In 2007, the collapse of the American financial system led the world into its worst economic catastrophe since the 1930s. As conditions deteriorated, governments across the globe deployed unprecedented counter-measures to soften the bust. The American government passed a large fiscal stimulus, and the Federal Reserve swiftly cut rates to zero and resorted to unconventional monetary tools, such as quantitative easing and a slew of Fed acronyms (e.g. TARP, TALF, PPIP). Despite these bold measures, the US economy hangs in a precarious state. One reason is that US government intervention, despite its impressive size, was unevenly distributed throughout the economy.
Today, the United States finds itself in a bizarre situation. The financial markets have stabilized, but the labor market is still in disarray. The S&P 500 has rallied over 50 percent from its trough in March 2009. The surviving Wall Street banks have returned to profitability. On the other hand, the unemployment rate spiked to 10.4 percent and remains high at 9.5 percent. The June jobs report was disappointing. A small increase in private sector employment was not enough to offset a larger decline in census jobs. The unemployment rate only fell due to Americans exiting the labor force. The ranks of the long-term unemployed (27 weeks or longer) swelled to 6.8 million people, 45.5 percent of the total unemployed. The obvious irony is that the crisis originated in the financial markets, but the labor markets have been left to shoulder the brunt of the pain.
This twisted outcome is in part the result of the government’s skewed response to the crisis. From 2007-2010, the government engaged in an asymmetric treatment of the financial and labor markets. As Wall Street teetered on the brink, the Treasury and Fed essentially underwrote the entire financial system. The government committed trillions of dollars to propping up the financial system. Loose Fed policy brought down the cost of borrowing, helping to return banks to profitability. Washington rushed to the aid of the banks while demanding few concessions. A recent New York Times article on the AIG bailout exemplifies the government’s leniency toward Wall Street banks. Even as taxpayers took a stake in AIG, the Treasury granted banks 100 cents on the dollar to unwind their credit default swap positions with AIG. The Treasury even forced AIG to sign a document waiving its legal right to sue several banks over mortgages it had insured prior to the crisis.
In contrast, the government displayed none of this excessive leniency in its bailout of the Big Three automakers. Unlike the Wall Street banks, the failure of the automakers would not have crippled the financial markets. Instead, their collapse would have sent shockwaves through the labor markets. According to the BLS, the automotive industry employed 950,000 workers in manufacturing and 1.9 million people in dealerships in December 2007. The government took a hard line in dealing with the Big Three, forcing the car companies to make fundamental changes to their businesses, the unions to make concessions, and the bondholders to take significant losses. The Big Three had been mismanaged, but not nearly to the same extent as the Wall Street banks. Last month, Washington again demonstrated its lack of support for the labor markets when the latest jobs bill failed to pass through the Senate.
The American government’s crisis response strategy prioritized rescuing the financial system over providing assistance to the real economy. Perhaps the authorities believed that the stabilization of asset prices and credit markets would prove sufficient to spark a recovery in the household and non-financial corporate sectors. Repairing balance sheets and restoring access to credit would restart the engine of private demand. The government committed a massive amount of financial and political capital to this strategy of bailing out the financial sector. The economy, however, continued its decline as propping up the financial system failed to prevent the deflation of the credit and asset bubbles.
Restarting the supply of credit failed to encourage actual borrowing because the private sector had lost its borrowing euphoria. From 1945 to 2007, the US private sector debt-to-GDP ratio marched upward from 60 percent to a record high of 230 percent. This growth accelerated in the decade preceding the crisis, as the rapidly inflating credit bubble fueled economic growth and asset bubbles. While the bank-induced “credit crunch” may have pricked the credit bubble, demand-side forces drive private sector deleveraging. By 2008, the private sector, having accumulated mountains of debt, could no longer sustain increased borrowing. Furthermore, equity and housing valuations were already greatly overstretched entering the crisis and thus set to revert to their historical levels. For these reasons, the government failed to stop the deflation of the credit, equity, and housing bubbles. The collapse of these bubbles constituted a massive negative wealth shock, forcing the private sector to retrench and driving the economy into recession.
While the American government succeeded in rescuing its financial system, it failed to facilitate a recovery in the real economy. This failure has less to do with the quantity than with the quality of the response. Contrary to its capitalist ideals, the US government bailed out the actors most deserving of failure, while exacting minimal concessions. The pending Frank-Dodd “financial reform” bill will not fundamentally restructure the financial system (nor will it prevent future financial crises). In fact, when the details of the bill were revealed on 25 June, the stock prices of the major banks actually rose. Failing to make the banking system bear the brunt of its own costly mistakes propagates moral hazard in this “too big to fail” sector. Given global macroeconomic imbalances, the United States was due for some inevitable pain, but the government bailouts spread it unevenly, shifting it away from those who deserved it to those who did not.
Christopher Wu—A recent graduate from Harvard College, where he studied economics, focusing on international macroeconomics and financial crises.
