The Great Recession of 2008 1

The Great Recession of 2008:

What happened and how it could have been prevented

James Gessel

Salt Lake Community College

The Great Recession of 2008 2

In 2008, a devastating financial crisis crippled the United States of America. Despite

aggressive efforts by the Federal Reserve and Treasury Department, it became the worst

economic disaster since the Great Depression of the 1930s. Many legislators and analysts

speculate as to what exactly went wrong, arguing that it was a lack of modernized legislation, the

bursting of the housing bubble, or Wall Street greed. There is not likely any one factor alone that

was significant enough to bring about one of the most catastrophic economic events in history,

but more likely a combination of poor legislation, mistakes made by financial institutions, and

consumer behavior. Because there are so many factors that precipitated the economic downfall,

multiple aspects need to be investigated, including various legislative acts, actions and reactions

of financial institutions, and consumer behavior.

For decades leading up to the Great Recession, consumer spending and demand were

booming. According to Washington University in St. Louis, in the mid 1980s, real personal

consumption grew almost thirty-seven percent from 1984 to 2007, considerably more than the

other components of real GDP.1 This period was dubbed by some as the Consumer Age.

Interestingly, this rise in consumer spending was not accompanied by a rise in consumer income,

but rather a decline in income growth. Top earners earned more while the rest of consumers

earned less, and simply had to borrow more money to keep up with their consumption habits.

The rate at which consumers were borrowing was unprecedented and ever increasing. According

to economic research by the Federal Reserve Bank of San Francisco, US household leverage (the

ratio of debt to personal disposable income), increased from sixty-five percent to one-hundred

and thirty-three percent from the mid 1980s to 2007.2 The US economy was no stranger to large

amounts of debt, but this economic shift began to resemble a credit bubble prominent around

eighty years before.

The Great Recession of 2008 3

In the 1930s, following the stock market crash and the Great Depression, congress

passed the Glass-Steagall Act in hopes to help America back onto its feet. Known as the

Banking Act of 1933, the Glass Steagall Act brought forth and instituted many strict

regulations as to what banks and other financial institutions could do. As stated by congress, the

act was intended to provide for the safer and more effective use of the assets of banks, regulate

interbank control, prevent the undue diversion of funds into speculative operations, and other

purposes.3 Enacted as an emergency response to the failure of almost five thousand banks, the

legislation created the Federal Deposit Insurance Corporation, which insured bank deposits with

a pool of money in case of another economic depression. Along with the creation of the FDIC,

the Glass-Steagall Act also restricted bank sales of securities, more specifically, forcing a

separation of commercial and investment banks by preventing commercial banks from

underwriting securities. Many believe that in the Great Depression, the bank of the United States

failed because certain activities involving security affiliates created artificial conditions in the

market. Although some argue that securities were not significantly affiliated with the great

depression and thus the Glass-Steagall act was never needed, it helped to bring the nation into a

state of financial stability. The faith of many was restored in the US financial system, and the act

was effectively in action until more than fifty years later, in 1999.

In the late 1990s, many historians, legislators, and economists began to argue that the

Glass-Steagall Act was outdated and needed to be repealed. Originally part of President

Roosevelts New Deal program, the act was not permanent until 1945. Since then for almost

fifty-five years, the act held its restrictions on commercial banks until 1999, when the Gramm-

Leach-Bliley Act was passed as a response to criticism. The Gramm-Leach-Bliley Act made

significant changes to the Glass-Steagall Act. Restrictions on bank and securities firm affiliations
The Great Recession of 2008 4

were repealed, allowing banks to involve themselves in the sale of securities once more. It also

amended the Bank Holding Company Act, which had prohibited affiliations between financial

services companies such as banks, securities firms, and insurance companies. In essence, it

removed the barriers that the Glass-Steagall Act had erected in attempt to modernize the

financial system. If the greed of wall street is to be blamed for the Great Recession, then the

1999 repeal of the Glass-Steagall Act give birth to the first stirrings of trouble.

Financial stability and the prevention of banks engaging in securities sales were two of

the main reasons that the Glass-Steagall Act was passed by congress. When it was repealed in

1999, many banks and financial institutions saw a booming opportunity to make money through

mortgage loans. Without the restrictions of the Glass-Steagall Act, getting approved for a loan

went from being fairly difficult to child's play. Prior to 1999, subprime borrowers with low credit

scores had a very difficult time receiving loans because of the many restrictions on banks. When

removed, however, banks were giving out loans left and right to millions of subprime applicants

as high-risk mortgages. These mortgages were funded by taking them and packing them into

pools of private-labeled mortgage-backed securities that were sold to investors. These pools were

viewed to have a much lower risk either because they were insured with new financial

instruments or because other securities would first absorb any losses on the underlying

mortgages. Because of the newfound ability to obtain mortgages, many Americans began

seeking homes, leading to a rise in housing market demand. Investors who invested in the pools

of PMBS were protected from losses by this rise in demand, thus making it seem like the pools

were, in fact, a low risk investment. The primary means of settling losses and debt became

refinancing mortgages and selling homes. However, when housing prices peaked, the primary

means of settling debt and covering losses became a less viable means of doing so. Losses began
The Great Recession of 2008 5

to pile up, and in 2007, several leading subprime lenders filed for bankruptcy, leading to a

downgrade in risk-ratings for the PMBS pools. Because they were all of a sudden high risk

investments, investors ceased to invest, which lead to a decrease in the number of subprime

mortgage loans. Demand for homes plummeted because of raised prices and lack of available

loans, making it very difficult for borrowers to pay off their high-interest rates. Thus, with the

struggle to pay off mortgage loans and the crash in demand for homes, the great housing bubble

of the United States of America burst, leading to thousands of foreclosures, a decrease in

consumer spending, and lack of funding for future loans.

In response to the great downfall in 2008, congress attempted to correct the failing

economy in multiple ways, one of which was the Dodd-Frank Act. In 2010, President Obama

signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. Essentially

the act restored various restrictions put in place by Glass-Steagall, and added many more

regulations on the financial industry. It was geared toward protecting consumers from abusive

lending and mortgage practices by banks.

Although the Dodd-Frank Act was passed to help America back onto its feet similarly to

circumstances in 1933, it has been criticized by many and deemed ineffective. Proponents

believe the act will prevent another crisis by limiting risks that a financial firm can take, but in

turn that also limits its profit-making ability. Detractors believe that the bill could harm the

competitiveness of US firms relative to their foreign counterparts. Due to higher reserve

requirements, banks are required to hold a higher percentage of their assets in cash, which

decreases the amount they are able to hold in marketable securities, effectively lowering profits.

These downsides could lead to a potential hurt in economic growth. Dodd-Frank in a sense

overcorrected Gramm-Leach-Blileys mistake, going from too few regulations to too many.
The Great Recession of 2008 6

The best way to correctly and effectively stabilize the economy is likely found in a sweet

spot in between the Dodd-Frank and Glass-Steagall acts. Dodd-Frank limits and restricts banks

too much while Glass-Steagall was created for a less modernized economy. Banks should not be

prohibited from engaging in securities sales, though there should be restrictions. One example is

the pools of private-labeled mortgage-backed securities. According to The Economist, such

pooling works when the risks of each loan are uncorrelated.4 Banks should not be allowed to

pool together so many high risk securities that all have a common weakness. This was a primary

cause of the 2008 downfall, and legislation should be made to prevent the same occurrence, but

financial institutions should still be able to engage in profitable securities markets.

Although there were many causes of the Great Recession of 2008, the repeal of Glass-

Steagall in favor of Gramm-Leach-Bliley was undoubtedly one of the largest mistakes, and

surely one of the primary reasons. Ultimately, it was a major cause of the downfall and bursting

of the housing bubble, resulting in millions of lost jobs, foreclosures, unpaid debts, and crippled

financial institutions. The Dodd-Frank act is a start to improved legislation concerning financials,

but there are too many prohibitions and limitations to allow for a thriving, profitable financial

market. Only time will tell if the Dodd-Frank Act will successfully fulfill its purpose, but I

wouldnt be surprised if there is more legislation put into practice before all the components of

Dodd-Frank are carried out.

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References

"Crash Course." The Economist. The Economist Newspaper, 07 Sept. 2013. Web. 27 July
2017. Retrieved February 27, 2017
http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-
being-felt-five-years-article

"FULL TEXT: The Glass-Steagall Act A.k.a. The Banking Act of 1933". N.p., n.d. Web.
27 February 2017 from https://archive.org/stream/FullTextTheGlass-
steagallActA.k.a.TheBankingActOf1933/1933_01248_djvu.txt

Muddy Water Macro. (n.d.). Retrieved July 27, 2017, from

https://muddywatermacro.wustl.edu/node/92

U.S. Household Deleveraging and Future Consumption Growth. (2009, May 15).
Retrieved July 27, 2017, from http://www.frbsf.org/economic-
research/publications/economic-letter/2009/may/us-household-deleveraging-
consumption-growth/Muddy Water Macro. (n.d.). Retrieved July 27, 2017, from
https://muddywatermacro.wustl.edu/node/92