Is Obama's New Deal Better Than the Old One?

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June-July 2011

The New Deal failed to reduce unemployment, and the policies of the Obama administration and the Democratic Congress since the financial crisis look to be a repeat performance. These similar outcomes seem to rest on a similarity in policies. In both cases, the administration and Congress blamed the private market for the state of the economy when they assumed power, and in both cases they sought to impose needless and badly thought out regulations on private business activity. The result was to raise the private sector's perception of future risk and suppress the employment gains that come in a normal recovery.

Key points in this Outlook:

  • The Obama administration and FDR's New Deal approached serious economic downturns in the same way--as the result of misconduct and greed inherent in a competitive capitalist system.
  • Their similar remedies--large increases in government spending together with increased control over the economy--produced similar outcomes: an unstable recovery and a failure to reduce unemployment to precrisis levels.
  • Since neither spending nor monetary policy has worked, recent government programs, particularly the Patient Protection and Affordable Care Act and the Dodd-Frank Act, deserve attention. The uncertainties caused by government programs get relatively little coverage because they cannot be quantified, yet they appear to be common factors in the failure of both the Obama and New Deal policies substantially to reduce unemployment.

When the new Democratic Congress convened in 2008, Representative Barney Frank (D-MA)--then the powerful chair of the House Financial Services Committee--exuberantly declared that what the public would see in ensuing months was a "New New Deal." For once, he was right. The policies of the Obama administration and the Democratic Congress bear an uncanny resemblance to the policies of Franklin D. Roosevelt (FDR) and the Democrats after the Democratic sweep of 1933, and the results for the US economy have been much the same.

Yet the Democratic Party's left wing has unshakeable faith in the myth of the New Deal. To that group, it was a kind of golden age, a time when government showed its ability to improve the lives of the American people. The staying power of that myth--plus the realignment of the parties along conservative and liberal lines--has made the Democratic Party the party of government in the United States. Thus, when the Democrats took power after the 2008 financial crisis, their reflexive action was to use the opportunity ("Never let a good crisis go to waste," said the president's chief of staff) to increase the authority of government over the economy and the financial system. To make this work, it was necessary to argue that the crisis--like the Depression itself--was the result of faults in the private sector.

Despite the myth, and measured against its effectiveness in restoring jobs and a functioning economy, the New Deal was a failure. When FDR took the oath of office in March 1933, the unemployment rate in the United States was over 24 percent. It fell to 21.6 percent in 1934 and 19.97 percent by the end of 1935. Two years later, having hit 14.18 percent in 1937 after five years of New Deal policies, it rose again in 1938 to 18.9 percent before declining to 14.45 percent in 1940. Only in 1941, as the United States prepared for war, did the rate fall below double digits.[1] Yet before the New Deal, during the 1920s, the average unemployment rate in the United States was about 6 percent.[2]

There appear to be things going on in the economy—unmeasurable things, beyond the economists' models—that are at
least as influential as fiscal and monetary policy.

The New Deal's eight-year failure to return unemployment numbers to the pre-New Deal rate is often ignored by the Left. Instead, FDR's policies are justified by the counterfactual and untestable claim that they "saved capitalism"--that conditions were so bad in the United States when FDR took office that, at the very least, his policies warded off a US turn toward socialism, or worse. An echo of this claim is heard today, when the failure of Obama's economic stimulus policies of 2009 are challenged. In that case, it is argued that if the government had not intervened, unemployment would now be much worse. These issues can never be settled, but the question this Outlook will address is whether the similarities between the policies followed in the New Deal, and those followed by the Obama administration and the Democratic Congress elected in 2008, are responsible for the similar employment outcomes observed thus far.

Policies of FDR and the New Deal Congress

The New Deal was characterized by two key elements: substantial growth in government spending on public works and government job creation, and widespread intervention in the economy to keep wages and prices high and eliminate "cutthroat competition." From today's perspective, this prescription seems internally inconsistent--keeping wages and prices high would work against additional private-sector jobs--but it was based on a fundamental misreading of the causes of the downturn that began in 1929. FDR and his advisers apparently believed that the inherently competitive nature of a capitalist or free-market economy would eventually bring about financial collapse, manifested in falling prices. Accordingly, before there could be a recovery, the private sector's competitiveness had to be controlled.

In 1932, the last year of the Hoover administration, federal government spending was considerably higher than in 1931--6.9 percent as opposed to 4.8 percent of gross domestic product (GDP). But after the Roosevelt administration took over, spending moved to 8 percent of GDP in 1933, 10.7 percent in 1934, and over 9 percent on average through 1940.[3] The most significant and emblematic piece of New Deal legislation was the National Industrial Recovery Act of 1933 (NRA), which authorized industries to establish codes for managed or "fair" competition, including standards for preventing price and wage declines. The president was given authority to forbid specific companies from reducing prices and wages, and to require any company to apply for and receive a license to participate in any business.

This astonishing law, which the Supreme Court even-tually struck down in 1935, was based on the notion that excessive or cutthroat competition had caused the financial collapse. A statement by the head of the National Recovery Administration at the time gives a sense of the thinking behind the legislation: "There is no choice presented to American business between intelligently planned and uncontrolled industrial operations and a return to the gold-plated anarchy that masqueraded as 'rugged individualism.' . . . Unless industry is sufficiently socialized by its private owners and managers so that great essential industries are operated under public operation appropriate to the public interest in them, the advance of political control over private industry is inevitable."[4] In other words, the competitive nature of private industry is not sufficiently devoted to public purposes; the invisible hand does not produce the public good. As might be expected, the NRA stimulated some economic growth, coming off the floor of the Depression, but efficient companies could not cut prices to gain market share and lacked incentives to expand and hire new employees. As an ironic remark went at the time, "The Depression wasn't so bad if you had a job."

A similar motive lay behind the Agricultural Adjustment Act (AAA), which attempted to keep farm prices high by creating artificial shortages. Again, the idea was to curb overproduction and return farmers' incomes to "parity"--their revenue in relation to their purchases of goods and equipment--which they had earned in the years before and during World War I. There seemed to be no recognition among New Deal policymakers that mechanization, global competition, and increasing agricultural productivity had been stimulating a decline in farm products and a steady move to the cities and industry well before the onset of the Depression--that the face of America was changing. The AAA was intended to improve the national economy by increasing the purchasing power of the 30 percent of the country that then lived on farms. It was a peculiar policy when so much of the country was ill fed and ill clothed, and like so many New Deal policies--and the echo these policies had eighty years later--it was based on unsound economic theories and assessments.[5] "At its core," said a monumental history of the time, "the thinking that underlay AAA derived from the same conviction about the salutary effects of scarcity that had produced the NRA industrial codes." The AAA was also declared unconstitutional in 1936.[6]

With unemployment rising again after a period of improvement, the New Deal recovery pattern seems to be setting in.

By 1939, so little improvement had occurred in the country's economic conditions that Treasury Secretary Henry Morgenthau noted in his diary: "We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and now if I am wrong . . . somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises. . . . I say after eight years of this Administration, we have just as much unemployment as when we started. . . . And an enormous debt to boot."[7] This was not the lesson the Democratic Left took from the New Deal experience.

Policies of the Obama Administration and the Democratic Congress

When President Barack Obama took office in January 2009, the unemployment rate in the United States was 7.8 percent. It rose to 10.1 percent in October 2009, before declining to 9.9 percent at the end of that year and 9.4 percent at the end of 2010. In March 2011, twenty-seven months after Obama's inauguration, it stood at 8.8 percent. For a time, because of tax incentives and government spending, the economy seemed to recover, if slowly. For the three months ending in May 2011, net new jobs increased by more than two hundred thousand each month. But then the economy slowed and unemployment began to rise again, reaching 9.1 percent in May.[8] In June, only 18,000 net new jobs were created, and unemployment rose again to 9.2 percent. To be sure, the Obama administration has only had two and a half years to deal with the unemployment that developed in the recession following the financial crisis. Still, with unemployment rising again after a period of improvement, the New Deal recovery pattern seems to be setting in.

The Obama administration and the Democratic Congress elected in 2008 have pursued three major initiatives, which largely parallel the initial measures in the New Deal. The first was a package of substantial spending and tax cuts totaling over $780 billion, eventually enacted by Congress in February 2009 as the American Recovery and Reinvestment Act of 2009. This measure, together with the funds voted in 2008 for the Troubled Asset Relief Program (TARP), increased the percentage of GDP represented by government spending. This went from 19.6 percent in 2007 and 20.7 percent in the last two years of the Bush administration to 24.7 percent in 2009, 25.4 percent in 2010, and an estimated 25.1 percent in 2011.[9]

The other principal legislative initiatives were an expansion of federal health care coverage requirements through the Patient Protection and Affordable Care Act (PPACA), enacted in March 2010, and a sweeping regulatory measure for the financial system known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA), enacted in July 2010. Both acts are complex pieces of legislation that require substantial regulatory action before they can be fully implemented.

In addition to these major initiatives, the Obama administration has intervened in the housing market to slow the decline in housing prices by providing tax credits for home purchases and keeping defaulting or delinquent homeowners in their homes. In February 2009, shortly after taking office, Obama announced a $75 billion plan to help as many as 9 million Americans avoid foreclosure.[10] The Department of the Treasury initially predicted that the Home Affordable Modification Program (HAMP) would help 3-4 million homeowners by modifying their mortgages so they could more easily meet their obligations. The funds for this program came from TARP and thus the program was overseen by the special inspector general for TARP, Neil Barofsky, who reported to Congress in March 2011 that in two years of operation HAMP had resulted in permanent mortgage modifications for only 238,000 home-owners. According to Barofsky, a similar program operated by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac modified about an equal number of mortgages.[11]

Possible Causes of the Slow Recovery

Attempting to assess the effect of similar policies in two different eras is potentially instructive in part because many scholars believe that the Fed followed overly restrictive monetary policies after the Depression began, tightening credit when it should have been easing. Thus, they argue, the Depression and its signal unemployment persisted despite substantially increased government spending. Federal Reserve chairman Ben Bernanke, as a scholar, was a student of the Depression and wrote about the errors of the Fed's monetary policy during that period. In a frequently cited speech in 2002, Bernanke expressed confidence that a combination of monetary and fiscal policy could revive the economy:

In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.[12]

In the last two and a half years, this has been the Fed's policy. Indeed, as suggested in this speech, the Fed has brought short-term interest rates down nearly to zero and has been purchasing Treasury and agency securities to bring down long-term rates. None of this activity, however, has stimulated significant GDP growth or had a significant effect on unemployment. So it can at least be observed that loose fiscal policy--in the form of substantial government deficit spending--accompanied by a stimulative monetary policy does not necessarily guarantee a return to economic growth. Something--perhaps many things--are still missing. What are they?

In terms of their propensity to cause uncertainty, there could hardly be two more troubling laws for business than the
PPACA and the DFA.

First, there is the possibility that increased government spending itself has a negative effect on employment. In an article published in early June in the Washington Times, Richard Rahn, a noted free-market economist, argues that, if anything, the data show an inverse relationship between government spending and employment.[13] Citing recent scholarship, Rahn posits that government spending, by taking resources from the private sector, reduces the propensity of the private sector to hire additional workers.

In addition, there are numerous possible causes of the slow recovery that have not been adequately considered in the media, which have generally focused on the debate about whether the stimulus was large enough. Despite evidence that deficit spending per se, and now deficit spending plus significant monetary loosening, does not produce substantial economic growth, there has been little attention to less tangible causes of the extremely slow recovery. These possible causes include:

  • Uncertainty in the business community about the costs of new Obama administration policies, particularly the PPACA and the DFA;
  • A failure on the part of the administration and Congress to understand the causes of the financial crisis; and
  • Administration intervention in the housing market to prevent foreclosures and declines in home prices.

These explanations for the slow recovery have gotten relatively little attention in the media or among scholars, principally because by their nature they are anecdotal and not susceptible to measurement or validation with numbers, tables, or charts. Like the "animal spirits" described by John Maynard Keynes as a way of explaining business activity that does not follow from any obvious stimulus, they are intangible but powerful features of human nature that can influence economic conditions. Like the drunk who searches for his keys not where he dropped them, but where the light is, it may well be that economists and other commentators, by focusing attention only on things that can be measured, are ignoring some important explanations for the slow recovery.

Business Uncertainty

"In terms of US output contractions," wrote economists Gary Becker, Steven Davis, and Kevin Murphy eighteen months ago, "the so-called Great Recession was not much more severe than the recessions in 1973-75 and 1981-82. Yet recovery from the latest recession has started out much more slowly. For example, real GDP expanded by 7.7% in 1983 after unemployment peaked at 10.8% in December 1982, whereas GDP grew at an unimpressive annual rate of 2.2% in the third quarter of 2009. Although the fourth quarter is likely to show better numbers--probably much better--there are no signs of an explosive takeoff from the recession."[14] Becker et al. were correct about the fourth quarter of 2009, and their comment that there was still no sign of an explosive takeoff was an understatement. Figure 1 shows the record, thus far, of the recovery from the Great Recession of 2008.

FSO 2011-07 Figure 1 FSO 2011-07 Figure 1

Writing in 2007, before the financial crisis, Amity Shlaes, author of The Forgotten Man, explained the slow recovery from the Depression as the product of FDR's constant economic experimentation and changes in policy:

NRA rules were so stringent they perversely hurt businesses. They frightened away capital, and they discouraged employers from hiring workers. Another problem was that laws like that which created the NRA--and Roosevelt signed a number of them--were so broad that no one knew how they would be interpreted. The resulting hesitation itself arrested growth. . . .

The trouble, however, was not merely new policies that were implemented but also the threat of additional, unknown, policies. Fear froze the economy, but that uncertainty itself might have a cost was something the young experimenters simply did not consider.[15]

Again, it is hard to escape the similarities between the current slow recovery and the seven years from 1933 to 1940 during which the US economy failed to reduce unemployment below 14 percent. If uncertainty about policies and costs was a cause of business reluctance to hire in the Depression, the Obama administration's policies are subject to the same indictment. In terms of their propensity to cause uncertainty, there could hardly be two more troubling laws for business than the PPACA and the DFA. In a real sense, they are successors to the NRA and the AAA of the New Deal. Both embody enormously complex and costly requirements and have to be implemented by a vast number of regulations, most of which have not yet been drafted or proposed. Moreover, the DFA, like the AAA before it, tries to impose a US-based straitjacket of regulation on a global industry that is changing rapidly under the influence of new communications technology.

The effect of all this on business is well illustrated in a May 2011 article in Bloomberg by Stephen L. Carter, in which the Yale law professor describes a conversation with a businessman who sat next to him on a recent airplane flight:

The man in the aisle seat is trying to tell me why he refuses to hire anybody. His business is successful, he says, as the 737 cruises smoothly eastward. Demand for his product is up. But he still won't hire.

"Why not?"

"Because I don't know how much it will cost," he explains. "How can I hire new workers today, when I don't know how much they will cost me tomorrow?"

He's referring not to wages, but to regulation: He has no way of telling what new rules will go into effect when. His business, although it covers several states, operates on low margins. He can't afford to take the chance of losing what little profit there is to the next round of regulatory changes. And so he's hiring nobody until he has some certainty about cost.

It's a little odd to be having this conversation as the news media keep insisting that private employment is picking up. But as economists have pointed out to all who will listen, the only real change is that the rate of layoffs has slowed. Fewer than one of six small businesses added jobs last year, and not many more expect to do so this year. The private sector is creating no more new jobs than it was a year ago; the man in the aisle seat is trying to tell me why.[16]

The sense that this conversation reflected more than one businessman's opinion was reinforced by the news in early June and again in July that--after three months of employment growth--the economy stalled in May, with an increase of only 25,000 jobs and 18,000 in June, causing unemployment to tick up to 9.1 percent in May and 9.2 percent in June. The decline in new job growth has been a shock to forecasters, who had expected a confirmation of the jobs recovery that had seemed to be underway earlier in the year. There appear to be things going on in the economy--unmeasurable things, beyond the economists' models--that are at least as influential as fiscal and monetary policy.

As one example, by modifying the incentives for employers--perhaps unintentionally--the PPACA completely changed the traditional role of employer-paid health coverage in employee compensation. A survey by McKinsey & Co. published in June 2011 indicated that as many as 30 percent of employers were planning to terminate their health care coverage and allow their employees to buy their own health insurance after the new system becomes mandatory in 2014.[17] This contrasts with an initial estimate by the Congressional Budget Office that only 4 percent of employees would lose coverage when the new system goes into effect. According to McKinsey, the 30 percent figure increases to more than 50 percent among employers who have a thorough understanding of the new law. If the McKinsey study is correct, it could partly explain the reluctance of employers to hire new workers. Employers do not know whether they will be able to retain the employees they hire now if they are compelled to terminate health coverage after 2014, nor do they know how much it will cost to continue to include health insurance in their employees' compensation packages.

The Democratic Party’s left wing has unshakeable faith in the myth of the New Deal. To that group, it was a kind of golden age, a time when government showed its ability to improve the lives of the American people.

In addition, the PPACA imposes numerous taxes and fees that are bound to increase the cost of coverage for employers who choose to retain it. Apart from the rising cost of medical care itself and excluding the new Medicare taxes on individuals with incomes over $200,000, the PPACA imposes new taxes on health insurance providers, fees on manufacturers and importers of branded drugs and medical devices, reduced health insurance tax deductions for certain employers, and other revenue raisers that will amount to approximately $400 billion over the next ten years.[18] Undoubtedly, the cost of employee coverage will increase, but by what amount is unknown and unknowable.

The most troubling of the new legislation from the standpoint of economic growth is probably the DFA, which strikes directly at the US credit system and thus affects all businesses. The DFA is over 2,300 pages long and covers banking, securities, commodities, housing finance, rating agencies, derivatives, debit cards, proprietary trading by banks, insurance, investment advisers to hedge funds and mutual funds, resolution of failing financial firms, and all firms (to be named)--of whatever kind--that are considered to pose a threat to the stability of the financial system if they suffer financial distress. It also creates a new consumer protection agency with powers to prevent "abuse"--an undefined term that raises the potential regulatory cost profile for every firm that engages in financial transactions with consumers, from the largest banks to the smallest check-cashing stores. In a count by the New York law firm Davis Polk, there are 243 regulations required by the DFA, of which only twenty-four have been completed in the year since the law passed. Extensions of time to comment on major proposals have now been granted to affected industries and, according to the New York Times, twenty-eight statutory deadlines have already been missed.[19]

Even if a business is not in the financial industry, it must rely on credit. The costs of bank credit, derivatives, securities issuance and reporting, accounting, consulting and legal services, financial advice, commodity futures, insurance, pension fund management, or providing credit to customers cannot be known until these regulations are proposed, debated, and finalized. That could easily take five years at the pace it is going today. Again, here is Carter's seatmate, who has a business "somewhere in the Dakotas":

My seat-mate seems to think that I'm missing the point. He's not anti-government. He's not anti-regulation. He just needs to know as he makes his plans that the rules aren't going to change radically. Big businesses don't face the same problem, he says. They have lots of customers to spread costs over. They have "installed base."

For medium-sized firms like his, however, there is little wiggle room to absorb the costs of regulatory change. Because he possesses neither lobbyists nor clout, he says, Washington doesn't care whether he hires more workers or closes up shop.

Former Fed chairman Alan Greenspan has done some groundbreaking work in trying to find evidence that these increased risks are affecting the real (nonfinancial) economy. In a 2011 paper, Greenspan pointed to the unusually low level of corporate illiquid investment--for example, investment in plants or equipment with long useful lives. This kind of investment would be most susceptible to devaluation as a result of future events, and the allocation of liquid funds to an illiquid investment represents a risk in itself if liquidity is not readily available to the company in the future. He notes, "For nonfinancial corporate businesses (half of gross domestic product) the disengagement from illiquid risk is directly measured as a share of liquid cash flow they choose to allocate to long-term fixed asset investment. . . . In the first half of 2010, this share fell to 79%, its lowest peacetime percentage since 1940."[20] The only time it has been lower--perhaps not coincidentally--is during the period from 1932 to 1940. Greenspan attributes this decline to enhanced risk associated with "government activism." One element of that would be the DFA, which through new and far-reaching regulation of the entire financial market in the United States raises serious questions about the availability of financing for the nonfinancial sector in the future. Given these facts, it is little wonder that legislation has been introduced in the Senate to repeal the DFA. The wonder is that anyone who worries about unemployment and a sluggish recovery continues to support the act.

Failure to Understand the Causes of the Financial Crisis

The precipitating cause of the financial crisis was, by common agreement, a mortgage meltdown that began in 2007. Congress never bothered to find out, before legislating on the subject, why this collapse in the housing finance system was so destructive. If it had done so, it would have realized that the financial crisis was not the result of deregulation or regulatory laxity but of government housing policies that fostered the creation of 27 million subprime and nonprime mortgages--half of all mortgages in the US financial system--in an effort over two administrations to increase homeownership by reducing mortgage underwriting standards.[21] The desire to protect the government against challenge was so strong among Democrats (and, of course, in the government itself) that the Financial Crisis Inquiry Commission--set up by the Democratic Congress to find the causes of the financial crisis--refused even to acknowledge that this number of weak and risky mortgages existed in the financial system before the 2008 crisis. Instead, the commission sought to lay the blame for the financial crisis on private-sector risk taking, greed, and regulatory laxity.[22]

The failure to acknowledge the number of low-quality mortgages in the financial system, and the refusal to look into the role of government policies in creating the weak and risky loans, distorted the response to the financial crisis by the administration and the Democratic Congress in two ways. First, it encouraged the view--prevalent on the left--that the financial crisis was the result of the normal operation of the US financial system when it is not effectively regulated. This ignored several facts, among them that this was the first financial crisis of anything like this size in at least eighty years; that while deregulation had taken hold in many parts of the US economy there had been very little deregulation in the financial sector; and that regulation of banks in particular had been tightened substantially in 1991 with the enactment of the Federal Deposit Insurance Corporation Improvement Act. If these points had been seriously considered, by Congress or the Financial Crisis Inquiry Commission, the solution chosen--far tighter regulation of the financial system--would have looked a lot less attractive.

Second, the sheer size of the low-quality mortgage problem--the fact that so many homeowners were likely to default on their mortgages--might have produced a legislative response that focused on the weakness in the mortgage market rather than a lack of sufficient regulation in the financial system as a whole. As it was, Congress spent eighteen months trying to adopt the DFA rather than considering how to deal with the avalanche of mortgage defaults that would inevitably come from the collapse of the 1997-2007 housing bubble. If Congress had attempted to understand the size of the subprime mortgage problem, it might have been able to predict and address in advance the 30 to 40 percent decline in housing prices that ultimately occurred. This is not the place to discuss what legislative actions might have been taken, but it is clear that by focusing on strengthening and broadening regulation of the financial system Congress entirely missed the real problem that would bring on and prolong the recession--the unprecedented decline in housing values and the vast number of delinquencies and defaults that ensued.

The results are plain to see in figure 2. After a short but disastrous decline in prices, the market began an apparent recovery, stimulated in part by tax credits for new home purchases, but it was not enough. The market was overwhelmed by the vast number of foreclosures arising principally from the 27 million weak and risky mortgages that had suffused the financial system before the financial crisis, and it has now begun a double dip. If the administration and Congress had paid more attention to the mortgage problem rather than the ideologically driven desire for tighter regulation of the financial system, they might have adopted policies to mitigate the resulting losses.

FSO 2011-07 Figure 2 FSO 2011-07 Figure 2

Tinkering with Housing Prices

The failure of the administration and Congress to recognize the dimensions of the impending housing price collapse and the weakness of almost half of all outstanding mortgages led to the adoption of policies that were doomed to fail. No one seemed to be aware that with a decline in housing prices that far exceeded anything that had happened previously, the usual policies that attempted to put a floor under prices or achieve widespread loan modification through HAMP would not work.

Of the 27 million subprime and other nonprime mortgages that were outstanding before the financial crisis, most were accompanied by little or no equity in the home before the price decline. This was because the Department of Housing and Urban Development (HUD), over the previous fifteen years, had been encouraging a decline in mortgage standards and particularly a reduction in down payments. Although less than one mortgage in two hundred involved a down payment of less than 3 percent in 1990, by 2007 that was true of almost 40 percent (80 in 200) of all mortgages. Because of the affordable-housing requirements imposed on Fannie and Freddie in 1992 and gradually tightened by HUD through 2007, the GSEs were required to buy increasing numbers of subprime and other deficient loans. The Federal Housing Administration, the Community Reinvestment Act, and a HUD program applicable to mortgage bankers such as Countrywide also contributed to a huge increase in the stock of lower-quality mortgages.[23]

Under these circumstances, tax credits and HAMP could never be effective to stanch the bleeding. Too many homes had too little equity to provide homeowners with incentives to hang on. The sheer number of defaults--strategic and otherwise--overwhelmed every government program that was attempted. In fact, these programs made things worse by preventing housing prices from falling to the bottom. If that had happened, buyers would have come in without tax inducements; the gradual recovery of housing prices would have encouraged homeowners who were under water (with homes worth less than their mortgages) to stay with their homes in the hope that values would eventually recover. But the prolonged period of gradual decline has kept potential buyers out of the market until they are sure that prices have hit bottom and encouraged others to walk away from what came to look like unrecoverable losses. It is likely that this process will be strung out until the government stops trying to mitigate the losses.


The New Deal failed because its supporters sought to address the weak economy by substantially increasing government spending and imposing significant new regulations on the private sector. They thought, incorrectly,that the Depression was caused by excessive or "cutthroat competition"--which they saw as driving down prices and causing business failures and unemployment--and that government spending would restart the economy.

The polices of the Obama administration and the Democratic Congress--infatuated with the New Deal myth and following the New Deal pattern--sought to blame the financial crisis on the private sector, and to use it to take control of the financial system the way they have taken control of the health care system. Although the approach succeeded in attaining its ends, the risks and uncertainties these policies created suppressed the usual growth and hiring that pulls the country out of recessions. In addition, the failure to understand the dimensions of the mortgage problem--indeed a seeming intent to ignore it entirely in favor of more regulation--left the country without a policy to combat the effects of the mortgage meltdown that began in 2008 and accelerated in 2009.

Peter J. Wallison ([email protected]) is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.

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1. Data are from US Bureau of the Census, Historical Statistics of the US: Colonial Times to 1957 (Washington, DC, 1960), 70.

2. Infoplease, "United States Unemployment Rate," (accessed July 1, 2011).

3. Office of Management and Budget, Historical Tables: Budget of the US Government Fiscal Year 2011 (Washington, DC, 2010), 24.

4. Arthur Schlesinger Jr., The Coming of the New Deal: 1933-1935 (New York: Houghton Mifflin Books, 2003), 115.

5. David M. Kennedy, Freedom from Fear: The American People in Depression and War, 1929-1945 (New York: Oxford University Press, 1999), 200-203.

6. Ibid., 203.

7. Burton Fulsom Jr., New Deal or Raw Deal? How FDR's Economic Legacy Has Damaged America (New York: Simon & Schuster, 2008), 2.

8. Bureau of Labor Statistics, "Databases, Tables, and Calculators by Subject," (accessed June 28, 2011).

9. Ibid.

10. Declan McCullagh, "FAQ: How Will Obama's Housing Plan Work?" CBS News, February 8, 2009, (accessed June 28, 2011).

11. Home Affordable Modification Program, Before the House Committee on Financial Services, Subcommittee on Insurance, Housing, and Community Opportunity, 112th Cong. (2011) (statement of Neil Barofsky, Special Inspector General of the Troubled Asset Relief Program), 2-3, barofsky.pdf (accessed June 28, 2011).

12. Ben Bernanke, "Deflation: Making Sure 'It' Doesn't Happen Here" (remarks before the National Economists Club, Washington, DC, November 21, 2002), /boardDocs/speeches/2002/20021121/default.htm (accessed June 28, 2011).

13. Richard W. Rahn, "How to Create Jobs," Washington Times, June 7, 2011.

14. Gary Becker, Steven Davis, and Kevin Murphy, "Uncertainty and the Slow Recovery," Wall Street Journal, January 4, 2010.

15. Amity Shlaes, The Forgotten Man (New York: HarperCollins, 2007), 8-9.

16. Stephen L. Carter, "Economic Stagnation Explained, at 30,000 Feet,", May 26, 2011.

17. Janet Adamy, "Study Sees Cuts to Health Plans," Wall Street Journal, June 8, 2008.

18. Joint Committee on Taxation, Estimated Revenue Effects of the Amendment in the Nature of a Substitute to HR 4872, the "Reconciliation Act of 2010," as Amended, in Combination with the Revenue Effects of HR 3590, the "Patient Protection and Affordable Care Act ('PPACA')," as Passed by the Senate, and Scheduled for Consideration by the House Committee on Rules on March 20, 2010, 112th Cong., 1st sess. (March 20, 2010), JCX-17-10, load&id=3672&chk=3672&no_html=1 (accessed June 29, 2011).

19. Louise Story, "Financial Overhaul Is Mired in Detail and Dissent," New York Times, June 8, 2011.

20. Alan Greenspan, "Activism," International Finance 14, no. 1 (Spring 2011): 165-82.

21. The causes of the financial crisis are discussed in Peter J. Wallison, "The Lost Cause: The Failure of the Financial Crisis Inquiry Commission," AEI Financial Services Outlook (January/February 2011),

22. Financial Crisis Inquiry Commission, Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (Washington, DC, January 2011), (accessed June 28, 2011); and Peter J. Wallison, Dissent from the Majority Report of the Financial Crisis Inquiry Commission (Washington, DC: AEI, January 2011),

23. Peter J. Wallison, Dissent from the Majority Report of the Financial Crisis Inquiry Commission, note 20.

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Monday, October 27, 2014 | 10:00 a.m. – 11:30 a.m.
State income taxes and the Supreme Court: Maryland Comptroller v. Wynne

Please join AEI for a panel discussion exploring these and other questions about this crucial case.

Tuesday, October 28, 2014 | 9:30 a.m. – 12:15 p.m.
For richer, for poorer: How family structures economic success in America

Join Lerman, Wilcox, and a group of distinguished scholars and commentators for the release of Lerman and Wilcox’s report, which examines the relationships among and policy implications of marriage, family structure, and economic success in America.

Tuesday, October 28, 2014 | 5:30 p.m. – 7:00 p.m.
The 7 deadly virtues: 18 conservative writers on why the virtuous life is funny as hell

Please join AEI for a book forum moderated by Last and featuring five of these leading conservative voices. By the time the forum is over, attendees may be on their way to discovering an entirely different — and better — moral universe.

Thursday, October 30, 2014 | 2:00 p.m. – 3:00 p.m.
A nuclear deal with Iran? Weighing the possibilities

Join us, as experts discuss their predictions for whether the United States will strike a nuclear deal with Iran ahead of the November 24 deadline, and the repercussions of the possible outcomes.

Thursday, October 30, 2014 | 5:00 p.m. – 6:15 p.m.
The forgotten depression — 1921: The crash that cured itself

Please join Author James Grant and AEI senior economists for a discussion about Grant's book, "The Forgotten Depression: 1921: The Crash That Cured Itself" (Simon & Schuster, 2014).

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