Chapter 15

The Financial
Crisis and the
Great Recession
Chapter Outline

1. Prelude to a Crisis
2. Economic Impacts of the Crisis
3. Underlying Causes of the Financial Crisis
4. Remedies and Ideas for Averting Future Crises

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Learning goals

 After today’s lecture, you will be able to:

– Describe the development of the housing bubble and the reasons for its collapse.

– Understand how a crisis in one sector spread to the whole economy.

– Understand the similarities and differences between the Great Recession and the
Great Depression.
– Be aware of how factors such as inequality, bank size, regulatory policy, corporate
incentive structures, and global financial imbalances can contribute to
macroeconomic instability.
– Describe the major fiscal and monetary responses to the crisis.

– Be aware of financial regulatory reforms implemented in response to the crisis,

criticisms of these reforms, and proposals for further reform.
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The housing bubble in the U.S.

 increase in demand for real estate

 increase in real estate prices
 increase in home prices fed a speculative frenzy

– millions rushed to buy, believing that prices could only go up

 speculative flurry was fed by:
– the “dot-com bubble”

– the unprecedented access to credit in the form of mortgages

– very low mortgage rates among other factors

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 Figure 15.1 Historical housing prices in the U.S.

Source: Shiller dataset. www.econ.yale.edu/~shiller/data.htm.

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 Figure 15.2 Housing bubble and credit access

Sources: Federal Reserve (www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html/ and

www.federalreserve.gov/releases/h15/data.html);
Shiller dataset, www.econ.yale.edu/~shiller/data/ie_data.xls.
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 Mortgage-backed security (MBS)
people take out
Mortgage default mortgages

investment banks
group mortgages into
Pools MBS MBS MBS MBS MBS Mortgage-Backed
lower yield first paid Securities (MBS)
AAA
each MBS is divided
AA into tranches; the first
A is to be paid in the
BBB event of mortgage
BB unrated default and hence
higher yield last paid the safest
CDO
CDO tranches financial institutions developed collateralized debt
AAA obligations (CDOs): making a “bundle of bundles” of
AA mortgages.
A hierarchy of tranches is available, each carrying a
A
calculated risk-return balance
BBB
unrated Chapter 15 7
Credit default swap

credit default swap: a security that is effectively an insurance

policy against defaults related to MBS and CDOS

a buyer of the CDS pays a fee to the seller

Investment
Bank
or Insurance
Company
Investment
Bank
credit default swap seller credit default swap buyer

the seller agrees to cover losses in case of default

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The subprime crisis

 rising demand for bundled securities

 banks relaxed lending criteria
 subprime mortgage: a mortgage that does not meet
the quality standards of traditional mortgages
 2006: wave of subprime foreclosures hastened
downward spiral of prices (glut in house supply)

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From housing crash to banking crisis

 falling house prices

 limited equity of home owners
 many mortgages became worthless
 losses in the value of MBSs and CDOs
 banks put part of their funds in CDOs
 presumption: every bank is a high-risk borrower
 banks stopped lending to each other and to
customers
 output contracted sharply

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Housing bubbles in Europe

 house prices increased tremendously in Ireland, Spain

and Britain
 MBSs and CDOs played no role in European countries
 with the end of the U.S. housing bubble, real estate
bubbles in Europe also burst
 banks in Europe became more careful in lending
 with falling house prices, households started to
default on their mortgages and property developers
on their loans
 national banking crises in European countries
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Economic Impacts of the
Crisis
Unemployment and the vicious recessionary spiral

 in the industrialized world, 14 million jobs were lost

 households saw their wealth diminished
 vicious circle:
Income
falls
Employme Banks increase
lending
nt falls standards

Less aggregate
demand Less credit

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The Great Depression and the Great Recession
compared
 both downturns were preceded by a period of
economic strength
 but: consequences are different due to
– social safety net
– government regulations to protect ordinary citizens
– activist macroeconomic policy
 government programs kept current downturn from
becoming far worse

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 Table 15.1: Selected economic indicators for ten industrialized economies* in the Great
Depression and the Great Recession

Indicator Great Depression Great Recession

1932 vs. 1929 2009 vs. peak 2007/8
GDP, real, change in percent -10.0 -4.0
Manufacturing production, change in percent -23.2 -20.2
Exports, change in percent -58.5 -20.9
Stock market index, change in percent -55.4 -53.4
Employment, change in percent -17.3 -2.5
Unemployment rate (1932 and 2010) 19.6 9.2
Unemployment rate, change in percentage 13.2 3.1
points
Inflation, in percent -12.8 1.0

Source: Karl Aiginger (2010). The Great Recession versus the Great Depression: Stylized Facts on Siblings That
Were Given Different Foster Parents. Economics: The Open-Access, Open-Assessment E-Journal, 4 (2010-18): 1—41.
* Austria, Germany, Belgium, Spain, France, Finland, Sweden, United Kingdom, the United States and Japan.
Numbers are unweighted averages for these ten countries.
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Underlying Causes of the
Financial Crisis
Inequality

 U.S.:
– since 1999, low and middle incomes started to decline

– majority of families faced difficulties to maintain level of consumption

– debt-financed consumption
 Germany:
– wages of the poorer half of the population declined

– consumption stagnated

– rich households and corporations earned more money than they could
(or would) spend
– net savings increased
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Bank size and deregulation

 since the 1980s, bank mergers led to a growing

number of large banks
 financial sector became deregulated
 “too big to fail”: when a company grows so large that
its failure would cause widespread economic harm in
terms of lost jobs and diminished asset values
 “too big to fail” mentality of banks encouraged more
risk taking
 governments had to bail out banks

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 Figure 15.3 Increasing bank size in the U.S.
Percent of Total Bank Sector Assets

Source: Federal Deposit Insurance Corporation Chapter

(www2.fdic.gov/qbp/);
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www.fdic.gov/bank/statistical/stats/2012dec/industry.html.
Misguided corporate incentive structure

 CEO pay in the form of stock options

 performance related pay scheme encouraged short-
term orientation
– focus on short-term gains
– ignoring long-term risks

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Globalization and long-term economic trends

 distribution of gains and losses from globalization

reinforce growing patterns of inequality
– in the U.S.: debt financed consumption
– in Germany: increase in savings
 savings from other parts of the world contributed to
U.S. housing boom and asset price inflation
 investment banks and hedge funds possessed large
amounts of capital, took on more risk and debt to
multiply returns

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Remedies and Ideas for
Averting Future Crises
Fiscal and monetary responses

 governments passed stimulus packages

 innovative policy measures
– “cash for clunkers” programs (Car Allowance Rabat System
in the U.S.; “Umweltprämie” in Germany
 higher multiplier effect than government transfers
 monetary policy: central banks implemented stimulus
plans
 but: monetary policy has limitations:
– if consumers and businesses are pessimistic, they save
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Reregulating the financial sector

 in the U.S.: Dodd-Frank Wall Street Reform and

Consumer Protection Act
– minimum criteria to lend to prospective homeowners
– commercial banks exposed to a minimum amount of the
mortgage default risk
– restrictions on CDSs
–…

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Reregulating the financial sector

 at the European level:

– pan-European institutions were created to coordinate the
regulation of the financial sector
– a systemic risk board was created to spot macroeconomic
risks through the financial system
– limits on manager compensation
– markets for derivatives more strictly regulated
– new rules for rating agencies

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Beyond current regulations

 criticism of financial regulation:

– bills create significant costs for financial firms, slowing
down business and job creation
– legislation is too complex
– legislation has been “watered down” by lobbying efforts

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But how to redirect finance to the goal of increasing
overall benefits to society?
 limit speculative activities of banks
 ban overly complex products or risky products
 ask investors to pay a modest tax on financial
transactions (Tobin tax)

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What to take home

 the financial crisis of 2007-2008 and its aftermath are

widely referred to as the “Great Recession”
 the crisis began in 2007 with a crisis in the subprime
mortgage market in the U.S. and developed into an
international banking crisis
 many causes for the financial crisis have been
suggested
 in the aftermath of the financial crisis, the financial
sector was reregulated

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