Trying to Understand the 2008-2009 Recession: Part 1, Perspective and Causes

[1] The unemployment rate—the fraction of adults currently working for pay among those who are either working or actively looking for a job the nation’s labor force that is unable to find work—was officially measured at 7.6 percent in January of 2009 by the Bureau of Labor Statistics (BLS), the federal agency tasked with measuring the current state of the U.S. labor market. That rate represented a 0.4 percentage-point increase in the unemployment rate from a month earlier, and a 3 percentage-point (and 65 percent) increase over a two-year period. During the month of January 2009, the BLS also estimated that 598,000 more U.S. workers lost their jobs than found new ones, and that a total of 3.6 million jobs have been lost on net since December 2007, when the current recession was estimated to have begun. This sharp increase in joblessness is one measureable symptom of the general downturn in economic activity that the U.S. is currently experiencing.

[2] In this article, I will explore a number of questions related to the current state of the U.S. economy. Much of the discussion in the popular press, by journalists and economists alike, refers to the unique nature of the current economic situation. So, I will begin by asking whether and how this recession is different from others the U.S. economy has experienced. This discussion will naturally lead to the question of what caused the current economic crisis. It should be noted that it is too early to know for sure the answer to that question, though I will speculate on some of the possible causes. Even with the luxury of the passage of time it would be impossible, however, to list every root cause, and so this discussion will necessarily be incomplete. And in a companion article, I examine some of the different remedies that have been enacted or proposed by the federal government.

How different is the current recession?

[3] In considering whether the current economic situation is a unique event in recent U.S. history, it is useful to compare the numbers discussed at the outset of this article to similar measurements from earlier recessions. Figure 1 shows the unemployment rate, adjusted to account for seasonal fluctuations, for each month from January 1948 to January 2009. This is the period for which a reasonably consistent measure of the unemployment rate is available. Looking at this figure, it is apparent that the U.S. economy has endured a number of downturns in the past 60 years. Increases in the unemployment rate during recessions have historically been followed by decreases during expansions. There has been variation in the length of time between these economic downturns—some expansionary periods have been especially long, like the ones following the recessions of the early 1960’s, early 1980’s and early 1990’s, while others have been quite short, like the period between the two large recessions of the 1970’s.

guryan chart

[4] How does the current unemployment rate compare with previous highs? Thus far, the unemployment rate has reached a level that is fairly typical of past post-World War II recessions. It is at the same rate that it was at the peak of the 1992 recession, and just slightly higher than it was at the worst of the recessions of 1949, 1958 and 1961. The unemployment rate is still significantly below the levels it reached during the two worst recessions of the post-war period, in 1975 and 1982. And, it is far below the sometimes-mentioned 24.9 percent unemployment rate from 1933 (though it is difficult to compare pre-World War II unemployment rates to current rates because the methods of estimating the rates have changed significantly). Does this mean things are not as bad as everyone seems to be saying? In short, no.

[5] For one, the current concerns about the state of economic distress are not only based on how many workers currently cannot find work, or the current health of businesses. They are based in part on expectations about the future, and are driven by worries that things might get significantly worse. Many businesses have not yet laid off workers, in hopes that the economy will turn around soon. And others who have already laid off workers may have to let more go if the economy continues to worsen. In terms of the figure, the unemployment rate is not yet higher than it was at its peak in 1982, but it has increased almost uninterrupted for a year at an average of a little more than 0.2 percentage points per month. Since mid-September, this pace has quickened to almost 0.4 percentage points per month. If this rate were to continue, the unemployment rate would pass the 1982 high of 10.8 percent by the early fall of 2009. There is no way to tell for sure at this point whether such a scenario is optimistic or pessimistic.

[6] For another, though the unemployment rate is a useful measure of the state of the economy (it has been fairly consistently measured over a long period of time, and is easier to measure than many alternative gauges of the economy), it of course does not tell the whole story. The unemployment rate only measures the fraction of workers with a job among those who are actively looking for work or are working. So, when economic conditions get bad enough that people stop looking for work thinking the search is not worth the effort, the unemployment rate goes down, not up. An alternative measure of unemployment that includes as unemployed so-called “discouraged” and “marginally attached” workers, two groups who say they would be willing to work if they were offered a job, puts the January 2009 unemployment rate at 8.8 percent, 1.2 percentage points higher than the official rate. And, including those who are working part-time but would work full-time if offered the chance increases the rate to a troubling 13.9 percent. Furthermore, economic downturns affect far more than just those who lose their jobs. The fear of possible job loss is heightened during uncertain times, and wages and other benefits can decline even for those with stable jobs.

[7] Employment is also not the only current source of economic hardship. Those with substantial amounts invested in the stock market, whether their personal or retirement savings, have lost dearly. Furthermore, many are not able to make their mortgage payments, resulting in foreclosure. And many more are at risk of foreclosure in the near future. This is one way that the current recession is atypical—the central role of the housing market and the banking sector. Though it is too early to say definitively, many economists believe that the current economic situation has its roots in the housing and financial markets. As I will discuss in the succeeding sections, this feature of the recession has important implications for understanding its causes and for thinking about the possible ways in which governmental action might help to turn things around.

What caused all of this?

[8] As just mentioned, it is far too early to say for sure what caused the current economic crisis. And so, this section will necessarily be speculative. There are, however, a few things that are known, beginning with the state of the nation’s large financial institutions. On September 15, 2008, Lehman Brothers, a 150 year-old financial industry giant, filed for bankruptcy. This followed the failure of IndyMac Bank, at the time the fourth largest bank failure in U.S. history, the federally supported purchase of Bear Stearns, a large investment bank, and the $85 billion bailout of American International Group, an insurance conglomerate with complex and varied interconnections to financial markets. In the weeks that followed it became clear to the public that these failures and cries for help were outward signs of systemic problems that touched virtually all of the major financial institutions in the U.S.

[9] These large banks had made what turned out to be risky investments in real estate markets, and when housing prices fell in 2007 and 2008 the banks lost on those investments. This is of course a vast simplification, partly because only the banks themselves know exactly what investments they made, partly because the array of investments they made are too complicated to explain in a few paragraphs, and partly because the banks themselves still do not know for sure what those investments are worth today.

[10] It may be helpful, though, to describe one type of these investments as a way to see the link between housing markets and the financial well-being of banks and the broader economy: the mortgage-backed security. Just as shares of stock are ownership-stakes in companies, mortgage-backed securities are ownership-stakes in loans made for the purchase of a house. A stock-owner has claims on the future profits of the company, while the owner of the mortgage-backed security has claims on the future mortgage payments from the borrowers. When a bank makes a home loan it typically does not retain ownership of the loan. Most commonly, it either sells the loan to a federal agency like Fannie Mae or Freddie Mac, or it sells it to investors in the form of a mortgage-backed security. To create the security, banks combine large numbers of loans. Investors then receive streams of payments based on the repayment of that large group of loans.

[11] Why are many loans combined into one security? Combining many loans into a single security yields the benefit of diversification. Whereas the risk that a single borrower does not repay his loan is sizeable, the chances that hundreds, or even thousands, of borrowers all default at the same time is significantly less. Imagine 100 banks making loans to 100 home buyers. Imagine further that borrowers either pay back the loan in full plus interest or default right away. Each bank either gets its money back plus interest or it loses the entire value of the loan. If there is a one-percent chance that each borrower will default, we should expect about one of those banks to lose out completely and the other 99 to make a nice profit. Now, consider an agreement the banks could make where they insure each other against the risk of default. They all agree to pool their profits and to pay all 100 banks the same share of the total repayments made to the loans. On average, the profits of the banks will be the same. But, now no banks face the risk of losing the entire loan amount. Each bank makes a nice profit, 99 percent as much as the lucky banks in the original scenario.

[12] This is exactly the logic of a mortgage-backed security. Each shareholder is paid an equal fraction of the mortgage payments on the set of loans combined in the security. By making the payments dependent on a large number of loans, the risk to the investor is reduced. The risk is only reduced to the extent that mortgage defaults are independent of each other – that the thing that makes one person default on his mortgage is not correlated with the things that make other borrowers default on theirs. It appears this turned out not to be the case. Economists call this the problem of “correlated risks.”

[13] Mortgage-backed securities carry another significant pair of problems, which economists call “adverse selection” and “moral hazard.” When a group of loans are combined into one mortgage-backed security, all of the loans essentially are sold for the same price. Banks selling good loans at this price lose out (they are selling something valuable for an average price) while banks selling bad loans benefit greatly (they are selling something worth less for the same price). The security designer tries to mitigate this problem by putting loans into categories within which there are fewer differences, but even within these categories there is variation in the riskiness of the borrowers.

[14] Importantly, the banks making the loan, the ones who interact with the borrower, know this information better than the buyers of the securities. Adverse selection refers to the phenomenon whereby the securities will be more likely to attract the riskier loans. Additionally, if the security market is still willing to buy these loans, banks have an incentive to make more and more of these risky loans with the knowledge that they can sell the loans at a price that is generous relative to the loans’ risk. This phenomenon is moral hazard. There are many stories of borrowers who were previously unable to get home loans being actively pursued by lenders. Lenders offered these potential new home buyers complicated loans that appeared attractive in hopes of making as many loans as they could, knowing that they could turn around and sell the loan to someone who would package it in one of these mortgage-backed securities. Some have argued that many of the people who are now facing foreclosure entered into their loans under pressure from lenders who promised low monthly payments and who failed to point out that after some period of time the teaser interest rate would reset and the monthly payments would increase substantially.

[15] This discussion naturally raises the question of why anyone would buy such a security. The answer is complicated but I speculate that three general factors were important. First, many of the nation’s large financial institutions were earning high returns by making these investments. The accepted wisdom apparently was that by packaging a large number of loans into a single security, the benefits of diversification would reduce the risk. Stable high returns and low risk are an attractive combination for investors. And, when other banks were making profits it was hard to argue that staying away from these investments was a good idea. The second related reason presumably had to do with the individual incentives that can arise within large organizations. Since they cannot monitor everything their employees are doing, those at the top of the organization have to create incentives to guide employees’ actions to suit the larger goals of the company. Doing so is difficult and my guess is that we will learn that people within these banks who chose to invest large sums in mortgage-backed securities and other similar financial instruments were largely responding to the incentives they faced.

[16] The third reason relates to the way in which banks, the purchasers of these securities, evaluated the risk associated with the loans on which they were based. It would be prohibitively time-consuming and costly for each potential investor to investigate the facts on each loan packaged in a mortgage-backed security. It is far more efficient for private companies to aggregate this information, to collect it once and share the information with interested investors. These private companies charge a fee to the seller of the mortgage-backed security, and in turn issue the security a public rating. Rating agencies offer similar services to companies that wish to sell bonds. A good rating indicates a low risk that the loans will default (or that the company will fail to make payments to the bond holder), and the price of the security is higher as a result. A poor rating indicates a higher default risk, and causes the security to sell for a lower price. As it turned out, the rating agencies gave mortgage-backed securities what turned out to be overly optimistic risk ratings.

[17] We do not yet and may never know exactly why the credit rating agencies underestimated the risk associated with mortgage defaults. And, it is hard to know for sure that they did in fact underestimate the chances of aggregate default rates increasing. The situation we are in may just be a very unlucky occurrence. But, the discussion above about correlated risks, moral hazard and adverse selection suggests mortgage-backed securities are inherently riskier assets than bonds issued by large companies. In many cases, the rating agencies indicated these risks were comparable.

[18] Though it is impossible to know for sure, some have speculated that market incentives may have biased their assessments. Their clients were the security issuers, and the security issuers were able to choose which rating agency to use. It was only natural that the security issuers would prefer the rating agency that gave them the best rating. Knowing this, it would not be surprising if the rating agencies’ assessments were affected. This is not to absolve the banks from fault, however. As an investor, and particularly as an informed and sophisticated investor, banks had a responsibility to gather information for themselves and to assess the validity of the ratings.

In summary, it is clear that we are in the middle of a very difficult economic situation and that concerns about its severity are driven as much by worries about what might come as by what has happened so far. This recession is unique as much because its root cause lies in the banking sector as for the depths to which the economy may or may not reach. In a companion piece that follows, I explore the various remedies being implemented and discussed. Recognizing this recession’s source is helpful for understanding the array of strategies being used to try to reverse it.