Global Economy in the New Millennium
The Great Recession began at the end of 2007, but its causes were hidden in what had happened at the start of the new millennium. The chairman of the Federal Reserve in 2000 was Alan Greenspan, whose first term began in 1987, the year of the greatest stock market crash in history. Share prices fell more than 21 percent on October 19, 1987, almost double the level of a single-day fall in the Dow Jones Index in October 1929. Greenspan acted with great speed, increased the supply of money, and cut interest rates sharply soon after the 1987 crash. With more money available to banks and brokerages, share prices stabilized within a few months, and the economy began to grow again.
Greenspan learned an important lesson from this experience. Share prices crashed again in 2000 at the start of the new millennium. Greenspan cut interest rates again. Then came the massacre of 9/11 and the shaky stock markets fell more, and Greenspan cut rates one more time. So, in the new millennium the rate of interest fell repeatedly. This was bound to have unexpected consequences in markets that benefit from low interest rates.
2.1 The Housing Bubble
A nation’s central bank normally lowers interest rates by cutting the federal funds rate, which is a fee that a bank charges another bank for overnight loans. The central bank does this by supplying extra funds to banks. In 2001, Greenspan lowered the federal funds rate, and did this again in 2002. The rate fell from 6.5 percent in 2001 to just 1 percent in 2002. This was a drastic and unprecedented fall.
The housing market is usually the first to react to lowering of rates. Homes are expensive and the vast majority of people buy them through borrowed money. The fall in the federal funds rate caused a big fall in the mortgage rate, so that home buyers could get money cheaply and afford to buy new homes. Demand for homes rose and with money available at very low rates, it kept rising year after year. Mortgage rates also declined in other countries and demand for homes rose all over the world.
As demand for homes rose, home prices began to rise, and as interest rates remained low for a long time, both demand for homes and prices rose year after year. When the price of something rises so swiftly and for so long, it is said to produce a bubble, especially when people start speculating in it. With home prices rising again and again, speculators moved into this market. Speculators bought homes either to rent them or sell them quickly at a profit. When one speculator made quick money, others also came in to make quick profit. This way the demand for homes kept rising from the actions of those who bought homes as their residence and others who bought them for speculation. So, the housing bubble continued to expand for many years. The bubble started in 2001, and it kept on going until the middle of 2006.
Money lenders benefitted a lot from the housing bubble. With money available cheaply from the Federal Reserve, banks loaned it out to home buyers and speculators. They earned huge fees for themselves and great profits for the speculators. Easy money also made the bankers take unusually large risks. They loaned out vast amounts to the public through home equity loans. People mortgaged their old homes, borrowed money, and spent it freely. Some banks also acted with fraud. They did not care if the borrower had good credit or had enough assets to repay the loan. All they wanted was to earn a fat fee from the loan. In some cases, the loan amount was more than the market value of the house because the bigger the loan, the greater the fee earned by a banker.
By the middle of 2007, the home market had reached its saturation; home prices had risen so much that demand for homes began to fall. That is when the housing bubble began to pop. At first the pop was slow, but as expectations were suddenly reversed the bubble popped more. So, the housing market crashed by the end of 2007.
The economy had benefitted a lot from low interest rates, as home production rose in response to rising demand for homes. Demand for automobiles and other expensive items usually bought on credit had also risen sharply because of very low interest rates, and unemployment had fallen to about 4 percent by 2007. But when the housing market crashed, things began to move in the opposite direction.
First, some workers were laid off in the housing industry and since some of these workers had bought homes at inflated prices, they could not pay their monthly mortgage to their banks. The housing crisis began to spread and gradually became the banking crisis. Layoffs began to expand from one industry to another. As more people were fired from their jobs, they could not service their automobile loans. Millions of people had bought cars on zero percent financing by making no down payment. The multiplier process began working in the negative direction, and layoffs kept spreading.
By the middle of 2008, several financial firms were under pressure and were facing bankruptcies. Bear Sterns, AIG, Merrill Lynch, Lehman Brothers, among many others, were on the verge of default on their own loans. Even the government-based organizations such as Fannie May and Freddie Mac faced trouble from bad mortgage loans that they had made to millions of home buyers. The debt supported economic system began to collapse. It was clear that this was not an ordinary recession.
The government moved quickly to bail out the financial institutions. Even very large institutions such as AIG and Merrill Lynch were bailed out with federal money. The Federal Reserve also bailed many banks out. Still thousands of people were laid off every month. General Motors and Chrysler declared bankruptcy and were bailed out. The rate of unemployment, which was around 4.5 percent in 2007, rose past 6 percent in 2008 and past 10 percent in 2009, which was the year when the recession was declared over. In fact, unemployment kept rising in 2010 as well. Normally, economic recovery comes after a recession, but this time it did not show itself. The layoffs continued even when output stopped failing.
The budget deficit rose, and continued to rise. The Federal Reserve also kept printing money to bring down the federal funds rate and the discount rate. The discount rate is the interest rate that a central bank charges for its loans to commercial banks. By 2010, the discount rate fell from 5 percent in 2007 to just 1 percent and the federal funds rate from 6 percent to 0.05 percent. Financial institutions could now borrow money at practically no cost from the Federal Reserve, something that had not occurred since the Great Depression.
All these were Keynesian and neo-Keynesian policies, and while they had been quite effective in prior recessions, this time around they were too slow to have much positive impact. Indeed, they stabilized the economic system eventually but created huge waste for the entire system.
Supply-side economic policies that had been put in practice in the 1980s were still prevalent. President Reagan had endorsed these policies and despite his promises to bring down the budget deficit, the deficit had stayed high throughout his 8 years. President George Bush Jr. and Vice President Dick Cheney were in charge in 2007 and 2008, and they continued what President Reagan had started. In fact, Dick Cheney once said that Reagan showed deficits didn’t matter. They seemed to matter a lot during the Great Recession because the government spent trillions of dollars by 2014, and yet total employment was no higher than its level in 2007, as shown in Figure 2.1.
Figure 2.1 Nonfarm employment between 2005 and 2017 (in thousands)
Source: This graph is a reproduction from Federal Reserve Economic Data and has no title in the original. It shows that nonfarm employment in 2014 was essentially the same as in 2008 and has been increasing steadily rising since 2010 till date (https://fred.stlouisfed.org/series/NPPTTL).
Where did all this money go? This is a question that will be answered in subsequent chapters of this book. For now, we just raise this question before the government wishes to increase its spending further.
The Great Recession started in the United States with the collapse of the housing market, but it quickly spread to the rest of the world, especially Europe and Japan. It looks like the same type of macroeconomics is taught all over the world. Central bank policies are also the same everywhere. Interest rates fell sharply in most countries after the recession became worse in the United States. Some other nations had experienced a stronger speculation boom in housing, especially Britain and Australia.
Once housing collapsed in America, it collapsed in other countries too. The unemployment rate in Eurozone had reached a low of 7 percent in 2008, but it jumped to 10 percent in 2010. This was also the year in which unemployment peaked in the United States, but in Europe it kept rising and reached a high level of 12 percent in 2013.
In some nations such as Greece and Spain, unemployment rates were as high as those in the Great Depression. Asian nations such as Japan and South Korea also suffered a great deal with output falling and unemployment rising. Both nations have large trade surpluses with America and as the American economy fell sharply, their exports also fell a lot. BRIC nations that include Brazil, Russia, India, and China also suffered, although economic growth did not become negative in India and China. But Russia and Brazil experienced a fall in output and a rise in unemployment.
2.3 Most Nations Print Money
Economic policy around the world was similar to that followed in the United States. Every economically advanced nation cut interest rates sharply by printing a lot of money. Nowadays money supply rises in two steps, one by printing extra money and two by the central bank writing more checks to other banks. There is also another way that money supply rises. When the central bank buys government bonds in the bond market from other banks and writes more checks to them, they get more cash from the central bank. This also raises their money supply.
After 2008 central banks bought not only more government bonds but also bonds from other financial institutions. For example, the Federal Reserve bought mortgage bonds from some financial institutions in addition to bonds from the federal government. The effect of these practices is the same as that of printing money. Thus, most nations printed tons of money to fight rising unemployment. The chairman of the Federal Reserve at the time was Dr. Ben Bernanke. He came to be known as ‘Helicopter Ben’ for his alleged remark that he would drop money from a helicopter if it became necessary to stabilize the economy. And his monetary policy appears to show that he faithfully followed his words.
In the United States, interest rates fell nearly to zero, but in some other nations, they even became negative. Japan and Europe had negative interest rates after 2012. Negative rates had never existed before. When Keynes criticized classical economics, his argument was that it would require negative interest rates to bring savings down to the level of investment, and that he argued was very unlikely. If savings exceeded investment then aggregate demand would remain less than the economy’s potential output and that full employment would not return. Keynes must be very disturbed in his grave to see what his followers have done to his economic advice of balancing the budget deficit over the business cycle, but not every year. Hardly anyone bothers about balancing the budget anymore.
The 5-year German government bond had a negative yield of −0.2 percent in June 2017 compared to more than 1.8 percent in the United States. In Japan, the 5-year bond also had a negative yield. This means that a bond-buyer in Germany and Japan loaned money to the government and also paid it some money for safekeeping. All this reflects the vast amounts of euros the European Central Bank (ECB) had printed since the start of the Great Recession; similarly, the government of Japan had also printed huge amounts of yen.
Who knows why they had followed such policies? The results were not very encouraging. They had a goal of achieving a 2 percent rate of inflation as if inflation is very desirable. Their beliefs in the Phillips curve were as strong as ever, even though the hypothesis of inflation-unemployment trade-off had badly failed in the late 1970s. This is certain to disturb Milton Friedman in his grave. Friedman had criticized these policies sharply during the 1970s, when it was clear that high money growth had resulted in double-digit inflation. His advice that money growth should not exceed GDP growth was totally ignored. In June 2017, the unemployment rate in Eurozone was still above 9 percent compared to 7 percent in 2008. Almost a decade had passed and after printing trillions of euros, this is all that easy money policy had achieved.
The Federal Reserve began to realize in 2015 that rates had been low long enough. They then started raising the federal funds rate by 0.25 percent about every 6 months. By the middle of 2017, they had raised the rate to 1.25 percent. They also announced that they were going to reduce their bond holdings of about $4.5 trillion, which was below one trillion in 2007.
2.4 Most Nations Have a Huge Budget Deficit
According to the Economic Report of the President issued in 2017, the U.S. federal deficit was $342 billion in 2007; it almost doubled in 2008 and peaked in 2009 at more than $1.5 trillion. After that it remained above $1 trillion until 2012 and then slowly declined in coming years. Even in 2013, the level of employment was below that in 2007. What an irony? Trillions of dollars were spent by the government just to show that employment was still below the level 6 years before.
In percentage terms, the situation looked even worse. In 2007, the deficit as a percentage of GDP was about 1 percent; it jumped to 3 percent in 2008 and peaked at 10 percent in 2009. Even in 2013, when employment had caught up with that prior to the recession, the deficit was 4 times the level in 2007. In 2017, it was still more than double the level in 2007. The main point is that the policy of fiscal expansion is subject to diminishing returns. As a result, the US public debt jumped manifold as shown in Figures 2.2 and 2.3.
Figure 2.2 US public debt (1993–2013)
Source: Bjonnes, Roar, Hargreaves, Caroline. Growing A New Economy. Figure 15, p. 32. Other Sources: Bureau of Public Debt, United States Department of Treasury.
Figure 2.3 Federal debt (1980–2016)
Source: Batra, Ravi. End Unemployment Now. p. 21. Other Source: Council of Economic Advisers, The Economic Report of the President, 2017.
Budget deficits and debts in other nations also jumped, as is clear from Figure 2.4. The Euro government deficit peaked at 6 percent of Eurozone GDP in 2010 and Germany’s deficit peaked at 4 percent. Since then the deficits have declined while Germany had a surplus in 2016 and 2017. The German economy has performed the best in Europe, which shows that prosperity does not depend on high deficits.
Figure 2.4 Government debt as % of GDP (2013)
Source: Bjonnes, Roar, Hargreaves, Caroline. Growing A New Economy. Figure 14, p. 31. Other Sources: World Bank Economic Outlook Database April 2013.
Japan has had high budget deficits since 1990 when its stock market crashed. The Nikkei index reached its peak at around 40,000 and even after several decades of money printing and high budget deficits, the index moves around 20,000. Japan has been the most prominent in following Keynesian policies. Please remember that these policies are not policies of Keynes but those of his followers. They are also what supply-side economists like, namely record budget deficits along with low income tax rates but high taxes on other items such as high sales and excise taxes.
Japan’s budget deficit peaked at 9.5 percent of GDP in 2009 and has steadily declined since then. In 2017, it was at 4.5 percent, but its unemployment rate is the lowest among advanced economies, at less than 3 percent in 2017. However, some economists say this rate is low because of its shrinking labor force.
2.5 Most Nations Have Stagnant Wages
It is well known by now that the real wage has stagnated in the United States ever since 1981 when supply-side economics took over. But it has also stagnated in most other countries. According to the 2017 Economic Report of the President, the real wage of production workers in 1980 was at 291, fell to 284 by 2000, and then recovered to 291 by 2007. Between 1980 and 2007, there was no improvement in the real wage as shown in Figure 2.5. The production workers are also called non-supervisory workers while others are known as supervisory workers. Since there are relatively few supervisors in any factory, production and non-supervisory workers constitute a large fraction of the labor force. According to the Economic Report of the President (2017), “These groups account for four-fifths of the total employment on private nonfarm payrolls” (p. 582, Table B-15). Thus, for a very large number of Americans, wages had been constant while their biggest tax burden coming from the social security tax and the sales tax had risen sharply.
Figure 2.5 Growth in productivity and average wage (1947–2013)
Source: Council of Economic Advisers, The Economic Report of the President, 2014.
Finally, the huge budget deficit and money printing had something positive to show, because by 2015 the real wage had risen to 305. In the meanwhile, the real per-capita GDP had risen from about 28,000 in 1980 to about 52,000 in 2017, which was a rise of 86 percent. Thus, while the real wage went up by 5 percent, the nation’s productivity, which some say is represented by real per-capita GDP, had gone up by 86 percent. This is clearly wage stagnation. The workers should be thankful to the vast rise in the budget deficit to have at least this 5 percent raise over four decades. (Note that the real GDP is the purchasing power of what the current value of output buys. It is obtained by estimating a price index known as GDP deflator. By contrast, per-capita GDP is real GDP divided by population.)
Wages had also been stagnant in most of the nations. According to a study by McKinsey Global Institute, up to 70 percent of people in 25 developed economies had seen no rise in their incomes between 2005 and 2014. The study focused specially on six nations including the United States, UK, France, the Netherlands, Italy, and Sweden. Ninety-seven percent of Italy’s families saw flat or falling incomes during the recession decade ending in 2014 compared to 80 percent for the United States, 63 percent for France, and 70 percent for the UK and the Netherlands. Sweden did the best, where incomes declined for only 20 percent of the families.
2.6 Rising Poverty
The Great Recession has also raised poverty sharply in many countries. Even the United States, one of the richest in the world, has seen a big rise in poverty. According to the 2017 Economic Report of the President, about 14 percent of Americans lived below poverty line in 2015, which is around where it was in 1967 when President Lyndon Johnson started his war on poverty. In 2007, the poverty rate was 12.5 percent and reached a peak of 15 percent in 2012, which according to the Census Bureau was the worst in almost 50 years. It is clear that the welfare programs such as food stamps, cash grants to very poor families, medical care, and cheap housing have yet to make a dent in poverty. By some estimates, the United States has spent more than $20 trillion to fight the war on poverty. In 2014 alone, the nation spent almost $1 trillion for this war. It looks like this war will never be over and the government will have to provide increasing amounts of money to prevent poverty from rising further.
Recessions are bad for poverty and the Great Recession was worse. The Great Depression was the worst, but the question is this: Is rising government spending the right answer for the war on poverty? We will study this question in detail in Chapter 6, but for now it seems to be clear that some new approach is needed to reduce poverty.
Poverty has also risen sharply in many other countries since 2007. Jessica Hartogs, citing a report issued by the ILO in 2016, writes that poverty has increased recently in developed countries, especially Europe. This should not be surprising because recessions often do this, in spite of a vast network of welfare spending that exists in Europe.
This chapter tells us where the world stood in 2017, in terms of economic growth, unemployment, debt, wage stagnation, inequality, and poverty. The picture does not look bright even though almost the entire world had printed vast amounts of money and raised government budget deficits sharply since the start of the Great Recession.
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