Great Recession

Supplementary material

Links to news reports of the key events of the recession are available on the timelines subpage, accounts of the impact of the recession on individual countries are available on the addendum subpage, and definitions of the terms employed are available in the economics glossary and the finance glossary.

Overview

The Great Recession followed a twenty-year period that has been termed the "Great Moderation", during which recessions had been less frequent and less severe than in previous periods, and during which there been a great deal of successful financial innovation. Attitudes and habits of thought acquired during that period were to have a significant influence upon what was to come. Among other significant influences were the globalisation of financial markets, with the development of large international capital flows, often from the developing to the developed economies; the large-scale granting of credit to households in some of the major economies; and the creation there of house price booms, that have since been categorised as bubbles, but were not recognised as such at the time. It struck the major economies at a time when they were suffering from the impact of a supply shock in which a surge in commodity prices was causing households to reduce their spending, and as a result of which economic forecasters were expecting a mild downturn.

The trigger that set it off was the malfunction of a part of the United States housing market that resulted in the downgrading by the credit rating agencies of large numbers of internationally-held financial assets to create what came to be known as the subprime mortgage crisis. That crisis led to the discovery that the financial innovations that had been richly rewarding traders in the financial markets, had also been threatening their collective survival. The crucial nature of that threat arose from the fact that the global economy had become dependent upon the services of a well-functioning international financial system. What was generally considered to be the impending collapse of the international financial system was averted towards the end of 2008 by widespread governmental guarantees of unlimited financial support to their countries' banks.

The consensus view among economists was that the combination of monetary and fiscal expansion that was then undertaken by policy-makers was nevertheless necessary to avoid a global catastrophe, possibly on the scale of the Great Depression of the 1930s - although there was a body of opinion at the time that considered a fiscal stimulus to be unnecessary, ineffective and potentially damaging. Before those policy actions could take effect, there were sharp reductions in the levels of activity in most of the world's developed economies, mainly because of the discovery by banks and households that they had been overestimating the value of their assets. That discovery prompted banks to reduce their lending, at first because of doubts about the reliability of the collateral offered by prospective borrowers and later, when those doubts receded, in order to avoid losing the confidence of their depositors by holding proportionately excessive amounts of debt. The practice of debt reduction (known as deleveraging) was also adopted by those households that had acquired historically high levels of indebtedness, many of whom were experiencing unaccustomed falls in the market value of their houses. The effect of deleveraging by banks and by households was, in different ways, to increase the severity of the developing recession.

By the spring of 2009, the recession had involved most of the world's developed and developing economies. The countries most affected (as noted on the addendum subpage) were those with relatively large financial sectors (chiefly the United States, the United Kingdom, Iceland and Japan), those that were affected by the downturn in world trade because of their relatively large export sectors (including Germany and Japan) and those that experienced the bursting of house price bubbles (including The United States, The United Kingdom, Ireland and Spain), and although economic growth had returned to many economies by the end of 2009, unemployment continued rising and output gap estimates revealed the continuation of substantial underutilisation of productive capacity. Governments had been forced to borrow money by issuing bonds to offset the fiscal consequences of their automatic stabilisers and their fiscal stimuluses, as a result of which there had beem substantial increases in national debt. In late 2009 and early 2010, the bond markets added several percentage points to the interest rates to be paid on the bond issues of several European governments to compensate for what was seen as a slight risk that they might default on repayment, and in 2010 the economic policies of most developed countries came to be dominated by the problem of reducing national debt without hampering recovery.

Background: the great moderation (1985 - 2007)

The western economies

For about twenty years before the onset of the Great Recession, all of the major market economies except Japan's had been experiencing a hitherto unaccustomed stability, following a sudden reduction of their output volatility in the mid-1980s to about a third of its previous level. It was not clear at the time whether the "Great Stability", as it came to be called, should be attributed to to luck or to judgement, but the US Federal Reserve's Ben Bernanke has been inclined to attribute it to the adoption of an economic policy , referred to by others in America as the "Greenspan effect" , and Charles Bean (the Deputy Governor of the Bank of England) has described the transition from what had been thought of as the Keynesian use of fiscal policy - through the unsuccessful monetarist attempts to target the money supply, to what he refers to as "the neo-classical synthesis" or as "new Keynesian", under which monetary policy was targetted on the output gap using an empirical relationship such as the Taylor rule. Confidence in the new policy in the early 21st century was such as to enable Robert Lucas, the then President of the American Economic Association, to announce that " the central problem of depression-prevention [has] been solved, for all practical purposes .

The international financial system

There was a contrasting increase in the volatility of the international financial system - which experienced 139 financial crises during the 24 years from 1973 to 1997, compared with 38 during the previous 26 years . Many of those crises were associated with the development of globalisation and its accompanying large and volatile international capital flows. At first the predominant direction of flow was from the developing countries to the developing countries, but that changed toward the end of the 20th century. The oil-exporting countries as well as Japan, China, and some other east Asian emerging developing nations accumulated large current account surpluses, and correspondingly large current account deficits developed elsewhere, especially in the United States, the United Kingdom, Ireland and Spain. Nearly all of the corresponding investments of the surplus countries were in the government bonds or government-guaranteed bonds of the deficit countries and the increased demand for those bonds enabled their issuers to reduce their yields - typically from a real (ie inflation-adjusted) yield of 3 per cent in 1990 to less than 2 per cent in the early 21st century.

Financial innovation

The reduction in the yields on government bonds prompted investors to seek higher-yielding alternatives, and the finance industry employed a great deal of high-powered ingenuity to meet that demand. They were helped in that endeavour by a series of Nobel-prize-winning advances in financial economics that had been made in the 1970s and early 1980s; by the deregulations of the 1980s; and by the work of a group of brilliant mathematicians that came to be known as the "quants". The economists had developed a succession of theories based upon adaptations of the the efficient market hypothesis, including portfolio theory and the capital asset pricing model; on the basis of which the quants developed and operated a range of computer packages that could provide precise estimates of an investor's "value at risk" derived from probability analysis of previous experience. Armed with more sophisticated methods of assessing risk, the banks and other financial intermediaries increased their capacity to provide credit to producers and consumers by distributing the risks and rewards involved more widely among those most willing to accept them. The devices adopted for that purpose included a vastly extended application of the techniques of securitisation, involving the conversion of their loans into packages of bonds that were graded according to the credit risk ratings provided by the credit rating agencies. The traditional banking practice of holding loans on their balance sheets until they were repaid, gave way to the strategy known as originate and distribute, under which those packages of bonds were sold to pension funds, insurance companies and other banks. That procedure removed the loans from the balance sheets of the banks, and the institutions of the growing shadow banking system, thus enabling them to increase activity without breaching the reserve ratio requirements of the financial regulators.

The housing markets

The increased availability of credit at low interest rates prompted large household debt increases in the United States and Europe, much of which was used to finance expenditure on housing. In response to the increase in demand there were almost unprecedented increases in house prices in several countries. In the United States real (inflation-corrected) prices rose by nearly 85 percent between 1997 and 2006, in the United Kingdom there was an (uncorrected) rise of 180 per cent , in Spain they nearly trebled, and in Ireland they more than quadrupled . By 2005, some economists in the United States had become convinced that an asset price bubble had developed , but Ben Bernanke (then Chairman of the President's Council of Economic Advisers) reported that "... although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals" and that "a moderate cooling in the housing market, should one occur, would not be inconsistent with the economy continuing to grow at or near its potential next year". In the event, price increases grew more rapidly over the following year and a half.

Commodity prices

International commodity prices doubled in real (inflation-corrected) terms between 2002 and 2007, a trend that has been attributed to their relative attractiveness as investments as well as growing demand by China and other developing countries . That trend continued into early 2008 and had the effect upon the commodity-importing economies of producing modest reductions of household spending power company profits.

Crisis (2007 - 2008)

What came to be known as the subprime mortgage crisis had its origin in repayment defaults by some Americans with low credit ratings who had borrowed money to help pay for house purchases. When house prices were rising, many of them had been able to get the money needed for repayments by further borrowing (because of the increased collateral that the price increases enabled them to offer). But the sharp fall in the market value of their houses that occurred in 2007 deprived them of that option, and left many of them owing more than their houses were worth - making default a rational, and sometimes unavoidable, recourse. The surge in defaults led the credit rating agencies to downgrade their ratings of securities based upon those mortgages, and banks holding such securities found themselves unable to use them as collateral for their borrowing needs. This created financial problems that started with Fannie Mae and Freddie Mac and then shifted to the major banks . In June 2007 hedge funds guaranteed by the American Bear Stearns bank had run into difficulties. Mortgage defaults led subsequently to the collapse and a government rescue from bankruptcy of Fannie Mae and Freddie Mac. Uncertainty about the quality of banking assets made banks reluctant to lend to each other and the important interbank market vitually ceased to operate.

The announcement on the 9th of August 2007, by the French bank BNP Paribas, that it had suspended withdrawals from three of its hedge funds on the grounds that it had become impossible to value their mortgage-backed assets, started an international financial panic. Other banks throughout the world cut back on their lending in an attempt to offset the increase in their leverage brought about by the downgrading of their mortgage-based assets. The fear of default fed on itself as a result of more and more major bank failures in 2007 and 2008 as well as many failures of other businesses - often because they found themselves unable to roll-over their debts. In March 2008 the United States authorities organised the rescue of the Bear Stearns (the world's fifth largest investment bank)], and in September they did not prevent the failure of the Lehman Brothers bank (the largest bankruptcy in the history of the United States), nor the massive losses that were consequently suffered by operators in the money market.

After the Lehman Brothers failure, the banks suddenly lost confidence in each other, investors suddenly lost confidence in the banks, and fears that borrowers might default made everyone reluctant to lend money. Banks and other businesses found that they could not borrow for longer than overnight, and by early October even overnight credit became scarce. It become apparent that a collapse of the entire financial system had become a distinct possibility, and the Governor of the Bank of England warned that "Not since the beginning of the First World War has our banking system been so close to collapse".

Policy response (2008 - 2009)

Financial policy

In the course of the first two weeks of October 2008 a series of banking systems rescue plans had been launched. The UK had announced large scale plans to inject capital into its banks and to offer unlimited guarantees on the debts of all of its banks, and similar action had shortly after been agreed by European leaders and by the President of the United States. The national rescue systems that were actually adopted by the principal banking countries differed only in detail from those initial proposals. It was recognised that those actions were temporary treatments, not remedies, and remedial measures were also set in motion in the course of 2009, as described in the paragraph below on diagnosis and remedies.

Monetary policy

The Federal Reserve Bank, the Bank of Japan and the [[Bank of England made a series of discount rate reductions to near zero levels in the 4th quarter of 2008 and the 1st quarter of 2009 (and the European Central Bank made a series of reductions to reach 1 per cent in the 2nd quarter. When it became clear that those moves had not achieved the intended easing of the credit crunch it was decided to adopt the controversial and largely untried policy of quantitative easing.

Fiscal policy

In a significant departure from the accepted practice of relying solely upon monetary policy to stabilise their economies, most industrialised countries adopted fiscal stimulus packages to augment the already substantial expansionary influence of the automatic stabilisers. Those moves frequently involved departures from recently adopted deficit-limiting rules, including The European Union's Stability and Growth Pact, and the United Kingdom's Code for Fiscal Stability and levels of national debt ranging from the UK's 44 per cent of GDP to Japan's 188 per cent were forecast to rise to at least double their existing proportions of GDP .