After reading this section, you should be able to answer the following questions:
The US economic system is capitalismAn economic system that emphasizes a free market, individual entrepreneurship, and limited government intervention in the economy and produces economic inequality.. It encourages individual enterprise, a free market, and relatively low taxation. It discourages government intervention in and regulation of the economy.
Capitalism can produce vast wealth and vast economic inequality. The top 300,000 earners pocket almost as much income as the bottom 150 million. This inequality has been increasing in recent years. From 1980 to 2001 the income of the top 5 percent of Americans went up from eleven to twenty times the income of the poorest fifth.
Economic inequality is related to social inequality. Women and men now attain similar levels of education. The earnings gap between them is shrinking, but it still exists. On average, working women earn seventy-eight cents to every dollar earned by working men. Professions most populated by women usually pay less than professions most populated by men. For instance, in medicine, nurses (mostly women) are paid less than physicians (mostly men); in the airline industry, flight attendants (mostly women) are paid less than pilots (mostly men).Nancy McGlen and Karen O’Connor, Women, Politics and American Society (Englewood Cliffs, NJ: Prentice Hall, 1995), table 4-11. Income gaps exist even in the same profession. Female university professors are generally paid less than male university professors, even at the same rank and with similar years of service.
Income differs dramatically by race and ethnicity. The household income of whites, Asian Americans, and Pacific Islanders averages well above $50,000; for African Americans and Latinos it is under $32,000. African American families and Latino families are three times more likely to live in poverty than white families, although this gap, particularly between black and white individuals, has shrunk over time.
In 2007, the US economy was humming along with the stock market soaring, employment high, and inflationA rise in prices. (increases in the cost of living) low. Earlier in the decade, the media had reported the financial frauds and scandals of individual companies such as Enron and WorldCom and the failure of the companies’ accountants to catch them. Now, especially in the Wall Street Journal and on cable channel CNBC, they reported the booming economy, especially housing.
Public policies encouraged the dream of home ownership by enabling people to deduct on their tax returns the interest they paid on their mortgage loan and by a Clinton-era law excluding from tax all or most of the profit they made from selling their homes. But these policies did little for people unable to obtain mortgages because of low income and poor credit records. So President George W. Bush, promoting an “ownership society,” pushed policies to enable the disadvantaged and those with poor credit, especially minorities, to buy homes.
Home Ownership and President Bush(click to see video)
President Bush pursued policies making it easier for minority Americans to buy their homes. The results were far different than he expected.
This vastly increased the number of subprime mortgagesLoans to buy a house or apartment made to someone usually unqualified to receive them.—home loans made to people usually unqualified to receive them. Lenders peddled easy credit, asked for low or no down payments, and did not require incomes to be documented. Some borrowers were given adjustable mortgages with low initial teaser interest rates, which would later rise much higher, and charged big fees hidden in the interest rates.
The Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac) were shareholder-owned and profit-driven corporations sponsored by the government to buy mortgages from banks, thereby freeing up cash for new mortgages. They financed most of the home loans made in America. They plunged deeply into the market for subprime mortgages, relaxing credit requirements on the loans they bought from lenders. They also spent heavily on lobbying so that Congress did not raise their capital requirements.
Propelling the subprime mortgage market was the tremendous growth in complicated and opaque securities. Lenders sold the original mortgages to Wall Street and then used the cash to make still more loans. The investment and commercial banks sold packages of mortgages as mortgage-backed securities (MBS). These were then combined with other securities (e.g., commercial mortgages, credit card debt, and student loans) and sold as collateral debt obligations (CDOs).
Taking fees each time a loan was sold, packaged, securitized, and resold, the sellers made rich profits. They reaped even more by leveraging—borrowing to invest in more loans and packages. In 2004, the Securities and Exchange Commission allowed large investment banks to increase their leverage, a policy change the media barely reported. At its height the ratio of borrowed funds compared to total assets soared to 33:1. Investors thereby vastly increased their purchases and profits—but also their potential losses.
Protecting investors from losses, each package could be insured by a credit default swap (CDS). These guaranteed that if any borrowers in an MBS defaulted, the seller of the swap would pay the loss. The leading issuer was the American Insurance Group (AIG), with insurance on more than $400 billion in securities.
These arcane securities were rated “very safe” by the rating agencies. But these raters had an obvious conflict of interest: they were paid by the institutions whose securities they rated—rather like a movie producer paying a reviewer to write favorable reviews of his movies.
Gripped by a fervor for deregulation, the government had reduced its oversight of the financial system. In 1999, Congress enacted and President Clinton signed legislation enabling commercial banks, which collect deposits and loan money, to deal in securities—and thereby engage in speculative investments. The government also abolished many restrictions on affiliations between banks, investment companies, and insurance companies.
Regulation was the responsibility of an “alphabet soup” of federal agencies. These included the Federal Reserve Board, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation. Their jurisdictions were splintered and confusing. Some mortgage lenders did not fall under any regulatory agency.
The government sometimes refused to seek regulatory authority even when it was desirable. The Federal Reserve Board, the Securities Exchange Commission, the Clinton administration, and bipartisan majorities in Congress blocked proposals to regulate credit default swaps. Even when they had regulatory authority, agencies failed to use it. The Federal Reserve Board did not investigate mortgage risks, and the Securities and Exchange Commission did not restrict the amount of debt assumed by investment banks.
As long as home prices went up, the value of homes increased, and interest rates remained low, homeowners could continue to pay their mortgages or sell at a profit. Flipping, or buying and selling property repeatedly to make money, became common.
Disaster loomed beneath this glittering surface. The American dream of home ownership turned into a nightmare. The Federal Reserve Board raised interest rates, thus increasing monthly payments for the many people with adjustable-rate mortgages. Some of them defaulted on their loans, losing their homes. House prices fell by around 25 percent in many major markets. Lenders or mortgage holders repossessed property, reselling it for less than the amount owed on the mortgage and thus taking a loss. There were so many failed mortgages that the sellers of credit default swaps did not have enough money to pay the claims.
Starting in June 2007 but only fully acknowledged in the fall of 2008, the financial system failed. Investment firms and banks declared bankruptcy or were taken over at fire-sale prices. The stock market collapsed. People’s retirement accounts and the endowments of universities and colleges dropped precipitously. Fannie Mae and Freddie Mac, which had taken on debt to finance their purchases of mortgages, experienced huge losses on the defaults and were on the verge of insolvency.
There was a liquidity crisis: the credit market froze, making credit unavailable. Banks hoarded their capital and refused to lend. They assumed that other financial institutions were in financial trouble and would not be able to repay them. State and local governments, businesses, and families had difficulty borrowing and thus spending. There was a drastic fall in the demand for construction, investments, goods, and services.
Millions of Americans lost their jobs and thus their employer-provided health insurance. The crisis affected not only those with subprime mortgages but also those with regular mortgages; both groups often faced foreclosure on their homes. Nearly a quarter of all homes with mortgages became worth less than the money owed; these homeowners were thereby encouraged to default on (i.e., walk away from) their loans. Governments at all levels faced massive budget deficits as their income from taxes decreased and their expenditures to pay for the safety net of unemployment compensation and welfare increased.
The federal government’s involvement in the economy, once controversial, is now tolerated if not expected. It was spurred by the Great DepressionThe period of high unemployment, severe decreases in business activity, and falling prices in the United States that started in 1929 and ended with the onset of World War II. of the late 1920s and 1930s in which the unemployment rate reached 25 percent. The task of policymakers faced with the new crisis was to rescue the economy and try to prevent the meltdown from happening again. This would entail far more government action to manage the economy than ever before.
Policymakers’ responses initially lagged behind the crisis and were improvised and contradictory. The Bush administration requested $700 billion to buy up toxic mortgage securities but then used the funds to purchase stock in banks.
The responses became more focused. The Federal Reserve Board slashed interest rates to lower borrowing costs, bolster the real estate market, and encourage spending. Intervening in Wall Street in unprecedented ways, it committed trillions of dollars to rescue (bail out) the financial system and prevent the failure of major financial institutions. It gave them loans, guaranteed their liabilities, and brokered deals (e.g., takeovers or sales of one financial institution to another). It carried out these actions on the grounds that an economic collapse would cost millions of jobs.
President Obama’s Treasury Secretary Timothy Geithner devised a Public-Private Investment Program (PPIP) to buy up and hold as much as $1 trillion in toxic assets. The Treasury and Federal Reserve Board carried out stress tests to determine whether individual banks had the resources to survive a recession.
The government took over Fannie Mae and Freddie Mac. It extended as much as $400 billion credit to them and spurred them to refinance millions of homeowners at risk of losing homes. It left their future and fate to be decided later. The government also funneled $185 billion into AIG to keep it in business.
The Obama administration sought to create 2.5 million new jobs or at least protect existing jobs with a stimulus recovery plan of $787 billion. It invested in infrastructure—roads, bridges—and alternative sources of energy. It sent billions to the states for public schools, higher education, and child-care centers.
These programs would take time to be effective. So for immediate relief the administration provided funds for some people unable to pay their mortgages and sent the states additional monies for the safety net: unemployment insurance and other benefits.
On July 21, 2010, President Obama signed legislation imposing new regulations on the financial industry. The law was the result of detailed negotiations, compromises, and intense lobbying.
It was up to the regulators to work out the numerous details and implement the new law. Their actions would most certainly be subject to intensive lobbying by those affected. Meanwhile, the law was attacked by Republicans and the financial industry for creating more government bureaucracy and, they argued, undermining the economy’s competitiveness. Advocates of more stringent regulation criticized it for, they claimed, doing little to reduce economic risk and not ending the likelihood of government bailouts.Joe Nocera, “Dubious Way to Prevent Fiscal Crisis,” New York Times, June 5, 2010, B1, 7.
The government’s response to the economic crisis was unusual. We now turn to the government’s usual economic policies and the institutions, most of which we have already mentioned, responsible for deciding on and implementing the policies.
Monetary policyEconomic policy enacted by the Federal Reserve Board to manipulate the money supply and interest rates. involves the amount of money available to the economy from such sources as banks, savings and loans, and credit unions. The Federal Reserve Board (the Fed)The body that supervises the US banking system and executes monetary policy. is responsible for monetary policy. The Fed supervises and regulates banking institutions and maintains the financial system to attain economic stability and promote growth. It uses three tools: the discount rate, reserve requirements, and open market operations.
Federal Reserve Board (the Fed)
Learn more about the Fed at http://www.federalreserve.gov.
The discount rate is what the Fed charges commercial banks for short-term loans. Lowering rates increases the banks’ access to money, allowing banks to offer cheaper credit to businesses and the public, thereby stimulating the economy. The Fed does the reverse to slow down an “overheating” economy.
Reserve requirements stipulate the portions of deposits that banks must hold in reserve. By reducing reserve requirements, the Fed increases the money supply, thereby stimulating economic activity. Increasing the reserve requirements combats inflationary pressures.
Through its open market operations the Fed controls the money supply by buying and selling US government securities. To stimulate the economy, the Fed increases the money supply by buying back government securities. To combat inflation, the Fed sells securities to the public and to businesses. This reduces the money supply as the Fed can take the cash paid out of circulation.
Fiscal policyGovernment economic policy involving taxation and spending. is the government taxing, spending, and borrowing. In theory, cutting taxes and increasing spending expand the economy and increase employment, while raising taxes and decreasing spending contract the economy and reduce inflation. Reality is more complex. Higher corporate and personal tax rates reduce the profit margins for companies and the disposable income for the population at large. But the higher tax rates may be necessary for the government to afford its expenditure program, much of which can also increase demand and activity in the economy.
Fiscal policies are inherently political, favoring some people and groups more than and often at the expense of others. No wonder fiscal policies are debated and disputed by politicians and the political parties and lobbied by interest groups. Some of these policies, such as tax cuts, tax increases, and tax deductions (e.g., the oil and gas depreciation allowance), are reported and discussed in the media.
The main devisers of President Obama’s economic program, in consultation with his political advisers, are the director of the White House National Economic Council (NEC), the secretary of the Treasury, the chair of the Council of Economic Advisors (CEA), and the director of the Office of Management and Budget (OMB). The president’s Economic Recovery Advisory Board, composed of outside economists, CEOs, and labor officials, was introduced in November 2008.
The NEC coordinates domestic and international economic policymaking. Its director has an office in the West Wing and is responsible for brokering the ideas of the other economic policy advisers and controlling the president’s daily economic briefings.
The secretary of the Treasury usually comes from the financial or business world. The degree to which a Treasury secretary influences economic policy depends on his political skill and relations with the president. The Treasury Department is largely responsible for tax collection, payments and debt services, and enforcing federal finance and tax laws. Its interests include trade and monetary policy, international finance, and capital movements.
The CEA consists of three economists, usually academics. Ostensibly nonpartisan, they are appointed by the president and are members of the presidential staff. The chair of the CEA represents it at the president’s economic briefings. The CEA’s job is to diagnose the health of the economy, analyze trends and developments, and offer recommendations. It also helps produce the president’s annual economic report to Congress stating and justifying the administration’s fiscal and monetary policy and priorities.
The OMB is largely responsible for preparing the president’s budget and for establishing the budgets of federal agencies. It has substantial authority to control the bureaucracies and to enact the presidential policy agenda. It reviews every piece of proposed legislation submitted to Congress. Changes in agency regulations require OMB approval.
The legislative branch influences fiscal policy through its “power of the purse” and authority over approval of the president’s budget. The president needs congressional consent on all taxes and nearly all federal expenditures as well as any increase of the national debt limit. Congressional committees revise and alter the president’s policies. Congress can also check the Fed by lessening its autonomy in setting monetary policy.
Members of Congress have party preferences, constituency needs, and interest group objectives in mind when considering policies. One or more of these may cause them to oppose or support the president’s proposals. For example, Congress has historically been more protectionist (of domestic industries) on trade policies than presidents.
The budgetA statement of the president’s policy goals and priorities for the next fiscal year. It consists of receipts and expenditures. is a statement of the president’s policy goals and priorities for the next fiscal year. It consists of two main parts. Receipts are the amounts anticipated in taxes and other revenue sources. Expenditures (outlays) are what the federal government expects to spend.For a comprehensive analysis of federal budgeting, see Dennis S. Ippolito, Why Budgets Matter: Budget Policy and American Politics (University Park, PA: Penn State University Press, 2003).
The budget is supposed to be submitted to Congress by February 1 of each year. It is studied by the House and Senate Budget Committees with the help of the Congressional Budget Office (CBO). The two committees prepare a budget resolution that sets ceilings for each of the items in the budget. In May, Congress adopts these budget resolutions. Over the summer, the House and Senate Appropriations Committees and their subcommittees decide on the specific appropriations. In September, Congress passes a second budget resolution that reconciles the overall and itemized budget ceilings with the overall and itemized appropriations. By the end of this process the specific budgetary allocations to various spending areas such as health, education, and defense have been approved by Congress. The modified document is then submitted to the president for signing, which he does if he accepts the congressional modifications. The president may choose to veto them, compelling the process of reconciliation to continue.
In reality, the timing of the passage of budget resolutions and the budget itself are dependent on the degree and intensity of partisan conflict, disagreement between Congress and the White House, disagreement between the House and Senate, and other clashes.
In recent years, credit, mortgage, and regulatory policies contributed to an economic crisis in the United States. Responding to the economic crisis, the government has become more involved in managing the economy than ever before. Monetary policy is mainly determined by the Federal Reserve Board. Fiscal policy is mainly made by the president’s economic advisors and Congress. Deciding the federal budget is a complicated and often contentious process involving the presidency and Congress.