The financial crisis of 2008, more commonly referred to as the “Great Recession,” was a pivotal point that changed the world’s economic course. Many factors created a perfect storm that led to general economic instability.
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Causes of the Crisis
The US’ risky lending practices in housing market were the cause of the crisis. Prior to 2008, the financial firms in the US distributed subprime mortgages to people with bad credit records. These loans were sold to investors from all parts of the world in the form of MBS, a complex financial product.
At the time, this was a win-win for both parties. Investors gained from the appreciating housing market, while at the same time, homebuyers were able to get finance. Sadly, as the value of real estate started to fall, many homeowners did not pay back their loans. The value of MBS thus fell precipitously, causing huge losses in banks and among investors themselves.
It was exacerbated by risk-taking by financial companies combined with a lack of regulatory oversight. The toxic assets were diffused through the global financial system using complex derivatives like collateralized debt obligations, usually referred to as CDOs. Panic set in when Lehman Brothers, one of the large investment banks, collapsed in September 2008. Credit markets froze, and economists were compelled to watch as economies tanked all over the world.
Consequences of the Crisis
The Great Recession was characterized by sharp stock market declines, a rise in the level of house foreclosures, and rapidly increasing unemployment. Millions lost their jobs and life savings. This was followed by massive bailouts of banks to try to prevent further economic collapse by governments around the world, central banks lowered interest rates and implemented quantitative easing to stimulate economic recovery.
Lessons Learned
The crisis shed light on the need for tighter controls over finances. Since the event was not to happen again, reforms accompanying it, like the Dodd-Frank Act in the United States, included measures such as stress tests for banks and more open financial markets. It also brought into focus the need for governments to monitor the risk taken by financial institutions and people being cautious with debt.
Even as the global economy has healed, the crisis is a grim reminder of how connected and vulnerable financial systems can be. The better we understand its causes and consequences, the better equipped we are to start building a better economic future.
Sources:
- Financial Crisis Inquiry Commission Report (2011) – A comprehensive government report on the causes of the financial crisis. Available online at the U.S. Government Printing Office
- Investopedia’s article on the 2008 Financial Crisis: Investopedia – 2008 Financial Crisis
- Federal Reserve history summary of the crisis: Federal Reserve History
- BBC’s retrospective analysis of the crisis: BBC – The Financial Crisis Explained
- Reinhart, Carmen M., and Kenneth S. Rogoff. This Time is Different: Eight Centuries of Financial Folly. Princeton University Press (2009) – An academic exploration of financial crises.