The Nomad Economist
Premiered May 8, 2022
What causes a financial crisis? Can financial crises be anticipated or even avoided? What can be done to lessen their impact? Should governments and international institutions intervene? Or should financial crises be left to run their course?
In the aftermath of the recent Asian financial crisis, many blamed international institutions, corruption, governments, and flawed macro and microeconomic policies not only for causing the crisis but also unnecessarily lengthening and deepening it.
At the turn of this century, most economists in the developed world believed that major economic disasters were a thing of the past, or at least relegated to volatile emerging markets. Financial systems in rich countries, the thinking went, were too sophisticated to simply collapse.
Markets were capable of regulating themselves. Policymakers had tamed the business cycle. Recessions would remain short, shallow, and rare. Seven years later, house prices across the United States fell sharply, undercutting the value of complicated financial instruments that used real estate as collateral—and setting off a chain of consequences that brought on the most catastrophic global economic collapse since the Great Depression.
Over the course of 2008, banks, mortgage lenders, and insurers failed. Lending dried up. The contagion spread farther and faster than almost anyone expected. By 2009, economies making up three-quarters of global GDP were shrinking. A decade on, most of these economies have recovered, but the process has been slow and painful, and much of the damage has proved lasting.
“Why did nobody notice it?” Queen Elizabeth II asked of the crisis in November 2008, posing a question that economists were just starting to grapple with.
Ten years later, the world has learned a lot, but that remains a good question. The crash was a reminder of how much more damage financial crises do than ordinary recessions and how much longer it takes to recover from them.
But the world has also learned that how quickly and decisively governments react can make a crucial difference. After 2008, as they scrambled to stop the collapse and limit the damage, politicians and policymakers slowly relearned this and other lessons of past crises that they never should have forgotten.
That historical myopia meant they hesitated to accept the scale of the problem and use the tools they had to fight it. That remains the central warning of 2008: countries should never grow complacent about the risk of financial disaster.
So how the financial crisis of 2007-08 unfolded ? Before the Beginning . Like all previous cycles of booms and busts, the seeds of the subprime meltdown were sown during unusual times. In 2001, the U.S. economy experienced a mild, short-lived recession.
Although the economy nicely withstood terrorist attacks, the bust of the dot-com bubble and accounting scandals, the fear of recession really preoccupied everybody’s minds. To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times – from 6.5% in May 2000 to 1.75% in December 2001 – creating a flood of liquidity in the economy.
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