13.2 Recent Uses of Macroeconomic Stabilization Policy
We conclude our discussion of countercyclical macroeconomic stabilization policy with a description and analysis of the two most recent U.S. recessions: The Great Recession of 2008–2009 and the Pandemic Recession of 2020. These macroeconomic fluctuations were very different in their causes, duration, and aftermath.
The Great Recession
One of the worst macroeconomic events in the U.S. since the Great Depression was the recession of 2008 and 2009. The recession was initiated by a severe financial crisis that had its origin in the housing market boom following a short recession in 2001. The Fed had used expansionary monetary policy to promote recovery from the 2001 recession, and interest rates were historically low. The housing boom was driven by low mortgage rates and by Home mortgage loans obtained by borrowers with poor credit histories and high risk of default. —home mortgage loans obtained by borrowers with poor credit histories and high risk of default. The use of subprime mortgages was encouraged by government policies designed to increase home ownership among low-income households. Subprime mortgage lenders were able to avoid the high risk of default through The process of bundling subprime mortgages together into financial assets called mortgage-backed securities. of the mortgages.
Securitization refers to bundling the subprime mortgages together into financial assets called A bundle of subprime mortgages sold to investors. . The securities were then sold to other financial institutions. Rising housing prices reduced the perceived risk of default, because even if the borrower defaulted, the repossessed house would be worth more than the defaulted mortgage loan if housing prices continued to rise. Because mortgage-backed securities were complicated financial instruments, purchasers may not have understood the magnitude of the underlying risk.
The Financial Crisis
The financial crisis began when the housing boom ended. By 2006, there was a surplus of new homes on the market, and housing prices stopped rising. By 2009, average housing prices had fallen by almost 30 percent. Because many homebuyers had purchased homes with minimal down payments, the decline in housing prices left them When the value of a house is less than the amount still owed on the mortgage. , i.e., the value of their house was now less than the amount remaining on the mortgage. As a result, there was a sharp rise in mortgage defaults and home foreclosures, as homebuyers stopped making mortgage payments. Banks were left owning houses that they sold quickly to minimize their losses from the defaulted loans. The increase in the supply of houses on the market accelerated the decline in housing prices and led to even more defaults. Faced with unsold inventory and declining prices, contractors stopped building new housing.
As mortgage defaults increased, the market for mortgage-backed securities collapsed. Financial institutions that were heavily invested in these risky securities were now unable to sell them. In the absence of demand, no market price was determined, and the securities could not be valued. The banks, insurance companies, and other institutions holding the securities suffered huge losses. Some declared bankruptcy, and many others were close to being bankrupt. The willingness and ability of financial institutions to lend money was sharply reduced, loans dried up, and there was a liquidity crisis—a full-blown financial crisis in the U.S. Even the most creditworthy customers could not obtain loans for new investment.
The collapse of the housing construction industry and new investment caused a large decrease in aggregate demand. Between the fourth quarter of 2007 and the second quarter of 2009, real GDP decreased by 4.7 percent. Between May 2007 and October 2009, the unemployment rate increased from 4.4 percent to 10.0 percent.
Policy Response
There were three major policy responses to the Great Recession, all designed to restore aggregate demand to the full-employment level. The first of these was expansionary monetary policy. Between September 2007 and December 2008, the Fed cut its federal-funds rate target from 5.25 percent to almost zero. In addition, its use of open-market operations included purchasing mortgage-backed securities and other assets from banks, with the purpose of increasing reserves in the banking system and encouraging more bank lending for investment.
The second policy response was unprecedented. In October 2008, Congress passed a bill authorizing $700 billion to increase liquidity in the banking system. Under this legislation, the Treasury would inject equity into Wall Street financial institutions in return for stock, which the Treasury would eventually sell. This program served the dual purpose of bringing financial institutions back from the brink of bankruptcy and allowing them to make loans again.
The third response was expansionary fiscal policy. In February 2009, the new Obama administration signed into law a stimulus bill authorizing $787 billion of new government spending. As a result of these policies, a recovery started in June of that year. It was a slow recovery, and the unemployment rate did not fall to its pre-recession level until April 2017. GDP finally reached its full-employment level in the second half of 2018, more than 8 years after the recession had ended.
The Pandemic Recession of 2020
The global COVID-19 pandemic, which began in December 2019, led to a global economic recession. The U.S. economy had been experiencing historically low unemployment rates but went into sharp decline beginning in late February 2020. The stock market crashed on February 20, and by the end of March, stock prices had fallen by almost 30 percent. Government-mandated lockdowns and voluntary social distancing led to massive job losses. In March alone, more than 16 million U.S. workers became unemployed. By the end of April, more than 25 million U.S. workers had lost their jobs, and another 8 million had left the labor force. The rate of job losses in March and April exceeded the worst periods of the Great Depression. The unemployment rate, which had been 3.5 percent in February 2020, rose to 14.8 percent in April (22.8 percent including underemployed workers), the highest since the Great Depression. Between the fourth quarter of 2019 and the second quarter of 2020, real GDP fell by more than 9.1 percent (an annualized rate of 31.4 percent). The decline in output in the second quarter of 2020 was the greatest quarterly decline in U.S. history. Although the 2020 recession was very sharp and very deep, it was also the country’s shortest. By May 2020, a recovery had begun, initiated by rapid response of fiscal and monetary policy to the economic contraction.
Policy Response
On March 27, 2020, President Trump signed into law a $2.7 trillion stimulus package, the CARES Act, the largest expansionary fiscal policy in history. The package included a wide variety of provisions to help businesses retain workers and to help households maintain their income. This package, combined with additional relief legislation and partial reopening of the economy, brought about a sharp recovery beginning in May. The Federal Reserve had lowered the federal-funds rate target to almost zero, ensuring that there was sufficient liquidity in the financial system to facilitate investment demand; in addition, it implemented a series of programs to provide liquidity to specific sectors of the economy to maintain business operations. During the third quarter of 2020, real GDP increased by 7.6 percent.
When the recovery slowed down later in 2020, a $900 billion stimulus bill was passed in December. By March 2021, the unemployment rate had fallen to 6.1 percent. That month, President Biden signed a $1.9 trillion fiscal stimulus bill, the American Rescue Plan. The legislation was controversial, with some economists—most notably former Treasury Secretary and Obama economic advisor Lawrence Summers—warning that the increased fiscal stimulus would cause long-run inflation. The Biden administration, the Fed, and some other economists believed that inflation, which was at a 2.6 percent annual rate in March, would be temporary. In fact, inflation, which had been 1.8 percent in 2019 and 1.2 percent in 2020, rose steadily until it peaked at a 9.1 percent annual rate in June 2022, the highest inflation rate since the early 1980s. The Fed, which had kept the federal-funds rate target near zero to stimulate the economy, began using contractionary monetary policy in March 2022. By then, inflation had been increasing for more than a year. The Fed’s federal-funds rate target rose steadily until July 2023, when it reached 5.5 percent. By August 2024, the inflation rate had fallen to 2.5 percent, and the unemployment rate, which had reached a post-recession low of 3.7 percent in January 2024, was 4.2 percent. In September 2024, the Fed initiated expansionary monetary policy by reducing its target interest rate to 5.0 percent.
While supply-chain problems, disruptions in the oil market, and other factors contributed to the increase in the rate of inflation after the recession, some economists believe that the stimulus bill of March 2021 and the slow response of the Fed were major factors in the long period of inflation that accompanied the economic recovery from the 2020 recession. The full analysis of the recession, the expansionary monetary and fiscal policies used to promote recovery, and their role in the inflation that began in 2021 is still ongoing.