Economic Reflexes

Economic Reflexes A Look at the Government's Responses During Two Economic Disasters

Eric Margulies November 3, 2008 AP US History II GL Period 1 Ms. Robinson

“This country is not in good condition,” said former President Calvin Coolidge in 1931.1 He was correct. Nearly 25%2 of the United States' 122 million citizens3 found themselves unemployed. On average, 100,000 workers were fired each week.4 These statistics could not possibly be wrought from any other man-made disaster than the Great Depression. The “worst economic collapse of the modern industrial world”5 kicked off on the 29th of October, 1929 when the stock market crashed, losing billions of dollars.6 That day was known forever afterwards as “Black Tuesday.” This sudden stock market implosion was primarily the result of over speculation7, meaning that too many individual investors bought too much stock on too much credit. Speculation grew so wild that, according to legend, one speculator sold a bearskin before catching the bear, leading to the term “bear market.”8 After the crash, consumers felt increasingly uncertain. Meanwhile, the banking industry was paralyzed. Over 5,000 banks closed 9, and since “people concluded that cash in their mattresses was wiser than accounts at local banks,”10 they proceeded to withdraw their savings. On top of this, the gap between the rich and poor was widening, due to a horribly imbalanced distribution of income. In 1929, the aggregate income of the 6 million poorest families was one-third that of the 24,000 richest families. 11 This in turn caused a major disparity between the country's consumption power and its production capability, the former struggling to keep pace with the latter. Indeed, “the nation had experienced depressions before, but none approached this crisis.”12 In 2008, the United States found itself in the midst of another economic disaster. Wall Street was in its worst shape since the Great Depression 80 years before. 13 “As hundreds of billions in mortgage-related investments went bad, mighty investment banks that once ruled high finance have crumbled or reinvented themselves as humdrum commercial banks.”14 The “credit crisis,” as it is termed, had its roots in sub-prime mortgage lending. Eight years prior to the crisis,

1

the stock market had fallen sharply after much growth in the late 1990s. In order to limit the damage, the Federal Reserve lowered interest rates, which meant that people could get a mortgage much more easily. Many risky loans were made, and thus the sub-prime market expanded dangerously. “As we all know,” said United States Treasury Secretary Henry Paulson, “lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing.”15 In 2006, the lending continued despite an increase in default and delinquency rates. The following year, banks realized that securities they thought were safe were actually contaminated by “toxic mortgages.”16 In addition, the many foreclosures across the country depressed housing prices, and soon the number of prime mortgages in default started to rise. As a result, “the channels of credit, the arteries of the global financial system, [had] been constricted.”17 The credit crunch consumed Wall Street and slowed not just the United States' economy, but the global economy as well. There are certainly some analysts out there who have already compared the credit crisis to the Great Depression.18 It is true that the parallels are definitely existent, one being the fact that both disasters were caused by too much easy credit. However, there are also many differences, and these can be found in the government's responses to the crises, under President Herbert Hoover during the Great Depression and under President George W. Bush during the credit crisis. The responses contrast with each other chiefly because the governments played two different roles during their respective economic catastrophes: the government under Hoover was less involved and farther removed, acting as an umpire, whereas under Bush the government was much more active right from the beginning, acting as a player. The Great Depression began in 1929 and lasted until the United States' wartime economy in 1939 finally alleviated it. Because Herbert Hoover's presidency was right in the middle of the

2

calamity, and because the economy did not improve whatsoever during this time, Hoover has been consistently blamed throughout American history as having done nothing. The many shantytowns constructed from old packing cartons and car bodies were called “Hoovervilles” to symbolize the President's complicity in the disaster,19 while “Hoover blanket” came to mean the newspaper that covered a sleeping man on a park bench.20 In truth, however, Herbert Hoover was just caught in the wrong place at the wrong time. A brilliant man, Hoover was one of the leading mining engineers in the world and several times a millionaire. He was also a great humanitarian; his resume included providing food, clothing, and shelter to victims of floods in the Mississippi Valley in 1927. Before that, he had helped the Belgians during World War I and aided starving Russians in the postwar famine. As President, Hoover reorganized the Federal Bureau of Investigation and enabled the prosecution of Al Capone. He reformed the federal prison system and established the Federal Bureau of Prisons. However, the Great Depression presented a different challenge. Although the President attempted to end the nightmare, his efforts were in vain. Hoover's approach to the Great Depression stemmed from his political and economic philosophies. In his 1928 campaign speech about rugged individualism, an idea he avidly supported, he expressed his view that the United States government should not intrude on the economy. “I should like to state to you the effect of the extension of government into business upon our system of self government and our economic system. But even more important is the effect upon the average man. That is the effect on the very basis of liberty and freedom not only to those left outside the fold of expanded bureaucracy but to those embraced within it.”21

Additionally, Hoover stated that the American system, “...is founded upon the conception that self-government can be preserved only by

3

decentralization of Government in the State and by fixing local responsibility; but further than this, it is founded upon the social conception that only through ordered liberty, freedom and equal opportunity to the individual will his initiative and enterprise drive the march of progress.”22

Therefore, when the Great Depression began President Hoover was reluctant to pursue legislative relief since he felt it would lead people to become dependent on the federal government, which would have been contrary to traditional American values, or so he believed. However, he was not a proponent of a totally laissez-faire, free-for-all economy either. Instead, he advocated volunteerism as the principle means for healing the nation, and he encouraged state and local government responses. Secretary of the Treasury Andrew Mellon advised Hoover to use “shock treatment.” This meant immediately releasing price and currency controls, withdrawing state subsidies, and liberalizing trade. In other words, convert to a completely laissez-faire economy. As this idea ran counter to his philosophies, the President dismissed it. Herbert Hoover's first major response to the Great Depression was the Mexican Repatriation program, authorized in 1929. It was a large-scale effort to deport illegal immigrants out of the country, and it had two primary goals. The first was to create more jobs for American citizens by vacating jobs occupied by these immigrants. The other was to prevent them from leeching onto the welfare system. Over the depression, between 500,000 and 1 million Mexicans were deported to Mexico.23 Unfortunately, the program was seriously flawed. For one thing, it was an extremely discriminatory forced migration and a violation of basic civil liberties. Also, many of those deported were either legal citizens or children born in the U.S. The vast majority of deportation efforts were concentrated in areas with large Hispanic populations, including California, Texas, and Colorado. The program as a whole encouraged the idea that Mexicans were detracting from the system, and it strengthened anti-Mexican sentiment. Consequently, 4

many Mexicans who were not deported chose to leave because they were not welcomed and discriminated against. The program was cut off from federal funds when Franklin D. Roosevelt became President, but continued at a state and local level until 1937. Sixty-eight years later, the state of California passed the Apology Act for the 1930s Mexican Repatriation Program, which acknowledged the unconstitutional removal of the Mexicans. Like most of Hoover's responses to the Great Depression, this one had an insignificant amount of impact in abating the country's woes. An outstanding example of Hoover's belief in volunteerism was the National Credit Corporation. In 1931, Hoover urged the creation of a consortium that consisted of the country's major banks. This became the NCC, and Hoover encouraged the banks to make loans to smaller banks in order to save them from collapse. However, the member banks of the NCC were unwilling to provide loans, and when they did they required the largest assets the bank had as collateral. Therefore, Hoover quickly realized that the NCC was not the correct answer and abandoned it. In its place, the Reconstruction Finance Corporation was established in 1932. Modeled upon the War Finance Corporation which was in place during World War I, the RFC was an independent agency of the government. Its goal was to save insurance companies and philanthropic organizations, and to restore confidence to the banking system. The RFC loaned to banks, railroads, farm mortgage associations, and other businesses. By the end of 1932, it had loaned to 5,000 shaky firms a total of $1.5 billion.24 “But this intended “shot in the arm” did little to invigorate a faltering economy.”25 In fact, only one of Herbert Hoover's programs resulted in a noticeable, positive influence. This was his public works program, which built roads, highways, schools, public buildings, and dams. By far the most well known project to come out of this program, and

5

probably the whole decade, was the Hoover Dam. From the beginning of the project, Hoover had played an instrumental role in the dam's construction. In 1922, as Secretary of Commerce, he negotiated the Colorado River Compact with representatives from each of the Basin states of Arizona, California, Colorado, Nevada, New Mexico, Utah, and Wyoming. Also known as the Hoover Compromise, it was a fair arrangement for dividing the waters of the Colorado River, on which the dam is situated, for the states' use. Eight years later, it was decided by Secretary of the Interior Dr. Ray Lyman Wilbur that the dam would be named the “Hoover Dam” instead of the original proposal, “Boulder Dam.” Actual construction began in 1931. It was built in the Black Canyon of the Colorado River, on the border between Arizona and Nevada. Surprisingly, it was completed in 1935, two years ahead of schedule. In that time, the dam created 21,000 jobs 26 and cost $48.9 million.27 700 feet tall and made out of more than 3 million cubic yards of concrete 28, the dam was the largest electric-power generating station in the world and the largest concrete structure in the world upon its completion. Boasting these statistics, the dam showed just how capable America was of achieving greatness, even in such extenuating circumstances as the Great Depression. More importantly, however, is the fact that the Hoover Dam paved the way for the public construction portion of the New Deal under Franklin D. Roosevelt. As President, FDR created the Works Progress Administration and the Public Works Authority. The results were thousands of miles of roads, thousands of schools, parks, and hospitals, and other large construction projects including New York's Triborough Bridge and Lincoln Tunnel. All of these projects followed the example set by the monumental Hoover Dam. The Great Depression did not truly end until the outbreak of World War II in 1939, when the United States' wartime economy rescued the nation. Over the next 68 years, America did have several periods of economic downturn, but nothing came close to the Great one. Then in

6

2008, a new economic cataclysm emerged, one that appeared to be the worst since the Great Depression. Shortly after the urgency of the situation became apparent, the federal government became actively involved in stabilizing the economy. In each of its responses, the government assumed one of three roles; it acted either as a bank, an investor, or an insurer. The federal government under President George W. Bush acted like a bank in several of its responses to the turmoil in the financial world, meaning it made low-interest loans to financial institutions. On November 28, 2007, the Federal Reserve made $8 billion available in short-term loans to large banks.30 The next month, December, the Federal Reserve began auctioning loans to the large financial institutions. Starting at $40 billion, the loan program was expanded numerous times over the following months; it was increased to $60 billion by January, and to $100 billion in March.31 In the same month, the Fed offered another $100 billion in loans and allowed banks to use mortgage-backed securities as collateral.32 Days later, it offered $200 billion more in the form of 28-day loans, accepting mortgage-back securities, and even riskier securities, as collateral.33 In May the loan auction program was extended to $150 billion.34 At the end of July $50 billion in 84-day loans was made available, and this was raised to $150 billion by the beginning of October.35 These programs were meant to get normal lending for businesses and consumers flowing again. Luckily, all of them helped to save many large financial institutions from going under, at least for a while. However, acting solely as a bank would not have been nearly enough for the government to do in order to solve the crisis. It also had to play the role of an investor to secure, at least temporarily, stability in the economy. This meant that the government took stakes in big financial companies in exchange for cash, the primary purpose of which was to steady the banking system by adding capital. The first time the government made such a move was on September 16, 2008.

7

American International Group, or AIG, was “potentially on the hook for billions of dollars' worth of risky securities that were once considered safe.” Facing bankruptcy, the financial giant was desperately in need of a rescuer after it failed to secure a bank loan. AIG's collapse would have had immense ramifications. Fortunately, the Federal Reserve bailed out the insurer for $85 billion, giving the government control over it.36 The New York Times reported that it was “the most radical intervention in private business in the central bank's history.” 37 In October, the Fed made an additional $38 billion available to AIG.38 Then, beginning on October 14th, the Treasury invested $250 billion in banks in exchange for shares. This marked a fundamental shift away from the government's previous roles in financing, primarily because it made the government a major investor and owner in the banking industry.39 In addition to being a banker and an investor, the federal government, under President Bush, was also an insurer, meaning that it guaranteed investors and depositors against defaults. This was the case on March 16th, 2008, when the Federal Reserve guaranteed $29 billion of the global financier Bear Stearns' assets to prevent it from going bankrupt.40 At the same time, the Fed brokered a deal to sell the company to JPMorgan Chase, the largest banking company in the United States. Next, on September 7th, the Bush administration put the nation's two largest mortgage finance corporations, Fannie Mae and Freddie Mac, into conservatorship. The Treasury pledged as much as $200 billion in order to cover their losses.41 By this time, the government had already committed an unprecedented amount of money to stabilize the economy. So when another huge investment bank, Lehman Brothers, lost more than half its market value and struggled to survive, the government did not come to its rescue as it had with Bear Stearns. Lehman Brothers subsequently filed for bankruptcy, and the very next day the Dow Jones Industrial Average fell a staggering 504 points, the index's worst loss in seven years.42

8

Yet by far the most ground-breaking response of the federal government to the credit crisis was the Emergency Economic Stabilization Act of 2008, more informally known as the $700 Billion Bailout Plan. In one of the largest government interventions in the nation's economy ever, the bailout plan was intended to rescue the financial system by enabling the Treasury to take ownership stakes in struggling banks. The plan actually makes the government a sort of silent partner with the banks. According to the Wall Street Journal, the “legislation ranks alongside other broad federal attempts to prop up the economy, such as Roosevelt's New Deal and the resolution of the Savings and Loan debacle of the late 1980s and early 1990s.”43 Clearly the federal government under the leadership of President Bush responded much more quickly and efficiently to the 2008 Credit Crisis than the government under Herbert Hoover did to the Great Depression. Hoover believed that the government should have been the umpire on the economic field, while Bush believed that it should be a key player, especially in an economic crisis. While the steps taken by the Bush administration to aid the situation were considered by many to be necessary, Treasury Secretary Paulson asserted that, “More is needed. We must now take further decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses.”44 President Bush was confident about the responses taken by the government, saying, “They're big enough and bold enough to work.” 45 Evidently, the problem with Herbert Hoover was that he failed to realize the exigency of the Great Depression. Had he seen it in the same light as he saw the Mississippi Valley floods of 1927, 46 to which he devoted enormous time and effort, he might have been able to at least prevent the depression from getting as bad as it did. Fortunately, the Bush administration acted quickly and efficiently, using all of the resources available to it. Even so, whether or not its responses will have positive effects remains to be seen.

Endnotes 1

Howard Zinn, A People's History of the United States (New York: HarperCollins Publishers Inc., 2003) 387. 2

“People and Events: The Great Depression,” Public Broadcasting Service, http://www.pbs.org/wgbh/amex/dustbowl/peopleevents/pandeAMEX05.html 3

“Census of Population and Housing: 1930 Census,” U.S. Census Bureau, http://www.census.gov/prod/www/abs/decennial/1930.htm 4

Richard Hofstadter, William Miller, Daniel Aaron, and Leon F. Litwack, The United States: A World Power (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1976) 536. 5

“People and Events: The Great Depression.”

6

“Stocks Collapse In 16,410,030-Share Day, But Rally At Close Cheers Brokers; Bankers Optimistic, To Continue Aid,” New York Times 30 Oct. 1929, A1. 7

Zinn, 386.

8

Ernest R. May and LIFE Editors, The Life History of the United States, Volume 10: War, Boom and Bust (New York: Time Inc., 1964) 132. 9

Zinn, 387.

10

N. Gregory Mankiw, “But Have We Learned Enough?” New York Times 25 Oct. 2008.

11

Hofstadter, 536.

12

Hofstadter, 536.

13

“Credit Crisis – The Essentials,” New York Times, http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/index.html

14

“Credit Crisis – The Essentials.”

15

“Eight Weeks of Financial Turmoil,” New York Times 27 Sept. 2008, http://www.nytimes.com/interactive/2008/09/27/business/economy/20080927_WEEKS_TIMELI NE.html 16

“Credit Crisis – The Essentials.”

17

“Credit Crisis – The Essentials.”

18

N. Gregory Mankiw.

19

Hofstadter, 536.

20

May, 134.

21

Herbert Hoover, "Rugged Individualism" Presidential Campaign Speech, New York, N.Y., 22 Oct. 1928 (available online at ). 22

Hoover, “Rugged Individualism.”

23

Rosa Prieto, Veronica Smith, Rosa Moreno, Jonatán Jaimes, Adri Alatorre and Ruth Vise, “Mexican Repatriation in 1930s is Little Known Story,” El Paso Community College, http://www.epcc.edu/nwlibrary/borderlands/24/mex%20repat.htm. 24

Hofstadter, 537.

25

Hofstadter, 537.

26

Bureau of Reclamation: Lower Colorado Region, “Hoover Dam: Workforce,” http://www.usbr.gov/lc/hooverdam/History/articles/hhoover.html National Geographic, Eyewitness to the 20th Century (Washington: National Geographic Society, 1999) 125. 27

28

National Geographic, 125.

29

Steve Lohr, “Federal Leap Into Banking Has Its Perils,” New York Times 18 Oct. 2008,

30

Lohr, A16.

31

Lohr, A16.

32

Lohr, A16.

33

Lohr, A16.

34

Lohr, A16.

35

Lohr, A16.

A16.

36

Edmund L. Andrews, Michael J. de la Merced, and Mary Williams Walsh, “Fed's $85 Billion Loan Rescues Insurer,” New York Times 16 Sept 2008. 37

Andrews, “Fed's $85 Billion Loan Rescues Insurer.”

38

Lohr, A16.

39

Lohr, A1.

40

Lohr, A16.

41

“Eight Weeks of Financial Turmoil.”

42

“Eight Weeks of Financial Turmoil.”

43

Greg Hitt and Deborah Solomon, “Historic Bailout Passes As Economy Slips Further,” Wall Street Journal 4 Oct. 2008. 44

“Eight Weeks of Financial Turmoil.”

45

Lohr, A16.

46

May, 134.

Bibliography Andrews, Edmund L., Michael J. de la Merced, and Mary Williams Walsh. “Fed's $85 Billion Loan Rescues Insurer.” New York Times 16 Sept 2008. Associated Press. “Wilbur Renames Boulder Dam for Hoover And Starts Work on $165,000,000 Project.” New York Times 18 Sept. 1930. Bureau of Reclamation: Lower Colorado Region. “Herbert Hoover and the Colorado River U.S. Department of the Interior.” Bureau of Reclamation: Lower Colorado Region. “Hoover Dam: Workforce.” “Census of Population and Housing: 1930 Census.” U.S. Census Bureau. (accessed 27 Oct 2008). “Credit Crisis – The Essentials.” New York Times. (accessed 31 Oct 2008). “Eight Weeks of Financial Turmoil.” New York Times 27 Sept. 2008. (accessed 27 Oct 2008). "Emergency Relief and Construction Act." Wikipedia, The Free Encyclopedia. 15 Sep 2008, 19:26 UTC. 1 Nov 2008 .

"Federal Home Loan Bank Act." Wikipedia, The Free Encyclopedia. 6 Oct 2008, 15:13 UTC. 21 Oct 2008 . "Great Depression." Wikipedia, The Free Encyclopedia. 27 Oct 2008, 07:52 UTC. 27 Oct 2008 . "Herbert Hoover." Wikipedia, The Free Encyclopedia. 21 Oct 2008, 17:04 UTC. 21 Oct 2008 . Herszenhorn, David M. “Administration Is Seeking $700 Billion for Wall Street.” New York Times 20 Sept. 2008. Hitt, Greg, and Deborah Solomon. “Historic Bailout Passes As Economy Slips Further.” Wall Street Journal 4 Oct. 2008. Hofstadter, Richard, William Miller, Daniel Aaron, and Leon F. Litwack. The United States: A World Power. Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1976. Hoover, Herbert. Campaign Speech at Madison Square Garden. New York, N.Y., 31 Oct. 1932 (available online at ). Hoover, Herbert. "Rugged Individualism" Presidential Campaign Speech, New York, N.Y., 22 Oct. 1928 (available online at ). House Committee on Financial Services. H.R. 1424: Emergency Economic Stabilization Act of 2008. 28 Sept 2008. (available online at ).

Kennedy, David M., Lizabeth Cohen, and Thomas A. Bailey. The American Pageant: Twelfth Edition. New York: Houghton Mifflin Company, 2002. Labaton, Stephen, and Edmund L. Andrews. “In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans.” New York Times 7 Sept. 2008. Lohr, Steve. “Federal Leap Into Banking Has Its Perils.” New York Times 18 Oct. 2008, A1. Mankiw, N. Gregory. “But Have We Learned Enough?” New York Times 25 Oct. 2008. May, Ernest R. and LIFE Editors. The Life History of the United States, Volume 10: War, Boom and Bust. New York: Time Inc., 1964. National Geographic. Eyewitness to the 20th Century. Washington: National Geographic Society, 1999. “People and Events: The Great Depression.” Public Broadcasting Service. (accessed 27 Oct 2008). Prieto, Rosa, Veronica Smith, Rosa Moreno, Jonatán Jaimes, Adri Alatorre and Ruth Vise. “Mexican Repatriation in 1930s is Little Known Story.” El Paso Community College. (accessed 29 Oct 2008). "Revenue Act of 1932." Wikipedia, The Free Encyclopedia. 2 Apr 2008, 02:35 UTC. 1 Nov 2008 . Smiley, Gene. “Great Depression.” Library of Economics and Liberty. (accessed 27 Oct 2008).

"Smoot-Hawley Tariff Act." Wikipedia, The Free Encyclopedia. 15 Oct 2008, 16:55 UTC. 21 Oct 2008 . Sorkin, Andrew Ross. “Lehman Files for Bankruptcy; Merrill Is Sold.” New York Times 14 Sept. 2008. “Stocks Collapse In 16,410,030-Share Day, But Rally At Close Cheers Brokers; Bankers Optimistic, To Continue Aid.” New York Times 30 Oct. 1929, A1. "Subprime mortgage crisis." Wikipedia, The Free Encyclopedia. 25 Oct 2008, 01:52 UTC. 25 Oct 2008 . Zinn, Howard. A People's History of the United States. New York: HarperCollins Publishers Inc.,

2003.