Economic Crisis &
the Plan for Recovery

By Alan Shapiro

To the Teacher:

The economic crisis affecting Americans is also a global crisis. We haven't experienced anything like it since the Great Depression of the 1930s. But the current deep recession has elements that make it unique.

The first student reading below offers an overview of how and why the crisis developed and its impact. The second outlines President Obama's economic recovery plan, with special attention to the economic stimulus program, its pros and cons, and its approval (without bipartisan support) by Congress.

Teachers may also find useful "FDR and Barack Obama: Leading the Nation Through Hard Times" and other materials on the economic crisis available on www.teachablemoment.org.

Student Reading 1:
Why is the American economic system in crisis?

Millions of Americans have lost their jobs or have been cut back to part time. Millions have been forced into home foreclosure. It's almost impossible to get a loan to buy a house or a car, finance a business or go to college. Businesses and banks teeter on the brink of collapse, schools and colleges face losses of staff and programs.

Tax receipts have plummeted. States and cities across the country are in deep trouble. For instance, California will receive some money from President Obama's economic stimulus program to meet a budget deficit of $41 billion. But it will not be enough to avoid slashing $9.3 billion from public schools. That means bigger classes and program cuts. Social service program cuts of $1.3 billion in California mean less help to the disabled and people in the state's welfare-to-work program.

How did all this happen?

The real estate bubble

"Irrational exuberance." The "social contagion of boom thinking." The "psychology of the real estate bubble." These are terms used by Robert Shiller, a Yale University economist, to describe the economic crisis, which he predicted in 2005. Shiller believed back then that home prices could not rise indefinitely, as many others thought. He believed their collapse was inevitable.

In the 20th century, banks were conservative about giving people home mortgage loans. A potential borrower could not get home financing until the bank checked out a person's credit history and had reasonable evidence that the borrower was a good risk to pay back a loan with interest over 20 or 30 years.

But the "psychology of the real estate bubble" changed all that. It led banks and mortgage broker companies to lend money to just about anyone who walked through their doors and wanted to buy a house. Credit was easy. For little or no money down, a home buyer could get an adjustable rate mortgage with very low fixed payments for maybe two years before payments would rise.

Banks and mortgage companies were eager to provide loans to these risky borrowers because there was much money to be made. In the past decade or so, bankers, brokers, and other financial wizards began dreaming up new ways to resell mortgages and multiply their profits: "securitization," the process of turning bundles of mortgages into stock securities. Millions of high-risk mortgages were repackaged and sold as relatively low-risk but high-yielding investments to people and institutions all over the world. Securitization led in turn to "derivatives," or investments based on other investments. An example of this lucrative business was the sale of "credit default swaps." Each derived from a mortgage-backed security and offered a kind of insurance an investor could buy to guarantee the safety of a mortgage-backed security.

Easy money and regulatory failure

Until the collapse, everyone was happy. Consumers were able to buy houses on borrowed money they might never be able to repay -- but they figured they could always sell their house for more than they owed, since housing prices were soaring. Banks sold mortgage-backed securities at a handsome profit. Investors collected the returns on these lucrative securities.

Besides human greed, these new securities and the careless, even fraudulent speculation on them were made possible because government agencies had failed to regulate the financial industry. The depression-era Glass-Steagall Act of 1933, which barred bank speculation (among other things), was repealed during the Clinton administration, during a time when Congress was on an anti-regulatory kick. Many elected officials of both parties had come to office with the support of the financial industry, and had little interest in curbing or even investigating its excesses.

The Securities and Exchange Commission (SEC), also created during the depression, was charged with overseeing and regulating the stock market. But it saw no problems in the housing and securities extravaganza. Nor did Secretary of the Treasury Henry Paulson, Federal Reserve Chairman Ben Bernanke, or CEOs of banks, who presided over huge profits, received gargantuan salaries and bonuses, and seemed ignorant of danger.

Alan Greenspan, Federal Reserve Chairman, 1987-2006, confessed to a congressional committee in October 2008 that he did not see the collapse coming. "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms…" He was one of the very few officials to admit he was wrong.

The bubble bursts

In 2006 home sales began to stall in an overstuffed housing market. By 2007 home prices were falling. In 2008 came the deluge. Increasing numbers of new homeowners fell behind on their rising mortgage payments. In a declining market, they were unable to sell their homes at any price, much less a profit. Home foreclosures became an epidemic.

The nose-diving housing market also meant that banks and other mortgage providers were unable to sell their mortgage-backed securities or to pay off credit default swaps. They were left with pieces of paper worth far less than their face value.

Stock markets worldwide fell sharply, creating huge losses for investors. Lenders became unwilling to lend, even to individuals and businesses with good credit histories. Investment banks with famous names--Bear Stearns, Lehman Brothers, Merrill Lynch--either collapsed or were absorbed by other banks.

Businesses struggled or failed to pay their bills as credit tightened and consumers pulled back on spending. Big companies like General Motors fired thousands of employees. The jobless often also lost their health insurance.

A global crisis

Simultaneously, the crisis was going global. Job losses across continents--in Chile, Greece, China--led to worker protests and threatened governmental stability. In the U.S., the official unemployment rate is 7.6%. In Spain it is 14.4%.

Iceland's banks collapsed under the weight of the same kind of bad debt held by American banks. Dubai's booming real estate sales swooned for lack of buyers, Russia's oil-fueled economy foundered as drivers got off the road. China's huge export market declined as consumers stopped buying.

America's new National Intelligence Director, Dennis Blair, told the Senate Intelligence Committee that the most immediate security threat to the United States is "the global economic crisis and its geopolitical implications." Risks of "regime-threatening instability," cutbacks on "defense obligations," and "mishandling of humanitarian issues" could "help foster terrorist movements," he told the committee. (2/12/09)

The words John Maynard Keynes, a famous British economist, used to describe the Great Depression seem relevant today: "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." (The Great Slump of 1930)

For discussion

1. What questions do students have about the reading? How might they be answered?

2. What was a major cause for the rise in home prices? Why was it so easy to buy a house? What role did mortgage-backed securities play in rising home prices and in home sales?

3. Why didn't government officials and regulatory agencies prevent a looming crisis?

4. Why did home prices begin to fall? What effects did falling prices have on home foreclosures? On banks and other mortgage providers? On stock markets? On employment? Why?

5. What reasons are there for the global spread of the crisis?

6. Why does Dennis Blair regard the global crisis as America's most serious security threat?

7. What evidence is there in the reading to apply Keynes' words about "The Great Slump of 1930" to today?

Student Reading 2:
What does the economic recovery program aim to do?

President Obama's economic recovery program has two major parts: 1) an economic stimulus program and 2) a financial program. While both are enormously expensive, the basic argument for both is that only the government has the huge resources needed to bring about America's economic recovery.

The economic stimulus program approved by Congress includes

• Infrastructure projects: repair and building of roads and bridges, school construction, modernization of transit systems
• Green energy projects: tax incentives for wind, solar and other renewable power sources; purchase of plug-in hybrid cars and solar panels for schools; funding to make federal buildings more energy efficient; funding to enable people to weatherize their homes
• Extension of unemployment benefits
• Extra money for food stamps
• Middle class income tax cuts
• Money to computerize medical records
• Aid for state budgets
• Environmental protection-flood control, pollution cleanup

Cost: $787 billion

"I think my initial measure of success is creating or saving 4 million jobs. That's bottom line number one, because, if people are working, then they've got enough confidence to make purchases, to make investments. Businesses start seeing that consumers are out there with a little more confidence, and they start making investments, which means they start hiring workers…" A second measure of success, the president said, is helping homeowners avoid foreclosure and stabilizing the housing market.

Several days later President Obama announced a $275 billion plan aimed at helping an estimated 9 million households refinance their mortgages or avoid foreclosure. The president said the plan "will give millions of families resigned to financial ruin a chance to rebuild...and by bringing down the foreclosure rate, it will help to shore up housing prices for everyone."

He also said the plan would not help "dishonest lenders who acted irresponsibly" or "folks who bought homes they knew from the beginning they would never be able to afford." The largest group of households not helped by this plan are millions of borrowers who are "under water" -- people holding mortgages that are bigger than the sharply declining market value of their homes.

Another measure of success for Obama's financial program is whether it deals effectively with the bad debt that is weighing down banks, which would make credit more readily available. Secretary of the Treasury Timothy Geithner has estimated this debt to be a staggering $2 trillion or more.

Not officially included in the economic and financial recovery efforts is the federal bailout of General Motors and Chrysler. GM and Chrysler have already received $17.4 billion, but are seeking another $21.6 billion to avoid bankruptcy. The auto companies have already sharply cut workers, plants and product lines. Ford, the third major U.S. automaker, has so far not asked for help.

The president admitted that his economic stimulus plan is "not perfect. No plan is. I can't tell you with complete confidence that everything in this plan will work exactly as we hoped, but I can tell you with complete confidence that a failure to act will only deepen this crisis, as well as the pain felt by millions of Americans." The president later amended his prediction of the job creating and saving potential of the stimulus program to 3.5 million jobs.

Critics

Republican legislators were very critical of the stimulus program. Most of the elements in it, they argued, were long-time liberal projects. Whatever their merits, they had nothing to do with stimulating the economy. A second major criticism was that while the program included income tax cuts, they were insufficient. Larger tax cuts stimulate the economy, Republicans argued. They put money into people's hands quickly by decreasing withholding from paychecks.

Other critics found fault with tax cuts because, they argued, it has been demonstrated in the past that they do little to stimulate the economy. Perhaps more importantly, critics said, the stimulus package should have included much more money for education, health, and state budget needs. Some cited Japan's 1990s recession, which many economists think was prolonged by the government's initial inadequate response.

The president met with Republican as well as Democratic legislators to discuss his economic stimulus measures and to listen to suggestions and criticisms. He has named three Republicans to his cabinet, although one decided not to take the position. He has socialized with members of both parties and spoken repeatedly about the need for bipartisan support, particularly at a time of economic and financial crisis.

But Obama did not get Republican support for his economic stimulus program. The House voted 246-183, with 7 Democrats and all 176 Republicans in opposition. Senators voted 60-38 to support the bill, with all Democrats voting for it, but only 3 Republicans.

For discussion

1. What questions do students have about the reading? How might they be answered?

2. What are President Obama's three priorities for stimulating the economy? Why?

3. What cautions about success did he include in his press conference?

4. What criticisms have been made of the president's economic stimulus program?

5. Why has he tried to get bipartisan support? Why has he not received it?

For inquiry

The economic stimulus plan includes many programs, only a portion of which are described in the reading. A complete list is easily available online (including on the Obama administration's new website on the economic stimulus, www.recovery.gov). Individual students and/or small groups might investigate what happens with any of these particular programs during the remainder of the school year. For example, students might consider:

• What does X part of the stimulus package aim to accomplish?
  
• Why?
  
• How much will it cost?
  
• How effective is it in saving and creating jobs?
  
• What obstacles are there to its success?
  
• What is being done to overcome these obstacles?

For citizenship

See in the high school section of www.teachablemoment.org "Student Action on the Economic Crisis."

This lesson was written for TeachableMoment.Org, a project of Morningside Center for Teaching Social Responsibility. We welcome your comments. Please email them to: lmcclure@morningsidecenter.org.

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