Great Recession

Based on Wikipedia: Great Recession

In September 2008, the global financial system came within hours of complete collapse. Banks stopped lending to each other. The shadow banking system—a vast network of investment banks, hedge funds, and money market funds that had grown to rival traditional banking in size—experienced the equivalent of an old-fashioned bank run, except instead of depositors lining up outside branch offices, it was institutions frantically pulling their money from other institutions in a digital panic.

This was the climax of the Great Recession, though the story had begun years earlier and would continue long after.

What Actually Happened

The Great Recession was a period of market decline across economies worldwide that ran from late 2007 to mid 2009. The International Monetary Fund (IMF) called it the most severe economic and financial meltdown since the Great Depression of the 1930s. But those dates—December 2007 to June 2009 in the United States, according to the National Bureau of Economic Research—tell you when it officially started and stopped without capturing what it felt like to live through it.

The journalist Robert Kuttner has argued that calling it the "Great Recession" is actually a misnomer. Recessions, he points out, are supposed to be mild dips in the business cycle that either correct themselves or respond to modest government intervention. What happened in 2008 was something else entirely—a deflationary trap that left economies stagnant for years. He suggests we should call it "The Lesser Depression" or "The Great Deflation" instead.

The technical definition of a recession is straightforward enough: two or more consecutive quarters of negative GDP growth. By that measure, the recession ended in mid-2009. But the lived experience of economic hardship extended far beyond those eighteen months. Median household wealth in the United States fell thirty-five percent between 2005 and 2011, dropping from $106,591 to $68,839. Income inequality grew in more than two-thirds of American metropolitan areas during the supposed "recovery" period from 2005 to 2012.

The recession wasn't felt equally around the world, either. While North America, South America, and Europe all experienced severe, sustained downturns, several developing economies actually grew substantially during this period. China, India, and Indonesia continued expanding. Australia and New Zealand suffered minimal impact, partly due to their close ties to Asian markets that were still growing.

The Bubble Before the Burst

To understand what happened, you need to go back to the years before 2007. This was a period of what economists diplomatically call "exorbitant rise in asset prices"—which is to say, a housing bubble.

The United States had developed something called the shadow banking system. Traditional banks—the kind where you have a checking account—are called depository institutions. They take deposits, they make loans, and they're heavily regulated. They have to keep a certain amount of money in reserve, they're subject to regular examinations, and if they fail, the Federal Deposit Insurance Corporation (FDIC) steps in to protect depositors.

The shadow banking system was different. It consisted of investment banks, hedge funds, structured investment vehicles, and money market funds. By the mid-2000s, this shadow system had grown to rival the traditional banking system in size. But here's the crucial difference: it wasn't subject to the same regulatory oversight. There were no reserve requirements, no regular examinations, no deposit insurance safety net.

This shadow system had become deeply enmeshed with the housing market through something called mortgage-backed securities. Here's how they worked: banks would make mortgage loans to homebuyers, then bundle thousands of those mortgages together and sell them as investments. These securities offered higher yields than U.S. government bonds, which made them attractive to investors around the world.

The problem was that many of these mortgages were what's called "subprime"—loans made to borrowers with poor credit histories, often with little documentation of income or assets. As long as housing prices kept rising, this seemed fine. Even if a borrower couldn't make their payments, they could simply sell the house for more than they owed, or refinance based on the home's increased value.

But housing prices don't rise forever.

The Bubble Pops

The U.S. housing bubble began deflating in 2006. Home prices, which had been climbing for years, started to fall. Suddenly, homeowners who had counted on rising values found themselves underwater—owing more on their mortgages than their homes were worth. Default rates on subprime mortgages began climbing in 2007.

This is where the interconnected nature of the financial system turned a housing problem into a global crisis. Those mortgage-backed securities that had been sold around the world? Their value depended on homeowners making their monthly payments. When defaults started mounting, the securities became worth less. In some cases, much less. In some cases, it became nearly impossible to determine what they were worth at all.

Investment banks had loaded up on these securities. They had also borrowed heavily to buy them—a practice called leverage. Leverage amplifies both gains and losses. If you put down ten dollars of your own money and borrow ninety more to buy a hundred dollar asset, and that asset rises to a hundred and ten dollars, you've doubled your money. But if it falls to ninety dollars, you've lost everything.

Many financial institutions had leverage ratios of thirty to one or higher. When the assets they held started falling in value, their losses quickly exceeded their capital.

The Panic

On September 15, 2008, Lehman Brothers filed for bankruptcy. It was the largest bankruptcy in American history, and it triggered something close to a complete financial panic.

The shadow banking system experienced what amounted to a bank run. In a traditional bank run, depositors rush to withdraw their money because they fear the bank will fail. In the shadow banking system, the equivalent was institutions refusing to lend to each other overnight, pulling their money from money market funds, and refusing to roll over short-term loans.

The problem was that many financial institutions had become dependent on these short-term loans—called repurchase agreements, or "repos"—to fund their operations. They would borrow money overnight, using their assets as collateral, then pay it back the next day and borrow again. When lenders stopped providing this funding, institutions that were technically solvent suddenly found themselves unable to operate.

The interbank lending market—where banks lend to each other—effectively froze. Credit, which modern economies run on the way cars run on gasoline, became unavailable. Businesses that needed short-term loans to make payroll or buy inventory couldn't get them. The financial crisis had become an economic crisis.

Who Was to Blame?

After the dust settled, the U.S. government convened the Financial Crisis Inquiry Commission to figure out what had gone wrong. The commission, composed of six Democrats and four Republicans, issued its report in January 2011.

Their conclusion was blunt: the crisis was avoidable.

They identified several causes. There had been widespread failures in financial regulation, including the Federal Reserve's failure to stop the proliferation of toxic mortgages. There had been dramatic breakdowns in corporate governance, with financial firms acting recklessly and taking on excessive risk. There had been an explosive combination of excessive borrowing by both households and Wall Street. And key policymakers had been caught unprepared, lacking a full understanding of the financial system they were supposed to oversee.

Not everyone agreed with this analysis. Three Republican commissioners filed a dissenting report arguing that there were multiple causes and that the majority had been too focused on Wall Street. Commissioner Peter Wallison went further, writing a separate dissent that primarily blamed government housing policy, particularly the actions of Fannie Mae and Freddie Mac—the government-sponsored enterprises that bought and guaranteed mortgages.

Federal Reserve Chairman Ben Bernanke, testifying before the commission, offered his own framework. He distinguished between "triggers" and "vulnerabilities." The triggers were specific events that set off the crisis—losses on subprime mortgage securities, the run on the shadow banking system. The vulnerabilities were structural weaknesses that amplified those triggers: financial institutions' dependence on unstable short-term funding, excessive leverage, gaps in regulatory authority, and the problem of institutions that had become "too big to fail."

Five Competing Narratives

Economists and commentators have offered several different stories about what really caused the crisis. These narratives overlap in places, but they emphasize different factors.

The first narrative focuses on the shadow banking system. This system had grown to rival traditional banking in scale without being subject to the same safeguards. When it failed, it disrupted the flow of credit to consumers and corporations throughout the economy.

The second narrative emphasizes the housing bubble itself. When the bubble burst, private residential investment—that is, housing construction—fell by over four percent of GDP. Consumption that had been enabled by paper wealth from rising home values also slowed. This created a gap in annual demand of nearly one trillion dollars. The government, for various reasons, was unwilling to make up for this shortfall in private sector spending.

The third narrative focuses on household debt. In the decades before the crisis, American families had accumulated record levels of debt. Household debt as a percentage of annual disposable income reached 127 percent by the end of 2007, up from 77 percent in 1990. When housing prices started falling, consumers found themselves with debts they couldn't pay. They cut back on spending to pay down that debt, which slowed the economy even further.

The fourth narrative blames government policies that encouraged homeownership even for people who couldn't really afford it. These policies, the argument goes, led to lax lending standards, unsustainable price increases, and ultimately unsustainable debt.

The fifth narrative challenges the conventional wisdom that the crisis was caused by subprime borrowers with poor credit. New research has found that the biggest growth in mortgage debt during the housing boom actually came from people with good credit scores. These weren't poor families stretching to buy their first homes; they were middle-class and wealthy speculators flipping houses. When prices fell, they defaulted on their mortgages in large numbers, devastating local housing markets and financial institutions.

There's an underlying thread connecting the first three narratives: growing income inequality and wage stagnation may have encouraged families to take on more debt to maintain their living standards. As more income flowed to the top of the distribution, wealthy interests gained political power, which they used to deregulate or limit regulation of the shadow banking system.

The Global Dimension

The crisis wasn't purely an American phenomenon, even though it originated in the U.S. housing market. Global capital flows played a crucial role.

The Economist magazine, writing in 2012, pointed to the U.S. trade deficit as a major cause. That deficit—the difference between what America imports and what it exports—had been less than one percent of GDP in the early 1990s. By 2006, it had ballooned to six percent. To finance this deficit, money flowed into the United States from abroad, particularly from East Asia and the Middle East.

Much of that foreign money went into mortgage-backed securities, which offered attractive returns. In effect, savings from China, India, Saudi Arabia, and Abu Dhabi were being channeled into American mortgages—including dodgy subprime mortgages used to buy overvalued houses.

NPR's award-winning 2008 program "The Giant Pool of Money" traced this phenomenon in detail. The pool of global fixed-income savings had grown from around thirty-five trillion dollars in 2000 to about seventy trillion dollars by 2008. Much of this came from developing countries that had become wealthy selling manufactured goods and oil to the developed world. This money was looking for safe, profitable investments, and Wall Street was happy to provide them—packaging up American mortgages and selling them worldwide.

Europe had its own version of this story. As economist Paul Krugman noted, after the creation of the euro, capital flooded from northern Europe to southern Europe. Countries like Spain, Greece, and Ireland saw massive inflows of investment, leading to their own housing bubbles and financial crises.

The Role of the Federal Reserve

One persistent debate centers on the Federal Reserve and its chairman during the bubble years, Alan Greenspan.

The main point of controversy is the Fed's decision to lower the federal funds rate—the interest rate at which banks lend to each other overnight—to just one percent and hold it there for more than a year in the early 2000s. Critics argue this injected huge amounts of cheap money into the financial system and inflated the housing bubble.

Defenders of Greenspan point out that he was trying to prevent a deeper recession following the bursting of the dot-com bubble in 2000-2001. The economy was struggling, and low interest rates were meant to stimulate growth. But even some defenders acknowledge that while this policy may have averted an immediate crisis, it may have only postponed a larger one.

The American mortgage market had some distinctive features that made it particularly vulnerable. Mortgage funding in the United States was unusually decentralized and competitive. Lenders competed fiercely for market share, which contributed to declining underwriting standards. In the rush to make loans, mortgage originators stopped carefully checking whether borrowers could actually repay.

The Response

Governments and central banks around the world responded to the crisis with both fiscal policy—government spending and tax cuts—and monetary policy, including cutting interest rates and programs called quantitative easing, where central banks essentially create money to buy financial assets.

The crisis renewed interest in the ideas of John Maynard Keynes, the British economist who argued during the Great Depression that governments should spend money to stimulate demand during economic downturns. Keynesian economics, which had fallen somewhat out of fashion in the decades of free-market enthusiasm before the crisis, suddenly seemed relevant again.

The Federal Reserve and other central banks cut interest rates to near zero and kept them there for years. They also engaged in unprecedented interventions to rescue failing financial institutions and stabilize markets. Several large banks received government bailouts, becoming a source of ongoing political controversy.

Economists advised that these extraordinary measures should be withdrawn once economies recovered enough to sustain growth on their own. But defining "enough" proved contentious, and the withdrawal of stimulus was gradual and halting.

The Long Aftermath

The technical recession may have ended in mid-2009, but the effects lingered for years. Some economists predicted at the time that recovery might not truly arrive until 2011, and that the recession would prove to be the worst since the Great Depression. The Nobel Prize-winning economist Paul Krugman worried publicly that the world might be entering "a second Great Depression."

Those worst-case scenarios didn't fully materialize, but the recovery was painfully slow by historical standards. Unemployment remained elevated for years. Wages stagnated. Housing prices took years to recover. And as noted earlier, wealth inequality actually increased during the supposed recovery period.

The political aftershocks were perhaps even more profound. The financial crisis and the government's response—particularly the bank bailouts—contributed to a wave of populist anger on both left and right. The Tea Party movement emerged in 2009, and Occupy Wall Street followed in 2011. The sense that ordinary people had suffered while banks were rescued would reshape politics for years to come.

The Great Recession also changed how economists and policymakers think about financial regulation. The shadow banking system that had grown up largely outside regulatory oversight was now understood to pose systemic risks. The Dodd-Frank Act, passed in 2010, attempted to address some of these gaps, though debates continue about whether it went far enough—or perhaps too far.

What's in a Name?

In the end, we call it the Great Recession, even though that name may not capture its true nature. A recession implies something cyclical, something that the economy moves through on its way to the next expansion. The Great Recession was more like a rupture—a moment when the financial architecture that had been built up over decades nearly collapsed entirely.

It revealed deep vulnerabilities in the global financial system: the risks of excessive leverage, the dangers of regulatory gaps, the interconnections that could turn a problem in one market into a crisis everywhere. It showed how quickly confidence could evaporate and how dependent modern economies are on the continuous flow of credit.

Whether we learned enough from it to prevent the next crisis remains an open question.