The Great Recession

The 2007–2012 global financial crisis, also known as the 2008 financial crisis, is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market also suffered, resulting in evictions, foreclosures, and prolonged unemployment. The crisis played a significant role in the failure of key businesses, with declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to the 2008–2012 global recession and contributing to the European sovereign-debt crisis.

Contributing Factors

Corporate Fraud

The first decade of the 21st century was marked by widespread corporate fraud and scandal. After years of reaping tremendous profits in the deregulated energy markets, Houston-based Enron imploded in 2003 over allegations of massive accounting fraud. Its top executives, Ken Lay and Jeff Skilling, received long prison sentences, but their activities were illustrative of a larger trend in the nation’s corporate culture that embroiled reputable companies like JP Morgan Chase and the accounting firm Arthur Anderson. In 2003, Bernard Ebbers, the CEO of communications giant WorldCom, was discovered to have inflated his company’s assets by as much as $11 billion, making it the largest accounting scandal in the nation’s history. Only five years later, however, Bernard Madoff’s Ponzi scheme would reveal even deeper cracks in the nation’s financial economy.

The Housing Bubble

Despite economic growth in the 1990s and steadily increasing productivity, wages had remained largely flat relative to inflation since the end of the 1970s; despite the mild recovery, they remained so. To compensate, many consumers were buying on credit, and with interest rates low, financial institutions were eager to oblige them. By 2008, credit card debt had risen to over $1 trillion. More importantly, banks were making high-risk, high-interest mortgage loans called subprime mortgages to consumers who often misunderstood their complex terms and lacked the ability to make the required payments.

These subprime loans had a devastating impact on the larger economy. repay. Changes in finance and banking laws in the 1990s and early 2000s gave banks the ability to afford to make bad loans, because they could sell them and not suffer the financial consequences when borrowers failed to repay. Once they had purchased the loans, larger investment banks bundled them into huge packages known as collateralized debt obligations (CDOs) and sold them to investors around the world. Even though CDOs consisted of subprime mortgages, credit card debt, and other risky investments, credit ratings agencies had a financial incentive to rate them as very safe. Making matters worse, financial institutions created instruments called credit default swaps, which were essentially a form of insurance on investments. If the investment lost money, the investors would be compensated. This system, sometimes referred to as the securitization food chain, greatly swelled the housing loan market, especially the market for subprime mortgages, because these loans carried higher interest rates. The result was a housing bubble, in which the value of homes rose year after year based on the ease with which people now could buy them.

The Bubble Bursts 

When the real estate market stalled after reaching a peak in 2007, the house of cards built by the country’s largest financial institutions came tumbling down. People began to default on their loans, and more than one hundred mortgage lenders went out of business. Large financial institutions, which had once been prevented by federal regulations from engaging in risky investment practices, found themselves in danger. A financial panic ensued that revealed other fraudulent schemes built on CDOs.  

The bursting of the U.S. housing bubble, which peaked in 2007, caused the values of securities tied to U.S. real estate pricing to plummet, damaging financial institutions globally. The financial crisis was triggered by a complex interplay of valuation and liquidity problems in the United States banking system in 2008. Questions regarding bank solvency, declines in credit availability, and damaged investor confidence had an impact on global stock markets, where securities suffered large losses during 2008 and early 2009. Economies worldwide slowed during this period as credit tightened and international trade declined. Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion, and institutional bailouts. Although there have been extensive aftershocks, the financial crisis itself ended sometime between late-2008 and mid-2009. In the U.S., Congress passed the American Recovery and Reinvestment Act of 2009. In the E.U., the United Kingdom responded with austerity measures of spending cuts and tax increases without export growth, and it has since slid into a double-dip recession.

Many causes for the financial crisis have been suggested, with varying weight assigned by experts. The U.S. Senate's Levin-Coburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." Two factors that have been frequently cited include the liberal use of the Gaussian copula function and the failure to track data provenance.

Government Response and Aftermath 

Bailing out the Banks 

Members of Congress agreed to use $700 billion in federal funds to bail out the troubled institutions, and Congress subsequently passed the Emergency Economic Stabilization Act, creating the Troubled Asset Relief Program (TARP). One important element of this program was aid to the auto industry: the Bush administration responded to their appeal with an emergency loan of $17.4 billion—to be executed by his successor after the November election—to stave off the industry’s collapse.

Effects

Many posit that the actions of the Federal Reserve, Congress, and the president prevented the complete disintegration of the nation’s financial sector and warded off a scenario like that of the Great Depression. However, the bailouts could not prevent a severe recession in the U.S. and world economy. As people lost faith in the economy, stock prices fell by 45%. Unable to receive credit from now-wary banks, smaller businesses found that they could not pay suppliers or employees. With houses at record prices and growing economic uncertainty, people stopped buying new homes. As the value of homes decreased, owners were unable to borrow against them to pay off other obligations, such as credit card debt or car loans. More importantly, millions of homeowners who had expected to sell their houses at a profit and pay off their adjustable-rate mortgages were now stuck in houses with values shrinking below their purchasing price and forced to make mortgage payments they could no longer afford.

Without access to credit, consumer spending declined. Some European nations had suffered similar speculation bubbles in housing, but all had bought into the mortgage securities market and suffered the losses of assets, jobs, and demand as a result. International trade slowed, hurting many American businesses. As the Great Recession of 2008 deepened, the situation of ordinary citizens became worse. During the last four months of 2008, one million American workers lost their jobs, and during 2009, another three million found themselves out of work. Under such circumstances, many resented the expensive federal bailout of banks and investment firms. It seemed as if the wealthiest were being rescued by the taxpayer from the consequences of their imprudent and even corrupt practices.

In response to the financial crisis, both market-based and regulatory solutions have been implemented or are under consideration. Paul Krugman, author of End This Depression Now! (2012), argues that while current solutions have stabilized the world economy, the world economy will not improve unless it receives further stimulus. Buchanan, Gjerstad, and Smith argue that fiscal and monetary policy are ineffective, failing to reignite residential investment and construction as they have in past contractions. The current type of contraction requires balance sheet repair via currency depreciation and export-driven growth. Fiscal stimulus extends a current account deficit and retards export growth. If the world economy does not improve, many economists fear sovereign default is a real possibility in several European countries and even the United States.