Great Depression II - Financial Crisis

The 2007-2012 global financial crisis, also known as the Global Financial Crisis, late-2000s financial crisis or the second “Great Recession”, is considered by many economists to be the worst financial crisis since The Great Depression of the 1930s/ The recent crisis emphasizes that a “crisis” is a distinct, singular, event. It also raises questions about what constitutes bank money, and what is a “bank”, and what is the “banking system”? It resulted in the collapse of the large financial institutions, the bailout of banks by national governments and downturns in stock markets around the world. In many areas, the housing market also suffered, resulting in numerous evictions, foreclosures and prolonged unemployment. It contributed to the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a significant decline in economic activity.

Understanding the crisis has run into problems from a lack of data, leaving researchers in the dark on many important questions. Of course, knowing what data to collect requires an understanding of the crisis. Ironically, if governments and economists knew what data to collect prior to crisis, they would then likely understand the fragility of the system and could possibly avoid a crisis. It seems that a lack of data and the occurrence of a crisis go hand-in-hand. A crisis is a surprise, coming from an unexpected source. As a result, there is little data. There are other inherent difficulties in studying crises. Although crises are perhaps more common than many supposed before the current crisis, still the usable sample size of events is small.

Many firms relied on short term credit market to fund products. However, when many prestigious institutions declared bankruptcy in 2008, the media spread the news rapidly, resulting in a sudden decline in confidence from investors, and less capital flow. Investors’ sensitivity to shock and panic resulted in a sudden decrease in liquidity, which firms heavily relied on. The failure of one firm offset the risk of contagion, and led to failures of many other firms.

Another cause of the crisis is the quality of financial assessments and securities. Credit-rating companies, issuers and investors were all too optimistic about investments. Many firms held securities containing highly positively correlated risks, and failed to diversify their portfolio to decrease risk. Thus, their operations ran on very risky investments that were incorrectly evaluated by credit-rating companies. As a result, these toxic financial assets are a major cause of failure of many firms.

The influence of foreign investments also caused the financial crisis. Countries with large trade surplus with the US, such as China, preferred safe investments. They bought huge amounts of treasure bonds, and pushed rate of yield down. As a result, foreign investors started to invest in mortgage market related securities. This huge amount of foreign investment gave US mortgage firms more money to lend out; thus, raising the price of housing. In response to the abundance of investments, lenders became overly optimistic, and loaned money to individuals that were not able to pay back the loan. Then, the large number of foreclosures drove down the real estate value as well as these mortgage-related securities. These foreign investments gave American mortgage firms false optimism, which led to over lending and the downfall of the housing market.

The Fed realized that one of the main causes of the crisis is the decrease of liquidity due to the decrease of short term debts. In response, the Fed improvised liquidity programs to increase liquidity. They practiced quantitative easement by purchasing mortgage securities, long-term assets, and lowering interest rate. Also, Fed Funds target rate was decreased to nearly 0% to encourage short term lending.

My analysis of the current crisis suggests that governance problems in banks and excessive short term leverage were at its core. These two causes are related. Any attempt at preventing a recurrence should recognize that it is difficult to resolve governance problems, and, consequently, to wean banks from leverage. Direct regulatory interventions, such as mandating more capital, could simply exacerbate private sector attempts to get around them, as well as chill intermediation and economic growth. At the same time, it is extremely costly for society to either continue rescuing the banking system, or to leave the economy to be dragged into the messes that banking crises create. If despite their best efforts, regulators cannot prevent systemic problems, they should focus on minimizing their costs to society, without dampening financial intermediation in the process.