Financial crises and stabilisation
Some of the deepest downturns have followed financial crises. Understanding them helps explain modern stabilisation policy.
Asset bubbles
An asset bubble occurs when prices of assets such as houses or shares rise far above values justified by fundamentals, driven by expectations of further rises. Examples include the Dutch tulip mania of the 1630s, the dot-com bubble that burst in 2000, and the US housing bubble that peaked around 2006.
Leverage and fragility
Leverage is the use of borrowed money to buy assets. It magnifies gains when prices rise but also losses when they fall. When households and banks are highly leveraged, a fall in asset prices can wipe out their equity, forcing fire sales that push prices down further.
The 2008 global financial crisis
In the 2000s, US house prices soared, fuelled by lax lending, including subprime mortgages, and complex securities that spread mortgage risk worldwide. When house prices fell from 2006, defaults rose and banks holding these securities suffered huge losses. The collapse of Lehman Brothers in September 2008 triggered panic and a global recession.
Why financial crises are severe
Financial crises tend to cause deeper and longer recessions than ordinary downturns, as Carmen Reinhart and Kenneth Rogoff documented. Banks cut lending to rebuild capital, households cut spending to pay down debt (deleveraging), and confidence falls. Recovery often takes years.
Policy responses to 2008
Governments and central banks responded with interest rate cuts to near zero, quantitative easing, bank rescues and capital injections (such as the US Troubled Asset Relief Program), fiscal stimulus, and coordinated international action through the G20. These measures are widely credited with preventing a repeat of the Great Depression, though the recovery was slow.
Lessons from the Great Depression
In the 1930s, the US Federal Reserve allowed thousands of banks to fail and the money supply to shrink, while governments often tried to balance budgets. Milton Friedman and Anna Schwartz argued that these policy mistakes turned a recession into a depression. Ben Bernanke, who studied this period and later shared the 2022 Nobel Prize, led the Fed's aggressive response in 2008.
Macroprudential policy
After 2008, regulators introduced macroprudential policies aimed at the stability of the whole financial system: higher bank capital requirements (the Basel III rules), stress tests, limits on mortgage lending relative to house values or incomes, and extra requirements for systemically important banks.
Worked example
A household buys a 300,000-dollar house with a 30,000 deposit and a 270,000 mortgage: leverage of 10 to 1. If house prices rise 10%, its equity doubles to 60,000. If prices fall 10%, its equity is wiped out entirely. Millions of such households in 2007-2009 found themselves owing more than their homes were worth.
Key takeaways
Bubbles occur when asset prices exceed fundamentals. Leverage magnifies gains and losses, creating fragility. The 2008 crisis grew from a housing bubble, subprime lending, and complex securities, erupting with Lehman's collapse. Financial crises cause deep, long recessions. The 2008 response, informed by Great Depression lessons, used aggressive monetary, fiscal, and rescue policies. Macroprudential rules now target system-wide stability.
Flashcard
Prices far above fundamentals
Check your understanding
Why do financial crises tend to cause longer recessions than ordinary downturns?