There is little doubt that the housing bubble in the US and other economies had a sizeable adverse impact on the crisis. Years of relatively cheap money channelled into largely unproductive and speculative housing investment contributed to inflated residential house prices. As interest rates remained low through the monetary policy settings of the Federal Reserve in the United States and in central banks in other countries, investment and construction in residential housing began to take off. This led in turn to higher residential real estate prices, which attracted the attention of investors and lenders worldwide.
The era of low interest rates at the beginning of 2001 in the United States and other parts of the developed world coincided with the 9/11 terrorist attacks in New York. Concerned that the terrorist attacks would induce a recession in the United States, the US Federal Reserve aggressively reduced key benchmark interest rates 11 times, so that the official cash rate stood at 1.75% at the end of 2001.12 According to the Financial Crisis Inquiry Commission, at the end of 2001 the United States had the “lowest [cash rate] in 40 years.”13
The US Federal Reserve was not alone in aggressively reducing interest rates in the immediate aftermath of the 9/11 terrorist attacks. Central banks in the United Kingdom, Australia and the European Union reduced interest rates over the same period. In the UK, the Bank of England reduced the official interest rate from a high of 6.00% in February 2000 to a 30-year low of 3.50% in May 2003.14 There was a similar aggressive reduction in interest rates in Australia, with the Reserve
orderly purchase by the US government of “troubled” or distressed assets from the private sector, principally held by US banks and investment banks. The total troubled asset buy- back was to be from $US700 billion and was to take place in stages coordinated and paid by the US Treasury. Initially, the TARP program was to be used to purchase toxic mortgage- backed securities flowing from US sub-prime mortgages. As time passed, monies from the TARP program were also used to prop up and bail out segments of the US automotive industry.
12 Ibid., (n. 5), p. 84.
13 Ibid.
14 See the Bank of England Official Bank Rate history. Available at: <http//www.
bankofengland.co.uk/mfsd/iadb/Repo.asp>.
Triggers of the Crisis 37 Bank of Australia reducing the official cash rate from a high of 6.25% in August 2000 to a 30-year low of 4.25% in December 2001.15 The European Central Bank cut its official bank rate for EU member states from 3.75% in 2000 to 1.00% in 2003.16
Before the Financial Crisis Inquiry Commission, former US Federal Reserve Chairman Alan Greenspan testified that he had expressed his concerns about the state of the US housing market as early as 2002 in the Federal Open Market Committee.17The current Chairman of the Federal Reserve, Ben Bernanke, also raised similar concerns regarding the excessive growth of leverage and household debt in the United States and its consequential adverse effect on house prices.18
As is discussed in Chapter 1, the current crisis has interesting parallels with previous economic catastrophes, particular with the Great Depression of the 1930s.
With the Great Depression there had been a large build-up in household debt in
15 See the Reserve Bank of Australia Official Cash Rate statistics. Available at:
<http://www.rba.gov.au/statistics/cash-rate.html>.
16 See the European Central Bank Monetary Rate Policy settings. Available at:
<http://www.ecb.int/stats/monetary/rates/html/index.en.html>.
17 Alan Greenspan, then Chairman of the Federal Reserve, expressed concern about the potential of a housing price bubble emerging in the US: “In 2002, I expressed concerns to the FOMC, noting that ‘our extraordinary housing boom […] financed by very large increases in mortgage debt – cannot continue indefinitely.’ It did continue for longer than I would have forecast at the time, and it did so despite the extensive two-year-long tightening of monetary policy that began in mid-2004. The house price bubble, the most prominent global bubble in generations, was engendered by lower interest rates, but, as demonstrated in the Brookings paper I previously provided to the Commission, it was long term mortgage rates that galvanized prices, not the overnight rates of central banks, as has become the seeming conventional wisdom.” Greenspan 2010b. (Testimony of Alan Greenspan before the Financial Crisis Inquiry Commission, 7 April 2010, Stanford, CT: Stanford Law School), p. 5.
18 In providing testimony before the Financial Crisis Inquiry Commission, Ben Bernanke also expressed concerns regarding the excessive growth in leverage and household debt, particularly in the US housing market: “Excessive leverage is often cited as an important vulnerability that contributed to the crisis. Certainly, many households, businesses, and financial firms took on more debt than they could handle, reflecting in part more permissive standards on the part of lenders. A notable example was the decline in down payments required of many home purchasers, which, together with the increased use of exotic mortgage instruments and the availability of home equity lines of credit, resulted in some homeowners becoming highly leveraged. When house prices declined, the equity of those homeowners was quickly wiped out; in turn, ‘underwater’ borrowers who owed more than their houses were worth were much more likely to default on their mortgage payments.
Nonfinancial firms, in contrast, do not seem to have become overleveraged before the crisis;
collectively, these firms did see a small increase in debt-to-asset ratios from 2006 to 2008, but these ratios tend to be volatile, and the short-term increase was superimposed on a two-decade-long downward trend.” Bernanke 2010c (Ben Bernanke. Statement before the Financial Crisis Inquiry Commission. Stanford, CT: Stanford Law School), pp. 8–9.
The Global Financial Crisis 38
the period leading up to the Great Crash of 1929. Most household borrowings had been channelled into speculative and largely unproductive investments in stocks on Wall Street. As stock prices continued to rise, an increasing number of investors with higher debt levels were required to continue to propel stock prices higher.
When the great bull run of the 1920s ended, the stock price bubble also ended and precipitated the Great Crash on Wall Street in 1929 and then again in 1932.
Both the Great Depression and the current crisis were underpinned by excessive leverage and speculation in unproductive assets. The lure of higher prices led investors and lenders into a dangerous feedback loop whereby asset prices (stock prices in the 1920s and house prices between 2000 and 2007) were pushed ever higher, with alarming levels of debt. We know from our history that asset bubbles do not always go in one direction – upwards. By definition, a bubble must deflate at some point in time. The Great Depression followed the Crash of 1929 on Wall Street, which deflated stock prices suddenly in one day. Similarly, the equally spectacular sub-prime mortgage implosion in the United States in 2007 and 2008 led to a great crash in residential house prices in most developed countries.19
The current US Federal Reserve Chairman, Ben Bernanke, investigated the link between US house prices and easy monetary policy.20 Other economists have also explored the link.21 According to Bernanke, US house prices rose strongly in the 1990s in the period prior to the easing of monetary policy. Similarly, house prices rose in other countries over the same period. Hence, when previous periods are taken into account, the link between house prices and monetary policy is less convincing.22 Bernanke suggests that a much stronger relationship may in fact
19 The house price decline has been felt in a number of countries, including the United States, Spain, Portugal, Ireland and the United Kingdom. A number of states in the USA have experienced severe price falls and foreclosures, which have increased the stock of vacant houses. The Comptroller of the Currency Administrator of National Banks reported that a number of cities across the USA had foreclosure rates for sub-prime mortgage loans of over 20%. Not only were cities within a manufacturing centre such as Detroit and Cleveland hit particularly hard but also high-end “service” cities such as Las Vegas and Miami suffered significant foreclosures. US Department of the Treasury 2010. Comptroller of the Currency Administrator of National Banks. The importance of preserving a system of national standards for national banks, OCC White Paper. Washington, DC: OCC, Department of the Treasury, Attachment 1.
20 Bernanke 2010b. Monetary policy and the housing bubble. Speech by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, delivered at the Annual Meeting of the American Economic Association, Atlanta Georgia, 3 January 2010.
21 See Del Negro, M. and Otrok, C. 2007. 99 Luftballons: Monetary policy and house price boom across US states. Journal of Monetary Economics, 54(7), pp. 1962–85;
Jarocinski, M. and Smets, F. 2008. House prices and the stance of monetary policy. Federal Reserve Bank of St Louis Review, 90(4), pp. 339–65.
22 According to Bernanke, “when historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader economic environment.” Ibid., (n. 20), p. 7.
Triggers of the Crisis 39 exist between US house prices and capital inflows from emerging markets, which may well have been channelled into US housing and residential construction, and this might provide a better explanation for the rise in US house prices.23
What we also know from our history of previous crises is that not all deflating bubbles lead to, or contribute to, economic recessions or depressions. Sometimes a bubble will burst and asset prices deflate over time, or remain flat, and the economic consequences tend to be somewhat benign or inconsequential. Economists often refer to such occurrences as a “soft landing.” The corollary to a soft landing is a
“hard landing,” which by its very nature conjures more severe consequences, often leading to recessions, higher unemployment and bouts of deflation. The severity of the ensuing recession following a deflating asset bubble varies from mild – as is evidenced by the dot-com bubble bursting in early 2000 – to the more severe, such as the Great Depression of the 1930s and the current Great Recession.
It is not known for certain what makes a bubble burst, nor is it clear why some deflating bubbles lead to inconsequential outcomes for the wider economy, whilst others lead to significant, widespread and systemic downturns. The supporters of Keynesian theory have suggested that government intervention can smooth out erratic business cycles through expansionary fiscal policy. Taking this one step further, expansionary monetary policy can also aid in providing additional stimulus to a depressed economy. Supporters of this approach have argued that through expansionary measures the economy can overcome the debilitating effects of a deflating bubble.
As is discussed in Chapter 5, the use of scarce taxpayer funds to prop up or bail out investors, entities and public and private pension funds is not without controversy. Arguments that are used in support of such strategy usually involve considerations of balancing the needs of society on the one hand with the desire to maintain appropriate moral hazard standards on the other. If governments become too liberal in their support of investors and provide full or partial compensation for their current losses, investors can lack sufficient discipline to properly scrutinize future investments. In this sense a hazard is created, because investors could take excessive risks with their investment decisions, comfortable in the knowledge that if an investment does not turn out as they had expected, governments would subsidize any losses they incur.
The ongoing debate as to whether the US Federal Reserve, the US Treasury, or any other governmental authority should step in to bail out distressed entities, or purchase toxic assets from private banks and investors, further contributed to unnecessary delay. Delay, and even inaction, in turn exacerbated the crisis. As is discussed in Chapter 3, the decision by the US Treasury and the US Federal Reserve not to bail out Lehman Brothers was possibly the single largest contributory factor undermining confidence in financial markets.
23 Bernanke 2005. The global savings glut and the US current account deficit.
Remarks by Governor Ben S. Bernanke at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, 10 March 2005.
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