Eleven years ago, the global economy was shaken to its core by a cataclysmic event that later came to be known as the ‘Great Recession.’ As a cold chill ran down the spine of the global economic machine, governments scurried around to manage the contagion. Although timely intervention prevented much of the destructive capacity of this event, there were still losses on a mammoth scale. As another anniversary goes by, it is instructive to have a brief overview of what set this calamity in motion.
The story takes us to the heart of global capitalism, the USA. After the dot com bubble burst in 2001, investors (individuals, banks, investment institutions, portfolio funds, etc.), were on the lookout for another good investment from where they could reap above normal returns. Their quest took them to the housing sector, where new forms of investments (thanks to financial engineering) had recently propped up. Somehow, investors came to believe that property prices will keep rising and good days will never end. Part of the explanation of their belief lay in human psychology, another part involved the nature of global financial flows, while another was embedded in US politics.
The rising prices of houses in early 2000s made it a natural object of attraction for investors. The result was a substantial diversion of investment to the housing sector by big banks, investment firms and individuals. The early wave of investments was followed by additional investment flows, creating (not surprisingly) a situation where property prices rose precipitously, earning high rates of return for initial investors and property owners. This laid the ground for a continuous flow of investment from the other sectors that were not performing well. The scenario fits well with what economist term the ‘herd behaviour’ or the ‘bandwagon effect.’ Put in a non-technical manner, people tend to believe that something is a better if a lot of other people are indulging in it, thus incentivising them to tow the same line.
Financial wizards, ever eager to capitalise on such an opportunity, quickly innovated mortgage backed securities (‘securities’ are financial instruments that derive their value from their related assets), and sold them off to eager customers. In short, all and sundry jumped into the fray. In a short span of a few years, most institutions and individuals had invested small or large amounts into the mortgage business. People who could not afford to pay mortgage for one house now had financing options for at least three.
The global financial factor comes into play due to the open nature of capital flows. The US has been the preferred destination for investors in financial sector for a long time, and it has responded in kind by making it easier to invest and buy through lax checks on financial flows. In fact, a research paper (Why foreigners invest in US) argued that the financial sector of the US is the biggest factor in attracting outside investment. The bandwagon effect, or the herd behaviour, lured the foreign investors too. They, including central banks around the world (like China’s) awash with huge dollar reserves, rushed to buy the newly introduced mortgage backed debt instruments and securities. European banks were the ones that invested most heavily into them, and also suffered the most after the US when recession struck. Leverage ratios (ratio of an institution’s debt to its assets) were relaxed to facilitate these investments.
The internal political dynamics of the US, specifically its politics, also played its part. The government, under pressure mainly from the democrats in the Senate, directed Freddy Mac and Fannie Mae (two of the country’s biggest public lenders of house building loans) to relax the lending rules considerably. This step had its genesis in the early 1990s, when a study published by the Boston Federal Reserve implied that where lending norms are concerned, there was evidence that minorities (especially African Americans) were being discriminated against. From then on, there had been a consistent movement to ease the lending rates to make loans more accessible to minorities. But many economists challenged the study for its inaccurate data, and Stephen Liebowitz (an economist) even published a paper in 1998 that forewarned a crisis due to relaxation of the rules and regulations. Similarly, Paul Krugman (a Nobel Prize winning economist) had warned that years of lax rules and regulations had made borrowing easier and that people had borrowed way beyond what their real incomes could support. Yet their criticism went unheard, and politics prevailed over discretion and evidence. As stated above, this created a situation where individuals or families who could hardly take out loan for one home now assumed a position to get finance for three. A sudden jump in demand pushed the prices higher, and market for housing became an attractive investment avenue. It also helped that since mid-1990s, the US Federal Reserve has maintained a policy of low interest rates, making borrowing and lending less costly.
The first signs of trouble appeared when individuals and other borrowers started to default on their re-payments of mortgage loans. They had bought houses in the hope that these will easily sell at a premium, enabling them to make profit and easily pay-off their mortgages. However, it largely remained an unfulfilled dream. The severity of this crisis became apparent as Bear Stearns, a large Wall Street investment firm, filed for bankruptcy. The US treasury secretary, Henry Paulson, personally took the initiative to bail it out so as to prevent fear from spreading. But by that time, it was too late. The fear of defaults and bankruptcies spread fast and markets all over the world saw pessimism run amok (Japan’s total investment in these toxic financial instruments was hardly two percent. Yet its stock index (NIKKEI) plummeted 24 percent between 10th to 20th October, a vivid demonstration of the bandwagon effect or the herd behaviour). The crisis came to a full head when Lehman Brothers, another reputed investment firm, filed for bankruptcy. On October 6 and 7, stock markets around the globe tumbled and experienced losses worth $6.5 trillion. The whole financial system had come down like a pack of cards, and governments all over the world stepped in to save their financial systems.
Although a detailed discussion of the changes in policies in the aftermath of this event is beyond the scope of this article, it did deal a substantial blow to free-market policies that were the dominant mode of policymaking around the globe, especially the interconnectedness of global economies that helped spread the contagion. Even more importantly, the nature and working of the financial sector came under intense scrutiny. After all, a sector that hardly contributed two percent to the global economy (in terms of real economic output) brought its moving wheels to a screeching halt, causing massive job losses and trillions lost in investment value.
Global economy’s biggest challenge nowadays is how to prevent another such crisis from occurring. In this quest, lessons from the Great Recession of 2008 will serve as an able guide.
The writer is an economist