The Long Boom and the Great Recession - Sample Recession Analysis Term Paper

This sample international finance term paper examines how the excesses of the "long boom" from 1980-2006 created the conditions for a severe economic crisis. The essay examines how changes in technology, an emphasis on deregulation and growing corporate debt lead to the "Great Recession." It builds its case using relevant theories, such as Hyman Minsky's Financial Instability Hypothesis and examples from the financial crisis. It would be a useful reference for business and economics students who want background on the recession and how it relates to economic theory.

Surviving an economic hangover: A "morning-after" perspective of the Long Boom 1980-2006

For the average American, the "long boom" from the 1980s to 2006 seems like a distant memory as the country emerges from the worst financial crisis since the 1930s. While many understandably look forward to economic recovery, it is instructive to examine the last two decades if we are to learn from what happened. This paper will examine how technological change and government deregulation drove the boom, and how critics say these "golden egg" years set the stage for what some now call the "Great Recession."

While the long boom had negative consequences, it was a period of economic growth and opportunity. President George W. Bush's 2007 State of the Union Address showcases the view of American prosperity at the time:

A future of hope and opportunity begins with a growing economy -- and that is what we have. We're now in the 41st month of uninterrupted job growth, in a recovery that has created 7.2 million new jobs -- so far. Unemployment is low, inflation is low, and wages are rising.

At the beginning of 2007, Bush and most of America had little reason to believe the country was on the verge of a severe economic downturn. The previous year, 2006, was the height of the boom period and a banner year for the U.S. economy - the golden egg seemed stronger than ever. As Roy Allen writes in Financial Crises and Recession in the Global Economy, the U.S. had received over $800 billion a year in financial inflows from the rest of the world, and there was a "150 percent increase in the average US house price from $100,000 in the late 1990s to $250,000 at the peak in early 2006" (Allen 114). Likewise, the stock market was skyrocketing, and the Dow Jones Industrial Average hit a peak of 14,198 on October 9. It should be noted that much of the wealth creation during this time occurred in financial markets, and not in GDP / "real" markets for goods and services. While these figures seem overinflated and dangerous two years later, at the time they appeared to most people (with the exception of a few economists) as signs of a vibrant economy.

The long boom - like the recession it preceded - had a dramatic start. Like numerous business cycles in American history, this one was kick started by a technological revolution: information and communication technology progressed rapidly in a short period of time. Allen explains how this revolution was aided by the miniaturization and widespread use of computers. The first widely recognized computer, the ENIAC, weighed 30 tons and stood two stories tall in 1946. But by "1956, there were 600 computers in the US, in 1968, 30,000, in 1976, half a million, in 1988, several million, and by the end of the century half of all the households in the U.S. had a free-standing computer" (Allen 7). Likewise, changes in communication technology opened up new opportunities for productivity. Allen writes:

First-generation fax machines from the 1970s took six minutes to send one page of documentation, but by the late 1980s the transmission time was down to three seconds and the popularity boomed. In 1987, 460,000 facsimile machines were installed in the U.S., compared to 190,000 in 1986 . . . By the early 1990s, there were over one million installations per year (Allen 8).

That a change in technology would bring about economic expansion is hardly unprecedented. Joseph Schumpeter, writing in 1934, suggested that innovation is "is largely responsible for most of what we would at first sight attribute to other factors" (Schumpeter 82), such as a change in consumer tastes or growth in general. Indeed, Schumpeter goes on to say that economies tend to operate on waves of technological innovation, and this "creative destruction" opens up new opportunities, while making others outdated.

But by themselves the last few decades of innovation in the IT sector, while impressive, at first don't seem like gateways for the unparalleled wealth creation of the long boom. However, Allen notes that "changes in communications have always affected the structure of finance, but these developments of the last few decades were responsible for the truly global nature of today's financial markets" (Allen 7-8). He points out how these technologies, when used by stock exchanges for example, made the process of trading incredibly efficient, and made access to global markets easier and cost-effective. When the U.S. NASDAQ index was connected to London's off-exchange market, "It was estimated that between $200 million and $300 million of foreign stock shares changed hands daily" which was "roughly double the levels of 1981" (Allen 9). As technology improved, it's no wonder that "from late 1980 to 1985, global foreign exchange trading volume doubled to a level of $150 billion per average working day," which was "at least 12 times the value of world trade and services" (Allen 2).

Clearly, there was money to be made in financial markets, and people flocked to the financial sector both for investment opportunities and jobs. The Wall Street Journal reported about the growth and decline of financial service jobs on September 18, 2009. The newspaper writes about how the financial services industry dominated the mindset of jobseekers:

Over the past 20 years, finance grew faster than almost any other sector of the U.S. economy, offering rich pay and luring a growing share of bright minds to trade securities, make loans, manage portfolios, engineer mergers and turn complex mortgages into complex derivatives (Bannon 1).

The Journal goes on to say that creating such complicated financial instruments "drew brainy and aggressive people" and that by 2005 a finance professional earned 30% to 40% more money than engineers with a similar degree level (Bannon 2). It would take an unprecedented recession to halt the growth of this industry, which declined by 4.8% at the end of 2008.

But technological change was not the only driver of the long boom. Government deregulation across the financial sector also contributed to financial market globalization and massive wealth creation. Allen writes that as technology made it easier to make a profit in financial markets, "governments began rushing toward financial market deregulation and internationalization in order to capture a large share of the new profitability for their own money centers, and in order to attract new international funds into their own economies" (Allen 12). The deregulation efforts were spearheaded by Ronald Reagan in the U.S. and Margaret Thatcher in the U.K. "Deregulation was advanced under the consensus that financial market protectionism had failed," Allen writes, adding that proponents said taxes encouraged people to place their money overseas" (Allen 12). The U.S. ultimately dismantled aspects of the Glass-Steagall Act, which had separated investment banks from commercial banks, in order to make financial institutions more competitive. Likewise, the U.K. followed up with its "Big Bang" deregulation, which "scrapped 85 years of fixed commissions for brokers" (Allen 13). Other countries, not wanting to be left behind, soon followed. In 1986, Canada announced "it would open the highly restricted Canadian financial services industry to unrestricted access by foreigners and Canadian institutions." Japan by 1984 gave "U.S. banks virtually free access to many Tokyo financial markets, including the underwriting of Japanese government bonds." Even China and the USSR began moving towards more financial liberalization (Allen 14-15).

Collectively, these moves created a global financial system that greatly expanded the ability to make money while investing. With access to globalized, open markets, investors found it easy to move their money around the world. As they did so, market behavior began to change. Interestingly, as time went on, global interest rates for the same currency eventually equalized; a phenomenon Allen calls "interest rate parity." Likewise, P/E ratios for U.S., German, and Japanese companies for example, converged, in an example of "financial strategy parity." The U.S. especially reaped the benefits from deregulation - as mentioned earlier, over $800 billion in foreign savings flowed into the U.S. in 2006 alone, as investors were drawn by attractive interests rates and the opportunity to invest in a growing economy. Indeed, Allen writes that "the removal of structural differences and impediments between financial markets everywhere encouraged a more general foreign buying of America" (Allen 26). Ironically, the U.S. became the world's largest dissever country, as it sold trillions of dollars in bonds to China and other nations, to finance its growing fiscal expenditures.

While deregulation allowed financial markets to thrive, critics have suggested that unfettered markets were responsible for the country's economic weaknesses during the boom. They often cite the issue of income inequality, and say that while the boom helped the rich get richer, the poor and middle class were hardly better off. Jack Rasmus' The War at Home details some of these arguments. Rasmus explains that the Organization for Economic Cooperation and Development (OECD ) compared the economies of several member nations, and found that "Income inequality is high (and rising) in the United States compared to the rest of the OECD" while at the same time "income mobility appears to be lower in the U.S." (Rasmus 45). One does not need to be an economist to see there is some merit to this statement - after all, executives in the financial services sector frequently earned multi-billion dollar bonuses, and President Barack Obama has appointed a pay czar to address executive compensation for some firms. Rasmus, writing in 2006, observed that the gap between rich and poor was getting worse:

Unlike the other OECD nations, in the U.S. the spread between those with the lowest income and those with the highest is growing rapidly. In America workers in the lowest 10% income range make only 39% of the midpoint median earnings level. Conversely, the richest 10% in the U.S. on average make 210% of that median earnings level. (Rasmus 45).

He goes on to say that workers have seen few benefits from the boom period. Observing that the median wage had hardly adjusted between 1995 and 2000, Rasmus concludes that "As a whole, workers were now back roughly where they were in 1979." While highly skilled individuals, as previously noted above, did far better, economic growth from 1995-2000 only left "the larger mass of American workers doing less well and [a wider gap had formed] between them and the more highly educated and better paid" (Rasmus 118). As a side note, while Rasmus would likely approve of the Obama Administration's reaction to executive compensation, he would probably call for additional regulation to help bolster the working class and reduce income inequality, a negative consequence of the boom.

Critics go even further, suggesting that the boom period's lax regulatory standards set the stage for the "Great Recession." This argument is a potent one, and it's hard to argue that dismantling Glass-Steagall and other regulations did not lead to increased risk-taking by financial institutions. Indeed, one simply has to look at the derivatives market, where the subprime loan crisis took its toll, to see the implications of little regulation. The Economist examined the derivatives market on November 12, 2009 and found that the over the counter (OTC) market, was close to $4 trillion. This market, full of customized, little-understood financial instruments, did not help the financial system during the height of the crisis. Derivatives "concentrated risk as much as they spread it, and amplified bad judgments," the magazine writes. "Their leverage magnified losses on underlying assets like mortgages and crippled even the biggest firms" (1-2), it continues. The article explains that since the crisis, some suggest clearing OTC derivatives through "central counterparties (CCPs)" to ensure transparency and avoid further meltdowns.

Critics go even further, suggesting that the boom period's lax regulatory standards set the stage for the "Great Recession." This argument is a potent one, and it's hard to argue that dismantling Glass-Steagall and other regulations did not lead to increased risk-taking by financial institutions. Indeed, one simply has to look at the derivatives market, where the subprime loan crisis took its toll, to see the implications of little regulation. The Economist examined the derivatives market on November 12, 2009 and found that the over the counter (OTC) market, was close to $4 trillion. This market, full of customized, little-understood financial instruments, did not help the financial system during the height of the crisis. Derivatives "concentrated risk as much as they spread it, and amplified bad judgments," the magazine writes. "Their leverage magnified losses on underlying assets like mortgages and crippled even the biggest firms" (1-2), it continues. The article explains that since the crisis, some suggest clearing OTC derivatives through "central counterparties (CCPs)" to ensure transparency and avoid further meltdowns.

The most convincing evidence that activity during the boom set the stage for the downturn can be found in Hyman Minsky's Financial Instability Hypothesis. Minsky's argument is simple but compelling. He starts by saying that capitalist societies feature financial intermediaries which are constantly pursuing higher profits. As the business cycle continues, more opportunities for profit emerge, and these corporations tend to take on debt in order to expand and compete. Minsky identifies three forms of debt financing used by corporations: hedge, speculative, and Ponzi. In hedge financing, corporations can fulfill all of their contractual payment obligations by their cash flows" (Minsky 7). Here, there is a healthy balance of debt to equity. But as it becomes more difficult to finance profit opportunities, corporations must take on more debt, and they enter a speculative financing phase. Companies who engage in speculative finance, "meet their payment commitments on "income account" on their liabilities, even as they cannot repay the principle out of income cash flows" (Minsky 7). These companies use their cash flow to pay off interest on their debt. Finally, Minsky suggests corporations ultimately turn to Ponzi financing, named after the famous swindler. Corporations that operate with Ponzi financing are not able to make their interest payments, and often borrow more to cover their old debt. Minsky explains that "A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts" (Minsky 7), making it inherently unstable. What Minsky has to say next seems to mirror the long boom and the bust that followed:

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values (Minsky 9).

To apply Minsky's theory, as the long boom continued, financial institutions took on a great amount of debt to continue financing their operations. But when the markets began to collapse, these corporations found themselves with dangerously low reserves, and some went bankrupt, while others were bailed out. Minsky would likely argue for increased regulation of financial institutions, including higher reserve ratios and some form of debt management that would allow them to survive serious downturns. As the U.S. learned at the end of the long boom, there is a price for success.

Booms and busts are a way of economic life. While there doesn't seem to be a cure for business cycles, a more intelligent mix of regulation and free-market principles could help make the next bust less painful. But perhaps a little preventative medicine could help too - the nation's financial gurus in the Federal Reserve and Treasury need to be on alert for a boom that is accelerating out of control. Take green energy for example. A recent TIME magazine article points out that government support for alternative-energy technology could mean economic profits down the road: "The venture capitalists behind the high-tech and bio-tech booms see clean teach as the next big score. The necessary engineers, scientists, accountants, lawyers, marketers, and other knowledge workers are already there" (Grunwald 30). The dilemma, of course, for policymakers is when to time their actions appropriately, so as to not short-circuit an expansion. History has shown that policymakers like the Federal Reserve are reluctant to step in, which unfortunately may mean additional pain down the road. But whenever analysts suggest a new technology is the "next big score," this means the money will start flowing in - and regulators had better be ready.

Works Cited