The Great Global Recession began in the United States in December 2007 and will likely continue well into 2010 in many parts of the world. The global contagion began in March 2008 with the collapse of the investment house Bear Stearns. Citizens, analysts, and policymakers are appropriately anxious to understand how this disaster came about and what can be done to prevent a repetition.
The first inkling of a pending recession was felt early in 2005. After four years of extraordinary home building and home price appreciation, the real estate market slowed and then began to implode. Even so, the U.S. economy did not succumb to recession until December 2007. The recession initially was so mild that total economic output was unchanged after 12 months. However, as the overall economy muddled through 2008, tremendous contractionary forces built up below the surface with the epicenter in home financing. The mild U.S. recession that began toward the end of 2007 evolved into a global financial contagion in 2008 and a deep global recession toward the second half of 2008.
The Global Recession. At the outset of the recession, various theories were proposed to explain who or what was at fault, but most have long since fallen by the wayside as events outgrew the theories. In particular, theories specific to the U.S. housing sector, housing finance, and even the United States in general fail to explain the global financial contagion and global recession. These early suspects-- including the Community Reinvestment Act and Fannie Mae and Freddie Mac--were at most incidental to the recession's causes.
The global nature of the financial contagion and recession strongly suggests that the essential cause or causes must be global, rather than country-specific. Two explanatory theories stand out, one centered on monetary policy and the other centered on an exceptional, sustained surge in global savings. These theories describe complementary, mutually reinforcing economic forces.
"The Fed Did It" Theory. Monetary policy can lead to asset price bubbles if central banks print too much currency and artificially depress short-term interest rates, leading to excessive speculation and "hot money." The Federal Reserve loosened monetary policy significantly with the onset of the 2000-2001 recession and the subsequent slow recovery. In hindsight, the Federal Reserve clearly appears to have pursued an overly accommodative monetary policy from late 2001 to late 2005 or early 2006, pushing the federal funds rate too low and keeping the rate too low for an extended period.
Yet was Fed policy sufficiently overly accommodative to be the chief villain? Two factors challenge this explanation. First, the Federal Reserve is the central bank of the United States, not the world. According to a study by the Organisation for Economic Co-operation and Development, while other central banks were similarly overly accommodative for a period, their cumulative efforts were likely not adequate to explain fully the run-up in asset prices and financial imbalances.
Second, short-term interest rates disconnected from long-term rates in this period--the so-called Greenspan conundrum. This suggests the effectiveness of Fed policy in this period was muted, both in terms of the Fed's ability to address the 2000-2001 recession and its effects on asset prices subsequently.
The Global Savings Glut: Alternative Cause or Accomplice to the Fed. Frothy asset prices and historically excessive leverage are sure signs of fundamental distortions in global credit markets. Monetary policy was at least a major contributing factor to these distortions, but an alternative explanation is that a steady, extraordinary surge in global savings exceeded what the global economy could normally absorb in new investment.
The global savings glut likely had a variety of sources, including Chinese trade surpluses, enormous new riches acquired by oil-exporting nations and recycled through the global financial system, and U.S. corporate profits. This glut of saving would be expected to drive down the price of saving as reflected in interest rates. Throughout the middle of this decade, commentators noted that risk seemed to be systematically underpriced as reflected in unusually low longer-term interest rates.
Conclusion. Future analysts and historians will sift through the facts to determine whether the excessive monetary accommodation by the Federal Reserve and other central banks or excessive global saving played the greater role in the conditions that led to the global recession and contagion. Most important for the present is the realization that these forces likely played the major roles; that they are complementary, even mutually reinforcing and operate through credit markets; and that their operation would produce the temporary, extreme run-up in asset prices and misallocation of investment witnessed prior to the collapse.
Understanding the causes of the Great Global Contagion and Recession is not merely a matter of history. It is also important for interpreting events and anticipating problems in the near term as economies around the world struggle to regain vitality. Clearly identifying the true causes and discarding the false ones is also important as policymakers attempt to create new protections against a repetition. In this vein, discarding false theories regarding causal forces that could give rise to unnecessary and economically harmful policies is as important as implementing new policies to address true causes.
J. D. Foster, Ph.D., is Norman B. Ture Senior Fellow in the Economics of Fiscal Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. The author thanks Dr. Michael J. Boskin of Stanford University and Dr. John B. Taylor of the Hoover Institution and Stanford University for their helpful comments and suggestions. Any errors that remain are the author's responsibility.
