The financial crisis began more than three years ago and it’s been two years since the failure of Lehman Brothers kicked off a broad financial panic. It’s well known that recessions that are caused by financial crises tend to be more severe and longer-lasting, and the recovery process is typically lengthy. Believe it or not, the U.S. economy is getting better, but the pace of improvement will be slow-going for some time.

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A Long Recovery Road
September 20 – October 1, 2010
The financial crisis began more than three years ago and it’s been two years since the failure of Lehman
Brothers kicked off a broad financial panic. It’s well known that recessions that are caused by financial crises
tend to be more severe and longer-lasting, and the recovery process is typically lengthy. Believe it or not, the
U.S. economy is getting better, but the pace of improvement will be slow-going for some time.
We all know that the housing bubble was the main cause of the economic downturn, but there were many
factors that combined to set off the financial crisis.
Subprime lending occupied a small, but important, niche in the mortgage market. Those without a good credit
history could get a mortgage, at a higher rate, and lenders, accounting for the greater risk, could make a good
return. However, subprime lending got way out of hand in the middle of the last decade. Mortgage lending
supervision was lacking and most of the excesses occurred outside of the banking system. The “shadow”
banking system was not subject to the regulatory rules put in place after the Great Depression (rules designed to
prevent a financial implosion). Subprime loans, offering higher returns (and higher risks), were then securitized
and sold around the world to investors who were willing to stretch for yield.
Some blame the Fed for keeping interest rates too low amid the bubble. However, a global savings glut, a
consequence of America’s large trade deficit, helped push long-term interest rates lower, helping to fuel the
bubble.
In past recessions, business leverage often led to debt service problems once the economy slowed. However,
outside of the financial sector, leverage in business was relatively low heading into the recession. The leverage
problems were concentrated in the financial sector.
There was a huge degree of complacency. Investors spoke of the “Greenspan put” (later, the “Bernanke put”) –
no matter what happens, the Fed was there to lower short-term interest rates and make everything okay again
(that complacency has now been flipped 180 degrees).
Another factor, in the summer of 2008, was $4 gasoline, which broke the back of the consumer. Higher oil
prices have been associated with recessions in the past. However, that has usually been because the Fed raises

2. interest rates to choke off inflation. The late Rudi Dornbusch once quipped that economic expansions never die
of old age, asleep in their beds. “The Fed kills them,” he said. However, the recent recession has been a lot
different than usual. Tight bank credit certainly magnified the downturn, but that was a consequence of credit
concerns in general, not a function of tighter monetary policy.
Once Lehman Brothers failed, we were in a different world. Large global banks simply stopped doing business
with each other, fearful of counterparty risk. This was a frightening time, much worse than the general public
seemed to appreciate at the time. The Federal Reserve and other central banks lowered short-term interest rates
and made other efforts to promote liquidity in a number of financial markets (asset-backed commercial paper,
the money markets, etc.). The Fed also began its credit easing program, ultimately buying $1.25 trillion in
mortgage-backed securities and $300 billion in long-term Treasury securities. Some observers feared that the
Fed’s moves would stoke inflation. However, inflation in the U.S. has fallen, not risen, since these steps were
taken. The Fed does not take these efforts lightly. Considerable effort has been made this year to clear the exit
paths, should the economy pick up more substantially and inflation start to rise.
The bank rescue was not well received politically, but was an essential step in stabilizing the financial system.
Without it, the economy would have weakened a lot more than it did.
The $800 billion federal fiscal stimulus, approved a year and a half ago, was also controversial. Presumably, the
President’s Council of Economic Advisors had pushed for a larger plan, around $1.2 trillion, but administration
officials did not think that was feasible, following on the heels of the unpopular bank rescue package. In
addition, the stimulus plan was made less effective to get three Republican senators to vote for it (that is, added
government spending was replaced with tax cuts, which are more likely to be saved than spent in a severe
economic downturn). Fiscal stimulus was meant to be large, targeted, and temporary, functioning like a bridge,
supporting growth while the private sector recovers. In hindsight, that bridge likely needed to be longer. Some
of the federal fiscal stimulus was offset by contractionary policies in state and local governments. Evaluating
the effectiveness of the stimulus is not entirely straight forward. Counterfactuals (how much worse would things
have been if we hadn’t had the stimulus) are based on models which implicitly assume that such policy is
effective. Yet, in 1Q09, we were losing 750,000 private-sector jobs per month. This year, we’ve seen a return of
private-sector job growth. That turnaround might have happened by itself, but the fiscal stimulus seems like a
more likely explanation.
In a “typical” recession, consumers postpone purchases of homes and motor vehicles. As the economy recovers,
you get a slingshot effect as that pent-up demand comes back into play. However, that’s not going to happen
this time. The key element in this recovery is time. Fiscal and monetary policy can help limit the downside, but
there’s no miracle cure. Ultimately, the recovery is dependent on the private sector.