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Chapter 15 The Global Financial Crisis

A World in Crisis

The following quotation describes a meeting held in Washington, DC, among the G-20 countries.Associated Press, “World Leaders Pledge to Combat Global Crisis,” Minnesota Public Radio News, November 17, 2008, accessed July 25, 2011, http://minnesota.publicradio.org/display/web/2008/11/17/financial_meltdown. The G-20 countries are a group of 20 of the richest countries in the world.

President George W. Bush, who served as host for the G-20 discussions, said it was the seriousness of the current crisis that had convinced him that massive government intervention was warranted.

He said he felt “extraordinary measures” were needed after being told “if you don’t take decisive measures then it’s conceivable that our country could go into depression greater than the Great Depression.”

As we wrote this chapter in 2011, the world economy was slowly emerging from the worst financial crisis since the Great Depression. Economists and others formerly thought that the Great Depression was an interesting piece of economic history and nothing more. After all, they thought, we now understand the economy much better than did the policymakers at that time, so we could never have another Great Depression. But this belief that monetary and fiscal policymakers around the world knew how to ensure economic stability was shattered by financial turmoil that began in 2007, blossomed into a full-fledged global crisis in the fall of 2008, and led to sustained downturns in many economies in the years that followed.

That was the background to the November 2008 meeting of the G-20 countries. The world leaders attending that meeting were attempting to cope with economic problems that they had never even contemplated. The events that led to this meeting were unprecedented since the Great Depression, in part because of the magnitude and worldwide nature of the crisis.

As the quotation from President George W. Bush attests, extraordinary times prompted extraordinary action. The US government passed an “emergency rescue plan” in October 2008 to provide $700 billion in funding to (among other things) buy up assets of troubled banks and firms. This was followed by a large stimulus package, called the American Recovery and Reinvestment Act of 2009, which was passed during the first year of the Obama administration. Other countries brought in similar stimulus packages. Increased government expenditures and cuts in taxes were enacted by governments around the world. Monetary authorities also took extraordinary steps, with many countries rapidly reducing interest rates to very low levels. In addition, the US Federal Reserve and other monetary authorities engaged in other unprecedented policies in an attempt to provide liquidity to the financial system.

Although the roots of the crisis can be traced to 2007 or before, and although the implications of the crisis are still being felt, the full-fledged crisis began in 2008. As shorthand, we therefore refer to all these events as the “crisis of 2008,” and the question we ask in this chapter is as follows:

What happened during the crisis of 2008?

Road Map

In this chapter, we explore the policies enacted by governments to deal with the crisis. First we need a framework to understand these events. We make sense of the events of the past few years by drawing on the tools that we have developed in this book. We aim to do more than just give a narrative account of what happened; we also offer explanations of what happened. Whereas other chapters in this book are largely self-contained, this chapter is designed as a capstone. We therefore make frequent references to topics discussed in other chapters.

The crisis of 2008 was a highly complex event, with many different and imperfectly understood causes. Moreover, some of the details involve highly arcane aspects of financial markets. We are not going to give you a comprehensive account of the crisis. But we will show you how you can use the tools you have learned in this book to make some sense of what happened. We highlight three themes in particular.

  1. As emphasized in Chapter 4 "The Interconnected Economy", markets in the economy and around the world are interconnected. Various connections among markets caused the crisis to spill over across different financial markets, from financial markets into the real economy, and from the United States to economies all around the world. These are sometimes called “contagion problems.”
  2. There were coordination failures in addition to contagion problems.
  3. Monetary and fiscal policies are interconnected. We will see that responses to the crisis around the globe often required monetary and fiscal authorities to work together.

We start by summarizing events in the United States. In doing so, we use a tool from game theory to study how financial instability might arise. We use this framework to consider both recent events in the United States and events from the Great Depression. We then look specifically at the housing market at the start of the 21st century.

After understanding the experience in the United States, we study how the crisis spread from the United States to other countries. We stress both financial and trade links across countries as ways in which the crisis spread. We look at a few countries in particular, such as the United Kingdom, China, Iceland, and the countries of the European Union. The crisis in the European Union is particularly interesting to economists because the interconnections between the monetary and fiscal authorities are very different to those in other places. Finally, we consider exchange rates and currency crises.