“The U.S. economy, once the envy of the world, is now viewed across the globe with suspicion. America has become shackled by an immovable mountain of debt that endangers its prosperity and threatens to bring the rest of the world economy crashing down with it.”
International Herald Tribune, 2007
From 2008–2009, the world experienced what the International Monetary Fund (IMF) in its 2009 World Economic Outlook called “by far the deepest global recession since the Great Depression.” This economic downturn was sparked by a global financial crisis.
The crisis originated in the United States. During the 2000s, Americans began to invest heavily in houses.
As more and more people purchased houses with borrowed money, the prices of houses rose and rose. This trend was partially fueled by low interest rates, which made it cheaper to borrow money.
Thus, Dean Baker, writing in Real-World Economics Review in 2008, noted that “extraordinarily low interest rates accelerated the run-up in house prices.” Price inflation of this sort is often referred to as a “bubble.” William Watson, writing in the Gazette in 2006, said that “A bubble . . . is a run-up in prices going beyond anything that reasonable economic calculation can justify.” Watson added that “when enough people do finally recover their senses . . . [the] bubble bursts.”
This is what happened in the United States in 2007, and by the end of the year, the bubble had collapsed, and housing prices had dropped more than 15 percent. During the bubble, banks had often lent money to people who were bad credit risks; these loans are known as subprime mortgages.
The banks figured that as long as housing prices went up, they would always be able to recover their money, because even if a creditor defaulted, the house itself could always be sold for a profit. Based on this theory, banks repackaged and sold these mortgages as investments, or mortgage based securities. Thus, an investor could buy a bunch of mortgages (or a small piece of a bunch of mortgages) which was guaranteed to pay back a certain return.
The banks were so sure that these mortgage-based securities would always pay that they even sold insurance on the investments. These insurance contracts were called credit default swaps. A credit default swap (CDS) means an investor in mortgage-based securities would pay a certain amount of money to the bank on a regular basis as long as the securities made money. If the securities ever stopped making money, though, the bank would have to pay the investor a large sum.
CDSs were very popular because they made investors feel safer, and banks were certain they would never have to pay on them; investments would never default because housing prices would go up forever, or so they believed. As a result, as Janet Morrissey reported in TIME in 2009, “The CDS market exploded over the past decade to more than $45 trillion in mid-2007. . . . This is roughly twice the size of the U.S. stock market.”
When the bubble burst and housing prices did start to go down, banks found themselves in a precarious position. Much of the banks’ money was invested in mortgages that were now shown to be bad debts. To make matters worse, the banks had in many cases promised to pay other investors through credit default swaps if these loans went bad.
The resulting strain caused a series of catastrophic failures of large banks in the United States. Bear Stearns, a large investment bank, first noted publicly that it was having trouble because of subprime loans in July 2007.
On September 7, 2008, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), the two largest mortgage lenders in the United States, had to be bailed out by the U.S. government.
On September 15, 2008, Lehman Brothers, another large bank, declared bankruptcy. In the following weeks, Washington Mutual also collapsed. The U.S. government also stepped in to save the nation’s largest insurance company, AIG. The rescue package was $85 billion.
The banking crisis was not confined to the United States. In the first place, other nations had their own housing bubbles. Even more important, banks and investors around the world had placed money in U.S. mortgages. As Jim Haughey wrote on the blog Market Insights, “Foreign investors were net buyers of about $20 billion a month of agency bonds throughout the 2004-2005 housing boom and through mid-2008.”
Thus, foreign banks faced many of the same problems U.S. banks did when the U.S. housing bubble burst. As a result, in October 2007, the German government was forced to spend $50 billion to prop up the bank Hypo Real Estate. Around the same time, Iceland nationalized, or imposed government control of, the country’s second largest bank. In February 2008, the British government also had to nationalize one of its major banks.
The problem was not solely confined to Europe. Investors in Asia, especially in China, also held many U.S. assets. The bank crisis has had a major impact on the world economy. Stock markets worldwide plunged; the U.S. Dow Jones average dropped to its lowest level since 1997. Britain’s stock market was down by more than 5 percent at one point, while Japan’s stock market fell by almost 4 percent.
Another impact of the financial storm has been a liquidity crisis. Liquidity is the ability to raise cash quickly. Many businesses rely on short-term borrowing to meet payroll or other obligations. But, as Chris Arnold noted in an October 2008 story for National Public Radio (NPR), “banks are already short of cash because of losses in the housing bust, so they’re a lot less willing to lend money to everybody else.”
Without liquidity, many businesses can’t function. As businesses fail, unemployment rises and the economy spirals into a recession. This has had a devastating effect worldwide. The International Monetary Fund and the World Bank released a joint statement in April 2009 calling the recession “a human and development calamity” which “has already driven more than 50 million people into extreme poverty.”
The International Labor Organization predicted that 20 million jobs would be lost by the end of 2009. Increases in poverty and unemployment have also resulted in angry protests from Iceland to France to China. Jack Ewing, writing in Business Week in March 2009, noted that “global political instability is rising fast.” Governments have responded in various ways to the crisis. As noted, some have bailed out or nationalized failing banks. Many nations have also put together stimulus packages to jump start the economy and create jobs. China announced a $586 billion stimulus plan in November 2008.
The United States passed a $780 billion stimulus in February 2009; in the same month Germany passed a $63 billion package and Australia a $27 billion one. In March 2009, Vikas Bajaj reported in the New York Times that the economy was turning around, or as he put it, “there was a sense among some economists and Wall Street analysts that if the bottom was not touched, perhaps the freefall was at least slowing.” Stock markets seemed to be ticking upwards, and some banks were reporting profits again. Few are willing to predict whether the recovery will last or what the long term effects of the economic crisis will be.