How Did The United States Government Cause The Current Economic Crisis

By Pallavi Mehra

Edited by Nandita Singh, Senior Editor, The Indian Economist

Monetary economist John B. Taylor and David Leonhardt, the managing director of The Upshot, and former The New York Times Washington bureau chief, draw out numerous causes of the recent financial crisis, which they claim, were produced by the United States (Hereafter U.S.) government.

John B. Taylor emphatically claims that the U.S. Government was responsible for the economic crisis, which commenced in October 2008. He states that it would be a big mistake to blame the private economy solely for the financial crisis. According to Taylor, the economic crisis was caused because the U.S. Government kept interest rates too low in the period of 2003-2005. This caused a huge expansion in the housing sector due to monetary excesses, which in turn caused the depression. Keeping interest rates low was a decision by the Federal Reserve Bank. The economist claims that the U.S. Government should have learnt from pervious experiences and not reduced interest rates. Here, he is referring to the government’s response to the Great Depression, which was one where the interest rates were too low.

            Taylor cites the Organization for Economic Cooperation and Development (OECD) to support his argument that the housing bubble was caused by the low interest rate decision made by the U.S. Government. According to OECD analysis, the size of the monetary surplus was directly proportional to the housing bubble in many international economies.

The U.S. government, through the Federal Reserve, kept the interest rate too low, which led to monetary surpluses leading to the economic crisis. Taylor states that low interest rates also supported excessive risk taking in the U.S. financial sector. He goes on to blame new financial innovations, specifically subprime and adjustable rate mortgages, as being a tool for excessive risk taking. These mortgages were pooled together with other assets to create Mortgage Backed Securities (MBSs). Taylor claims that these financial innovations worsened the consequences of the expansion and depression in the housing market.

 Taylor likewise lays the blame on rating agencies, which also played a part in causing the financial crisis. According to Taylor, these agencies made mistakes in evaluating the subprime-backed loans. This can be attributed to low accountability of the rating agencies to the U.S. Government. In other words, had the U.S. Government overseen the rating agencies’ actions, the economic crisis may not have been as severe as it was. Rating agencies gave subprime-backed loans AAA ratings, even though they had the least priority in terms of payback.

Moreover, Taylor sees a role played by Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). The institutions can be defined as private enterprises with a public purpose. Freddie Mac and Fannie Mae are also often called “government sponsored enterprises” because the U.S. Government gives them financial support like low taxes and subsidized loans. They have a mandate from the U.S. Congress to promote home ownership. Fannie Mae and Freddie Macs buy MBSs from lending institutions, such as commercial banks or public companies. With money released, lending institutions can give even more loans to consumers, and create even more MBSs to sell to Fannie Mae and Freddie Mac. According to Taylor, the government encouraged Fannie Mae and Freddie Mac to buy risky subprime mortgage-backed securities, which the institutions normally would not buy.

While Taylor is concerned with the role played by low interest rates and Fannie & Freddie, David Leonhardt, is primarily concerned with government deregulation as one of the major causes of the financial crisis. He reemphasizes Byron Dorgon’s warning regarding the replacement of the Glass- Steagall Act with the Gramm-Leach-Bliley Act (1999). Dorgan is a former Democratic senator from North Dakota. At the time the Gramm-Leach-Bliley Act was enacted, Dorgan stated the following, “I think we will look back in 10 years’ time and say we should not have done this, but we did because we forgot lessons of the past.” Here, Dorgan is referring to the fact that the Glass-Steagall Act (1933) was established to prevent another recession like the Great Depression. Therefore, the Act should not have been repealed. The Glass-Steagall Act included limitations such as prohibiting banks that held consumer deposits from engaging in risky practices, and preventing financial bank-holding companies from owning other financial institutions. Citigroup, Bank of America and J.P. Morgan Chase were formed as a result of the repeal of the Glass-Steagall Act.

Additionally, Leonhardt refers to the Futures Modernization Act (2000), a law that prohibits regulation of Credit Default Swaps (CDSs). The economist claims that this Act was a contributing factor to the crisis as the banks used the derivatives market and specifically, CDSs without any regulation of any kind to deceive their consumers.

In addition, deregulation, allowed banks to have high leverage ratios. A leverage ratio is how much a bank relies on borrowings to finance its assets. Less regulated banks are more reliant on borrowed funds to finance assets. Consequently, when the value of assets falls during a crisis; this results in higher chances of the bank becoming insolvent. This is what happened during the recent economic crisis as stated by Leonhardt.

Leonhardt further asserts that there were other factors that contributed to the crisis, such as the ideology of laissez-faire, which was held by numerous top governmental officials in charge of U.S economic policy, which is the reason it can be attributed as a cause of the crisis. Leonhardt criticizes top government officials and regulators such as Alan Greenspan for believing in the false ideology of laissez-faire. Leonhardt states that Greenspan’s belief in ‘free market’ resulted in extensive deregulation of the financial sector, eventually causing a housing bubble and bust. This ‘free-market’ ideology caused top officials to overlook the regulation of risky subprime-backed mortgage securities, which turned toxic once the housing boom had ended.

In conclusion, both Taylor and Leonhardt claim that the U.S. Government can be held responsible for the recent economic crisis. In his research, Taylor explains a few of the mistakes made by the U.S. Government that caused the crisis. Whereas Leonhardt mainly blames the government’s deregulation of the financial sector, such as the repeal of the Glass-Steagall Act, the introduction of the Glass-Leach-Bliley Act and the Futures Modernization Act, Taylor ascribes the crisis to the U.S. Government’s decision to keep interest rates low in the period of 2003-2005. In addition, Taylor attributes the crisis to unregulated financial innovations, rating agencies’ fraudulent evaluation of MBSs and low accountability of Freddie Mac & Fannie Mae.

Leonhardt also attaches some of the blame to the wrong ideology prevalent in the U.S. Government before the economic crisis. Consequently, while both authors offer different causes of the crisis, these causes can all eventually be attributed to the actions of the U.S. government.

Pallavi Mehra is constantly consumed by wanderlust, is a concert enthusiast and a lover of food. She graduated from Dickinson College, USA as an Economics Major with Honors and was the President of the Model UN club. She has been taught by world-renowned Economics experts such as Vera Zamagni, the former president of a regional Italian government, and Gianfranco Pasquino, a former Italian Senator. Her areas of interest are contending economic perspectives, environmental economics, post Keynesian economics and European economic history. Pallavi is currently working at Rajvin Chemicals, Mumbai. Rajvin manufactures environmentally friendly crop-care products. She begins her Masters in Economic Policy Management at SIPA, Columbia University in July 2015. Email her at pallavi.mehra13@gmail.com.