A few weeks before Christmas 2016, the Federal Reserve Board (Fed for short) decided to raise the Fed funds rate—the lending rate on which all US interest rates are based—signaling to the world that economic activity in the world’s largest economy had become sufficiently strong to withstand an upward movement in interest rates on loans to producers and consumers. That action by the Fed was the definitive indication that Great Depression II–the worst world economic downturn since the Great Depression of the 1930s–had come to an end. It had begun eight years earlier.
As it made its way across the US, the financial storm of 2008 took an increasingly heavy toll on the American economy. Millions of Americans—particularly homeowners—became casualties, and institutions that had played a role in what had started out as a mortgage-backed securities scandal sustained severe damage or were forced out of existence. While millions of homeowners were thrown into bankruptcy, hitherto-revered institutions in Wall Street and elsewhere either closed shop or were forced into mergers. Undoubtedly the best-known among the top-level casualties was Lehman Brothers, which ceased to operate after a century of presence in Wall Street.
Realizing that the developing storm posed a very serious threat to the stability not just of the US financial sector but also of the entire US economy, the Fed took out its box of stabilization tools and swung into action. Working alongside was the Office of the Comptroller of the Currency, whose mandate is to regulate the operations of the banks and the quasi-banking institutions. Key to putting an end to the raging financial storm was the speedy restoration of the American people—producers and consumers alike—in their nation’s economy. Americans had to be encouraged to borrow and lend again.
Toward this end, the Fed, led by chairman Ben Bernanke, brought the Fed funds rate down to an unprecedented zero percent, which meant that American banks could now borrow from the Fed on an interest-free basis. Considering the state of the balance sheets of many US banks and the drift toward bankruptcy of numerous American manufacturing grants—including the world’s largest car producer, General Motors—drastic monetary action had to be taken. The Fed took it.
Being the central bank of the world’s largest economy, any interest-rate action produces an impact on financial centers around the globe. The Fed’s zero-rate action was no exception. With yields on debt instruments issued by US borrowers—especially by the world’s No. 1 borrower, the US Department of the Treasury—now at historically low levels, American and foreign fund managers pulled their clients’ funds out of the US and placed them abroad, especially the emerging countries, where yields were considerably higher.
This interest rate disparity and corresponding investment yield variance—low in the US, high in other countries—was bound to persist for as long as the Fed maintained its zero-rate policy in support of a belief that the US economy was not yet efficiently strong for a higher Fed funds rate. Termination of the zero-rate regime, and a return to normal interest-rate policy, would be a good signal to the world that in the Fed’s estimation the US economy had achieved full recovery.
That signal came towards end of 2016, eight years after the onset of the crisis spawned by the subprime-mortgages-backed securities scandal. It came in the form of the announcement of a 0.25 basis point rise in the Fed funds rate.
The world—particularly the emerging countries—had long dreaded the Fed’s announcement of the termination of the zero-rate policy because that would mean a flow of investment funds back to now-higher-yielding US debt instruments. It had been bracing for that event. As the probable day neared, securities markets around the world exhibited nervousness, but they were prepared. Now that the dreaded day had come, the nervousness was at an end.
Fed chairman Bernanke performed a heroic role in the entire Great Depression II episode. His stoic attitude, his steady-as-you-go handling of the monetary situation and his we-will-get-over-this confidence saw the US through a crisis whose true dimensions are only now being recognized. But Bernanke was not the only hero in that critical juncture of American history. There was another.
That other hero was Barack Obama, who assumed the US Presidency almost simultaneously with the onset of Great Depression II. Having been briefed by his economic advisers on the scope and depth of the situation, the new Chief Executive –the former Junior Senator from Illinois—lost no time (1) directing the Secretary of the Treasury and other concerned Executive Department officials to undertake investigation and rescue operations and (2) convincing his Democratic party mates in Congress to craft legislation designed to prevent a recurrence of the investment banking activities that had precipitated the financial crisis.
The outcome of the Executive Department efforts was, as already stated, the melting out of sanctions—closure, forced merger and huge fines—to the errant institutions. The outcome on the Congressional side was the passage of the law called the Dodd-Frank Act after Senator Dodd of Connecticut and Representative Barney Frank of Massachusetts. The new law further sharpened the distinction between banking and quasi-banking operations and tightened the regulations governing the quasi-banking operations of the banks.
So, Great Depression II has come to an end. It lasted eight years. At its most serious juncture Great Depression II threatened to plunge the world economy into a long period of decline and instability. That threat has been removed.
Is a recurrence of Great Depression II likely? I would have said No until Donald Trump came along. President Trump has set as one of his priorities the repeal of the Dodd-Frank Act. If that happens, Great Depression II can recur.
E-mail: rudyromero777@yahoo.com