Great Recession
What is Great Recession?
The Great Recession was the deep global downturn of 2007–2009 triggered by a housing and financial crisis.
Collapsing subprime mortgages and the failure of major financial firms froze credit and cut output worldwide. Governments and central banks responded with bailouts, stimulus, and near-zero interest rates plus quantitative easing.
Great Recession: a worked example
Leverage explains how a housing downturn became a financial crisis. Take a bank holding 100 dollars of mortgage assets funded by 96 dollars of borrowing and 4 dollars of its own equity, a leverage ratio of 25 to 1. A 4 percent fall in asset values wipes the equity out exactly, since 96 dollars of assets against 96 dollars of debt leaves nothing. Now suppose the fall is a milder 2 percent. Assets drop to 98, equity to 2, and leverage jumps to 49 to 1. To restore its 25 to 1 target the bank must shrink assets to 25 times 2, or 50 dollars, selling 48 dollars of loans and securities and repaying debt with the proceeds. A 2 dollar loss forces a 48 dollar contraction of the balance sheet. Multiply that across many leveraged institutions selling into the same falling market and credit to households and firms dries up.
The mistake students make with great recession
Students write that monetary policy failed because the central bank cut rates and output shrank anyway. The tempting assumption is that the policy rate can always fall further. Once the short-term rate reaches its floor near zero the conventional tool is spent, and extra stimulus has to arrive through asset purchases that pull down long rates, promises about future policy, or fiscal expansion. A second slip sizes the damage by the write-downs. The balance sheet above shows a 2 dollar loss forcing a 48 dollar sale, so the harm reached households through the supply of credit rather than through the losses themselves.
Great Recession questions
What caused the Great Recession?
Mortgage lending to borrowers who could only repay if house prices kept rising sat at the center. Those loans were bundled into securities and sold worldwide, spreading the exposure and obscuring it, while banks and shadow banks funded the holdings with very little equity of their own. When house prices turned, defaults climbed, the securities lost value, and thinly capitalized firms failed or came close. Credit to ordinary households and businesses froze, investment and consumption fell, and the downturn crossed borders.
Why was the recovery from the Great Recession so slow?
Recoveries from financial crises drag because balance sheets have to be repaired before normal spending resumes. Households owing more on a mortgage than the house was worth cut consumption to pay down debt, banks rebuilt capital instead of expanding loans, and firms postponed investment while demand looked weak. Long spells of unemployment eroded skills and pulled some workers out of the labor force altogether, so employment kept lagging even after output began to recover.
Did quantitative easing cause high inflation?
Quantitative easing expanded bank reserves without delivering the price surge many predicted, because inflation tracks spending rather than the size of the central bank balance sheet alone. Banks held much of the new reserves instead of lending them out, so broad money grew slowly and the money multiplier fell. With demand weak and unemployment high, firms had little room to raise prices anyway. Base money moves the price level only when the new money is actually spent.
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