Causes of the late-2000s recession
Encyclopedia
This information is related to the causes of the late-2000s recession, also known as the Great Recession, that is happening worldwide.
In 2003, a group of economists led by Mikhail Khazin
published the book titled "Sunset of the Dollar Empire and the End of the Pax Americana" introducing the causes of the upcoming crisis. The root cause was explained to be the inevitable decrease of the accumulative US consumers' demand due to the fact that the gradually decreasing(since late 1970ies) Federal Reserve's interest rate will one day reach nearly 0 (happened by 2008) and could not allow for debts' refinancing anymore.
On October 15, 2008, Anthony Faiola, Ellen Nakashima, and Jill Drew wrote a lengthy article in The Washington Post
titled, "What Went Wrong". In their investigation, the authors claim that former Federal Reserve Board Chairman Alan Greenspan
, Treasury Secretary Robert Rubin, and SEC Chairman Arthur Levitt vehemently opposed any regulation of financial instruments
known as derivatives
. They further claim that Greenspan actively sought to undermine the office of the Commodity Futures Trading Commission
, specifically under the leadership of Brooksley E. Born, when the Commission sought to initiate regulation of derivatives. Ultimately, it was the collapse of a specific kind of derivative, the mortgage-backed security
, that triggered the economic crisis of 2008.
While Greenspan's role as Chairman of the Federal Reserve
has been widely discussed (the main point of controversy remains the lowering of Federal funds rate
at only 1% for more than a year which, according to the Austrian School
of economics, allowed huge amounts of "easy" credit-based money to be injected into the financial system and thus create an unsustainable economic boom), there is also the argument that Greenspan actions in the years 2002–2004 were actually motivated by the need to take the U.S. economy out of the early 2000s recession
caused by the bursting of the dot-com bubble
— although by doing so he did not help avert the crisis, but only postpone it.
Some economists - those of the Austrian school and those predicting the recession such as Steve Keen - claim that the ultimate point of origin of the great financial crisis of 2007–2010 can be traced back to an extremely indebted US economy. The collapse of the real estate market in 2006 was the close point of origin of the crisis. The failure rates of subprime mortgages were the first symptom of a credit boom tuned to bust and of a real estate shock. But large default rates on subprime mortgages cannot account for the severity of the crisis. Rather, low-quality mortgages acted as an accelerant to the fire that spread through the entire financial system. The latter had become fragile as a result of several factors that are unique to this crisis: the transfer of assets from the balance sheets of banks to the markets, the creation of complex and opaque assets, the failure of ratings agencies to properly assess the risk of such assets, and the application of fair value accounting. To these novel factors, one must add the now standard failure of regulators and supervisors in spotting and correcting the emerging weaknesses.
Robert Reich
points out the amount of debt in the US economy can be traced to economic inequality, where middle class wages remain stagnant while wealth concentrates at the top, and households "pull equity from their homes and overload on debt to maintain living standards."
Any debt default has the possibility of causing the lender to also default, if the lender is itself in a weak financial condition and has too much debt. This second default in turn can lead to still further defaults through a domino effect
. The chances of these followup defaults is increased at high levels of debt. Attempts to prevent this domino effect by bailing out Wall Street lenders such as AIG, Fannie Mae, and Freddie Mac have had mixed success. The takeover of Bear Stearns is another example of attempts to stop the dominoes from falling.
by the 106th Congress
, and over-leveraging by banks and investors eager to achieve high returns on capital.
Others take full credit for deregulating the Banking Industry. In November 1999, Phil Gramm, Republican Senator from Texas, took full credit for the Gramm-Leach-Bliley Act with a Press Release from the Senate Banking and Finance Committee: "I am proud to be here because this is an important bill; it is a deregulatory bill. I believe that that is the wave of the future, and I am awfully proud to have been a part of making it a reality."
under the George H. W. Bush
administration weakened regulation of Fannie Mae and Freddie Mac with the goal of making available more money for the issuance of home loans. The Washington Post wrote: "Congress also wanted to free up money for Fannie Mae and Freddie Mac to buy mortgage loans and specified that the pair would be required to keep a much smaller share of their funds on hand than other financial institutions. Whereas banks that held $100 could spend $90 buying mortgage loans, Fannie Mae and Freddie Mac could spend $97.50 buying loans. Finally, Congress ordered that the companies be required to keep more capital as a cushion against losses if they invested in riskier securities. But the rule was never set during the Clinton administration, which came to office that winter, and was only put in place nine years later."
Others have pointed to deregulation efforts as contributing to the collapse. In 1999, the Republican-controlled 106th Congress
, under Bill Clinton, passed the Gramm-Leach-Bliley Act
, which repealed part of the Glass–Steagall Act of 1933. This repeal has been criticized by some for having contributed to the proliferation of the complex and opaque financial instruments which are at the heart of the crisis. However, some economists object to singling out the repeal of Glass–Steagall for criticism. Brad DeLong, a former advisor to President Clinton and economist at the University of California, Berkeley and Tyler Cowen of George Mason University have both argued that the Gramm-Leach-Bliley Act softened the impact of the crisis by allowing for mergers and acquisitions of collapsing banks as the crisis unfolded in late 2008.
Another probable cause of the crisis—and a factor that unquestionably amplified its magnitude—was widespread miscalculation by banks and investors of the level of risk inherent in the unregulated Collateralized debt obligation
and Credit Default Swap
markets. Under this theory, banks and investors systematized the risk by taking advantage of low interest rates to borrow tremendous sums of money that they could only pay back if the housing market continued to increase in value.
According to an article published in Wired
, the risk was further systematized by the use of David X. Li
's Gaussian copula model function to rapidly price Collateralized debt obligation
s based on the price of related Credit Default Swap
s. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article: "Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril...Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees."
The pricing model for CDOs clearly did not reflect the level of risk they introduced into the system. It has been estimated that the "from late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds...[o]ut of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi." The average recovery rate for high quality CDOs has been approximately 32 cents on the dollar, while the recovery rate for mezzanine CDO's has been approximately five cents for every dollar. These massive, practically unthinkable, losses have dramatically impacted the balance sheets of banks across the globe, leaving them with very little capital to continue operations.
ing gives rise to an artificial boom
, which is inevitably followed by a bust
. This perspective argues that the monetary policy
of central banks creates excessive quantities of cheap credit by setting interest rate
s below where they would be set by a free market. This easy availability of credit inspires a bundle of malinvestments, particularly on long term projects such as housing and capital assets, and also spurs a consumption boom as incentives to save are diminished. Thus an unsustainable boom arises, characterized by malinvestments and overconsumption.
But the created credit is not backed by any real savings nor is in response to any change in the real economy, hence, there are physically not enough resources to finance either the malinvestments or the consumption rate indefinitely. The bust occurs when investors collectively realize their mistake. This happens usually some time after interest rates rise again. The liquidation
of the malinvestments and the consequent reduction in consumption throw the economy into a recession, whose severity mirrors the scale of the boom's excesses.
The Austrian School argues that the conditions previous to the crisis of the late 2000s correspond exactly to the scenario described above. The central bank of the United States, led by Federal Reserve Chairman Alan Greenspan
, kept interest rates very low for a long period of time to blunt the recession of the early 2000s. The resulting malinvestment and over-consumption of investors and consumers prompted the development of a housing bubble that ultimately burst, precipitating the financial crisis. This crisis, together with sudden and necessary deleveraging
and cutbacks by consumers, businesses and banks, led to the recession. Austrian Economists argue further that while they probably affected the nature and severity of the crisis, factors such as a lack of regulation, the Community Reinvestment Act
, and entities such as Fannie Mae and Freddie Mac are insufficient by themselves to explain it.
A positively sloped yield curve
allows Primary Dealers (such as large investment banks) in the Federal Reserve system to fund themselves with cheap short term money while lending out at higher long-term rates. This strategy is profitable so long as the yield curve remains positively sloped. However, it creates a liquidity risk if the yield curve
were to become inverted and banks would have to refund themselves at expensive short term rates while losing money on longer term loans.
The narrowing of the yield curve
from 2004 and the inversion of the yield curve during 2007 resulted (with the expected 1 to 3 year delay) in a bursting of the housing bubble and a wild gyration of commodities prices as moneys flowed out of assets like housing or stocks and sought safe haven in commodities. The price of oil rose to over $140 dollars per barrel in 2008 before plunging as the financial crisis began to take hold in late 2008.
Other observers have doubted the role that the yield curve plays in controlling the business cycle. In a May 24, 2006 story CNN Money reported: "...in recent comments, Fed Chairman Ben Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no longer a good indicator of a recession ahead."
has argued that the increase in oil prices in the period of 2007 through 2008 was a significant cause of the recession. He evaluated several different approaches to estimating the impact of oil price shocks on the economy, including some methods that had previously shown a decline in the relationship between oil price shocks and the overall economy. All of these methods "support a common conclusion; had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the US economy would not have been in a recession over the period 2007:Q4 through 2008:Q3." Hamilton's own model, a time-series econometric forecast based on data up to 2003, showed that the decline in GDP could have been successfully predicted to almost its full extent given knowledge of the price of oil. The results imply that oil prices were entirely responsible for the recession; however, Hamilton himself acknowledged that this was probably not the case but maintained that it showed that oil price increases made a significant contribution to the downturn in economic growth.
Approximately 0.5 million dwellings have become permanently vacant as a result of a reduction in the illegal immigrant population
. The greatest impact has been on the California economy, where illegal immigrants comprise approximately 1/3 of the total population. The reduced demand for housing created permanent unemployment for hundreds of thousands of building contractors, realtors, and mortgage brokers.
Foreign investment in Mexico by businesses located in China and Venezuela have increased employment opportunities in Mexico. The number of illegal immigrants living in the US declined by 1.5 million since 2007, or about 12% of the total illegal immigrant workforce. The economic decline caused by reduced spending by illegal immigrants in the US occurred at the same time as a rise in unemployment of approximately 1 million legal US workers that provide goods and services for the illegal immigrant population. This increased the number of foreclosures and reduced automotive sales, contributing to an overall decline in value for real estate, vehicles, and other property.
Economic activity produced by illegal immigrant spending employs about 5% of the total US workforce. Illegal immigrants occupy over 3 million dwellings, or just under 4% of the total number of homes in the US. UCLA research indicates illegal immigrants produce $150 billion of economic activity equivalent to spending stimulus every year. Nearly every dollar earned by illegal immigrants is spent immediately, and the average wage for US citizens is $10.25/hour with an average of 34 hours per week, so approximately 8 million US jobs are dependent upon economic activity produced by illegal immigrant activities within the US.
and Peter Schiff
in his book Crash Proof, claim to have predicted the crisis prior to its occurrence. Schiff also made a speech in 2006 in which he predicted the failure of Fannie and Freddie. They are critical of theories that the free market caused the crisis and instead argue that the Federal Reserve's expansionary monetary policy
and the Community Reinvestment Act
are the primary causes of the crisis. Alan Greenspan, former Federal Reserve chairman, has said he was partially wrong to oppose regulation of the markets, and expressed "shocked disbelief" at the failure of self interest, alone, to manage risk in the markets.
An empirical study by John B. Taylor
concluded that the crisis was: (1) caused by excess monetary expansion; (2) prolonged by an inability to evaluate counter-party risk due to opaque financial statements; and (3) worsened by the unpredictable nature of government's response to the crisis.
It has also been debated that the root cause of the crisis is overproduction
of goods caused by globalization
(and especially vast investments in countries such as China
and India
by western multinational companies over the past 15–20 years, which greatly increased global industrial output at a reduced cost). Overproduction tends to cause deflation and signs of deflation were evident in October and November 2008, as commodity prices tumbled and the Federal Reserve was lowering its target rate to an all-time-low 0.25%. On the other hand, Professor Herman Daly
suggests that it is not actually an economic crisis, but rather a crisis of overgrowth
beyond sustainable ecological limits. This reflects a claim made in the 1972 book Limits to Growth, which stated that without major deviation from the policies followed in the 20th century, a permanent end of economic growth could be reached sometime in the first two decades of the 21st century, due to gradual depletion of natural resources.
In laissez-faire
capitalism, financial institutions would be risk-averse because failure would result in liquidation
. But the Federal Reserve's 1984 rescue of Continental Illinois and the 1998 rescue of the Long-Term Capital Management
hedge fund
, among others, showed that institutions which failed to exercise due diligence
could reasonably expect to be protected from the consequences of their mistakes. The belief that they could not be allowed to fail
created a moral hazard
which was a contributing factor to the late-2000s recession.
Debate over origins
The central debate about the origin has been focused on the respective parts played by the public monetary policy (in the US notably) and by private financial institutions practices.In 2003, a group of economists led by Mikhail Khazin
Mikhail Khazin
Mikhail Leonidovich Khazin , a Russian economist, publicist and president of the consulting firm, Neokon, is noted as the author of the book: "Sunset of the Dollar Empire and the End of the Pax Americana", published in 2003....
published the book titled "Sunset of the Dollar Empire and the End of the Pax Americana" introducing the causes of the upcoming crisis. The root cause was explained to be the inevitable decrease of the accumulative US consumers' demand due to the fact that the gradually decreasing(since late 1970ies) Federal Reserve's interest rate will one day reach nearly 0 (happened by 2008) and could not allow for debts' refinancing anymore.
On October 15, 2008, Anthony Faiola, Ellen Nakashima, and Jill Drew wrote a lengthy article in The Washington Post
The Washington Post
The Washington Post is Washington, D.C.'s largest newspaper and its oldest still-existing paper, founded in 1877. Located in the capital of the United States, The Post has a particular emphasis on national politics. D.C., Maryland, and Virginia editions are printed for daily circulation...
titled, "What Went Wrong". In their investigation, the authors claim that former Federal Reserve Board Chairman Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, Treasury Secretary Robert Rubin, and SEC Chairman Arthur Levitt vehemently opposed any regulation of financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
known as derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
. They further claim that Greenspan actively sought to undermine the office of the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
, specifically under the leadership of Brooksley E. Born, when the Commission sought to initiate regulation of derivatives. Ultimately, it was the collapse of a specific kind of derivative, the mortgage-backed security
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
, that triggered the economic crisis of 2008.
While Greenspan's role as Chairman of the Federal Reserve
Chairman of the Federal Reserve
The Chairman of the Board of Governors of the Federal Reserve System is the head of the central banking system of the United States. Known colloquially as "Chairman of the Fed," or in market circles "Fed Chairman" or "Fed Chief"...
has been widely discussed (the main point of controversy remains the lowering of Federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
at only 1% for more than a year which, according to the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
of economics, allowed huge amounts of "easy" credit-based money to be injected into the financial system and thus create an unsustainable economic boom), there is also the argument that Greenspan actions in the years 2002–2004 were actually motivated by the need to take the U.S. economy out of the early 2000s recession
Early 2000s recession
The early 2000s recession was a decline in economic activity which occurred mainly in developed countries. The recession affected the European Union mostly during 2000 and 2001 and the United States mostly in 2002 and 2003. The UK, Canada and Australia avoided the recession for the most part, while...
caused by the bursting of the dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
— although by doing so he did not help avert the crisis, but only postpone it.
Some economists - those of the Austrian school and those predicting the recession such as Steve Keen - claim that the ultimate point of origin of the great financial crisis of 2007–2010 can be traced back to an extremely indebted US economy. The collapse of the real estate market in 2006 was the close point of origin of the crisis. The failure rates of subprime mortgages were the first symptom of a credit boom tuned to bust and of a real estate shock. But large default rates on subprime mortgages cannot account for the severity of the crisis. Rather, low-quality mortgages acted as an accelerant to the fire that spread through the entire financial system. The latter had become fragile as a result of several factors that are unique to this crisis: the transfer of assets from the balance sheets of banks to the markets, the creation of complex and opaque assets, the failure of ratings agencies to properly assess the risk of such assets, and the application of fair value accounting. To these novel factors, one must add the now standard failure of regulators and supervisors in spotting and correcting the emerging weaknesses.
Robert Reich
Robert Reich
Robert Bernard Reich is an American political economist, professor, author, and political commentator. He served in the administrations of Presidents Gerald Ford and Jimmy Carter and was Secretary of Labor under President Bill Clinton from 1993 to 1997....
points out the amount of debt in the US economy can be traced to economic inequality, where middle class wages remain stagnant while wealth concentrates at the top, and households "pull equity from their homes and overload on debt to maintain living standards."
Excessive debt levels as the cause
In order to counter the Stock Market Crash of 2000 and the subsequent economic slowdown, the Federal Reserve eased credit availability and drove interest rates down to lows not seen in many decades. These low interest rates facilitated the growth of debt at all levels of the economy, chief among them private debt to purchase more expensive housing. High levels of debt have long been recognized as a causative factor for recessions.Any debt default has the possibility of causing the lender to also default, if the lender is itself in a weak financial condition and has too much debt. This second default in turn can lead to still further defaults through a domino effect
Domino effect
The domino effect is a chain reaction that occurs when a small change causes a similar change nearby, which then will cause another similar change, and so on in linear sequence. The term is best known as a mechanical effect, and is used as an analogy to a falling row of dominoes...
. The chances of these followup defaults is increased at high levels of debt. Attempts to prevent this domino effect by bailing out Wall Street lenders such as AIG, Fannie Mae, and Freddie Mac have had mixed success. The takeover of Bear Stearns is another example of attempts to stop the dominoes from falling.
Sub-prime lending as a cause
Based on the assumption that sub-prime lending precipitated the crisis, some have argued that the Clinton Administration may be partially to blame, while others have pointed to the passage of the Gramm-Leach-Bliley ActGramm-Leach-Bliley Act
The Gramm–Leach–Bliley Act , also known as the Financial Services Modernization Act of 1999, is an act of the 106th United States Congress...
by the 106th Congress
106th United States Congress
The One Hundred Sixth United States Congress was a meeting of the legislative branch of the United States federal government, composed of the United States Senate and the United States House of Representatives. It met in Washington, DC from January 3, 1999 to January 3, 2001, during the last two...
, and over-leveraging by banks and investors eager to achieve high returns on capital.
Others take full credit for deregulating the Banking Industry. In November 1999, Phil Gramm, Republican Senator from Texas, took full credit for the Gramm-Leach-Bliley Act with a Press Release from the Senate Banking and Finance Committee: "I am proud to be here because this is an important bill; it is a deregulatory bill. I believe that that is the wave of the future, and I am awfully proud to have been a part of making it a reality."
Government deregulation as a cause
In 1992, the Democratic-controlled 102nd Congress102nd United States Congress
-House of Representatives:- Senate :* President:Dan Quayle * President pro tempore: Robert Byrd - Majority leadership :* Majority Leader: George Mitchell* Majority Whip: Wendell Ford- Minority leadership :...
under the George H. W. Bush
George H. W. Bush
George Herbert Walker Bush is an American politician who served as the 41st President of the United States . He had previously served as the 43rd Vice President of the United States , a congressman, an ambassador, and Director of Central Intelligence.Bush was born in Milton, Massachusetts, to...
administration weakened regulation of Fannie Mae and Freddie Mac with the goal of making available more money for the issuance of home loans. The Washington Post wrote: "Congress also wanted to free up money for Fannie Mae and Freddie Mac to buy mortgage loans and specified that the pair would be required to keep a much smaller share of their funds on hand than other financial institutions. Whereas banks that held $100 could spend $90 buying mortgage loans, Fannie Mae and Freddie Mac could spend $97.50 buying loans. Finally, Congress ordered that the companies be required to keep more capital as a cushion against losses if they invested in riskier securities. But the rule was never set during the Clinton administration, which came to office that winter, and was only put in place nine years later."
Others have pointed to deregulation efforts as contributing to the collapse. In 1999, the Republican-controlled 106th Congress
106th United States Congress
The One Hundred Sixth United States Congress was a meeting of the legislative branch of the United States federal government, composed of the United States Senate and the United States House of Representatives. It met in Washington, DC from January 3, 1999 to January 3, 2001, during the last two...
, under Bill Clinton, passed the Gramm-Leach-Bliley Act
Gramm-Leach-Bliley Act
The Gramm–Leach–Bliley Act , also known as the Financial Services Modernization Act of 1999, is an act of the 106th United States Congress...
, which repealed part of the Glass–Steagall Act of 1933. This repeal has been criticized by some for having contributed to the proliferation of the complex and opaque financial instruments which are at the heart of the crisis. However, some economists object to singling out the repeal of Glass–Steagall for criticism. Brad DeLong, a former advisor to President Clinton and economist at the University of California, Berkeley and Tyler Cowen of George Mason University have both argued that the Gramm-Leach-Bliley Act softened the impact of the crisis by allowing for mergers and acquisitions of collapsing banks as the crisis unfolded in late 2008.
Over-leveraging, credit default swaps and collateralized debt obligations as causes
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
and Credit Default Swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
markets. Under this theory, banks and investors systematized the risk by taking advantage of low interest rates to borrow tremendous sums of money that they could only pay back if the housing market continued to increase in value.
According to an article published in Wired
Wired (magazine)
Wired is a full-color monthly American magazine and on-line periodical, published since January 1993, that reports on how new and developing technology affects culture, the economy, and politics...
, the risk was further systematized by the use of David X. Li
David X. Li
David X. Li is a quantitative analyst and a qualified actuary who in the early 2000s pioneered the use of Gaussian copula models for the pricing of collateralized debt obligations...
's Gaussian copula model function to rapidly price Collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
s based on the price of related Credit Default Swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article: "Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril...Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees."
The pricing model for CDOs clearly did not reflect the level of risk they introduced into the system. It has been estimated that the "from late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds...[o]ut of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi." The average recovery rate for high quality CDOs has been approximately 32 cents on the dollar, while the recovery rate for mezzanine CDO's has been approximately five cents for every dollar. These massive, practically unthinkable, losses have dramatically impacted the balance sheets of banks across the globe, leaving them with very little capital to continue operations.
Credit creation as a cause
The Austrian School of Economics proposes that the crisis is an excellent example of the Austrian Business Cycle Theory, in which credit created through the policies of central bankCentral bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
ing gives rise to an artificial boom
Boom and bust
A credit boom-bust cycle is an episode characterized by a sustained increase in several economics indicators followed by a sharp and rapid contraction. Commonly the boom is driven by a rapid expansion of credit to the private sector accompanied with rising prices of commodities and stock market index...
, which is inevitably followed by a bust
Boom and bust
A credit boom-bust cycle is an episode characterized by a sustained increase in several economics indicators followed by a sharp and rapid contraction. Commonly the boom is driven by a rapid expansion of credit to the private sector accompanied with rising prices of commodities and stock market index...
. This perspective argues that the monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
of central banks creates excessive quantities of cheap credit by setting interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s below where they would be set by a free market. This easy availability of credit inspires a bundle of malinvestments, particularly on long term projects such as housing and capital assets, and also spurs a consumption boom as incentives to save are diminished. Thus an unsustainable boom arises, characterized by malinvestments and overconsumption.
But the created credit is not backed by any real savings nor is in response to any change in the real economy, hence, there are physically not enough resources to finance either the malinvestments or the consumption rate indefinitely. The bust occurs when investors collectively realize their mistake. This happens usually some time after interest rates rise again. The liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
of the malinvestments and the consequent reduction in consumption throw the economy into a recession, whose severity mirrors the scale of the boom's excesses.
The Austrian School argues that the conditions previous to the crisis of the late 2000s correspond exactly to the scenario described above. The central bank of the United States, led by Federal Reserve Chairman Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, kept interest rates very low for a long period of time to blunt the recession of the early 2000s. The resulting malinvestment and over-consumption of investors and consumers prompted the development of a housing bubble that ultimately burst, precipitating the financial crisis. This crisis, together with sudden and necessary deleveraging
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
and cutbacks by consumers, businesses and banks, led to the recession. Austrian Economists argue further that while they probably affected the nature and severity of the crisis, factors such as a lack of regulation, the Community Reinvestment Act
Community Reinvestment Act
The Community Reinvestment Act is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods...
, and entities such as Fannie Mae and Freddie Mac are insufficient by themselves to explain it.
A positively sloped yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
allows Primary Dealers (such as large investment banks) in the Federal Reserve system to fund themselves with cheap short term money while lending out at higher long-term rates. This strategy is profitable so long as the yield curve remains positively sloped. However, it creates a liquidity risk if the yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
were to become inverted and banks would have to refund themselves at expensive short term rates while losing money on longer term loans.
The narrowing of the yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
from 2004 and the inversion of the yield curve during 2007 resulted (with the expected 1 to 3 year delay) in a bursting of the housing bubble and a wild gyration of commodities prices as moneys flowed out of assets like housing or stocks and sought safe haven in commodities. The price of oil rose to over $140 dollars per barrel in 2008 before plunging as the financial crisis began to take hold in late 2008.
Other observers have doubted the role that the yield curve plays in controlling the business cycle. In a May 24, 2006 story CNN Money reported: "...in recent comments, Fed Chairman Ben Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no longer a good indicator of a recession ahead."
Oil prices
Economist James D. HamiltonJames D. Hamilton
James Douglas "Jim" Hamilton is an US econometrician currently teaching at University of California, San Diego. His work is especially influential in time series and energy economics...
has argued that the increase in oil prices in the period of 2007 through 2008 was a significant cause of the recession. He evaluated several different approaches to estimating the impact of oil price shocks on the economy, including some methods that had previously shown a decline in the relationship between oil price shocks and the overall economy. All of these methods "support a common conclusion; had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the US economy would not have been in a recession over the period 2007:Q4 through 2008:Q3." Hamilton's own model, a time-series econometric forecast based on data up to 2003, showed that the decline in GDP could have been successfully predicted to almost its full extent given knowledge of the price of oil. The results imply that oil prices were entirely responsible for the recession; however, Hamilton himself acknowledged that this was probably not the case but maintained that it showed that oil price increases made a significant contribution to the downturn in economic growth.
Reverse Immigration
Reverse migration of illegal immigrants from the US back to Mexico began in 2006, and this has reduced the overall population of the US.Approximately 0.5 million dwellings have become permanently vacant as a result of a reduction in the illegal immigrant population
Illegal immigration to the United States
An illegal immigrant in the United States is an alien who has entered the United States without government permission or stayed beyond the termination date of a visa....
. The greatest impact has been on the California economy, where illegal immigrants comprise approximately 1/3 of the total population. The reduced demand for housing created permanent unemployment for hundreds of thousands of building contractors, realtors, and mortgage brokers.
Foreign investment in Mexico by businesses located in China and Venezuela have increased employment opportunities in Mexico. The number of illegal immigrants living in the US declined by 1.5 million since 2007, or about 12% of the total illegal immigrant workforce. The economic decline caused by reduced spending by illegal immigrants in the US occurred at the same time as a rise in unemployment of approximately 1 million legal US workers that provide goods and services for the illegal immigrant population. This increased the number of foreclosures and reduced automotive sales, contributing to an overall decline in value for real estate, vehicles, and other property.
Economic activity produced by illegal immigrant spending employs about 5% of the total US workforce. Illegal immigrants occupy over 3 million dwellings, or just under 4% of the total number of homes in the US. UCLA research indicates illegal immigrants produce $150 billion of economic activity equivalent to spending stimulus every year. Nearly every dollar earned by illegal immigrants is spent immediately, and the average wage for US citizens is $10.25/hour with an average of 34 hours per week, so approximately 8 million US jobs are dependent upon economic activity produced by illegal immigrant activities within the US.
Other claimed causes
Many libertarians, including Congressman and former 2008 Presidential candidate Ron PaulRon Paul
Ronald Ernest "Ron" Paul is an American physician, author and United States Congressman who is seeking to be the Republican Party candidate in the 2012 presidential election. Paul represents Texas's 14th congressional district, which covers an area south and southwest of Houston that includes...
and Peter Schiff
Peter Schiff
Peter David Schiff is an American investment broker, author and financial commentator. Schiff is CEO and chief global strategist of Euro Pacific Capital Inc., a broker-dealer based in Westport, Connecticut and CEO of Euro Pacific Precious Metals, LLC, a gold and silver dealer based in New York...
in his book Crash Proof, claim to have predicted the crisis prior to its occurrence. Schiff also made a speech in 2006 in which he predicted the failure of Fannie and Freddie. They are critical of theories that the free market caused the crisis and instead argue that the Federal Reserve's expansionary monetary policy
Expansionary monetary policy
In economics, expansionary policies are fiscal policies, like higher spending and tax cuts, that encourage economic growth. In turn, an expansionary monetary policy is monetary policy that seeks to increase the size of the money supply...
and the Community Reinvestment Act
Community Reinvestment Act
The Community Reinvestment Act is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods...
are the primary causes of the crisis. Alan Greenspan, former Federal Reserve chairman, has said he was partially wrong to oppose regulation of the markets, and expressed "shocked disbelief" at the failure of self interest, alone, to manage risk in the markets.
An empirical study by John B. Taylor
John B. Taylor
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution....
concluded that the crisis was: (1) caused by excess monetary expansion; (2) prolonged by an inability to evaluate counter-party risk due to opaque financial statements; and (3) worsened by the unpredictable nature of government's response to the crisis.
It has also been debated that the root cause of the crisis is overproduction
Overproduction
In economics, overproduction, oversupply or excess of supply refers to excess of supply over demand of products being offered to the market...
of goods caused by globalization
Globalization
Globalization refers to the increasingly global relationships of culture, people and economic activity. Most often, it refers to economics: the global distribution of the production of goods and services, through reduction of barriers to international trade such as tariffs, export fees, and import...
(and especially vast investments in countries such as China
China
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...
and India
India
India , officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with over 1.2 billion people, and the most populous democracy in the world...
by western multinational companies over the past 15–20 years, which greatly increased global industrial output at a reduced cost). Overproduction tends to cause deflation and signs of deflation were evident in October and November 2008, as commodity prices tumbled and the Federal Reserve was lowering its target rate to an all-time-low 0.25%. On the other hand, Professor Herman Daly
Herman Daly
Herman Daly is an American ecological economist and professor at the School of Public Policy of University of Maryland, College Park in the United States....
suggests that it is not actually an economic crisis, but rather a crisis of overgrowth
Exponential growth
Exponential growth occurs when the growth rate of a mathematical function is proportional to the function's current value...
beyond sustainable ecological limits. This reflects a claim made in the 1972 book Limits to Growth, which stated that without major deviation from the policies followed in the 20th century, a permanent end of economic growth could be reached sometime in the first two decades of the 21st century, due to gradual depletion of natural resources.
In laissez-faire
Laissez-faire
In economics, laissez-faire describes an environment in which transactions between private parties are free from state intervention, including restrictive regulations, taxes, tariffs and enforced monopolies....
capitalism, financial institutions would be risk-averse because failure would result in liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
. But the Federal Reserve's 1984 rescue of Continental Illinois and the 1998 rescue of the Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
, among others, showed that institutions which failed to exercise due diligence
Due diligence
"Due diligence" is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations...
could reasonably expect to be protected from the consequences of their mistakes. The belief that they could not be allowed to fail
Too Big to Fail
Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...
created a moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
which was a contributing factor to the late-2000s recession.