The Crash of 1929 and the ensuing Great Depression have always been a subject of interest and fascination for many of us. Most of us grew up understanding that such a financial calamity could never happen again. The history books tell us rules and regulations were created to prevent this type thing from happening again. These regulations were contained in the Glass-Steagall Act of 1933 and the Banking Act of 1933.
Some of the new conditions created in the 1930s included the creation of the FDIC to give bank customers confidence that their deposits in banks would be safe. Also included were rules to prevent banks from owning other financial institutions such as insurance companies, and vice versa, in order to prevent financial institutions from becoming so big and intertwined, that the failure of one huge company could bring down the entire financial system. By the way, this particular provision of Glass-Steagall was repealed with the passage of the Gramm-Leach-Bliley Act of 1999. Another aspect of Glass-Steagall sought to control speculation. There was more too.
In the post-Depression and post-World War II era, the economy and the markets performed well. There were periods of normal business cycle recessions and expansions and there were bull and bear markets with an occasional crash mixed in, like in 1987, but nothing that threatened the entire financial system. As scary of the crash of 1987 was, it had more to do with specifics to computerized program trading than anything that was happening in the economy as a whole. The financial system was not in jeopardy in 1987.
So how did we go from fairly normal, cyclical ups and downs to the disaster that culminated in the collapse or near collapse of the entire financial system of the whole western world in 2008?
Here is one of the biggest culprits: in addition to stripping away the Glass-Steagall protections throughout the 1980s and 1990s, the biggest factor laying the foundation for our recent financial meltdown was the ridiculously low level of interest rates from 2000 to 2008.
After the crash of 1987, the Federal Reserve, under the then new Fed chairman, Alan Greenspan, lowered interest rates, not to pump up the economy, but to help Wall Street pump up stock prices. This was not a traditional role for the Fed. The Fed took on a new role with this move and, more and more, become a protector of asset prices. They would step in time and again whenever there would be a big sell-off on Wall Street.
In January 2001, the Fed under Greenspan started cutting rates at an unprecedented pace. By the summer of 2001, the Fed lowered the Fed Funds Rate from 6% to 3.5%. After September 11th 2001, the interest rate cuts began in earnest. By December of 2001, they moved the Fed Funds rate down to 1.75%. By 2003, they brought it down to 1%. This was the lowest Fed Funds rate since 1962.
From December of 2001 to September of 2004 Greenspan kept the Fed Funds rate at no higher than 1.75% for a total of 33 months. In November of 2002, this key rate was moved to 1.25% and it was kept it there for 21 months. In June 2003, the rate was moved to 1.00% kept there for over 12 months.
So in 2000, the Fed Funds Rate was 6.5% but it was ultimately moved down to 1.75% where it stayed for 33 months. It was then moved lower still to 1.25% where it stayed for 21 months. It went all the way to 1.00% where it stayed for 12 months. Anyone who had money in a money market fund during this period remembers it well.
The bottom line is that never before in our history had the fed funds rate been this low for this long. There were significant ramifications resulting from these extremely low interest rates. One ramification was that ultra low interest rates caused speculation, including speculation in housing prices, mortgage backed securities, derivatives and more.
If Greenspan hadn't keep interest rates so low for so long there would not have been a housing bubble. Without a housing bubble, there would have been fewer mortgage-backed securities, fewer derivatives and no sub-prime crisis. You get the idea. The collapse was caused by mistakes that were made by so-called experts who should have known better.
The interest rate history contained in this article and the overall theme is from an excellent new book on the financial crisis called Bailout Nation by Barry Ritholtz.Powered by Sidelines