What Caused the Fiscal Crisis?

Macro economist, professor emeritus, and Helen Sheridan Memorial Scholar James Crotty shares insights from his current research and upcoming lecture: “The Battle Over Austerity: What Caused the Fiscal Crisis and Who Should Pay” in Boston on April 15.

Professor Emeritus James Crotty

What is the focus of your research?

I wrote a paper in 2006 that argued that very high risk was developing in important segments of financial markets, but it was hidden by the ideal conditions of the financial bubble—low interest rates and low default rates on home mortgages and corporate loans, for example. The immense complexity of important new financial products also made it difficult to detect the high risk that had developed in key markets.

With the Sheridan appointment, I was able to build on this work and write several papers explaining the underlying causes of the financial crisis that emerged when economic and financial conditions deteriorated. Along with my colleague, Jerry Epstein, I offered ideas on how to re-regulate financial markets to avoid future disaster and showed that bonus-based compensation systems, that induce reckless risk-taking on Wall Street, were a major cause of the financial crisis. 

What is the difference between the country’s financial and fiscal crisis? How did the two contribute to the recent economic collapse?

The term financial crisis refers to the collapse of much of our financial system in 2008 and early 2009, which caused a huge loss in financial wealth and dried up credit to most areas of business. Since the weakening economic expansion depended on home construction and massive household borrowing, the financial collapse triggered what has become the worst economic disaster since the 1930s.

Our fiscal health had already been severely impaired by large tax cuts in 2001 and 2003 that were targeted toward the very rich. We ran modest surpluses in the late 1990s. Prior to the tax cuts, The Congressional Budget Office forecasted a cumulative $5 trillion surplus for the decade ending in 2011. But the tax cuts lost $5 trillion in tax revenue by 2010, thereby eliminating the expected surpluses. If we add the costs of the wars in Iraq and Afghanistan, we can understand why we began to run deficits after 2002. 

The economic collapse after mid-2008 drastically cut tax revenues and led the government to launch a stimulus program to prevent the economic downturn from becoming a full-fledged depression. Add these developments together and you can see why we ran deficits of $1.4 and $1.3 trillion in 2009 and 2010.

The U.S. financial crisis has led to the worst recession since the Great Depression. In your opinion, what were the main causes?

From the election of President Reagan in 1980 through today, the country has been operating under an economic model based on deregulation of business and finance, global integration of all markets, hostility to unions, tax cuts primarily directed to the very rich and large corporations and the increasing influence of money on government policy. This has led to a substantial decline in the rate of growth in the economy, and a spectacular rise in inequality.

Even with the stimulus provided by a major boom in housing and household debt, the expansion from 2002 to 2007 was the weakest in modern history. Add the financial and economic collapse in 2008 and you can see why millions have lost their homes and 14 million are still unemployed.

How does government spending affect the economy, especially in a time of recession?

We get a recession when the money spent on goods and services is not enough to buy the amount of goods and services the economy can produce at full employment. This causes high unemployment and low profits.

In a recession, neither businesses nor households have the income or incentive to increase spending. The government can help by increasing its own spending and by cutting taxes on households or business so they might spend more. Dollar for dollar, government spending has a bigger impact on production and employment.

What is the state of the economy today and how is the recovery progressing?

The good news is that we avoided a depression. The bad news is that the job situation is disastrous and will remain so in the foreseeable future. Families continue to lose their homes, and poverty and hunger continue to increase. Moreover, the victims of the crisis, not those who caused it, are being asked to pay for deficit reduction through “austerity” budget cutting.

Though our deficits were caused by excessive tax cuts, unnecessary wars, and out-of control financial markets, politicians of both parties want to solve our fiscal problems through deep cuts in programs that alleviate the suffering of the victims of the economic crisis and help provide decent health care and economic old-age security for most Americans. This is not only bad economic policy for most Americans; it is in my opinion, immoral.

Join Professor Crotty for the first Helen Sheridan Memorial Lecture:
The Battle Over Austerity: What Caused the Fiscal Crisis and Who Should Pay?

Friday, April 15
University of Massachusetts Club
225 Franklin Street, Boston, MA
5:00 p.m. Social hour
6:00 p.m. Lecture

Register today!

The Helen Sheridan Memorial Scholar position was created with a generous bequest to the Economics Department from Mildred S. Barber ‘43 to honor her aunt, Helen Sheridan. The Sheridan Scholar is normally appointed for three years and engages in a combination of teaching and research connected to his/her area of specialty. James Crotty, UMass Amherst economics professor emeritus, is the first Helen Sheridan Memorial Scholar.