2008 Financial Crisis: The Government Response

Release Date
August 26, 2011

Topic

The Fed & Monetary Policy
Description

Have we fixed the problems that created the most recent boom and bust? How have government interventions in the economy altered the expectations of individuals moving forward? How does government debt affect the economy as a whole? These questions, along with many others, are answered by historian Stephen Davies.

2008 Financial Crisis: The Government Response
What is the grade that you would give the United States for responding to the boom and bust today? The answer is definitely a failing grade.
Have we fixed the problems that created this boom and bust? Sadly, no we have not. We still have a central bank that controls interest rates and which controls the monetary system. We still have a political class that is involved in manipulating the systems through the central bank for its own end, such as gaining reelection or making people feel good rather than angry with their rulers and governors.
We also have a financial services sector, which is connected to the political class and which is being bailed out by the political class. This has created a serious problem of moral hazard. Imagine you are playing a poker game and you confidently believe—and are right in believing—that if you lose a whole lot of money on it, somebody is going to reimburse you. What are you going to do? You’re going to behave recklessly. You will bet extravagantly and excessively on weak hands. By analogy this is exactly what the banking system did, and we have not removed the underlying institutions and practices that led them to do this. They are still like that poker player who thinks that he can be bailed out if he makes rash or foolish decisions. What this means is that another boom and bust of this kind is likely in the future, unless we change the way the monetary system works.
What is the grade that you would give the United States for responding to the boom and bust today? The answer is definitely a failing grade. If you look at the response of the United States to the financial crisis and compare it to that of other countries, it doesn’t come out very well from the American perspective.
The United States has done one thing, which almost everyone has done which is bad, and that is to bail out mistaken and insolvent financial institutions. It’s not alone in that. So that’s a case where everyone, if you like, gets a failing grade. However, at the same time, it has also failed to deal with the increasingly acute problem of the state of the nation’s finances.
The United States currently has a budget deficit of over a trillion dollars. This is simply staggering in terms of the amounts and numbers that are involved. A trillion dollars: one dollar bills, stacked side-by-side, would stretch all the way from New York to San Francisco and back to Salt Lake City. That’s the kind of numbers we’re talking about here. Every other country in the world, notably the European Union countries, have been making major cutbacks and retrenchments in public spending. The United States, by contrast, has been simply borrowing as though there’s no tomorrow and is looking to boost public spending rather than reduce it.
Why is that a bad move, and why does that mean they get a failing grade? Because it means all this spending—this public spending—is going to crowd out private spending. There isn’t a money tree somewhere in the gardens of the U.S. Treasury Department where that money comes from. So to the extent that money is being spent by the government, it has to be either raised through taxes or borrowed from private people with wealth. And that means that it can’t be used for something else. And in fact, just as in the 1930s, the most likely effect is to prolong economic failing adjustment, rather than having it brought to a rapid close.