12.2 The global financial crisis
9 min read•august 20, 2024
The of shook the world economy to its core. Originating in the US housing market, it exposed deep flaws in the global financial system and triggered a severe economic downturn that affected countries worldwide.
The crisis spread rapidly, causing a , bank failures, and a global . Governments responded with and stimulus packages, while central banks slashed interest rates. The aftermath led to regulatory reforms and long-lasting economic and social impacts.
Origins of the crisis
- The global financial crisis originated from a combination of factors in the United States housing market and financial system that led to a severe economic downturn
- The crisis exposed systemic vulnerabilities in the global financial system and highlighted the interconnectedness of economies worldwide
Subprime mortgage market
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- Subprime mortgages are loans given to borrowers with lower credit ratings or limited credit history
- These mortgages often had adjustable rates that started low but increased over time, making them difficult for borrowers to repay
- Banks and financial institutions packaged these high-risk mortgages into complex financial products () and sold them to investors worldwide
- When borrowers began defaulting on their loans, the value of these securities plummeted, causing significant losses for investors
Housing bubble in the US
- The U.S. housing market experienced a significant boom in the early 2000s, with rapidly increasing home prices and a surge in construction
- Low interest rates, lax lending standards, and speculation fueled the
- Many borrowers took out mortgages they could not afford, expecting to refinance or sell their homes at a profit later
- When the bubble burst in 2007, home prices fell sharply, leaving many borrowers with mortgages worth more than their homes (underwater mortgages)
Predatory lending practices
- Some lenders engaged in predatory practices, targeting vulnerable borrowers with unfavorable loan terms
- These practices included high fees, hidden costs, and aggressive marketing of subprime mortgages
- Lenders often failed to properly assess borrowers' ability to repay the loans, leading to a high number of defaults
- The lack of regulation and oversight in the mortgage market allowed these practices to proliferate
Spread of the crisis
- The interconnectedness of the global financial system allowed the crisis to spread rapidly from the U.S. housing market to other sectors and countries
- The spread of the crisis led to a severe global economic downturn, affecting both developed and developing nations
Collapse of Lehman Brothers
- Lehman Brothers, a major U.S. investment bank, filed for bankruptcy in September 2008
- The bank had heavily invested in subprime mortgage-backed securities and was unable to withstand the losses when the housing market collapsed
- Lehman Brothers' collapse sent shockwaves through the global financial system, causing a crisis of confidence and a freeze in credit markets
- The event highlighted the systemic risk posed by the failure of large, interconnected financial institutions
Credit crunch and liquidity crisis
- The collapse of Lehman Brothers and the losses in mortgage-backed securities led to a severe credit crunch
- Banks became reluctant to lend to each other, fearing that other institutions might also be holding toxic assets
- This lack of lending caused a , making it difficult for businesses and individuals to access credit
- The credit crunch and liquidity crisis further exacerbated the economic downturn, as companies struggled to finance their operations and investments
Contagion to global markets
- The crisis quickly spread from the U.S. to other countries through various channels
- Many international banks and investors had exposure to U.S. subprime mortgage-backed securities, leading to significant losses when the market collapsed
- The global nature of financial markets meant that the crisis affected stock markets, currency markets, and commodity prices worldwide
- Developing countries were hit particularly hard, as foreign investors withdrew capital, leading to currency depreciation and financial instability
Economic consequences
- The global financial crisis had severe economic consequences, leading to a worldwide recession and a slowdown in economic growth
- The crisis exposed the vulnerabilities of the global financial system and the need for stronger regulation and oversight
Recession in major economies
- The crisis led to a deep recession in many major economies, including the United States, the European Union, and Japan
- GDP growth slowed significantly or turned negative, as consumer spending and business investment declined
- The recession lasted from 2008 to 2009 in most countries, with some experiencing a more prolonged downturn
- The severity of the recession varied across countries, with some experiencing a more severe contraction than others
Rise in unemployment rates
- The economic downturn led to a sharp rise in unemployment rates worldwide
- In the United States, the peaked at 10% in October 2009, the highest level since the early 1980s
- Many countries experienced similar increases in unemployment, as businesses laid off workers or reduced hiring
- The rise in unemployment had significant social and economic consequences, leading to increased poverty and reduced consumer spending
Decline in international trade
- The global recession led to a sharp decline in , as demand for goods and services fell worldwide
- Exports and imports declined significantly, affecting countries that relied heavily on trade for economic growth
- The decline in trade also had a negative impact on global supply chains, as businesses reduced production and investment
- The slowdown in international trade contributed to the overall economic downturn and made recovery more challenging
Government responses
- Governments and central banks around the world implemented various measures to mitigate the impact of the crisis and stimulate
- These responses included bailouts of financial institutions, , and
Bailouts of financial institutions
- Many governments provided financial support to banks and other financial institutions to prevent their collapse and maintain stability in the financial system
- In the United States, the (TARP) provided $700 billion to purchase toxic assets from banks and inject capital into struggling institutions
- Other countries implemented similar bailout programs, using public funds to support their financial sectors
- While these bailouts helped prevent a complete collapse of the financial system, they also led to concerns about moral hazard and the use of taxpayer money to support private institutions
Fiscal stimulus packages
- Governments implemented fiscal stimulus packages to boost economic growth and support affected industries and individuals
- These packages included increased government spending on infrastructure projects, tax cuts, and direct transfers to households
- In the United States, the American Recovery and Reinvestment Act of 2009 provided $787 billion in stimulus spending
- Other countries implemented similar measures, with the size and scope of the packages varying based on their economic conditions and political priorities
Monetary policy interventions
- Central banks around the world implemented expansionary monetary policies to support the economy and maintain financial stability
- The U.S. Federal Reserve and other central banks lowered interest rates to near-zero levels to encourage borrowing and investment
- Central banks also engaged in quantitative easing, purchasing government bonds and other securities to inject liquidity into the financial system
- These monetary policy interventions helped to stabilize financial markets and support economic recovery, but also led to concerns about inflation and asset price bubbles in the long term
Social and political impact
- The global financial crisis had significant social and political consequences, leading to increased poverty, inequality, and political instability in many countries
- The crisis exposed the vulnerabilities of the global economic system and led to calls for greater regulation and reform
Increase in poverty and inequality
- The economic downturn and rise in unemployment led to an increase in poverty rates in many countries
- Low-income households and vulnerable populations were particularly affected, as they often had fewer resources to weather the crisis
- The crisis also exacerbated income and wealth inequality, as the benefits of the economic recovery were not evenly distributed
- In many countries, the gap between the rich and the poor widened, leading to increased social tensions and political polarization
Political instability in affected countries
- The economic and social impact of the crisis led to political instability in some countries
- Governments faced increased pressure to address the economic challenges and support affected populations
- In some cases, the crisis led to changes in government, as voters expressed their dissatisfaction with the handling of the economy
- The crisis also contributed to the rise of anti-establishment and , as people lost faith in traditional political parties and institutions
Rise of populist movements
- The global financial crisis contributed to the rise of populist movements in many countries
- These movements often criticized the global economic system, multinational corporations, and international institutions, arguing that they benefited elites at the expense of ordinary people
- Populist parties and candidates gained support by promising to protect jobs, reduce inequality, and challenge the status quo
- The rise of populism had significant political consequences, leading to changes in government policies and international relations
Regulatory reforms
- The global financial crisis exposed the need for stronger regulation and oversight of the financial system to prevent future crises
- Governments and international organizations implemented various regulatory reforms to address the weaknesses revealed by the crisis
Dodd-Frank Act in the US
- In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 to overhaul the financial regulatory system
- The Act established new regulatory bodies, such as the Consumer Financial Protection Bureau, to protect consumers from
- It also introduced stricter capital and liquidity requirements for banks, as well as rules for the regulation of derivatives and other complex financial instruments
- The aimed to reduce systemic risk in the financial system and prevent future bailouts of "too big to fail" institutions
Basel III international banking regulations
- The Basel Committee on Banking Supervision, an international body that sets standards for bank regulation, introduced the framework in response to the crisis
- Basel III aimed to strengthen the resilience of the banking sector by increasing capital requirements, improving risk management, and reducing leverage
- The framework introduced new liquidity standards to ensure that banks had sufficient high-quality liquid assets to withstand periods of stress
- The implementation of Basel III was gradual, with banks given several years to comply with the new requirements
Efforts to prevent future crises
- In addition to the Dodd-Frank Act and Basel III, other efforts were made to prevent future financial crises
- The was established to coordinate international financial regulation and monitor systemic risks
- Governments and central banks also increased their monitoring of financial markets and institutions, with a focus on identifying and addressing potential vulnerabilities
- There was also a greater emphasis on stress testing and scenario analysis to assess the resilience of financial institutions to adverse economic conditions
Long-term effects
- The global financial crisis had long-lasting effects on the global economy and financial system, with some countries experiencing a slow recovery and shifts in economic power
- The crisis also provided important lessons for policymakers and regulators on how to prevent and manage future economic shocks
Slow economic recovery
- Many countries experienced a slow and uneven recovery from the crisis, with some taking several years to return to pre-crisis levels of economic growth and employment
- The pace of recovery varied across regions and sectors, with some industries (housing, finance) and populations (youth, low-skilled workers) experiencing a more prolonged downturn
- The slow recovery was partly due to the depth of the recession, as well as the challenges of deleveraging and repairing balance sheets in the aftermath of the crisis
- The prolonged period of low interest rates and unconventional monetary policies also had unintended consequences, such as asset price inflation and increased risk-taking in financial markets
Shifts in global economic power
- The global financial crisis accelerated , with emerging economies such as China and India experiencing faster growth than advanced economies
- The crisis highlighted the importance of domestic demand and the need for more balanced growth models, as countries that relied heavily on exports and external financing were more vulnerable to global shocks
- The crisis also led to changes in the international monetary system, with the U.S. dollar facing increased competition from other currencies and the rise of alternative payment systems
- The shifts in economic power had geopolitical implications, as emerging economies gained greater influence in international institutions and global governance
Lessons learned for policymakers
- The global financial crisis provided important lessons for policymakers and regulators on how to prevent and manage future economic shocks
- The crisis highlighted the need for better monitoring and regulation of systemic risks in the financial system, as well as the importance of international cooperation and coordination in addressing global challenges
- Policymakers also learned the importance of having a range of tools and instruments to respond to crises, including fiscal stimulus, monetary policy, and financial sector support
- The crisis also underscored the need for more inclusive and sustainable growth models, with a focus on reducing inequality and promoting long-term economic resilience
Key Terms to Review (25)
2008: The year 2008 marked the onset of a severe global financial crisis, triggered primarily by the collapse of the housing bubble in the United States and the subsequent failure of major financial institutions. This crisis resulted in a worldwide economic downturn, leading to widespread unemployment, loss of savings, and significant government interventions in economies across the globe.
Bailouts: Bailouts refer to financial assistance provided by governments or institutions to prevent the collapse of companies or economies that are facing severe financial distress. This intervention often involves the infusion of capital to stabilize the entity in crisis, aiming to preserve jobs, protect stakeholders, and maintain economic stability. The use of bailouts can also spark debates over moral hazard and the responsibilities of corporations versus public interests.
Basel III: Basel III is a global regulatory framework established to strengthen the regulation, supervision, and risk management within the banking sector following the 2008 financial crisis. It aims to improve the banking sector's ability to absorb shocks arising from financial and economic stress, thereby promoting stability in the global economy. Basel III introduces more stringent capital requirements and introduces a leverage ratio to ensure that banks maintain adequate capital reserves.
Contagion: Contagion refers to the spread of economic crises or financial instability across countries or markets, often triggered by the interconnectedness of global financial systems. When one economy experiences a downturn, the negative effects can ripple through to others, leading to widespread financial distress. This phenomenon highlights the vulnerabilities in a globalized economy where events in one area can significantly impact distant regions.
Credit crunch: A credit crunch is a sudden reduction in the general availability of loans or credit, often triggered by a financial crisis. During such times, banks and financial institutions become more risk-averse, tightening their lending standards, which leads to less borrowing by consumers and businesses. This can result in a negative feedback loop, where reduced spending leads to economic slowdown and further exacerbates the financial instability.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive piece of financial reform legislation passed in 2010 in response to the global financial crisis of 2007-2008. Its primary aim is to increase financial stability by implementing strict regulations on financial institutions, improving transparency, and protecting consumers from abusive financial practices. By establishing new regulatory agencies and enhancing oversight, the act seeks to prevent another economic meltdown.
Economic recovery: Economic recovery refers to the phase of the economic cycle where the economy begins to grow after a period of recession or economic downturn. This phase is marked by increasing employment, rising consumer confidence, and an uptick in production and investment. It often involves government intervention and policy measures aimed at revitalizing economies that have faced significant challenges.
Financial Stability Board: The Financial Stability Board (FSB) is an international body established to monitor and make recommendations about the global financial system to promote stability. It was formed in the wake of the global financial crisis of 2008, aiming to address vulnerabilities in the financial system and enhance oversight and regulation across countries. The FSB brings together central banks, finance ministries, and international organizations to collaborate on strategies that mitigate systemic risks and improve resilience in the financial sector.
Fiscal stimulus packages: Fiscal stimulus packages are government programs designed to increase economic activity by boosting demand through increased public spending and tax cuts. These packages aim to counteract economic downturns, such as recessions, by injecting liquidity into the economy, supporting businesses, and enhancing consumer spending. During times of financial crisis, such as the global financial crisis, these measures become crucial in stabilizing economies and fostering recovery.
Global financial crisis: The global financial crisis refers to the severe worldwide economic downturn that began in 2007 and reached its peak in 2008, primarily triggered by the collapse of the housing bubble in the United States and the subsequent failures of major financial institutions. This crisis led to significant declines in consumer wealth, widespread unemployment, and a decrease in economic activity across various countries, highlighting vulnerabilities within the global financial system.
Great Recession: The Great Recession was a severe worldwide economic downturn that began in late 2007 and lasted until mid-2009, marked by significant declines in consumer wealth, widespread unemployment, and a global financial crisis. It was primarily triggered by the collapse of the housing bubble in the United States, leading to a cascade of financial failures and a crisis in the banking sector.
Housing bubble: A housing bubble is an economic cycle characterized by rapid increases in property prices driven by demand, speculation, and exuberant market behavior, followed by a sharp decline in prices when the bubble bursts. This phenomenon plays a crucial role in understanding the dynamics of real estate markets and their impact on the broader economy, particularly during financial crises when unsustainable price increases lead to severe repercussions.
International trade: International trade refers to the exchange of goods and services between countries. It is a crucial aspect of the global economy, allowing nations to specialize in the production of certain products, access resources they lack, and benefit from competitive advantages. The dynamics of international trade can be influenced by various factors such as tariffs, trade agreements, and economic conditions, which play a significant role in shaping the interconnectedness of global markets.
Lehman Brothers Collapse: The Lehman Brothers collapse refers to the bankruptcy of Lehman Brothers, a major global financial services firm, in September 2008. This event marked one of the largest bankruptcies in U.S. history and is widely seen as a pivotal moment in the global financial crisis, triggering widespread panic and significant losses across financial markets worldwide.
Liquidity crisis: A liquidity crisis occurs when financial institutions or markets experience a severe shortage of liquid assets, leading to an inability to meet short-term obligations. This situation often arises during periods of economic instability or financial distress, causing panic among investors and institutions as they struggle to access cash or cash-equivalents, which can amplify the crisis further.
Monetary policy interventions: Monetary policy interventions are actions taken by central banks to influence the economy by controlling the money supply, interest rates, and credit availability. These interventions aim to stabilize economic fluctuations, manage inflation, and promote employment. During times of economic crises, such as financial downturns, central banks may employ various strategies like lowering interest rates or implementing quantitative easing to stimulate economic activity.
Mortgage-backed securities: Mortgage-backed securities (MBS) are financial instruments created by bundling together a pool of mortgage loans and selling them to investors. These securities represent a claim on the cash flows generated by the underlying mortgages, allowing investors to earn returns based on the mortgage payments made by borrowers. MBS played a significant role in the global financial crisis as they were often linked to subprime mortgages and were a key factor in the housing bubble and subsequent market collapse.
Populist movements: Populist movements are political movements that claim to represent the interests of the 'common people' against a perceived elite or establishment. These movements often emerge in response to economic distress, social inequalities, and political corruption, seeking to mobilize public sentiment for reform and change.
Predatory lending practices: Predatory lending practices refer to unfair, deceptive, or fraudulent tactics used by lenders to entice, assist, or enable borrowers into loans that carry high fees and interest rates, often targeting vulnerable populations. These practices typically include misleading information, loan terms that are difficult for borrowers to understand, and pressure tactics that force individuals into loans they cannot afford. Such practices played a significant role in the financial crisis by contributing to the proliferation of subprime mortgages and widespread defaults.
Recession: A recession is a significant decline in economic activity across the economy lasting longer than a few months, typically visible in real GDP, income, employment, manufacturing, and retail sales. It often leads to increased unemployment rates and decreased consumer spending, creating a cycle that can further depress economic growth. Recessions can be triggered by various factors including financial crises, decreased consumer confidence, or external shocks to the economy.
Shifts in global economic power: Shifts in global economic power refer to the changes in the distribution of economic strength and influence among countries and regions over time. These shifts can be driven by various factors, including economic growth, technological advancements, resource availability, and geopolitical dynamics. Such changes significantly impact global trade patterns, investment flows, and overall economic stability.
Sovereign debt crisis: A sovereign debt crisis occurs when a country is unable to meet its debt obligations, leading to a situation where it cannot pay back or service its government debt. This can result from excessive borrowing, economic mismanagement, or external shocks, and often leads to severe financial instability and the need for international assistance or bailouts.
Subprime mortgage market: The subprime mortgage market refers to the segment of the mortgage industry that provides loans to borrowers with poor credit histories or limited financial resources, making them higher-risk candidates for traditional mortgages. This market became highly prominent during the early 2000s as lenders increasingly targeted individuals who would typically be denied credit, often leading to higher interest rates and unfavorable loan terms.
Troubled Asset Relief Program: The Troubled Asset Relief Program (TARP) was a U.S. government program initiated in 2008 to purchase toxic assets and equity from financial institutions to strengthen the financial sector during the global financial crisis. By injecting capital into banks, TARP aimed to stabilize the economy, restore confidence in the financial markets, and prevent a complete collapse of the banking system. It was a controversial program that sparked debates about government intervention in the economy and fiscal responsibility.
Unemployment rate: The unemployment rate is the percentage of the labor force that is jobless and actively seeking employment. This rate is a key indicator of economic health, as it reflects the ability of an economy to provide jobs for those who want to work. A high unemployment rate typically signals economic distress, while a low rate can indicate a thriving economy with ample job opportunities.