The financial and economic crisis that came to a head in the late summer of 2008 has brought forth a huge government response, many elements of which are without precedent. The crisis, however, did not come from nowhere. In important regards, its roots lie, first, in government policies to promote more widespread homeownership than would occur in a free market and, second, in the Federal Reserve System's mismanagement of interest rates and the money stock. The crisis is far from over, yet it already appears that the surge of extraordinary government actions and the new policies that the crisis has provoked will give rise to important, permanent increases in the government's size, scope, and power. In this way, it mimics the national emergencies of the past century.
DIMENSIONS OF THE CRISIS AND THE GOVERNMENT'S RESPONSES
Although the National Bureau of Economic Research places the recent peak of economic activity in the fourth quarter of 2007, (1) real gross domestic product (GDP) did not reach its peak until the second quarter of 2008. (2) By the second quarter of 2009, real GDP had fallen by four percent. (3) Likewise, financial stringencies in certain credit markets began to appear in 2007, though they did not become widely noticed until late September 2008, when a full-fledged financial panic developed, and commentary in the news media and the statements of public officials took on a frightened tone. The civilian unemployment rate began to rise after March 2007, when it stood at 4.4%, and by October 2009, it had reached 10.2%. (4)
In response to the growing economic troubles, especially the perceived "credit crunch" of September 2008, policymakers in the Bush Administration (most notably, Treasury Secretary Henry Paulson), in Congress, and at the Federal Reserve System (the Fed) responded by initiating a series of unprecedented actions to rescue tottering banks and other financial institutions and to inject credit into the financial system. (5) In September, the Fed took control of the insurance giant American International Group (AIG), (6) and the Federal Housing Finance Authority took over the huge government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, secondary lending institutions that held or insured more than half of the total value of U.S. residential mortgages. (7) On October 3, Congress passed and the President signed the Emergency Economic Stabilization Act of 2008. (8) Title 1 of this statute authorizes the Secretary of the Treasury to create the Troubled Assets Relief Program (TARP) and authorizes as much as $700 billion for the purchase of so-called troubled assets, primarily mortgage-related securities, held by banks and other financial institutions. (9) Unable to implement the planned acquisition of troubled assets, the Treasury instead used TARP mainly to inject funds into the banks by purchasing preferred shares and warrants to purchase common stock from them.
By the end of 2008, the Fed had made large, unprecedented types of loans and had given other forms of assistance, including loan guarantees, asset swaps, and lines of credit, to securities dealers, commercial-paper sellers, money-market mutual funds, Fannie Mae, Freddie Mac, the Federal Home Loan Banks, buyers of certain asset-backed securities based on consumer and small-business loans, Citigroup (related to losses resulting from a federal government guarantee of a specified pool of assets), and fourteen foreign central banks. (10) The Treasury and the Federal Deposit Insurance Corporation also took a variety of other large-scale actions to prop up credit and housing markets during the final quarter of 2008. (11)
After Barack Obama became President, his administration and Democratic leaders in Congress concentrated on gaining passage of a new "economic stimulus" bill. These efforts ultimately resulted in the American Recovery and Reinvestment Act of 2009, which the President signed into law on February 17. (12) This statute authorizes a great variety of spending increases, as well as some tax reductions, over the period from 2009 to 2019. According to Congressional Budget Office (CBO) estimates, the combined amount of these spending increases and tax cuts comes to $787 billion over these ten years. (13)
The Obama Administration also proceeded, at the end of April, with two complex "restructuring" arrangements that essentially amounted to government takeovers of General Motors and Chrysler, both of which were teetering on the brink of bankruptcy. Carl Horowitz called this action "one of the most radical moves in the history of American industry," noting that it came not long after the federal government had made huge emergency loans to the companies. (14) The government had also forced the resignations of the chief executive officers of the two companies, Rick Wagoner of GM and Robert Nardelli of Chrysler. (15) By the end of July 2009, total government aid to the two firms reached $65 billion. (16)
On June 15, 2009, the Wall Street Journal summarized the extraordinary surge of government actions as follows:
Since the onset of the financial crisis nine months ago, the government has become the nation's biggest mortgage lender, guaranteed nearly $3 trillion in money-market mutual-fund assets, commandeered and restructured two car companies, taken equity stakes in nearly 600 banks, lent more than $300 billion to blue-chip companies, supported the life-insurance industry and become a credit source for buyers of cars, tractors and even weapons for hunting. (17) Although this statement falls far short of a comprehensive account of the government's responses to the crisis, it suffices to justify the conclusion that within less than a year, the perceived emergency had provoked a huge surge in the federal government's size, scope, and power.
This surge also entailed major fiscal eruptions, including tremendous increases in federal expenditures and an even greater percentage run-up of federal debt. According to the August 2009 CBO update, federal outlays for fiscal year 2009 would total $3.69 trillion, an increase of 24% over the total for the previous year. This increase, which is wholly without peacetime precedent in U.S. history, would raise federal outlays from 21% of GDP to 26.1%. Moreover, because federal receipts were forecasted to contract by almost 17% in 2009, the annual federal budget deficit was expected to increase from $459 billion in 2008 to $1.59 trillion in 2009, an increase of 246%. The CBO forecasted that the 2009 deficit would be equal to 11.2% of GDP, up from 3.2% in the previous year. The borrowing required to finance this gargantuan deficit in the federal budget was forecasted to increase the U.S. debt held by the public from $5.80 trillion at the end of fiscal year 2008 to $7.61 trillion at the end of 2009, an increase of $1.81 trillion, or 31% in a single year. (18)
Although these U.S. Treasury figures are mind-boggling for an economist or financial historian, the Fed's recent actions have been even more astonishing. Figure 1 shows the most important of these actions, the abrupt increase in the monetary base, which must be seen to be believed. (19) As the figure shows, the monetary base--currency in circulation plus commercial bank reserves--historically has increased smoothly at a fairly modest rate of growth. Between August 2008 and January 2009, however, the Fed's actions caused the country's monetary base to double in only five months. After January 2009, the monetary base remained in this extraordinarily elevated range. In September and October 2009, it increased even further, reaching all-time highs.
[FIGURE 1 OMITTED]
The Fed's recent monetary policy places the purchasing power of the U.S. dollar in grave jeopardy because the monetary base, as its name indicates, is the foundation on which the U.S. money stock rests. Other things being equal, more than doubling the monetary base will ultimately result in more than doubling the money stock. Hence, the dollar's purchasing power will be tremendously reduced, with a variety of negative effects on the economy. As of November 2009, the banks as a whole have simply absorbed the additional reserves, rather than using them to increase the volume of their loans and investments, which would begin to increase the money stock through the commercial banks' creation of new checking account balances. Between August 2008 and January 2009, legally excess commercial-bank reserves at the Fed increased from less than $2 billion to nearly $800 billion. In October 2009, they amounted to $995 billion, an all-time high. (20) Should the banks begin to employ these excess reserves to make new loans and investments, however, the Fed will face a dilemma: either do nothing to mop up the excess reserves, allowing them to become the fuel for rapid price inflation; or mop them up, most likely either by traditional open-market operations or by offering the banks a much higher rate of interest on their reserve balances at the Fed. Both choices entail increasing the rate of interest, and the Fed will face political pressure opposing such an action, especially if the recession has not ended and the rate of unemployment remains high. Fed Chairman Ben Bernanke has stated that the Fed possesses "the tools" to deal with this problem, (21) but I remain skeptical that he will do so successfully. In any event, the Fed's emergency actions since August 2008 have created serious economic risks that make private planning much more difficult and thereby impede the market economy's successful functioning. In such circumstances, much "smart money" simply sits idle or goes into safe, low-yield investments, such as Treasury bills. (22)
CUMULATING POLICY CONSEQUENCES
The current crisis, like every major economic emergency, occurs in the context of predisposing conditions, institutions, and policies that took shape over a long period. Although many people are inclined...