The Financial and Economic Crisis of 2008:
What Brought Us to the Brink

Edward J. Dodson

[A presentation at the opening of the Henry George Historical Center, Philadelphia, Pennsylvania; 5 May 2015]


Good afternoon everyone. I have been invited to provide my analysis of the reasons our economy experienced a major financial and economic downturn in 2008. Hopefully, you will see some of the influence of Henry George's theory of business cycles in my analysis. Twice each year I produce an update on the U.S. economy and the benchmarks indicating whether the lives of people are improving or worsening. I have been doing this since 2005, the year I retired from my position as a market analyst and business manager with Fannie Mae.

What follows is a succinct examination of the historical record, the underlying market forces, and ongoing stresses that are pulling us toward yet another bust that could be worse than what occurred in 2008.

To start with, we need to acknowledge that the U.S. economy has never been very stable. Between 1948 and 2007 there have been ten recessionary periods of varying durations.

Lurking in the background of each business cycle was the Federal Reserve board, deciding whether to buy or sell government securities, raise or lower interest rates charged to member banks, or raise or lower currency reserve requirements on those same banks.

One characteristic of the U.S. economic system that has remained a constant from its earliest period of settlement was an addiction to speculation. Asset bubbles are nothing new. They have persisted since the colonial era, when speculation in land dominated investment activity.

Few economists or policymakers were aware of or expressed concern over the dramatic increases in income and wealth concentration that occurred during the decades leading up to the 1930s. A similar level of unconcern existed in the 1990s.

By the mid-2000s, the concentration of income in the top 1 percent of households had returned to the level reached on the eve of the Great Depression. As Henry George would have observed, this was a sure sign the economy was in for trouble.

As former World Bank economist Joseph Stiglitz has been telling anyone who will listen, every change in law related to property and to the taxation of income and property disproportionately favored what is called "rent-seeking" activities over the production of goods and services.

Other economists, specializing in what is called "public choice theory," focus on the continuous lobbying of government by special interests as another category of "rent-seeking" activities with quasi-monopolistic and destabilizing results.

It is out of this systemic set of legal arrangements that booms develop to a point that the increasing costs of living and doing business can no longer be absorbed or passed on to others. As a consequence, the growth in household debt was skyrocketing at a rate far greater than increases in household incomes.

Until the early 1970s one of the characteristics of the U.S. financial sector was the restriction on the payment of interest on demand deposit (that is, checking) accounts, and the imposition of maximum interest rates on other types of bank accounts and interest charges. In 1971 two innovative money managers created the first money market fund in the U.S. to circumvent these restrictions. This was the first development that changed everything.

This new investment vehicle, named The Reserve Fund, attracted investors interested in preserving liquidity while obtaining a higher rate of return than offered by the banks.

This was also the time when stagflation arrived. The price of fossil fuels skyrocketed. Inflation averaged over 8 percent in 1978 and by early 1980 was nearly 15 percent.

Paul Volcker, now running the Federal Reserve, decided that the only course of action was to lift restrictions on interest rates. The accepted price for taming inflation would be recession and rising unemployment.

What also resulted was a dramatic increase in the movement of financial resources into the money market mutual funds. A major source of these resources was the savings account balances held by the nation's savings institutions.

By 1995 one out of three savings institutions would fail. Deregulation fostered consolidation of the financial services industry, allowing Thrifts and commercial banks to merge.

University of California economics professor Mason Gaffney, one of the few economists who has specialized in the study of property market cycles, commented on what he saw as the state of macroeconomic understanding at the time:

"By the end of the 1970s, there was a general recognition that fiscal and monetary policy had failed. Instead of 'fine-tuning', we had 'stagflation'. Keynesianism foundered as it steered between the shoals of inflation and the rocks of unemployment and ran onto both at once."

While the Federal Reserve struggled with insufficient tools to manage the nation's money supply, the deepening recession gave new life to pre-Keynesian policy options described as "supply-side economics."

As taxes were lowered across-the-board, the stage was set for a shift to economic activity emphasizing the markets for financial instruments and for real estate. These are markets driven by speculation and rich in fees taken by a long list of participants.

Once Paul Volcker was certain inflation had been beaten out of the economy, the Fed began to lower the rate of interest charged to member banks. The Fed also expanded its purchase of government securities, releasing cash into the economy.

As mortgage interest rates fell, the property markets regained their upward momentum.

Until the 2008 fall in property prices, many residential properties sat on land comprising well above 50 percent of total value. During the Reagan years spending on domestic programs actually continued to increase but at a lower rate than previously. However, spending on the military skyrocketed.

Alan Greenspan replaced Paul Volcker at the Fed in August of 1987. Greenspan believed in market forces and thought regulation of the banks unnecessary.

Two months after Alan Greenspan came to the Fed the overheated stock market came to a sudden crash. Black Monday, as it came to be known, began in Hong Kong and quickly spread west to Europe, before hitting Wall Street, where the Dow fell by nearly 25%.

The nation's property markets proved to be primary drivers of the boom-to-bust character of our economic system.

The wave of financial deregulation began with a 1978 Supreme Court decision that authorized banks to expand the usury laws of their home state nationwide.

In 1980, passage of the Depository Institutions Deregulation and Monetary Control Act increased deposit insurance from $40,000 to $100,000, with ironic consequences on prudent bank lending policies.

The 1982 the Garn-St. Germain Depository Institutions Act deregulated the savings institutions altogether. For the first time the thrifts were permitted to issue certificates of deposit in competition with the money market mutual funds. However, for many thrifts the authority came much too late to prevent insolvency.

By the end of 1985, rising property prices pushed Fannie and Freddie to raise the loan limit for a one-family property to $115,300. By 1987 mounting failures of thrifts absorbed all of the premium reserves held by the Federal Savings and Loan Insurance Corporation. It took two more years, but in 1989, regulation of the thrifts was transferred to the Office of Thrift Supervision and responsibility to depositors came under the Federal Deposit Insurance Corporation.

Ronald Reagan signed two bills reducing federal taxes, in 1981 and 1986. A critical side-effect of the 1986 act was a dramatic increase in consumer spending secured by mortgage liens on residential property.

By 1989 consumer debt had doubled.

The Iraqi invasion of Kuwait in 1990 triggering another spike in oil prices, and the U.S. economy fell into yet another recession.

Corporate restructurings and mergers accelerated.

All restrictions on interstate banking ended in 1994.

Next came the demise of Glass-Steagall, achieved during the Clinton years in office.

Clinton then signed legislation in 2000 PREVENTING regulation of the over-the-counter derivative contracts. The derivatives market skyrocketed.

Asset managers on Wall Street sought ways to generate NOMINAL yield for investors and fees for themselves. They found their answer in private label mortgage-backed securities - the new junk bonds.

In 2000 Fannie and Freddie increased their maximum loan limits on a one-family property to $252,700.

In 2004, the Securities and Exchange Commission relaxed the rules on leverage for five leading banks. The beneficiaries were Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. Four years later only two of the five survived and they required government bailout.

Also in 2004, the Comptroller of the Currency PREEMPTED state laws regulating anti-predatory lending laws. Following this change, national lenders sold increasingly risky loan products in those states. Defaults and foreclosures skyrocketed.

By 2005, Fannie and Freddie set maximum loan limits on one-family properties at $359,650, higher in New York and other high cost markets. Land prices were increasing at double-digit rates.

As defaults snowballed, investors left the private label MBS market, then the entire MBS market altogether. The balance sheets of Fannie and Freddie collapsed. The financial meltdown had arrived.

The really scary thing is the failure of our government - and other governments - to focus on the systemic flaws in our economic systems so long ago identified by Henry George. Fed policy focused on recovery of property prices to bail out mortgage loan investors and homeowners who, if still employed, could refinance out of high-cost sub-prime mortgage loans. However, with household incomes not growing the demand for housing has again softened.

The analysis of Mason Gaffney, Joseph Stiglitz and other economists who have gained insight from Henry George, to this point, have been ignored.

So, what are the chances of real reform?

We shall see but don't hold your breath.