The Roots of the 2008 Financial Crisis

It is easy and natural for conservatives to blame the 2008 financial crisis, the great recession and the governments flawed response to it of using massive bailouts on political liberals, or on the Bush administration that was not willing to stick to conservative principles. In reality, though, the roots of the crisis go back to economic policy during the Reagan years and before. Yes, Reagan, the icon of many conservatives, pursued policy that contributed to the economic crisis. So says David Stockman in his book, The Great Deformation, and his critique reflects sound economic analysis, not bad feelings directed towards his former boss.

Defenders of Reagan could argue that he wanted to cut government spending more than Congress would let him, and so the high and persistent deficits during his administration were not his fault. That may be the case, but if he was serious about cutting the deficit, he could have done much more than he did both to limit military spending and to seek cuts in the welfare state. The large Reagan-era deficits were part of the process of abandoning old habits of fiscal responsibility that opened the door for reckless policy that brought about the 2008 crisis and the explosive growth of the monetary base and government debt that followed.

Both conservatives and liberals came to believe based on the short run consequences of policy during Reagan’s presidency that deficits don’t matter. In spite of early promises to cut spending along with taxes, federal outlays during Reagan’s second term averaged 21.7 percent of GDP. This level of government spending as a share of GDP was the highest level of peacetime spending in US history up to that time.

Although the Reagan supply-side tax cuts did have a positive effect on the economy, the Reagan deficits did as much or more to the demand side of the economy. Those deficits, which were consistent with Keynesian dogma, contributed to prosperity which lasted for more than twenty years. Supply side growth is reflected in expansion of private investment, but private investment expanded by only 2.5 percent during the Reagan years, while the demand side of the economy grew by 3 percent per year.

The demand side of the economy continued to grow rapidly during the 1990s, while savings rates fell and investment remained low. Thanks to falling import prices due to the growth of low-cost manufacturing in East Asia made possible by cheap labor, American standards of living rose rapidly in spite of low rates of investment. This prosperity, however, was not sustainable. Growing public and private debt ultimately brought about the day of reckoning with the 2008 financial crisis.

Erroneous ideas learned during the Reagan years continue to guide attitudes toward taxes of government spending of many conservatives and liberals, few of whom care any longer about deficits and the explosive growth of government debt. Unfortunately the future obligations of the federal government are now so large that becoming fiscally responsible again could not prevent the government from defaulting. Nevertheless, reducing spending could delay the day of reckoning and would reduce the political pressure for raising taxes that is sure to come when the government can no longer afford to keep its promises to retirees.