The Great Recession

Financial Crises in Advanced Economies

• Financial crises majorly disrupt financial markets, featuring sharp declines in firm failures and asset prices.
• Beginning in August 2007, the United States saw defaults in the subprime mortgage market

The Great Recession

• It was triggered by defaults in the subprime mortgage market that sent shudders through financial markets
• Alan Greenspan described it as a “once-in-a-century credit tsunami.”
• Wall Street firms and commercial banks suffered billions of dollars in losses, while households had to pay higher interest rates and faced difficulty obtaining credit
• Stock markets crashed globally
• The U.S market fell by over 50% from its peak
• Many financial firms, such as investment banks, commercial banks and insurance companies, failed
• A recession began in December 2007, with the economy in a tailspin by 2008 fall.
• The recession ended in June 2009 and was known as the “Great Recession.”

The Eurozone Debt Crisis

• Originates from the 2007–08 global financial crisis
• The Eurozone went through a severe crisis between late 2009 and 2012
• Bank bailouts and recession led to skyrocketing public debt
• Eurozone members' debt-to-GDP ratios rose from 68.7% in 2008 to 89.7% in 2012
• In Greece, the debt-to-GDP ratio went from 109% in 2008 to 172% in 2011
• Foreign investors doubted repayment capabilities, leading interest rates on debt securities to increase quickly and large capital outflows.
• Packages sought to restore fiscal balances but worsened domestic demand
• The Greek debt soared by almost 40 percent when austerity was implemented from other European countries Greece, along with liquidity support from the European Central Bank was required to write down the value of its private debt by more than 50 percent In July 2012, Mario Draghi stated ECB readiness to “whatever it takes” to save the euro led markets to calm down Eurozone countries were forced to take strict measures in order to increase economy while unemployment rates climbed to more than 10 percent

Major Disruptions of Financial Markets Characterized as Financial Frictions

• Financial frictions increase and make financial markets less able to channel funds from savers
• Financial frictions lead markets to collapse
• Economy experiences a particularly large disruption when it occurs

Financial Crises in Advanced Economies

• Financial crises occur in two or three stages
• Initial Phase: credit boom and bust or increase in uncertainty due to failures of financial institutions
• Financial liberalization promotes financial development, but in short-run, can prompt lending spree(credit boom)
• Lenders lack expertise or incentives to manage risk leading to overly risky lending
• Government safety nets weaken the lender's willingness to monitor credit risk, or screen risks leading to undisciplined risk taking grows
• With less capital, financial institutions cut back on lending to borrower-spenders(deleveraging)
• Riskier banks and financial institutions cause lender-savers to pull out funds meaning fewer loans and less productive investment.
• Lending boom turns into lending crash

Further Causes of Financial Crises

• Bubble bursts companies net worth declines
• Companies have less to lose when bankrupt
• Institutions then tighten lending standards for borrowers
• Asset-price bust causes a decline in institutions' net worth and further decline in economic activity

Uncertainty

• Financial crises usually begin after a recession, crash in the stock market, or failure of a major financial institution.
• Information hard to get
• Financial frictions increase and reduce lending and economic activity

Stage Two: Banking Crisis

• Balance sheets deteriorate and business conditions lead some financial institutions into insolvency
• Unable to pay depositors/creditors, some banks fail
• Severe factors can lead to bank panic in which multiple banks fail simultaneously that stem from asymmetric information
• Uncertainty about the health of the banking system, generally, can lead to runs on banks, forcing banks to sell off assets
• Fire sales of assets may cause their prices to decline, causing more banks to become insolvent
• Contagion leads to multiple bank failures and a full-fledged bank panic
• Severely worsening adverse selection and moral hazard problems cause declines in asset prices and failure of firms

Stage Three: Debt Deflation

• Economic downtown causes a sharp decline in the price level
• Debt deflation occurs when substantial unanticipated decline in price level sets in, leading to a deterioration in firm's net worth
• Moderate inflation countries have debt contracts w/ fixed interest rates with long maturity rates
• An unanticipated decline causes borrowing firms'/households' liabilities to increase but does not raise the real value assets
• Substantial decline in real net worth caused by a sharp drop in the price level, creates an increase in adverse selection and moral hazard problems for lenders.
• Most significant financial crisis that displayed debt deflation was the Great Depression

The Great Depression

• In 1928 and 1929, the U.S. stock prices doubled as the FED official viewed the stock market boom was caused by excessive manipulation, but the over tightening policy ended with a 40 percent loss
• Crash of the stock market in October 1929 causes arbitrage and panic propagates downwards trending stock prices throughout economies
• Worldwide commodity prices had been declining since the early 1920s
• After decline in asset prices, 1,860 banks failed because they had massive withdrawals from banks in the United States

THE GLOBAL FINANCIAL CRISIS OF 2007-2009

• Financial Crises and the Great Depression where supposedly a thing of the past for advanced countries

Causes of the 2007–2009 Financial Crisis

• Originated in the financial markets in the United States, and had a global nature
• The long run routes derived from the continuous inflows of a capital into the financial markets from countries including India and China
• Crisis system reached a systemic level by spreading quickly to other financial systems, derivates markets and exposure, non-U.S. financial and interconnected global economy facilitated contagion

Financial Innovation in the Mortgage Markets

• As of early 2000, advances in the info tech made it easier to securitize subprime mortgages, leading to an explosion in the subprime mortgage
• Development of sophisticated instruments, led to structured credit products
• Collateralized debt obligations(CDOs) are the most known of the products

Agency Problems in the Mortgage Markets

• Mortgage brokers didn’t make effort to evaluate whether they could payout the mortgage since loans went to distributes
• This originated the principal-agent problem and the act for the investors without their best interest at heart
• Adverse selection became a major problem which real-state investors lined up loans with high prices but would “walk away.” if the price drops
• Regulations from information problems to help help assess could afford loans where poor

Effects of the 2007-2009 Financial Crisis

• Afflicted consumers and businesses
• Key areas in, U.S. residential housing market, the shadow banking system financial institution balance sheets, debt markets and major firms failures

Residential Housing Prices Boom

• After recession ended by 2007, subprime mortgage took of to a trillion dollar market
• Economists and politicians encourage it to allow more credit for homeownership increase and led easy mortgages to occur that was well diverse across developed economies The decline in housing prices triggered problems with wealth

Deteriorating Financial Institutions Balance Sheets

• Mortgages led defaults to occur
• Balance sheets fell into banks and securities, leading to less value
• Bank lending had meant financial fractions increased through those without info to collect for loans reduce lending caused financial frictions to rise

Government Actions of The 2007-2009 Crisis

• The immediate short run was to emergency plans to avoid the constant decrease of monetary policy
• Bailout plans included extended, packages and plans where extended
• Some governments and sectors where saved, various affected institutions/ banks were rescued because they were large
• Dubai got bailout from bailout of investment firm Dubai world

Fiscal Stimulus Spending

• Utilized stimulus to boost individual economies that differed based on national and international spending and institutions
• Gradual funds boosted the banks and demand
• Various other nation had respective success and implementations in that order