The 2008 Financial Crisis was arguably one of the largest recessions in world history. Many countries continued to struggle economically well after 2008. What happened? Why did it affect so many economies? Who was accountable? Could it have been prevented? All these questions will be answered in this explanation.
The US economy before 2008
Prior to the 2008 global financial crisis, there was a boom in economic activity. Interest rates in the US were low with the aim to boost the economy through business and consumer spending.
Taking advantage of low mortgage rates, many borrowers took out loans to buy homes. Even those who had poor or no credit history were allowed to get loans and mortgages. These were known as subprime mortgages. This is quite significant because people with poor or no credit history are more likely to default on a loan.
A subprime mortgage is a loan given to consumers with poor credit scores. Such consumers wouldn’t qualify for conventional loans and mortgages. A subprime lender is a firm that offers/sells such mortgages.
Banks on Wall Street sold these loans classifying them, wrongfully, as low-risk financial instruments. At this point, banks were taking on larger risks: from allowing risky consumers to take up large loans and mortgages and borrowing money to increase investment returns.
Mortgage-backed securities (MBS) is one complex financial product that impacted the housing boom of 2008.
MBS are bonds secured by a home and other real estate loans. The investor who buys an MBS is lending money to individuals to buy a home. MBS turn a bank into an intermediary between the homebuyer and an investment firm. A bank can grant mortgages to its consumers and sell them at a discount when an MBS is included. It benefits the bank and they lose nothing even if the homebuyer defaults.
These were very popular because everyone benefited as long as everyone did their part.
Banks profited from MBS and it created a huge demand for mortgages. This caused mortgage lenders to lower rates and standards for new homeowners. MBS allowed banks to have more funds to lend, but it created so much liquidity in the market that it created the housing boom.
Another profitable and complex financial instrument during 2008 were credit default swaps (CDS).
CDS are a credit derivative that allows the buyer (in most instances an investor) to swap or offset their credit risk. Through this offset or swap, the buyer is protected from any event that might impact their investment. With the use of CDS, many investment firms, banks hedge funds, etc. could make a lot of money.
By the end of 2007, CDS had grown to nearly $60 trillion in business. However, CDS were sold as insurance to cover subprime mortgages and other exotic financial instruments. So when MBS had become nearly worthless, defaults were likely, and banks, hedge funds, etc. that sold CDS actually had to pay out large sums of money.
This is what happened to AIG (an insurance firm) that only sold CDS. They had to pay out when bonds started to default whilst no one was paying AIG. AIG had written almost $440 billion in CDS and didn't have enough money to cover all these payments.1
Eventually, interest rates rose and homeownership reached a high. During the start of 2006, house prices began to fall.
This meant that homes were valued less than what homeowners initially paid. Many still hadn’t finished paying their mortgages, so they couldn’t sell off their homes. As many had subprime mortgages, the increase in interest rates made it difficult for them to pay off the money they had borrowed.
The beginning of the crisis: 2007–09
At the start of 2007, one subprime lender filed for bankruptcy. Within a few months, many other subprime lenders also followed suit and filed for bankruptcy.
Then, in 2008, the infamous investment bank Lehman Brothers filed for bankruptcy, causing financial markets to waver. The Dow Jones (a US stock index) fell by 504 points, and oil prices plummeted.
Governments deployed massive bailouts of financial institutions and other monetary and fiscal policies to prevent the collapse of the global financial system.
You can learn more about these the monetary and fiscal policies governments can introduce in these articles; 'Monetary Policy' and 'Fiscal Policy'.
Money around the world started to freeze. Banks approached each country’s central bank for emergency funding. UBS was the first major bank to report losses of $3.4 billion from subprime related investments.2
Many central banks around the world tried to bring relief to the global credit market by providing billions of dollars in loans.
The financial crisis was classified in the summer of 2008. At this point, well-known banks started to fail, the largest one was IndyMac. The two largest home lenders in the US, Freddie Mac and Fannie Mae, were nationalised.
Causes of the 2008 financial crisis
The 2008 financial crisis had long roots but, as we said before, it wasn’t apparent to the world until the summer of 2008.
The immediate trigger was the rapid pace at which mortgages were sold and who they were sold to. Low-interest rates and low lending standards fueled an unsustainable housing price bubble. The bubble popped when many struggled to repay their mortgages and started to default, causing property prices to drop and assets to fall significantly in value.
Many argue that the crisis began farther back, with the deregulation in the financial markets. The loosely regulated financial market saw complex financial products as profitable which encouraged banks to take up more risks.
Global impact of the 2008 financial crisis
The 2008 financial crisis shook the global financial market and its impacts are still felt today in some economies. We will look at its impacts on the US economy as well as in the EU, and see how some countries managed to avoid a recession during this time.
Impacts on the US economy
The USA’s GDP fell by 4.3% and the recession lasted for 18 months. Unemployment doubled from 5% to 10%. 8.8 million people lost their jobs. Many struggled to find jobs after and there was a significant drop in productivity. $19.2 trillion in household wealth evaporated and home prices dropped by 40%.3
Fig 1. - USA's GDP growth between 2000–13. Source: World Bank, www.data.worldbank.org, StudySmarter Original
As we can see in figure 1 above, the USA's GDP fell to its lowest point in 2009 at -2.537. After the recession ended, the US still faced weak economic growth, only averaging about 2%. Unemployment rates remained high. To boost economic growth, the Fed initiated a loose monetary policy of quantitative easing and low interest rates.
The financial sector saw an increase in supervision and regulation to reduce financial risk and to prevent another situation like this from occurring again.
To learn more about the benefits to regulation in the financial market, read our Regulation of Financial System explanation.
Impacts in the EU
The financial crisis affected many European countries. Many bounced back from the recession, however, a few experienced a prolonged recession and a severe debt crisis. Many countries like Spain, Ireland, Greece, Portugal, and Cyprus took on large debts to cushion the effects of the fall of the financial market in their economy.
Greece, Ireland, Spain, Portugal, and Italy are a few of many European countries that experienced the long effects of this crisis.4
The crisis forced Greece into a budget deficit. It was 12.9% of its GDP which was more than 4 times the EU’s limit of 3%. Greece struggled to repay the loans they had received. The EU and the International Monetary Fund (IMF) provided Greece with €240 billion to prevent defaulting, but it was only enough money for Greece to back the interest on its existing loans. Fig. 2 - Greece's GDP growth between 2000–13. Source: World Bank, www.data.worldbank.org
As figure 2 shows, this crisis took a huge toll on Greece's GDP growth. It plummeted to -10.149% in 2011. The economy remained in a recession well after 2008.
In the end, the EU had to bail Greece out. Greece suffered a drop in their credit rating, making it harder for them to get financial aid from investors in the future.
In Ireland, many financial institutions almost collapsed due to being unable to repay their debts. The Irish government initiated a €64 billion bank bailout, but that wasn’t enough to solve the large financial problem the Irish government was facing.
In 2010, the IMF and the EU provided Ireland with an extra €67.5 billion in assistance, but Ireland struggled and was in a recession for 2 more years.
For Portugal, the 2000s were already a period of economic crisis. The Portuguese economy had already suffered a recession during 2002–03.
In 2008, the Portuguese economy didn’t grow and fell by 3% in 2009. In 2010, Portugal’s budget deficit continued to grow.
By 2011, Portugal was unable to repay its government debt and requested a bailout in April. Portugal’s debt to GDP ratio rose to 111% in 2011. Portugal’s economic growth struggled between 2000 to 2011.
The debt crisis hit Spain a little later than other European countries. In 2012, Spain was unable to bail out its financial sector and received a €100 billion rescue package.
The reason why the crisis hit Spain later, was because the Spanish government prolonged the housing bubble. The Spanish government made revenue from the booming property investment and construction sector as it produced high tax revenue. But as it was an unsustainable real estate bubble, Spain suffered from a strong economic downturn, high rates of unemployment, and bankruptcies of many major firms. This recession continued up until 2014.
The financial crisis hit the Italian economy in a different way. Italian banks didn’t engage in any risky investment behaviour. However, Italy had already suffered from high levels of public debt.
In 2011, Italy’s debt was 119.7% of its GDP. In that same year, interest rates on their national debt went out of control. This caused Italy to lose control of their financial markets and the government went bankrupt.
Fig. 3 - Italy's GDP growth between 2000–13. Source. World Bank
Figure 3 shows Italy's GDP growth rate before and after the crisis. In 2009, the GDP growth hit its lowest at -5.281% and Italy did recover in the next two years. However, Italy plummeted back into a recession in 2012 and 2013.
With the help of the European Central Bank (ECB), Italy was able to get its financial market back on track and they experienced economic growth again. But like in many other central European countries, unemployment skyrocketed and continues to remain high, especially for the youth.
Economies that avoided a recession
The impact of the financial crisis was not felt equally, as there are some countries that experienced a deep, long recession, while others completely avoided it.
Some of the countries that avoided a recession were Australia, Poland, China, India, and Indonesia. Let’s look at two of them.
Before the Covid-19 Pandemic, Australia’s last recession had been in 1991. Australia’s economy was able to grow by 0.3% in 2009. A few reasons why Australia managed to avoid a recession were:
- The Australian government acted quickly. They issued a $10.4 billion stimulus package that ensured stability in the country’s financial system and helped ease consumer and business concerns.
- Their close proximity to China’s booming economy. Asian countries are Australia’s main trading partners, so the Australian economy benefited from the growth of Asian economies despite the global slowdown.
Unlike many European countries, Poland avoided a recession due to low private debt, domestic demand, and its flexible currency. There is a low dependency on business and consumer credit in Poland and the Polish economy has a relatively big domestic market.
Their floating exchange rates and the depreciation of the Polish Zloty during 2008–09 made exports more competitive and stimulated economic growth.
Accountability for the 2008 financial crisis
Many economists put the blame on the loose mortgage lending policies that allowed consumers to borrow much more than they could. Some others put the blame on:
- The lenders. They were responsible for allowing consumers to borrow money despite having poor credit scores.
- The homebuyers. Many homebuyers bought houses that they could not afford.
- Investment professionals. They bought these mortgages and resold them as bundles to investors.
- Rating agencies. They rated those mortgages bundles, making them appear to be safe.
As you can see, there are a lot of factors and participants that contributed to this crisis. Ultimately, it was irrational human behaviour and greed that drove up demand and supply for these loans. But what can we learn from this financial crisis?
2008 financial crisis summary
The 2008 financial crisis can be summarised by three important lessons that investors, consumers and governments learnt:
- Too big to fail: the financial crisis showed us that there are many banks that are so large and so interconnected that their failure will result in a disaster for the greater economic system. This is why so many governments bailed out large banks. To avoid such a crisis again, there are many acts and regulations that require banks with assets over $50 billion to stress test and keep them under control from speculative bets.
- Generous risky lending: generous loans were handed out in an overheating housing market in 2008. Lending has become much tighter than before. There are many more requirements to qualify for a mortgage.
- Moral hazard: this refers to where individuals make decisions despite potential risks, knowing that they won’t be liable for any losses. Financial institutions, particularly investment banks, could’ve had all the blame passed onto them. Banks behaved badly, yet none were charged or indicted with any crimes.
The 2008 Financial Crisis is a good case study to keep in mind for your exams as it can be applied to many different topics in economics. Test your understanding of this crisis with the flashcards or move on to learn about other significant recessions.
2008 Financial Crisis - Key takeaways
The 2008 financial crisis was caused by the rapid pace at which subprime mortgages were sold and the low lending standards.(Video) Aging reversed? Testing the information theory of aging.
The lending and subprime mortgages led to the creation of a housing bubble. The burst of the bubble resulted in many struggling to repay mortgages, causing defaults on mortgage repayments and a fall in property prices and asset values.
The financial crisis resulted in high unemployment rates in the US and many countries experienced low economic growth.
Countries like Greece and Ireland experienced high debt, large bank failures, and defaulting on loan repayments.
More than $2 trillion was lost from the 2008 financial crisis and many economies struggled to get back to pre-2008 economic growth levels.
This crisis has taught many the importance of regulating the financial market, the large risk of over-lending, and the importance of high loan requirements.
1. Adam Davidson, ‘How AIG fell apart’, Reuters, 2008.
2. Lindsey K. Hanson and Timothy J. Essenburg, The New Faces of American Poverty: A Reference Guide to the Great Recession, 2014.
3. John Weinberg, ‘The Great Recession and its Aftermath’, Federal Reserve History, 2009.
4. European Commission, Economic Forecast, 2008, https://ec.europa.eu/economy_finance/publications/pages/publication13290_en.pdf