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A Tale of Two Crises–and Recoveries: Financial Crisis vs. COVID-19 Crisis Part 1: Causes and Cures

The Financial Crisis

The United States began 2009 with arguably the worst economic landscape since the Great Depression, an economic scenario that began to unfold in late 2007. A tanking stock market, falling housing prices, increasing unemployment, and an economic recession. The root cause of the crisis – the housing market. A collage of factors contributed to the housing market problems.

In the early 1980s interest rates in the U.S. were extremely high, with mortgage rates approaching 20%. The goal of the U.S. government was to find ways to make home ownership more available and affordable. Legislation was passed that encouraged riskier mortgage loans by financial institutions and allowed new types of mortgage loans, such as adjustable rate mortgages. The legislation, combined with the innovation of mortgage backed securities, heated up the housing market in the 1990s and 2000s, with home ownership and housing prices increasing in the U.S.

The growth of mortgage backed securities in the 1980s changed the risk in the mortgage market. Before the advent of mortgage backed securities, a financial institution generally had very diligent lending standards – it made the loan and suffered the consequences (it lost money on the loan) if the home buyer could not repay the mortgage (defaulted). However, the advent of mortgage backed securities meant financial institutions could sell mortgage loans to issuers of mortgage backed securities (Fannie Mae, Freddie Mac, and Wall Street firms), who in turn pooled the mortgages that they bought and subsequently sold mortgage backed securities to investors. A mortgage backed security (MBS) is a bond that represents an investor’s investment in a pool of mortgages. In essence, investors loaned money to home buyers with the expectation of receiving interest and principal payments when home buyers made their mortgage payments. Fannie Mae and Freddie Mac were organizations created by the U.S. government to pump more money into the mortgage market. They did that by buying mortgages from financial institutions and as a result provided financial institutions with more money to make more loans. That meant a financial institution was no longer stuck with risky loans – they could sell them to Fannie Mae, Freddie Mac, or Wall Street firms, who in turn sold MBS to investors.

As long as housing prices increased, risk was not much of an issue, because if a home buyer could not make a mortgage payment they could sell their home at a value which was greater than their mortgage loan. No default occurred. But if home prices declined, major problems would occur. Favorable legislation, the growth of mortgage backed securities and a period of generally declining interest rates led to increasing housing prices and a strong housing market.

The Federal Reserve significantly reduced interest rates in 2001 to counter an economic slowdown and the negative economic impacts of the terrorist attacks. As the economy recovered, interest rates began to increase in the early-mid 2000s in the U.S. As a result, the interest rate on adjustable rate mortgages (and the monthly mortgage payment) increased for many home buyers, The up-tick in interest rates resulted in many home buyers not being able to pay monthly mortgage payments; many homes were put up for sale. The result – home prices plummeted, defaults occurred on mortgage loans and MBS, foreclosures increased significantly, and the economy and stock market began a decline in late 2007 that lasted until early 2009.

The United States began 2009 with a two-fold problem: 1) a credit crisis in the financial markets, and 2) a lack of consumer and investment demand due to the economic downturn and increasing unemployment. The cure for the ailing economy would be dependent on solving both of these problems.

Through an array of government spending and programs, as well as Federal Reserve actions, those problems were solved. The financial crisis resulted in an economic recession that began in January 2008 but ended by June 2009; the longest period of U.S. economic growth began in July 2009.

Fiscal (government spending) programs included:

  • The Troubled Asset Relief Program (TARP) provided the Treasury with broad and flexible authority to buy or guarantee up to $700 billion in “troubled assets,” which included mortgages and mortgage-related instruments, and any other financial instrument whose purchase the Treasury determined was needed to stabilize the financial markets. TARP was basically a bailout of financial institutions.
  • Included in the TARP program was $80 billion for the financial bailouts of General Motors and Chrysler.
  • The Economic Stimulus Act of 2008, a $152 billion stimulus that consisted primarily of $600 tax rebates to low and middle income Americans.
  • The American Recovery and Reinvestment Act of 2009, which was a total of approximately $800 billion. The Act was expansive and took on the economic downturn through a variety of measures. Included was $260 billion for families through tax cuts, tax credits, and unemployment benefits. Programs to help small business included increased tax deductions, credits, and loan guarantees. Direct spending on industry programs focused on infrastructure, education, health, renewable energy, and science and technology.

Federal Reserve actions included:

  • Through quantitative easing, an aggressive program of purchasing Treasury securities, the Federal Reserve lowered interest rates and reduced the fed funds rate to 0.00-0.25%.
  • Increasing the short-term liquidity of banks and other financial institutions through providing greater access to short-term credit.
  • Increasing liquidity directly to borrowers and investors in key credit markets, including money market mutual funds, mortgage backed securities, and short-term credit markets for business.

The COVID-19 Crisis

Relative to the collage of factors causing the financial crisis, the cause of the COVID-19 crisis seems much simpler. What caused the economic downturn in 2020? The easy answer is the coronavirus. But it’s more than that. It was the response to the coronavirus.

According to the U.S. Center for Disease Control, the initial U.S. COVID-19 case appeared in March. By late August, there were over 5 million cases of COVID-19 in the United States with deaths approaching 175,000. The U.S. had more confirmed COVID-19 cases than any other country in the world. Adding to the consternation was the uncertainty surrounding the virus. It usually had more severe effects on the elderly than young people, but not always. It usually had more severe effects on people with underlying medical conditions, but not always. And the long-term effects of COVID-19? No one knows. In addition, if COVID-19 doesn’t physically kill you, it might financially if you require significant medical treatment or an extended hospital stay to recover.

The initial response by many states was to try to minimize the spread of the disease by preventing or limiting social contact, which included restricting economic activity in some degree, such as closing and/or limiting customer volume at retail businesses. By summer, many states had relaxed those restrictions, resulting in an increasing number of new coronavirus cases. The big questions – what will happen to the number of COVID-19 cases in fall, and when will a safe and effective vaccine be available?

Consumer spending was the driving force in the recent economic expansion. Consumer spending is the primary contributor to the Gross Domestic Product (GDP), which measures the U.S. output of goods and services and is the benchmark for measuring economic growth. Consumer spending generally comprises about two-thirds of GDP. During economic expansions, there is a snowball effect of when employment increases. As more people become employed, personal incomes and consumer spending increase, which lead to more employment. Unfortunately, there is also a snowball effect in economic downturns. As unemployment increases, personal incomes and consumer spending decline, which lead to more unemployment.

COVID-19 put the brakes on consumer spending, resulting in an economic downturn in 2020. Ultimately, the degree of economic downturn would be a function of how comfortable Americans were at shopping, traveling, and spending at retail businesses. COVID-19 was going to impact the economy, the question was how much and how long it would impact the economy. The primary factor in a successful economic recovery was not about re-opening the economy, the primary factor was getting the virus under control. If Americans felt safe shopping, traveling, and spending at retail businesses, economic growth would return. The quicker the virus was controlled then the quicker economic growth would return.

Once again an array of government spending and programs, as well as Federal Reserve actions, attempted to minimize the impact of COVID-19 on the economy. Further programs may be forthcoming.

Fiscal (government spending) programs included:

  • The Coronavirus Aid, Relief, and Economic Security (CARES) Act, that became law in March 2020. The CARES was the largest fiscal stimulus in the history of the United States – a $2 trillion stimulus package passed in March that more than doubled the $800 billion stimulus package that was implemented in 2009 to overcome the financial crisis. Components of the bill included:
    • $377 billion loan program for small businesses, including the payroll protection plan (PPP) administered by the Small Business Administration which provided cash-flow assistance to small businesses through 100 percent federally guaranteed loans to employers who maintained their payroll during the emergency. If employers maintained their payroll, the loans would be forgiven. Although the program was geared for small businesses, other organizations such as churches, social agencies, private colleges, and other non-profits received funding. (See link below.)
    • $500 billion lending fund for distressed businesses
    • $560 billion for tax rebates to individuals and extended unemployment benefits
    • $153.5 billion for public health
    • $339.8 billion for states, schools, community development programs, and child-care centers
    • $26 billion designated as a safety-net for school meals, food banks, and food stamps.

Federal Reserve responses included:

  • Through aggressively purchasing Treasury securities, the Federal Reserve once again lowered interest rates and reduced the fed funds rate to a rock-bottom 0.00-0.25%.
  • Creation of two credit facilities that supported large employers through making loans and bond financing more accessible.
  • Creation of additional credit facilities to help facilitate the flow of credit to consumers, small business, and municipalities.

Certainly the fiscal and monetary responses helped mitigate the short-term economic damage of the coronavirus. However, the long-term cure for the ailing economy will be dependent on controlling the spread of the virus. Unfortunately, COVID-19 arguably increased the divisiveness in America. Mask wearing and social distancing to stop the spread of the virus were accepted by many Americans, but not by all Americans. It became a political issue. Some Americans did not feel threatened by the virus, many did. However, for consumer spending to kick-up the economy to the growth enjoyed during the decade of 2010-2020, it will require that most (not just some) Americans feel comfortable in safely shopping, traveling, and spending at retail businesses. Short-term stimulus measures and “re-opening” the economy may help short-term economic growth, but ultimately long-term growth and preventing economic downturns will only be prevented by controlling the spread of the virus.

For more information:

  1. Current info on national and state COVID-19 cases from the CDC and John Hopkins:
    1. CDC U.S. COVID Cases
    2. John Hopkins Coronavirus Resource Center
  2. Information on the CARES Act:
    1. From the Tax Foundation: Tax Foundation – CARES Act
    2. From NPR: NPR – CARES Act
  3. Information on The American Recovery and Reinvestment Act of 2009:
    1. From the balance: ARRA Details
  4. Information on TARP from the Congressional Budget Office:
    1. A Report on the Troubles Asset Relief Program
  5. The Treasury released a list of organizations by state receiving PPP of at least $150,000 or greater. 
    1. PPP Recipients

CBEI Series: A Tale of Two Crises–and Recoveries: Financial Crisis vs. COVID-19 Crisis
Part 1: Causes and Cures
Part 2: Economic Growth – Before and During the Crises
Part 3: Unemployment – Before and During the Crises
Part 4: The Federal Reserve and Interest Rates

Kevin Bahr

Prof. Kevin Bahr, Ph.D. is the chief analyst of the Center for Business and Economic Insight at the University of Wisconsin-Stevens Point School of Business and Economics. Follow his blog for the latest news from CBEI.

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