Genesis of the Global Financial Crisis

Abstract

This chapter traces the genesis of the global financial crisis of 2008 as it started in the USA and later spread across the world. After the US dot-com bubble burst in 2001, the US Federal Reserve Board followed an easy money policy for boosting up aggregate demand. This policy was facilitated by a large increase in investment in the US Federal financial instruments by China, Japan, Germany and oil exporting countries. As the liquidity increased in the USA, the Fed Funds Rate and Real Interest Rate touched the levels close to zero. Simultaneously, complying with the US government policy of providing cheap housing finance to the poor, the banks reduced the margins for such housing loans to almost zero level. This encouraged borrowing for houses by the subprime borrowers . Demand for houses increased which resulted in rise in house prices. A bubble was created in the US housing market due to several reasons. Very low rates of interest increased the risk appetite of investors leading to the increase in speculative investment in real assets. Through time, securitization of assets became popular. As a result, instead of originate-to-hold model, originate-to-distribute model of housing loans was used by the lending banks. This along with other financial innovations made it possible for financial intermediaries to distribute risks and unload them on unsuspecting investors. Lax regulatory practices in general as also regulatory capture and flawed credit ratings given by rating agencies resulted in underestimation and underpricing of risk. Investment in risky and tainted assets multiplied. In 2006, following policy-induced increase in the Fed Funds Rate, house prices in the USA started falling leading to large-scale foreclosures of housing loans resulting in bank losses and a drastic fall in liquidity. This triggered the financial crisis. Given the negative externalities of the market failure in the financial sector and the linkages across markets and countries, the crisis became global.