What factors made the 2007–09 financial crises and Great Recession so severe?

​There were many underlying factors which contributed to both the financial crisis and the Great Recession. The trigger of crisis and recession begins with the burst of the housing bubble in mid-2007. As subprime mortgage default rates began to accelerate, overly leveraged financial institutions holding risky products such as mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) triggered a crisis of asset devaluation. Financial institutions holding both MBSs and CDOs and financial derivative products such as default swaps took a double hit inducing a liquidity crisis and immediate default risk.

According to economist James R. Crotty, retired professor at the University of Massachusetts Amherst, there are two major underlying causes which led to the financial crisis: The first was bad theories such as the efficient financial market theory, and, generally, New Classical Macroeconomics. Such theories made assumptions at odds with the real world. For example, efficient market theory included assumptions such as: a) investors can determine the true distribution of risk; b) liquidity is never a problem; c) markets maintain stable equilibrium; d) default is rare; e) agent borrowing is limitless at risk-free interest rates. All of these assumptions turned out to be false. The second underlying cause was the “New Financial Architecture” which primarily consisted of flawed institutions and erroneous practices related to aggressive risk taking, over leveraging, and light government regulation. These practices inevitably led to

​stimulated aggressive risk taking (not perceived as risky), pushed some security prices to unsustainable levels, dramatically raised systemic leverage and thus, to use Minsky’s phrase, financial fragility (the vulnerability of the financial system to problems that appear anywhere within it), and facilitated the creation of unprecedented financial market complexity and opaqueness. They also led to a secular rise in the size of financial markets relative to the rest of the economy, and created the preconditions for a global financial crisis (Crotty, 2008).

Once the crisis was underway, a liquidity trap ensued. Despite the federal funds rate being dropped nearly to zero, credit dried up in the interbank market requiring intervention from the Federal Reserve to facilitate loans and buyouts. Credit also dried up for the non-corporate business sector, which included smaller businesses despite banks sitting on large sums of cash and reserves unwilling to risk making bad loans (Pollin, 2012). Businesses and financial firms were not the only ones who were over-leveraged, households also became debt constrained. From 2000–2006, households experienced a sharp rise in debt primarily due to new borrowing (95 percent of which was comprised of mortgage debt), but also in part due to a rise in debt servicing from real interest rate growth outpacing real income growth (Mason and Jayadev, 2012). The severe devaluation in housing prices after the burst of the housing bubble resulted in households no longer able to borrow against their homes, and instead had to start repaying their mortgage debt (if possible). Although borrowing turned negative, there was little reduction in debt ratios for households as real income growth stagnated relative real interest rate growth (Mason and Jayadev, 2012). Between 2006 and 2008, household wealth plummeted by 25 percent ($17.6 trillion decrease), which according to research by Maki and Columbo (2001), assuming a modest wealth of effect of 3 percent, would reduce household spending by approximately $525 billion (Pollin, 2012). Such a massive reduction in spending due to a loss of wealth combined with a debt constrained household sector depressed consumer demand, and prolonged both the recession and the recovery after (Mason and Jayadev, 2012; Pollin, 2012; Eggertson and Krugman, 2012). There is also some empirical evidence suggesting the rise of income inequality since the 1970s are directly related to rising household debt. For example, Pollin (1988) and Christen and Morgan (2005) empirical studies which identify a negative correlation between declining real median incomes and household debt and a positive correlation between increasing income inequality and household debt, respectively. The conclusion of these economists and others, essentially, is that consumers have used credit to compensate for their lack of income growth since the 1970s (see Rajan, 2010; Pollin 1988, 1990; Van Treeck and Sturn, 2012). While the trend in income inequality has persisted since the 1970s, the Great Recession has exacerbated the problem with the 1 percent receiving 93 percent of total income growth in 2010 according Saez (2012) (Pollin, 2012). And rising income inequality has only continued to get worse since then. Piketty, Saez, and Zucman (2016) report that “Income has boomed at the top: in 1980, top 1% adults earned on average 27 times more than bottom 50% adults, while they earn 81 times more today. The upsurge of top incomes was first a labor income phenomenon but has mostly been a capital income phenomenon since 2000. The government has offset only a small fraction of the increase in inequality.” While the financial sector and upper strata of income earners have recovered, the rest of the country is still struggling with anemic growth and continued stagnation in wage growth. The most recent tax cuts by the Trump administration is not likely to address any of these issues, and more certainly will exacerbate inequality in America.

References

Crotty, J. (2008). Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’. University of Massachusetts — Amherst, Economics Department Working Paper Series №2008–14.

Eggertson, G. B. and Krugman, P. (2012). Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach. The Quarterly Journal of Economics. 1469–1513. doi:10.1093/qje/qjs023

Mason J. W. and Jayadev, A. (2012). Fisher Dynamics in Household Debt: The Case of the United States, 1929–2011. Piketty,T., Saez, E. and Zucman, G. (2016). Distributional National Accounts: Methods and Estimates for the United States. The National Bureau of Economic Research. NBER Working Paper №22945. Pollin, R. (2012). The Great U.S. Liquidity Trap of 2009–11: Are We Stuck Pushing on Strings? Political Economy Research Institute. Working Paper Series №284.

Van Treeck, T. and Sturn, S. (2012). Income inequality as a cause of the Great Recession? A survey of current debates. International Labour Office — Geneva: ILO, 2012. Conditions of Work and employment Series №39, ISSN 2226–8944 ; 2226–8952.

Originally published at aaronmedlin.weebly.com.