How Democrats, Not Dubya, Destroyed the Economy in 2007

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Nov 29, 2022
How the Democrats Created the Financial Crisis
By Kevin A. Hassett September 22, 2008

The financial crisis of the past year has provided a number of surprising twists and turns, and from Bear Stearns Cos. to American International Group Inc., ambiguity has been a big part of the story.

Why did Bear Stearns fail, and how does that relate to AIG? It all seems so complex.

But really, it isn’t. Enough cards on this table have been turned over that the story is now clear. The economic history books will describe this episode in simple and understandable terms: Fannie Mae and Freddie Mac exploded, and many bystanders were injured in the blast, some fatally.

Take away Fannie and Freddie, or regulate them more wisely, and it is hard to imagine how these highly liquid markets would ever have emerged.

Fannie and Freddie did this by becoming a key enabler of the mortgage crisis. They fueled Wall Street’s efforts to securitize subprime loans by becoming the primary customer of all AAA-rated subprime-mortgage pools. In addition, they held an enormous portfolio of mortgages themselves.

In the times that Fannie and Freddie couldn’t make the market, they became the market. Over the years, it added up to an enormous obligation. As of last June, Fannie alone owned or guaranteed more than $388 billion in high-risk mortgage investments. Their large presence created an environment within which even mortgage-backed securities assembled by others could find a ready home.

The problem was that the trillions of dollars in play were only low-risk investments if real estate prices continued to rise. Once they began to fall, the entire house of cards came down with them.

Turning Point

Take away Fannie and Freddie, or regulate them more wisely, and it’s hard to imagine how these highly liquid markets would ever have emerged. This whole mess would never have happened.

It is easy to identify the historical turning point that marked the beginning of the end.

Back in 2005, Fannie and Freddie were, after years of dominating Washington, on the ropes. They were enmeshed in accounting scandals that led to turnover at the top. At one telling moment in late 2004, captured in an article by my American Enterprise Institute colleague Peter Wallison, the Securities and Exchange Commission’s chief accountant told disgraced Fannie Mae chief Franklin Raines that Fannie’s position on the relevant accounting issue was not even “on the page” of allowable interpretations.

Then legislative momentum emerged for an attempt to create a “world-class regulator” that would oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks. Politicians who previously had associated themselves proudly with the two accounting miscreants were less eager to be associated with them. The time was ripe.

Greenspan’s Warning

The clear gravity of the situation pushed the legislation forward. Some might say the current mess couldn’t be foreseen, yet in 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie “continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,” he said. “We are placing the total financial system of the future at a substantial risk.”

What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.

Different World

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed.

But the bill didn’t become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn’t even get the Senate to vote on the matter.

That such a reckless political stand could have been taken by the Democrats was obscene even then. Wallison wrote at the time: “It is a classic case of socializing the risk while privatizing the profit. The Democrats and the few Republicans who oppose portfolio limitations could not possibly do so if their constituents understood what they were doing.”

Mounds of Materials

Now that the collapse has occurred, the roadblock built by Senate Democrats in 2005 is unforgivable. Many who opposed the bill doubtlessly did so for honorable reasons. Fannie and Freddie provided mounds of materials defending their practices. Perhaps some found their propaganda convincing.

But we now know that many of the senators who protected Fannie and Freddie, including Barack Obama, Hillary Clinton and Christopher Dodd, have received mind-boggling levels of financial support from them over the years.

Throughout his political career, Obama has gotten more than $125,000 in campaign contributions from employees and political action committees of Fannie Mae and Freddie Mac, second only to Dodd, the Senate Banking Committee chairman, who received more than $165,000.

Clinton, the 12th-ranked recipient of Fannie and Freddie PAC and employee contributions, has received more than $75,000 from the two enterprises and their employees. The private profit found its way back to the senators who killed the fix.

There has been a lot of talk about who is to blame for this crisis. A look back at the story of 2005 makes the answer pretty clear.

Oh, and there is one little footnote to the story that’s worth keeping in mind while Democrats point fingers between now and Nov. 4: Senator John McCain was one of the three cosponsors of S.190, the bill that would have averted this mess.
Obama Didn’t End the Great Recession That Bush Didn’t Cause
By James Pethokoukis

If you think George W. Bush’s economic policies caused the Great Recession and Barack Obama’s ended it, then your Election Day decision is likely an easy one. But placing politics aside, I don’t think the economic evidence supports that thesis. I’ve stated my reasons, in bits and pieces, across several blog posts. Maybe now would be a good time for a unified, though brief, rebuttal.

Let’s take the two strands of the argument and examine each. First, did Bushonomics cause the worst economic downturn and financial crisis since the Great Depression? To make that case, you need to specify a policy causality (or two or three) and a transmission channel. But when you go down the list of usual suspects, none of them pans out:

— It was the Bush tax cuts. Except lowering taxes increases demand and improves supply-side incentives. The only way this theory might be true is if bond markets feared tax cuts would be inflationary or would hurt the ability of the US to pay back its debts. But interest stayed low during the 2000s. Also note that Obama says he wants to again extend most of these cuts.

— It was Bush’s income inequality. Except that a 2012 study, Does Inequality Lead to a Financial Crisis by economists Michael Bordo and Christopher Meissner, seems to dismiss that linkage. Using data from a panel of 14 countries for over 120 years, they found “strong evidence linking credit booms to banking crises, but no evidence that rising income concentration was a significant determinant of credit booms. Narrative evidence on the US experience in the 1920s, and that of other countries in more recent decades, casts further doubt on the role of rising inequality.”

— It was the Bush budget deficits. Except both inflation and interest rates were low during the 2000s. This is really another version of the tax cut argument, but adds in deficits from Medicare expansion and the wars in Iraq and Afghanistan. Besides, annual budget deficits averaged just $220 billion from 2001-2007. During the 2010-2012 recovery, they’ve averaged roughly $1.3 trillion. So deficits caused the Great Recession even though they are six times higher now?

— It was Bush’s financial deregulation. Except the law that ended Glass-Steagall was signed by President Bill Clinton. And few analysts think the end of Glass-Steagall directly contributed to the financial crisis. Another candidate was a 2004 rule change by the Securities and Exchange Commission that supposedly allowed broker dealers to greatly increase their leverage, contributing to the financial crisis. But as Prof. Andrew Lo of MIT explains in a 2011 paper, ”… it turns out that the 2004 SEC amendment to Rule 15c3–1 did nothing to change the leverage restrictions of these financial institutions.”

So what did cause the Great Recession? Politicians love to blame big downturns on “market failures.” Doing so then allows them to expand government and their own power. That’s what happened during the Great Depression. But it wasn’t the free market that failed back then, it was the Federal Reserve.

And the same goes for the Great Recession. In The Great Recession: Market Failure or Policy Failure, Robert Hetzel, a senior economist at the Richmond Fed, pins the blame squarely on the US central bank. The downturn first started with “correction of an excess in the housing stock and a sharp increase in energy prices” — the housing bust and the oil shock. Those two things were enough, in Hetzel’s view, to cause a “moderate recession” beginning in December 2007.

But it was the Fed’s monetary policy miscues after the downturn began that turned a run-of-the-mill recession into a once-in-a-century disaster. Not only did the Fed leave rates alone between April 2008 and October 2008 as the economy deteriorated, but the FOMC “effectively tightened monetary policy in June by pushing up the expected path of the federal funds rate through the hawkish statements of its members.

In May 2008, federal funds futures had been predicting the rate to remain at 2% through November. By mid-June, that forecast had risen to 2.5%. As Hetzel writes in a Fed paper that inspired the book, “Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008. Irony abounds.’

And what ended the Great Recession? Was it the $800 billion Obama stimulus? As I have often pointed out, White House economists thought the stimulus would help lead to roughly 5% unemployment and 4% GDP growth in 2012.

Instead, the US economy is growing at half that pace and unemployment is sharply higher — even before you account for the massive drop in labor force participation.

But what do left-of-center or pro-Obama economists say? Here are Alan Blinder and Mark Zandi in a 2010 paper:

In this paper, we use the Moody’s Analytics model of the U.S. economy—adjusted to accommodate some recent financial-market policies—to simulate the macroeconomic effects of the government’s total policy response. We find that its effects on real GDP, jobs, and inflation are huge, and probably averted what could have been called Great Depression 2.0.

For example, we estimate that, without the government’s response, GDP in 2010 would be about 11.5% lower, payroll employment would be less by some 8½ million jobs, and the nation would now be experiencing deflation.

When we divide these effects into two components—one attributable to the fiscal stimulus and the other attributable to financial-market policies such as the TARP, the bank stress tests and the Fed’s quantitative easing—we estimate that the latter was substantially more powerful than the former.

So Blinder and Zandi credit the Fed and TARP, Bernanke and Bush, mostly for breaking the back of the downturn. Indeed, the steepest drops in GDP ended before Obama took office and before the stimulus kicked into gear. And eventually, of course, the economy would recover on its own as long as government didn’t interfere with anti-growth policies such as tax hikes or massive new regulations.

How Democrats, Not Dubya, Destroyed the Economy in 2007​


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