The Great Crisis: Behind the Scenes
The economic crisis exploded in 2008 had disastrous effects on the world’s economy, forcing governments to undertake massive taxpayer-financed bail-outs in order to bring the economy on the right track again. A large number of firms went bankrupt and many people lost their savings. The global economic slowdown, which took place after the Lehman Brothers’ collapse, can be considered as one among the most disruptive ever experienced. As a matter of fact, many rich countries are still struggling in order to completely recover from such a tragic rout. This is especially the case of the European Union, where the economic crisis evolved into a debt crisis.
Among the factors which made the economic crisis so severe, there is undoubtedly its seemingly unpredictable nature. During the 1980s, the patterns of the Phillips model, negatively correlating the level of unemployment within a country to its inflation rate, seemed not to hold anymore and in some cases they were even inverted. From the 1990s on in fact, the US and the European Union went through a continuous and solid growth phase, metaphorically a new “Great Moderation”. Markets were growing at an unprecedented level, unemployment was progressively lowering and consumption was becoming stable across the population. So how could this optimal scenario have turned into one of the most oppressive recessions of all the times? How could major economists fail to predict the advent of such a great cataclysm?
Despite the fact that all those questions do still not have found a precise answer, it is now evident that various instability signals were overlooked by the economists at the time. In order to have clear in mind the steps that brought to the general meltdown, it is essential to understand that the crisis was not generated merely by a single cause. It is then crucial to cautiously spot all the macroeconomic events which have influenced the global scenario from the 1990s on and to interpret them according to major economists’ most popular beliefs.
The story began in the 1970s, when the huge market turmoil generated by the first oil price crises brought about a dramatic surge in the inflation level after more than 45 years of stability. Investors in the US were no longer able to gain much benefit from their deposit accounts, since the ceilings imposed on deposit rates by the Regulation Q of the Banking Act prevented them from being profitable with such a high inflation rate. To bypass banks, the commercial paper market took over. Other financial institutions contributed to the creation of money market mutual funds in order to take advantage of this situation. With the aim of revamping the banking sector and allowing it to compete with money market mutual funds, a series of deregulating acts were implemented. This is the beginning of a period infamously known as the “Financial Deregulation”, a transition from the structural regulation to the prudential standards. Under the former, financial risk was assumed to be unpredictable and banks were therefore subject to bans and limitations in order to avoid dangerous situations. Compulsory reserves, constraints on competition, business restrictions and loan/interest rate ceilings were among the most common measures adopted by regulators. With the advent of the latter, the concept of financial risk was seen as forecastable and banks able to handle it by respecting determined capital requirements. Thus a progressive uncapping of deposit rates took place, granting banks the possibility to offer greater yields on their deposits and implying a shift to a riskier type of investments to provide these returns.
At the same time, many banks started to question the restrictions imposed by the Glass-Steagall Act, which forbade them to engage in other kind of activities, such as underwriting and security management. Using the blurring role of money market mutual funds as an argument, big banks succeeded in convincing regulators that the Glass-Steagall Act was somehow obsolete. Afraid that deregulation in foreign countries could have attracted national capital abroad, the Glass-Steagall Act was reinterpreted in 1986. Although the Federal Reserve Chairman Paul Volcker was strongly opposed, banks were allowed to obtain a portion of their revenues from underwriting activities and to freely deal with commercial papers and more complex assets, such as mortgage-backed securities.
In 1987, Alan Greenspan was elected president of the Federal Reserve. In this period, the financial sector grew wider and banking regulation became entirely prudential. By 1996, the Glass-Steagall Act was reinterpreted two times by the Fed, raising the percentage level of gross revenues obtainable from other business to 25% and thus making the act itself meaningless. In addition, the banking industry experienced a huge consolidation process, significantly fostered by the Riegle-Neal Interstate Banking and Branching Efficiency Act in 1994. An ad-hoc example could be the merger between Citicorp and Travelers Insurance Group, with the aim of forming Citigroup, Inc., the world’s largest financial service company at the time. In 1999, the Gramm-Leach-Bill Act fully repealed the Glass-Steagall Act allowing potential combinations of financial securities and insurance with the banking business. In addition, this hardly controllable scenario led to the proliferation of new financial instruments called derivatives, used to protect their owner from an unexpected decline in assets’ value. Alternatively, derivatives could also be seen in a speculative fashion. By betting on the occurrence of a particular event, an investor was enabled to profit off without even owning the asset, since derivatives do not entitle for the actual transfer of the good.
During the 1990s, many economists manifested their concerns on these unregulated instruments. The chairman of the Commodities Future Trading Commission Brooksley Born highlighted that records on derivative trades were not transparent enough, but the Fed Treasury Secretary Robert Rubin and his successor Lawrence Summers continued to promote no regulation on derivatives. In 2004, investment banks were allowed to hold smaller capital requirement and take on more debt.
The SEC outsourced the monitoring of risk to firms, convinced that self-regulation could have been sufficient to avoid any kind of issues. Among the new-developed securities, mortgage-backed assets deserved undoubtedly particular attention. Mortgages were acquired by big investment banks from their providers, classified according to their default risk and then packaged into mortgage-backed securities. Each security was composed by mortgages from three different classes, so that overall the safest loans would compensate for the higher risk embodied in the subprime products. Thanks to the contribution of large financial institution, this system proved to be incredibly profitable in the beginning and thus investment banks started to demand more mortgages to be used as collaterals. This is how the share of subprime mortgages with respect to the entire mortgages market went up from 8% in 2001 to 20% in 2006, accounting for a total of $685 billion and with an average contract value of $259.000. According to Greenspan, this “increasingly-complex” financial innovation contributed to the creation of a more flexible and efficient market. But perhaps he had overlooked something that could unexpectedly blow up his house of cards.
Another argument which needs to be thoroughly evaluated is the monetary policy carried out by the United States and the European Union prior to the 2008 crisis. The economic manoeuvres strongly relate to the financial deregulation, since the presence of liquidity in the market was a necessary condition for the deregulating process. However, if someone accurately observes the macroeconomic scenario, it is possible to track back also other reasons behind the implementation of the excessively lax monetary policy.
China and the Asian Tigers in fact, after having experienced a phenomenal growth from the end of the 1970s, started to commercialise their products at the global level. Thanks to the removal of multiple trade barriers and the key role played by the new-founded World Trade Organisation, both the United States and the European Union began importing many goods from China, Japan and South Korea given their cheaper price. In order to exploit the gains from trade of globalisation, Alan Greenspan pumped an excess of liquidity into the market by progressively cutting Fed rates almost down to zero. The so-called “wealth effect” experienced by Americans at the time was mainly due to the fact that the Asian Tigers were investing a lot in the US, therefore creating a substantial demand for the green currency which kept its value strong and prevented inflation from proliferating. The same happened in the European Union, where monetary policies were mainly expansive following the United States example.
Using the Taylor Rule, a flexible mechanism deriving from the Fisher Equation and used to establish the appropriate interest rate customised to the needs of each nation, it is possible to claim that the interest rate level substantially deviated from the optimal outcome not only in the United States but also in Italy, France, Spain, Portugal, Ireland and Greece. As a matter of fact, the bigger the difference from the Taylor outcome, the higher the expected costs in order to rescue the financial sector proved to be.
So eventually, rather this promising scenario prevented the entire world from noticing the presence of several financial instability signals. The key to fully comprehend what caused the economic wreck lies in the concept of market efficiency, which took on a predominant role among economics scholars at the time.
The Efficient Markets View, represented by the Fresh Water School, sustained that if markets were efficient at the micro level then also the macro performances were automatically efficacious. The idea of a supply-side driven economy was widely reputed the new economic frontier. According to this theory, movements in demand can be effortlessly predicted by suppliers and the market equilibrium is determined only by production effectiveness. Thus, solely policies aimed at increasing flexibility in labour markets and enhancing the enforcement of property rights were worth implementing. It was possible to obtain growth and stability at the same time, exactly as the inverted Philips Model patterns had observed. Instability phenomena such as the bubble underwent in the housing sector and the current accounts imbalances were therefore negligible.
Unfortunately, the influence of the financial world on the final outcome was completely omitted, causing the entire framework to crumble down once the sub-prime mortgages bomb set off. The deregulating process brought about a bigger, more complex and interconnected financial sector at the micro level. As a macro consequence, the level of leverage run not only by financial institutions but also by countries skyrocketed. Despite the fact that only 10% of the subprime mortgages receivers defaulted on their repayments, the entire financial system collapsed.
To conclude, the aim of this article is not to point at anybody for what has happened. Indeed, it attempts to build up a detailed framework comprehending all the reasons behind the great crisis exploded in 2008. A long-lasting deregulation implemented in the financial field combined with a huge monetary stimulus, brought about an extremely interconnected financial sector capable of amplifying the effects of a housing price bubble. Moreover, the article stresses the importance of relying on solid economic models, having wide consensus among the economic community. However, the awareness that models are always created with hindsight needs to be kept in mind at all times.
WRITTEN BY NICOLA BRUSSOLO FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT