Why the Financial Crisis Happened: Debt, Economy & the Stock Market - Paul Krugman (2008)
The financial crisis of 2007--2008, also known as the Global Financial
Crisis and 2008 financial crisis, is considered by many economists the
worst financial crisis since the Great Depression of the 1930s. It
resulted in the threat of total 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, declines in consumer wealth estimated in trillions of
U.S. dollars, and a downturn in economic activity leading to the
2008--2012 global recession and contributing to the European
sovereign-debt crisis. The active phase of the crisis, which manifested
as a liquidity crisis, can be dated from August 9, 2007, when BNP
Paribas terminated withdrawals from three hedge funds citing "a complete
evaporation of liquidity".
The bursting of the U.S. housing
bubble, which peaked in 2006,[5] caused the values of securities tied to
U.S. real estate pricing to plummet, damaging financial institutions
globally.[6][7] The financial crisis was triggered by a complex
interplay of policies that encouraged home ownership, providing easier
access to loans for (lending) borrowers, overvaluation of bundled
sub-prime mortgages based on the theory that housing prices would
continue to escalate, questionable trading practices on behalf of both
buyers and sellers, compensation structures that prioritize short-term
deal flow over long-term value creation, and a lack of adequate capital
holdings from banks and insurance companies to back the financial
commitments they were making.[8][9][10][11] 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.[12] Governments and central banks responded with unprecedented
fiscal stimulus, monetary policy expansion and institutional bailouts.
In the U.S., Congress passed the American Recovery and Reinvestment Act
of 2009.
Many causes for the financial crisis have been
suggested, with varying weight assigned by experts.[13] The U.S.
Senate's Levin--Coburn Report concluded 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."[14] The
Financial Crisis Inquiry Commission concluded that the financial crisis
was avoidable and was caused by "widespread failures in financial
regulation and supervision," "dramatic failures of corporate governance
and risk management at many systemically important financial
institutions," "a combination of excessive borrowing, risky investments,
and lack of transparency" by financial institutions, ill preparation
and inconsistent action by government that "added to the uncertainty and
panic," a "systemic breakdown in accountability and ethics,"
"collapsing mortgage-lending standards and the mortgage securitization
pipeline," deregulation of over-the-counter derivatives, especially
credit default swaps, and "the failures of credit rating agencies" to
correctly price risk.[15] The 1999 repeal of the Glass-Steagall Act
effectively removed the separation between investment banks and
depository banks in the United States.[16] Critics argued that credit
rating agencies and investors failed to accurately price the risk
involved with mortgage-related financial products, and that governments
did not adjust their regulatory practices to address 21st-century
financial markets.[17] Research into the causes of the financial crisis
has also focused on the role of interest rate spreads.[18]
In the
immediate aftermath of the financial crisis palliative fiscal and
monetary policies were adopted to lessen the shock to the economy.[19]
In July 2010, the Dodd--Frank regulatory reforms were enacted to lessen
the chance of a recurrence.
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