performed bank-like functions even though they did not offer conventional bank deposits (International Herald Tribune, January 9-1-2010).

5.

The evaluation by the BIS turns out to be euphemistic. On May 13th 2010 the U.S. Senate approved an
ammendment to the bill which would regulate financial institutions; which ammendment would end the intimate relationships between lenders and rating agencies. At a Hearings on April 23rd, by the Permanent
Sub-Committee on Investigations, a former managing director of Standard & Poors (Mr. Frank Reiter) stated
that analysts had tried unsuccessfully to persuade management to lower ratings of some housing-related securi-

The U.S. Great Recession. Its Genesis. (And a regeneration?)

21

ties. The negative response was reportedly justified by the reason that revenues would go down; which suggests
that lenders paid the rating agencies to obtain inflated ratings. At the Hearings, the Sub-Committees Chairman,
Sen. Carl Levin, offered the analogy: It is like one of the parties in court paying the judges salary.
6.

The following paragraphs include the description of only the most important steps. A fairly complete description of events and measures taken can be found in the 78th and 79th Annual Reports of the Bank for International
Settlements; and in the 2010 Economic Report of the President (to the Congress).

7.

It is important to point out that Fannie Mae and Freddie Mac are two of the Government Supported Agencies
(GSA) and that they have government guarantees. The purchase of their stock did not involve their bonds which
were issued to finance mortgage loans and MBS. Thus, holders of their bonds were protected and the main
beneficiaries have been the governments (and their sovereign wealth funds) of China, Japan, South Korea and
Taiwan, which, according to recent estimates, hold about $720 billion of these bonds.

8.

A prominent member of the House of Representatives, Mr. Stan Hoyer, stated in an interview in December
2009: As someone who voted to repeal Glass-Steagall, maybe that was a mistake.

References
Bank for International Settlements (2009): 79th Annual Report.
Economic Report of the President (2009 and 2010): United States Government Printing Office, Washington, DC.
Fleckenstein, William A. (2008): Greenspan Bubbles, McGraw Hill.
Kondratieff, Nikolai D. (1944): The Long Waves in Economic Life. (Original title: Die langen Wellen
der Konjunktur. English version in the Review of Economic and Statistics, Vol. XVII, November
1935, pp. 105-115. Reprinted in Readings in Business Cycle Theory. The Blakiston Co. pp.
20-42.
Krugman, Paul (2010): Bubbles and Banks, International Herald Tribune, January 9-10.
Kuznets, Simon (1954): Equilibrium Analysis and the Business Cycle Theory in Economic Change,
Heineman Ltd.
Paulson, Henry M. (2010): How to Save the System, International Herald Tribune, February 16.
Sloan, Alan, et al. (2009): Once Upon a Time in Mortgage land, Fortune, December 21.
Volker, Paul (2010): How to reform our Financial System, International Herald Tribune, February 2.
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