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The origins of the financial crisis

Crash course The effects of the financial crisis are still being felt, five years on. This article, the first of a series of five on the lessons of the upheaval, looks at its causes

Sep 7th 2013 |  From the print edition

THE collapse of Lehman Brothers, a sprawling

global bank, in September 2008 almost brought

down the world’s financial system. It took huge

taxpayer­financed bail­outs to shore up the

industry. Even so, the ensuing credit crunch

turned what was already a nasty downturn into

the worst recession in 80 years. Massive monetary

and fiscal stimulus prevented a buddy­can­you­

spare­a­dime depression, but the recovery remains feeble compared with previous post­war

upturns. GDP is still below its pre­crisis peak in many rich countries, especially in Europe, where

the financial crisis has evolved into the euro crisis. The effects of the crash are still rippling

through the world economy: witness the wobbles in financial markets as America’s Federal

Reserve prepares to scale back its effort to pep up growth by buying bonds.

With half a decade’s hindsight, it is clear the crisis had multiple causes. The most obvious is the

financiers themselves—especially the irrationally exuberant Anglo­Saxon sort, who claimed to

have found a way to banish risk when in fact they had simply lost track of it. Central bankers

and other regulators also bear blame, for it was they who tolerated this folly. The

macroeconomic backdrop was important, too. The “Great Moderation”—years of low inflation

and stable growth—fostered complacency and risk­taking. A “savings glut” in Asia pushed down

global interest rates. Some research also implicates European banks, which borrowed greedily in

American money markets before the crisis and used the funds to buy dodgy securities. All these

factors came together to foster a surge of debt in what seemed to have become a less risky world.

Start with the folly of the financiers. The years before the crisis saw a flood of irresponsible

mortgage lending in America. Loans were doled out to “subprime” borrowers with poor credit

histories who struggled to repay them. These risky mortgages were passed on to financial

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engineers at the big banks, who turned them into supposedly low­risk securities by putting large

numbers of them together in pools. Pooling works when the risks of each loan are uncorrelated.

The big banks argued that the property markets in different American cities would rise and fall

independently of one another. But this proved wrong. Starting in 2006, America suffered a

nationwide house­price slump.

The pooled mortgages were used to back securities known as collateralised debt obligations

(CDOs), which were sliced into tranches by degree of exposure to default. Investors bought the

safer tranches because they trusted the triple­A credit ratings assigned by agencies such as

Moody’s and Standard & Poor’s. This was another mistake. The agencies were paid by, and so

beholden to, the banks that created the CDOs. They were far too generous in their assessments

of them.

Investors sought out these securitised products because they appeared to be relatively safe while

providing higher returns in a world of low interest rates. Economists still disagree over whether

these low rates were the result of central bankers’ mistakes or broader shifts in the world

economy. Some accuse the Fed of keeping short­term rates too low, pulling longer­term

mortgage rates down with them. The Fed’s defenders shift the blame to the savings glut—the

surfeit of saving over investment in emerging economies, especially China. That capital flooded

into safe American­government bonds, driving down interest rates.

Low interest rates created an incentive for banks, hedge funds and other investors to hunt for

riskier assets that offered higher returns. They also made it profitable for such outfits to borrow

and use the extra cash to amplify their investments, on the assumption that the returns would

exceed the cost of borrowing. The low volatility of the Great Moderation increased the

temptation to “leverage” in this way. If short­term interest rates are low but unstable, investors

will hesitate before leveraging their bets. But if rates appear stable, investors will take the risk of

borrowing in the money markets to buy longer­dated, higher­yielding securities. That is indeed

what happened.

From houses to money markets

When America’s housing market turned, a chain reaction exposed fragilities in the financial

system. Pooling and other clever financial engineering did not provide investors with the

promised protection. Mortgage­backed securities slumped in value, if they could be valued at

all. Supposedly safe CDOs turned out to be worthless, despite the ratings agencies’ seal of

approval. It became difficult to sell suspect assets at almost any price, or to use them as

collateral for the short­term funding that so many banks relied on. Fire­sale prices, in turn,

instantly dented banks’ capital thanks to “mark­to­market” accounting rules, which required

them to revalue their assets at current prices and thus acknowledge losses on paper that might

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never actually be incurred.

Trust, the ultimate glue of all financial systems, began to dissolve in 2007—a year before

Lehman’s bankruptcy—as banks started questioning the viability of their counterparties. They

and other sources of wholesale funding began to withhold short­term credit, causing those most

reliant on it to founder. Northern Rock, a British mortgage lender, was an early casualty in the

autumn of 2007.

Complex chains of debt between counterparties

were vulnerable to just one link breaking.

Financial instruments such as credit­default

swaps (in which the seller agrees to compensate

the buyer if a third party defaults on a loan) that

were meant to spread risk turned out to

concentrate it. AIG, an American insurance giant

buckled within days of the Lehman bankruptcy

under the weight of the expansive credit­risk

protection it had sold. The whole system was

revealed to have been built on flimsy foundations:

banks had allowed their balance­sheets to bloat

(see chart 1), but set aside too little capital to

absorb losses. In effect they had bet on themselves with borrowed money, a gamble that had

paid off in good times but proved catastrophic in bad.

Regulators asleep at the wheel

Failures in finance were at the heart of the crash. But bankers were not the only people to

blame. Central bankers and other regulators bear responsibility too, for mishandling the crisis,

for failing to keep economic imbalances in check and for failing to exercise proper oversight of

financial institutions.

The regulators’ most dramatic error was to let Lehman Brothers go bankrupt. This multiplied

the panic in markets. Suddenly, nobody trusted anybody, so nobody would lend. Non­financial

companies, unable to rely on being able to borrow to pay suppliers or workers, froze spending in

order to hoard cash, causing a seizure in the real economy. Ironically, the decision to stand back

and allow Lehman to go bankrupt resulted in more government intervention, not less. To stem

the consequent panic, regulators had to rescue scores of other companies.

But the regulators made mistakes long before the Lehman bankruptcy, most notably by

tolerating global current­account imbalances and the housing bubbles that they helped to

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inflate. Central bankers had long expressed concerns about America’s big deficit and the

offsetting capital inflows from Asia’s excess savings. Ben Bernanke highlighted the savings glut

in early 2005, a year before he took over as chairman of the Fed from Alan Greenspan. But the

focus on net capital flows from Asia left a blind spot for the much bigger gross capital flows

from European banks. They bought lots of dodgy American securities, financing their purchases

in large part by borrowing from American money­market funds.

In other words, although Europeans claimed to be innocent victims of Anglo­Saxon excess, their

banks were actually in the thick of things. The creation of the euro prompted an extraordinary

expansion of the financial sector both within the euro area and in nearby banking hubs such as

London and Switzerland. Recent research by Hyun Song Shin, an economist at Princeton

University, has focused on the European role in fomenting the crisis. The glut that caused

America’s loose credit conditions before the crisis, he argues, was in global banking rather than

in world savings.

Moreover, Europe had its own internal imbalances that proved just as significant as those

between America and China. Southern European economies racked up huge current­account

deficits in the first decade of the euro while countries in northern Europe ran offsetting

surpluses. The imbalances were financed by credit flows from the euro­zone core to the

overheated housing markets of countries like Spain and Ireland. The euro crisis has in this

respect been a continuation of the financial crisis by other means, as markets have agonised

over the weaknesses of European banks loaded with bad debts following property busts.

Central banks could have done more to address all this. The Fed made no attempt to stem the

housing bubble. The European Central Bank did nothing to restrain the credit surge on the

periphery, believing (wrongly) that current­account imbalances did not matter in a monetary

union. The Bank of England, having lost control over banking supervision when it was made

independent in 1997, took a mistakenly narrow view of its responsibility to maintain financial

stability.

Central bankers insist that it would have been difficult to temper the housing and credit boom

through higher interest rates. Perhaps so, but they had other regulatory tools at their disposal,

such as lowering maximum loan­to­value ratios for mortgages, or demanding that banks should

set aside more capital.

Lax capital ratios proved the biggest shortcoming. Since 1988 a committee of central bankers

and supervisors meeting in Basel has negotiated international rules for the minimum amount of

capital banks must hold relative to their assets. But these rules did not define capital strictly

enough, which let banks smuggle in forms of debt that did not have the same loss­absorbing

capacity as equity.

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Under pressure from shareholders to increase

returns, banks operated with minimal equity,

leaving them vulnerable if things went wrong.

And from the mid­1990s they were allowed more

and more to use their own internal models to

assess risk—in effect setting their own capital

requirements. Predictably, they judged their assets

to be ever safer, allowing balance­sheets to

balloon without a commensurate rise in capital

(see chart 2).

The Basel committee also did not make any rules

regarding the share of a bank’s assets that should

be liquid. And it failed to set up a mechanism to

allow a big international bank to go bust without

causing the rest of the system to seize up.

All in it together

The regulatory reforms that have since been pushed through at Basel read as an extended mea

culpa by central bankers for getting things so grievously wrong before the financial crisis. But

regulators and bankers were not alone in making misjudgments. When economies are doing

well there are powerful political pressures not to rock the boat. With inflation at bay central

bankers could not appeal to their usual rationale for spoiling the party. The long period of

economic and price stability over which they presided encouraged risk­taking. And as so often

in the history of financial crashes, humble consumers also joined in the collective delusion that

lasting prosperity could be built on ever­bigger piles of debt.

From the print edition: Schools brief

What Caused the Great Recession? Assessing Two Explanations In this assignment you will take our model to the data to understand what might have been the cause of

the Great Recession.

A. Was it Caused by a Real Shock?

Suppose that the long run aggregate supply curve is given by

�⃑� 𝐿 = 3

4 𝐴 +

1

4 �⃑⃑�

Initially, 𝐴 = 2, �⃑⃑� = 0. Suppose the money supply is growing at a rate of 5 percent per year, and the

velocity of money does not change.

1. Derive the aggregate demand curve and the long-run aggregate supply curve

2. Solve for the initial long-run equilibrium.

a. What is real GDP growth? What is the rate of inflation?

b. Draw an aggregate supply-demand diagram. Make sure to label your axes, the curves,

equilibrium inflation and GDP growth, and vertical intercepts. For this part (and all

questions in Part A) you don't have to draw the short-run aggregate supply curve.

3. Here is a list of possible changes in the economy:

i. The growth rate of the capital stock increases to 3 percent per year

ii. The growth rate of the money supply falls to -4 percent per year

iii. The growth rate of productivity falls to -5 percent per year

iv. The growth rate of real consumption spending increases to 2 percent per year

Of the real shocks1 in this list, which of these changes is most likely to have caused the Great

Recession? Explain why your answer is right, and why each of the other three answers is not.

4. Suppose the answer you chose in Question 3 actually happened. Solve for the new long-run

equilibrium (don't worry about short-run equilibrium).

a. What is real GDP growth? What is the rate of inflation?

1 Shocks to the long-run aggregate supply curve, as compared to demand shocks, which move aggregate demand.

b. Add the new equilibrium to your aggregate supply-demand diagram from A.2.b, making

sure to shift any curves as necessary.

5. We have talked about several possible real shocks that might cause a recession. But it seems

implausible that there was a massive destruction of physical or human capital. It also seems

unlikely that there was technological regress.

The article shows that there was a seize-up in the financial system. Why might this cause the

change that you chose in Question 3? (Hint: Think back to our discussion of the role of the

financial market in the economy. What would happen if the financial system stopped working?)

B. Was it Caused by a Demand Shock? Suppose that the AD and LRAS curves are exactly as you derived in Part A.1.

1. What is the short-run aggregate supply curve?

2. Solve for the initial equilibrium.

a. What is real GDP growth? What is the rate of inflation?

b. Draw an aggregate supply-demand diagram. Make sure to label your axes, the curves,

equilibrium inflation and GDP growth, and vertical intercepts. (Unlike your diagram for

A.2.b, this one will have the short-run aggregate supply curve.)

3. Now suppose that the growth rate of the money supply falls to -4 percent per year. All else

remains unchanged.

a. What is the new aggregate demand curve?

b. Solve for the new short-run equilibrium (that is, before expectations have shifted).

What is real GDP growth? What is the rate of inflation?

c. Add the new short-run equilibrium to your aggregate supply-demand diagram from

B.2.b, making sure to shift any curves as necessary.

4. Assume the change in the growth rate of money is permanent. Also assume that neither

Congress nor the Federal Reserve take any action to address this shock.

a. In words, explain why, in the long run, the short-run aggregate supply curve will shift.

Why does this return to long-run equilibrium?

b. Solve for the new long-run equilibrium. What is real GDP growth? What is the rate of

inflation?

c. Write down the new short-run aggregate supply curve.

d. Add the new long-run equilibrium to your aggregate supply-demand diagram from

B.2.b/B.3.b, making sure to shift any curves as necessary.

5. Based on the article, does the shock from B.3 seem likely to be the cause of the Great

Recession? Why or why not?

6. Suppose instead that our setup is exactly as it was in B.2 (before the money supply fell). Now

suppose that the velocity of money is 𝑣 = 5𝐶 + 2𝐼 + 3𝐺 + 𝑁𝑋⃑⃑⃑⃑⃑⃑ . Suppose that a crash in the

prices of houses reduces the wealth of consumers. They respond by spending less, causing 𝐶 to

fall to -1. Meanwhile, turmoil in the financial market makes it hard for firms to borrow, causing a

decrease in investment. 𝐼 falls to -3. Everything else remains unchanged.

a. What is the new aggregate demand curve?

b. Solve for the new short-run equilibrium. What is real GDP growth? What is the rate of

inflation?

C. Which Explanation Does Better? We now have potential types of shock—a real shock or a demand shock—that might have caused the

Great Recession. As you saw in Parts A and B, our model predicts that each shock would have a different

effect on the aggregate economy. Now let's compare those predictions to reality. This comparison will

help us decide which of the two shocks is more likely to have caused the recession.

1. Look back at your answers to Part A. How does the model predict a real shock will affect

inflation in a recession? (That is, when GDP falls?)

2. Look back at your answers to Part B. How does the model predict a demand shock will affect

inflation in a recession? (That is, when GDP falls?)

3. The figure below shows what actually happened to inflation and real GDP growth during the

Great Recession. Which of the two predictions best matches the data? What does that imply is

the most likely cause of the Great Recession?

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

Inflation and Real GDP Growth During the Great Recession

Inflation Real GDP Growth