2008 financial crisis in historical perspective

by David F. Schmitz, Robert Allen Skotheim Chair of History

David Schmitz
David Schmitz, Robert Allen Skotheim chair of history, speaks to a campus and community audience about the recent financial crisis.

During the 1920s, then Secretary of Commerce Herbert Hoover remarked that “the only problem with capitalism is capitalists; they’re too damn greedy.” Hoover’s words of frustration stemming from working with bankers and industrial leaders to increase business-government cooperation (what he called the Associative State) raises the key point for understanding the financial crisis of 2008. That is, it stemmed from human choices and not impersonal market forces.

Financial crises were a common feature in the United States from the beginning of industrialization until the Great Depression, but nothing comparable has occurred in the past 79 years. Starting with the Panic of 1837 down to the Stock Market Crash of 1929, there were at least seven major financial crises that led to severe economic downturns and depressions. What the nation has faced since the summer of 2008 is a financial crisis, not a more common market correction or recession.

Why so many financial crises?

Financial crises occur for three broad, overlapping reasons. First, financial crises are a feature of laissez-faire capitalism. They come about when classical liberal economic thought, as exemplified by Adam Smith and John Stuart Mill, is prevalent and guiding government policy. Unregulated markets and financial institutions provide the opportunity for a wide variety of financial schemes and manipulations, such as efforts to corner markets, manipulate the money supply, Ponzi schemes, and the creation of monopolies that have led to panics and depressions. This situation was further exacerbated by the lack of government response, or in the case of the Great Depression, the wrong response with the Hawley-Smoot Tariff.

Second, unregulated markets led to easy credit and leverage buying, or buying on the margins, to fund purchases. For example, during the 1920s, it was common to purchase stocks by putting down only 10 percent of the cost and borrowing the other 90 percent. If someone purchased $100 worth of stock, he or she only had to pay $10. Those with a high tolerance for risk could then use the $100 of stocks as collateral to purchase $1,000. If the stock went up, it was easy to cover the initial investment and still make money, but if it went down, one had to cover the loss. During the 2000s, the leverage cost was often as low as 2 percent down.

statue
The sculpture “Man Controlling Trade” is one of a pair outside the Federal Trade Commission building in Washington, D.C. They were created by sculptor Michael Lantz in 1942. Schmitz uses it to illustrate unregulated capitalism.

The final feature of laissez-faire systems that leads to crises is an imbalance in society in terms of income distribution, wealth distribution, and political power among classes and groups in society. Prior to the 1930s, workers had few rights, markets were only loosely regulated, and business held overwhelming influence in society. These imbalances extended in other ways that were unhealthy for the economy and society. Most importantly, capital tended to move in only a few directions that promised quick, high return (in the 1920s to reconstruction in Europe and land), causing weak but vital parts of the economy, such as agriculture, to suffer.

The result of all of this was a boom-bust cycle that led to constant financial panics and depressions.

Financial stability

The key question to ask is why, after an average of one every 13 years, there was not a comparable crisis for 79 years, from 1929 to 2008? The answer is found in New Deal reforms. Franklin Roosevelt rejected classical economic thought and instead was guided by a combination of what would now be called Keynesian economics and the Mature Economy Theory. Roosevelt pursued a multi-variant approach to solving the Great Depression and preventing another crisis in the future. He sought to provide relief, reform and regulation. New Deal legislation provided jobs and relief through programs such as the Civilian Conservation Corps, the Public Works Administration and the Works Progress Administration, unemployment insurance and Social Security. The Roosevelt administration passed new regulations for banking, financial institutions and securities to prevent the abuses that created financial panics and plunged the economy into depression.

Roosevelt, guided by the Mature Economy Theory, also wanted to restore balance to American society through the establishment of the broker state. He, therefore, sought relief for farmers from foreclosures, price subsidies for crops, and land reclamation, water and electricity to ensure that rural America received a fairer share of the nation’s wealth and a higher standard of living. Unions gained the right to serve as the collective bargaining agents for workers to redress the imbalance of power in industrial America, and business was regulated to a greater extent than ever before. The sculpture by Michael Lantz, “Man Controlling Trade,” at the Federal Trade Commission building in Washington, D.C., captures Roosevelt’s view that unregulated capitalism was self-destructive and that its power had to be properly harnessed for the greater good.

It is common to hear that the New Deal failed to solve the Great Depression, a claim that is misleading. By its third year, 1935, overall production and wealth had passed the levels attained prior to the 1929 crash. What the New Deal did not solve was the problem of unemployment as business learned to do more with fewer workers. It was the latter problem that World War II ended. More importantly, the New Deal created the basis for postwar stability and prosperity.

Financial Crisis Returns

Why, after such a long time, was there a new financial crisis? The nation has been moving in this direction since the 1980s and the emergence of the so-called “Washington Consensus” that argued that deregulation and free markets were the best roads to economic growth and development. With that came a series of smaller crises, the Savings and Loan scandal of the 1980s, the dot.com bubble of the late 1990s and finally the real estate-driven crisis of today. With a steady series of deregulation of financial markets and banks, there was a return of imbalances of income and wealth that surpassed the 1920s, the decline of the power of unions and the abandonment of the broker state.

If the New Deal system was so successful, why was it abandoned? This is a complex question, but a number of points help explain how this came about. “Greed is good,” stated Gordon Gecko in the classic 1980s film “Wall Street.” It is a feature of capitalism, and powerful people are always looking for ways to make a great amount of money in a short period of time.

Moreover, Americans are poor historians. They look to the future. Thus, people forget why we have regulations, where they came from and what good purposes they served. This was especially true after the initial deregulations and rapid expansion of wealth during the 1980s. It appeared that there were no limits on the possibilities of economic growth and that higher profits than ever before were attainable. The restraints came to be seen as a vestige of the past, unsuited to current conditions. “We know more now, it will be different, trust us,” was the new mantra from Wall Street to its allies on Capitol Hill.

History cannot tell us exactly what to do as 2009 is not 1933. Still, there are lessons to be learned concerning the need for government action, a restoration of more balance in society, and the necessity for reform and regulation of the financial system.

David Schmitz joined the Whitman faculty in 1985. He earned his bachelor’s degree at the State University of New York, Plattsburgh; his master’s degree at SUNY, Stony Brook; and his doctorate at Rutgers University.