How They Killed the Economy

Barack Obama
Barack Obama; drawing by John Springs

The United States economy is slowly reviving: it grew by 2.2 percent in the third quarter of 2009 and by 5.7 percent in the fourth quarter, a trend that may signal an end to the worst recession we have had since the Great Depression. The country avoided a much more severe economic collapse only because government responses to this breakdown, both in the US and abroad, have been more effective than those of the 1930s were.

Nonetheless, housing is still depressed and nearly 10 percent of the labor force was unemployed in January. We have lost more than eight million jobs, over half of them permanently, since the recession began in December 2007; and long-term unemployment is at record highs. Even if the economy grows 5 percent a year over the next three years, which seems unlikely, the US will probably not return to full employment before 2013.1

That an even worse disaster has been averted, in part by people who studied the lessons of what happened in the past, underscores our need to understand what went wrong this time and what must still be done to restore the economy and avert another collapse. Almost everyone agrees that the crisis developed in part because of failures of regulation—principally of banks, mortgage brokers, and derivatives markets—and much effort is currently being devoted to revamping and shoring up the regulatory system.

Alan Greenspan’s Federal Reserve bears responsibility for some of these supervisory failures; it also kept interest rates “too low too long,” thereby exacerbating the dangers to the economy. The failures of the Fed’s monetary policy are particularly significant—without them the need for effective regulation would have been much less urgent. This may help explain why the embattled Fed Chairman Ben Bernanke, who was confirmed on January 28 for a second four-year term in the most contested vote ever for a Fed chairman, tried to counter those who blame the Fed in a speech before the American Economic Association a few weeks before the vote. But like many of the Fed’s critics, Bernanke focused only on whether the Fed should have started raising interest rates before it actually did in June 2004. He did not address a more critical issue: Did the slow and predictable pace at which it raised rates encourage the excessive risk-taking that brought down the financial system and the world economy?2

By any measure, the crisis was a consequence of extraordinarily reckless behavior—by banks and other financial institutions, by governments and their financial regulators, and by consumers—behavior that continued even in the face of a widely shared sense that serious trouble was brewing. Charles Bean, deputy governor for monetary policy of the Bank of England, was not the only central banker to admit, in November 2008, that major trends of the world economy had “vexed policymakers for some time. We knew they were unsustainable and worried that the unwinding…


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