The Great Recession - John Maynard Keynes

Good evening everyone, thank you for tuning in to this week's episode of Economic Thinker. My name is Kaitlyn and joining me today is my friend Kayla. It's great to be here, thank you for having me. Today we will be discussing the Great Recession, focusing specifically on the subprime mortgage crisis and how John Maynard Keynes connects to the topic. Interesting. So for those of you who don't know, the Great Recession is a term that represents the sharp decline in economic activity during the late 2000s, which is generally considered the largest downturn since the Great Depression. The term Great Recession applies to both the U.S. recession, officially lasting from December 2007 to 2009, and the ensuing global recession in 2009. The economic slump began when the U.S. housing market went from boom to bust and large amounts of mortgage-backed securities and derivatives lost significant value. How did the housing market collapse anyways? That's a great question. Well, during the early 2000s, the economy was at risk of a deep recession after the dot-com bubble burst in early 2000. This situation was compounded by the September 11th terrorist attacks in 2001. In response, central banks around the world tried to stimulate the economy. They created capital liquidity through a reduction in interest rates. In turn, investors sought higher returns through riskier investments. The U.S. housing market was the domino that, when it fell, toppled many of the world's major economies and led the world into recession. For the first half of the decade, aggressive investing by homebuyers, mortgage lenders, Wall Street investment houses, and insurers had driven up the median price of a single-family home by almost 10% a year, with housing in some parts of the country escalating even faster. By this, I mean mortgage lenders took on greater risks and approved subprime mortgage loans to borrowers with poor credit. Consumer demand drove the housing bubble to all-time highs in the summer of 2005, which ultimately collapsed the following summer. That's unfortunate, but who's to blame? There are a number of people who can be blamed for the subprime mortgage crisis. In my opinion, the blame is on the mortgage originators for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default. Why do you say that? When the central bank flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend, and like investors, an increased willingness to undertake additional risk to increase their investment return. Though, in defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were. Rates were low, the economy was healthy, and people were making their payments. Don't you think the homebuyers were at fault as well? I suppose. What were you thinking? Many homebuyers were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages offering low introductory rates and minimal initial costs, such as no down payment. Their hope lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in other spending. However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly. As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, and there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgages at higher rates they couldn't afford, and many of them defaulted. Foreclosures continued to increase through 2006 and 2007. You make a really good point. Sadly, we can't spend all our time discussing who's to blame. Right. Moving on to John Maynard Keynes, I suppose. You're absolutely right. John Maynard Keynes was born in 1883 and grew up to be an economist, journalist, and a journalist, thanks to his father, John Neville Keynes, an economics lecturer at Cambridge University. As for his mother, she was one of the first female graduates of Cambridge University and was active in charitable works for less privileged people. As an early 20th century British economist, Keynes was known as the father of Keynesian economics. Keynesian economics was developed during the 1930s in an attempt to understand the Great Depression. Keynes advocated increased government expenditures and lower taxes to stimulate demand and pull the economy out of depression. His theories of Keynesian economics addressed, among other things, the causes of long-term unemployment. In a paper titled The General Theory of Unemployment, Interest, and Money, Keynes became an outspoken proponent of full-time employment and government intervention as a way to stop economic recession. Through his career, he took on many jobs, a couple of them being active at MCURLS and government services. How does he connect to the Great Recession? Well, the initial response to the crisis followed Keynes' ideas pretty much to the latter, with an assumption that action should be taken to prevent what was clearly going to be a painful recession turning into a full-blown depression. Central banks were the first to act. They sought to make money cheaper and more plentiful through deep cuts in interest rates and quantitative easing. Keynes was primarily a monetary economist who believed that governments should only turn to fiscal policy, which is raising public spending and cutting taxes, when all other options have been exhausted. Fiscal policy was deployed in 2008-2009, but only as a supplement to monetary policy. Up to a point, the strategy worked, there was no second Great Depression, and within 6-9 months, output had steadied across most of the global economy. Attempts were made to return the business as usual as quickly as possible. That meant reducing the budget deficits that had ballooned during the recession and making only cosmetic changes to the debt-driven economic model from 2007-2009. Wasn't Keynes' father an advocate of laissez-faire economics? Yes, during his time at Cambridge, he thought of himself as a conventional believer in the principles of a free market. Funny enough, John's beliefs in advocating for government and intervention as a way to curb unemployment and resulting recessions is sort of the opposite of his father's beliefs. Getting back on topic, on January 28th, 2008, former Brookings expert and professor of the practice of economic policy at Harvard University, Jason Furman wrote an article titled, Recession Prevention. Keynes was right. In the article, he says, the economy appears to be slipping into a potentially serious downturn. The Federal Reserve has cut rates by 1.75%, but lags in the effect of monetary policy, meaning that much of the benefits of these rate cuts will not be felt until 2009. Fortunately, Congress and the President appear set to fill in some of the gap before 2009. It is likely that in May, June, and July, the U.S. Treasury will mail out $100 billion worth of checks to working households. If past experience is any guide, at least $50 billion of these funds will be spent, which together, with multiplier effects, will add about 3% to the annualized growth rate in the third quarter of this year. If extended unemployment insurance or food stamps increases are added to the final package, as demanded by many in the Senate, the macroeconomic benefits would be somewhat larger. This directly correlates with Keynesian economics because Furman discusses fiscal policy, monetary policy, and the multiplier effect in regards to government intervention, increased consumer spending, and growth in gross domestic product. Did Canada deal with similar issues during the Great Recession? Sort of. Overall, Canada's rapid rebound out of the recession has a lot to do with how much better off we were going in. Our housing market avoided many of the worst excesses that plagued the U.S., such as subprime mortgages. Canada's banks were more stable due to tighter rules on how much debt they could carry on, as well as a more conservative approach to risk. Government balance sheets were also better off thanks to years of difficult, cost-cutting measures in the 1990s. I guess we could say if Canada had lax lending standards like the U.S., they could have seen subprime mortgage loans as a way to increase overall profit, but they weighed the opportunity costs and decided against it for another course of action. Very good observation, though we have to consider other factors that make the U.S. market and Canadian market different when comparing. Since we are on the topic of discussing economic concepts, we can also connect substitutions to the Great Recession. The Great Recession forced many to find substitutes for many inelastic goods such as food and other basic necessities. Instead of buying brand name, they would go for more generic brands, and households were also seen to purchase more items that were on sale. In addition, there was also an increase in coupon usage and an increase in sales at discount stores at the time. That's really fascinating. Too bad we're running out of time. Thank you for tuning into this week's episode of Economic Thinker.