Lessons from the great recession (part 1)

1. Let the small fires burn

Quite possibly the biggest reason for why the great recession was so great was the heavy hand of government working in tandem with the heavy hand of the fed reacting to every single crisis, small or big. Sometimes the best way to avoid a major disaster is to let a small one fester. For example, take this analogy of wildfires, California and its Mexican neighbor Baja California both face wildfires at regular intervals, the difference between the two? Whereas California has a policy of dousing every fire small or big, Baja California has a policy of letting the small fires burn hence eliminating significant amounts of brush-land that cause big wildfires.

A similar case can hence be made for the economy. The hardest thing sometimes for us humans, specifically men in certain cases, isn’t doing something, it’s to sit on the sideline doing nothing. The Fed for example was created in response to the 1907 panic that saw a massive solvency run on trust companies. “Trust companies were state-chartered intermediaries that competed with banks for deposits. Trusts were not, however, a central part of the payments system and had a low volume of check clearing compared with banks. As a result, they held a low percentage of cash reserves relative to deposits, around 5 percent, compared with 25 percent for national banks. Because trust-company deposit accounts were demandable in cash, trusts were just as susceptible to runs on deposits as were banks.” It took the dual efforts of JP Morgan, and Benjamin Strong then a Vice President at Bankers Trust, and later the head the New York Fed, to come together to provide enough credit to the clearing houses and knickerbocker trust to stave off the run. But the crisis ended up scaring politicians and populace alike of the power that one man, JP Morgan, had at the time. The result?- The creation of the Federal Reserve System as we know it. But just because the Fed exists doesn’t mean that it necessarily wade into every single crisis, especially the small ones. Within a market economy the small crises exist as a self correcting mechanism, but by getting involved in every single small banking panic/crisis its caused the mechanism to relent and malfunction. It would serve the government/fed well moving forward to not wade into every crisis with missionary zeal as more often than not it precludes a major crisis in the same way a yield curve does. The .com/Y2K recession a case in point. 

2. Redistribute the costs more evenly

The other major issue with recessions is that it ends up hurting those the most that can least afford it- the lower/middle-class. While income equality and wage stagnation had been a problem with the American economy even before the recession, those issues were exacerbated in the aftermath of the recession. Despite the fact that all the money that had been lent out to private enterprises came back with a premium, the general populace was left seething due to the distrust against policy makers, which was primarily a result of how the costs associated with recession was spread out. We can observe the rise of populism across the world through a similar lens as well. The cost associated with the great recession for example, hurt the bottom 10 percent’s income 2.5x as it did the top 10 percent earners. Reflecting back it’s been a trend that’s carried on over the last 40 years, from the 1980-83 double dip recession that saw the poor getting hurt twice as much as the richest to the 2008 recession. The poor are hence well within their right to be deeply upset with the underlying fundamentals of the US economy. Cruelly enough the pattern reverses itself when it comes to booms, the top 10 percent then end up earning as much as 2.5x their bottom 10 percent counterparts. It’s one of the reasons why income mobility in the U.S has significantly stagnated in the past couple of decades. Even despite globalization’s obvious and significant advantages, its costs are also geographically concentrated. The redistribution of benefits/costs is something policy makers hence must be mindful of when the next recession inevitably hits. (P.S. As a free marketer the best solution then might be for the government to not get involved at all, but as somebody who understands that isn’t possible and that sometimes markets are not self correcting, redistribution might be the best way to avoid mass dis(trust/satisfaction))

3.  Simplifying our economic institutions

Simplifying our economic institutions are another major issue that deserves more attention. The main cause of the great recession as we’ve come to learn through academic and at times pop culture (Selena Gomez in the big short) were what we called mortgage backed securities (MBS) packaged into collateralized debt obligations (CDO). I could copy and paste a detailed an explanation but why not rewatch this fine piece of cinema instead, https://www.youtube.com/watch?v=EEXTqtH-Oo4.

You see, these so called special purpose vehicles (SPV’s) as MBS’ and CDO’s are frequently referred to aren’t the only piece of complexity that plagues our financial and economic institutions. Even most investors, investing in these SPV’s didn’t understand what they comprised of. For example, It took Warren Buffet one of the most richest and smartest men on the planet to pour through thousands and thousands of pages to fully understand the junk that comprised Lehman Brothers’ assets before he passed on buying it.

Governments are even worse offenders. From the tax code comprising of 26000 pages in 1986 to 70000 pages to it’s so long nobody is sure how long it is. Regulatory growth isn’t far behind either, since 1980 regulatory growth has contributed to at least $4 trillion in less U.S. economic output, according to research by the Mercatus Center. To let that sink in, this amount is roughly equal to Germany’s economy, the size of the federal budget, and the combined economies of California and Texas. But, more importantly, it equals lost prosperity of roughly $13,000 for every person in America. The complexity surrounding our economic and financial institutions directly benefits rent seekers and indirectly hurts households. It’s also one of the major reasons for the rise in income inequality (I wrote about at length last year here).

The lessons from the great recession are multi-faceted, hence why there’ll be a part 2 in this series, so check back in next month.

One response

  1. Shubhangi Avatar

    Very Insightful!

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