The 2008 Global Financial Crisis

How did American finance change in the thirty years before the crisis?

After the Great Depression the United States split banking in two. The Glass–Steagall provisions of the Banking Act of 1933 barred commercial banks, which take deposits, from underwriting securities or affiliating with securities firms, so that depositors' money would not be used to speculate in stocks and bonds. From the 1960s regulators' interpretations began to open holes in this wall, and in 1998, when the commercial bank Citicorp merged with the insurer Travelers to form Citigroup, the Federal Reserve gave the merger, which broke the law, a temporary waiver. The Gramm–Leach–Bliley Act, signed by President Bill Clinton in November 1999, repealed the two provisions that kept banks and securities firms apart and so legalised the merger after the fact. 1 2

The same current reached derivatives, contracts whose value depends on the price of another asset such as a share, a bond, an exchange rate or an interest rate, and which can be used both to avoid a risk and to bet on it. When Brooksley Born, chair of the Commodity Futures Trading Commission (CFTC), moved in 1998 to review the regulation of over-the-counter derivatives, Treasury Secretary Robert Rubin, Federal Reserve Chairman Alan Greenspan and SEC Chairman Arthur Levitt asked Congress to stop her. The Commodity Futures Modernization Act, signed on 21 December 2000, placed over-the-counter derivatives such as credit default swaps outside the oversight of both the CFTC and the SEC. In 2004 the SEC relaxed the net capital rule for the big investment banks, allowing them to take on far more debt. This stripping away of rules is called financial deregulation or liberalisation. 3 4

Outside the banks, institutions doing the work of banks grew too. Investment banks, money market funds, securitisation vehicles and hedge funds, which take no deposits and so escape bank regulation but borrow short-term to invest in long-term assets, are called shadow banking. In a June 2008 speech Timothy Geithner, President of the New York Fed, said that in early 2007 asset-backed commercial paper conduits and similar vehicles held some $2.2 trillion, assets financed overnight in tri-party repo $2.5 trillion, hedge funds $1.8 trillion and the five largest investment banks $4 trillion, against about $10 trillion for the whole banking system. 5 4

How did the housing bubble and subprime lending grow?

Average US house prices more than doubled between 1998 and 2006, the sharpest rise in American history. Home ownership rose from 64 percent in 1994 to 69 percent in 2005, and some 40 percent of net private job creation in 2001–05 came from housing-related sectors. Household mortgage debt grew from 61 percent of GDP in 1998 to 97 percent in 2006. Some argued that the Federal Reserve fed the bubble by holding its policy rate low for a long time after the 2001 recession (John Taylor); others that vast savings accumulated in East Asian and other emerging economies held down interest rates worldwide (Ben Bernanke's "savings glut"). 6 4

In the past, people with poor credit histories or no large down payment found it hard to get a mortgage. In the early and mid-2000s, lenders who bundled loans into securities and sold them on began lending to them too. Such loans to borrowers with low credit standing are called subprime mortgages. In 2006 a third of all mortgages were subprime or no-documentation loans. Many borrowers took adjustable-rate mortgages with a low "teaser" rate for the first two or three years, after which the interest reset to market rates. While house prices rose, a borrower who could not keep up could sell at a gain or borrow again against the higher price. 7 4 8

House prices peaked in 2006. As the Federal Reserve raised rates in 2004–06, monthly payments on adjustable-rate loans jumped, and in early 2007 a wave of defaults and foreclosures brought down subprime lenders. On 2 April 2007 New Century, a leading subprime lender, filed for bankruptcy protection. More and more homes were "underwater", worth less than the loans on them, and repossessed houses flooding the market drove prices down further in a vicious circle. Average house prices nationwide fell by more than a fifth between the first quarter of 2007 and the second quarter of 2011. 4 7 6

How did American home loans become securities held by financial institutions worldwide?

Securitisation means that a lender does not keep its loans to maturity but bundles thousands of them together, turns the right to their payments into securities and sells those to investors. Securities built from home mortgages are mortgage-backed securities (MBS); pooling these again and slicing the pool into layers called tranches produces collateralised debt obligations (CDOs). Payments flow first to the senior tranche at the top, and losses from defaults fall first on the bottom tranche, so even securities made from subprime loans could earn a top AAA rating for their upper layers. CDO issuance grew from about $20 billion in the first quarter of 2004 to over $180 billion in the first quarter of 2007, and the share of subprime and other non-prime mortgage debt in CDO assets rose from 5 percent in 2000 to 36 percent in 2007. 9 4

Once loans could be sold on, lenders had less reason to check whether borrowers could repay. A single mortgage tied together brokers, originators, securitisers, rating agencies, investors and insurers, and the further each stood from the underlying loan the more it relied on indirect information such as the agencies' computer models. Investors bought and sold the risk of default on these securities like insurance through credit default swaps (CDS): derivatives in which the seller agrees to cover the buyer's loss if a debt defaults, in return for a fee, and which could be bought even by those who did not own the underlying bond. By the end of 2007 CDS outstanding stood at $62.2 trillion. AIG, one of the world's largest insurers, sold such protection in bulk through an unregulated subsidiary while setting aside almost no collateral or reserves. 4 10 11

This structure stood on debt. In 2004–07 the five largest US investment banks greatly increased their debt relative to their own capital; for fiscal 2007 they reported $4.1 trillion in debt, about 30 percent of US GDP. In 2008 Lehman Brothers supported $680 billion of assets on only $22.5 billion of capital. Investing with borrowed money as a lever brings large gains when asset prices rise a little, and wipes out capital when they fall a little: for Lehman a decline of three to five percent in real estate values could erase all its capital. And these securities had been sold not only in the United States but to banks, pension funds and local governments in Europe and Asia. 4 12

Why did banks stop lending to one another in the summer of 2007? {france}

Banks operate by lending their surplus funds to one another and borrowing to cover shortfalls every day, and this interbank market runs on the belief that the counterparty will repay tomorrow. In June 2007 Bear Stearns tried to prop up two of its hedge funds invested in CDOs when they received margin calls, and at the end of July liquidated them. On 30 July Germany's IKB Deutsche Industriebank was rescued by the public lender KfW, the first banking casualty of the crisis. As no one could tell how much subprime paper was buried in which bank, banks began to distrust each other. 4 13

On 9 August 2007 the French bank BNP Paribas blocked withdrawals from three funds holding $2.2 billion in assets, citing "a complete evaporation of liquidity" that made it impossible to value them: with no buyers there was no price. Many observers date the crisis from that day. In the same month money market investors wary of subprime exposure fled the asset-backed commercial paper market. Paul McCulley of PIMCO had named after the economist Hyman Minsky the moment when risky borrowing bred by long stability collapses all at once, the "Minsky moment", and he dated the Minsky moment of this crisis to August 2007. 4 13 6 14

With funding cut off, the banks that lived on short-term borrowing fell first. Northern Rock of Newcastle had expanded its mortgage lending largely with money borrowed in financial markets rather than deposits. When news broke on 14 September 2007 that it had received emergency liquidity support from the Bank of England, depositors queued outside its branches to withdraw their savings; it was the first British bank in 150 years to fail through a bank run. Northern Rock was nationalised in February 2008. The Federal Reserve began cutting its policy rate from 5.25 percent on 18 September and in December created a facility to auction short-term funds to banks. 15 4

From Bear Stearns to Lehman Brothers: what happened in 2008?

In March 2008 money drained out of Bear Stearns, the fifth-largest US investment bank, in a run by its customers and counterparties outside the banking system proper. On 13 March Bear told the Federal Reserve it would not have enough money to meet its obligations the next day. The New York Fed lent $12.9 billion through JPMorgan Chase, and on 16 March Bear agreed to be taken over by JPMorgan. To help the deal the New York Fed set up a company, Maiden Lane, that bought some $30 billion of Bear's illiquid assets. Shares that had traded at $178 a year earlier went first for $2 and then for $10. 11 4 16

On 7 September the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac, the government-sponsored enterprises that owned or guaranteed half the US mortgage market, into conservatorship. The two had more than $5 trillion of mortgage-backed securities and debt outstanding, and the Treasury committed up to $200 billion. A week later, on 15 September, Lehman Brothers filed for bankruptcy. Over the weekend the Federal Reserve, the Treasury and the SEC had gathered the heads of the big financial firms to arrange a private takeover and failed, and unlike with Bear Stearns the government gave no guarantee. With more than $600 billion in assets it was the largest bankruptcy in American history. The same day Merrill Lynch was sold to Bank of America. 17 11 12 4

Lehman's failure set off a panic. The next day, 16 September, the Federal Reserve lent $85 billion to AIG, which could not meet the collateral calls on its credit default swaps, and took a 79.9 percent stake in return, judging that a disorderly failure of AIG would shake the whole financial system. The same day the Reserve Primary Fund, a large money market fund holding Lehman commercial paper, announced it could no longer redeem its shares at $1. On 17 September investors pulled $144 billion out of money market funds, freezing the short-term market on which companies relied for payroll and operating funds. On 21 September Goldman Sachs and Morgan Stanley turned themselves into bank holding companies to come under the Federal Reserve's protection, and on 26 September Washington Mutual was seized by the FDIC in the largest bank failure in US history. 18 11 4

How did governments and central banks hold up the collapsing financial system? {usa}

On 18 September Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke warned the congressional leadership, House Speaker Nancy Pelosi among them, that the credit markets were close to complete meltdown, and asked for $700 billion to buy up toxic mortgage assets. On 29 September the House rejected the Emergency Economic Stabilization Act by 225 to 208, and the Dow fell 777.68 points (6.98 percent) that day. Amended, the bill passed the House on 3 October and President George W. Bush signed it the same day. The Troubled Asset Relief Program (TARP) it created was first meant to buy banks' bad assets, but on 14 October it switched to a $250 billion programme of buying bank shares and injecting capital directly. The logic of this bailout was "too big to fail": firms so large that their collapse would bring down the whole economy, so that the state had no choice but to save them. 4 19 20

Britain was first to inject capital directly. When shares in the Royal Bank of Scotland (RBS) plunged 35 percent on 7 October, its chairman told Chancellor Alistair Darling that the bank was within hours of running out of money. On 8 October Gordon Brown's government announced measures to recapitalise the banks and guarantee their debt, and became the majority owner of RBS and Northern Rock. Europe and the United States followed this British model. On 8 October the world's main central banks also cut rates together before the US markets opened. On 23 November the US government agreed to absorb losses on some $306 billion of Citigroup's real-estate-related assets and put in another $20 billion, and in December TARP money went to General Motors and Chrysler too. 21 22 4 19 11

Rate cuts alone were not enough, and central banks reached for new tools. The Federal Reserve cut its policy rate from 5.25 percent in September 2007 to 0–0.25 percent on 16 December 2008, and by saying that exceptionally low rates would last "for some time" began forward guidance, announcing the future path of rates in advance. With no room left to cut, it announced on 25 November 2008 that it would buy $100 billion of GSE debt and $500 billion of mortgage-backed securities, and in March 2009 added $300 billion of longer-term Treasuries. This policy, in which a central bank creates money to buy long-term bonds in bulk and push down long-term interest rates, is called quantitative easing. Under the first round (QE1) the Federal Reserve bought about $1.75 trillion of longer-term assets. The Bank of England began quantitative easing in March 2009. 6 23 24 25

Public spending was mobilised too. On 17 February 2009 President Barack Obama signed the $787 billion American Recovery and Reinvestment Act. On 9 November 2008 China's State Council announced it would pour 4 trillion yuan ($586 billion) into infrastructure such as railways, roads and airports and into social welfare by the end of 2010. Filling the hole in demand with government spending was the prescription Keynesianism had put forward after the Great Depression. In the fourth quarter of 2008 the American, European and British central banks bought $2.5 trillion of government debt and troubled private assets, the largest liquidity injection in world history. 26 27 4

How did the crisis spread around the world, and what did South Korea go through? {iceland}

Outside the United States the greatest collapse was in Iceland. Its three banks, Kaupthing, Landsbanki and Glitnir, had grown on money borrowed in international money markets until by the end of the second quarter of 2008 their assets exceeded eleven times GDP. With banks far bigger than the country, the Central Bank of Iceland could not act as lender of last resort. In October all three failed, and the British government froze Landsbanki's UK assets under provisions of the Anti-terrorism, Crime and Security Act. More than half a million depositors outside Iceland lost access to their accounts in the foreign branches of Icelandic banks, and compensation for British and Dutch savers in Landsbanki's online "Icesave" accounts became the subject of the Icesave dispute. Iceland took an emergency IMF loan in November, and in January 2009 its government fell amid protests. 28 4

The crisis spread through trade and capital flows. American consumption had accounted for more than a third of the growth in world consumption in 2000–07, so when American households stopped spending the exporting countries were hit at once. In the first quarter of 2009 GDP fell at an annualised rate of 14.4 percent in Germany, 15.2 percent in Japan, 9.8 percent in the euro area and 21.5 percent in Mexico. On 24 October a currency crisis spread as investors fled into the dollar, the yen and the Swiss franc and emerging-market currencies collapsed, and many emerging economies turned to the IMF. In Europe the financial crisis led on to the euro area crisis, which began with the Greek government-debt crisis in late 2009. 4

South Korea was caught in the whirlpool too. When it was reported on 9 September 2008 that the state-run Korea Development Bank had put talks to buy Lehman Brothers on hold, Lehman's shares fell 45 percent in a day. The Bank of Korea's foreign exchange reserves held many of the depreciating bonds of Fannie Mae and Freddie Mac, raising fears of a currency crisis. As in the 1997 crisis the won swung violently, falling 34 percent against the dollar. GDP shrank 3.4 percent in the fourth quarter of 2008 from the previous quarter, the first contraction in ten years, and exports in January 2009 were 33.8 percent lower than a year earlier, cars down 55.9 percent and semiconductors 46.9 percent. 12 29 30

On 29 October 2008 the Federal Reserve set up swap lines of up to $30 billion each with the Bank of Korea, the Banco Central do Brasil, the Banco de Mexico and the Monetary Authority of Singapore: arrangements under which they could deposit their own currency and borrow dollars when needed. The Fed already had such arrangements with ten central banks, including the European Central Bank, the Bank of England and the Bank of Japan. The swap line became a safety net against the dollar shortage the markets feared. Helped by public spending and rate cuts, the Korean economy narrowly avoided a technical recession with growth of 0.1 percent in the first quarter of 2009, and grew 0.2 percent for the year. Korea was one of the three countries managing the G20 in 2009, and at the Washington summit President Lee Myung-bak proposed a "standstill" declaration on new barriers to trade and investment. 31 30 32 33

The crisis brought the first G20 summits. The first, in Washington on 14–15 November 2008, issued a declaration setting out a common understanding of the root causes of the crisis and principles for reforming financial regulation. The London summit of 2 April 2009 agreed $1.1 trillion for programmes to support international finance and trade, including more resources for the IMF. The coordination of the world economy, until then the business of the Group of Seven, was now shared with the G20, which included emerging economies such as China, India, Brazil and South Korea. 33 34

What did the Great Recession leave in people's lives?

The US economy went through the recession called the Great Recession from December 2007 to June 2009. Real GDP fell 4.3 percent, the largest decline of the postwar era, and unemployment rose from 5 percent in December 2007 to 10 percent in October 2009; some 8.7 million jobs were lost. House prices fell about 30 percent on average from their mid-2006 peak to mid-2009, and the net worth of US households and nonprofits fell from about $69 trillion in 2007 to $55 trillion in 2009. Poverty rose from 12.5 percent in 2007 to 15.1 percent in 2010. The wealth of the rich who owned shares came back with the stock market, but households whose home was all they owned lost it to foreclosure, and Black home-owning households recovered more slowly than white ones, widening the racial wealth gap. 6 4

The financial industry that received the bailouts was hardly held to account. Forty-seven bankers went to prison over the crisis, more than half of them in Iceland; in the United States only one, a Credit Suisse banker who manipulated bond prices to hide losses. The bonuses AIG paid its executives after its bailout caused a storm of protest. Lehman's Richard Fuld had received $484 million in pay from 2000 until the bankruptcy. Regulation was tightened again. The Dodd–Frank Act, signed on 21 July 2010, created the Consumer Financial Protection Bureau and the Financial Stability Oversight Council, introduced the Volcker Rule restricting speculation by deposit-taking banks on their own account, and required derivatives to trade through regulated clearinghouses. Internationally, the Basel III standards raised banks' capital and liquidity requirements. 4 35 36

The anger spilled into the streets. Occupy Wall Street, which began on 17 September 2011 in Zuccotti Park in New York's Financial District, held the park for fifty-nine days in protest against economic inequality, corporate greed and the power of finance and money in politics. Its slogan "We are the 99%" targeted the gap in income and wealth between the richest 1 percent and everyone else. The protesters took decisions by consensus in general assemblies, and after they were cleared from the park on 15 November they turned to occupying banks, foreclosed homes and campuses. In Europe the Greek riots of December 2008 and the protests against the 2009 London G20 summit had come first. 37 4

How do mainstream and Keynesian economists explain the causes of the crisis?

In its January 2011 report the US Financial Crisis Inquiry Commission (FCIC) concluded that the crisis had been avoidable. The causes it named were widespread failures of financial regulation and supervision, failures of corporate governance and risk management at major financial institutions, excessive borrowing and risky investment, the collapse of mortgage-lending standards and the securitisation pipeline, the deregulation of over-the-counter derivatives including credit default swaps, and the failures of the credit rating agencies. But the report was adopted with the votes of the six members appointed by Democrats, and the four appointed by Republicans dissented. Alan Greenspan told a congressional hearing on 23 October 2008 that those who had looked to the self-interest of lenders to protect shareholders' equity, himself especially, were "in a state of shocked disbelief", and admitted that he had "found a flaw" in his view of the world. 4 38 39

There were explanations from the opposite direction. Commentators of the Austrian school such as Ron Paul held that the problem was not too little regulation but a Federal Reserve that had held interest rates artificially low in the early 2000s and created a credit bubble, and government agencies such as Fannie Mae and Freddie Mac that had pushed home ownership too far. Some blamed the Community Reinvestment Act of 1977, which encouraged lending to low-income borrowers, but Federal Reserve economists found in 2009 that only a small portion of subprime loans were related to the act and that they performed comparably to other subprime loans. On the repeal of Glass–Steagall, too, Joseph Stiglitz argued that it let the investment-bank culture take over commercial banking, while Bernanke held that most of the activities behind the crisis had never been prohibited by that law. 4 1

The economist most reread after the crisis was Hyman Minsky, who had died in 1996. He divided borrowers into three kinds: "hedge" borrowers, who can pay interest and principal from the cash their investments bring in; "speculative" borrowers, who can pay the interest but must keep rolling over the principal; and "Ponzi" borrowers, who cannot even pay the interest and rely on the asset rising in value. Long stability makes people bolder, so debt drifts towards the riskier kinds, and stability itself breeds instability: this is his "financial instability hypothesis". In April 2009 Janet Yellen said that Minsky had understood the "paradox of deleveraging", in which asset prices collapse when everyone tries to cut debt at once. 40 4

Keynesians saw this "paradox of deleveraging" as having the same structure as the "paradox of thrift", in which saving that is sensible for one person deepens a recession when everyone does it at once, and argued that public spending had to fill the gap in demand. Paul Krugman called the run on the shadow banking system "the core of what happened" and argued that all banking-like activity should have been regulated. Bernanke, who won the 2022 Nobel prize in economics for his analysis of the Great Depression, argued in his 2015 memoir The Courage to Act that only the Fed's novel efforts, together with other agencies, had prevented a catastrophe greater than the Great Depression. Barry Eichengreen located the roots of the crisis in the deregulation of financial markets. 4 41

How did Marxists read the crisis?

Marxist economists' readings split broadly in two. One side holds that the crisis came from long-term tendencies of the capitalist process of production, above all a rate of profit that fell in the postwar decades and never fully recovered: Robert Brenner, Anwar Shaikh, Michael Roberts, Guglielmo Carchedi, Andrew Kliman and Chris Harman. The other concentrates on the financial dimension of the crisis and plays down the law of the tendency of the rate of profit to fall; Costas Lapavitsas is its leading representative. The Monthly Review school of John Bellamy Foster and Harry Magdoff, and David Harvey, are sometimes grouped as a further strand stressing the underconsumption of the masses, deficient demand and the long stagnation that follows market saturation. The two positions cannot be neatly separated: those who stress profitability also deal with finance, and those who stress finance also deal with production. 42 43 4

In a January 2009 interview with Seongjin Jeong for South Korea's Hankyoreh, Brenner rejected calling the crisis simply a financial crisis. In his account the rate of return on capital investment had fallen deeply and lastingly since the end of the 1960s, mainly because of persistent overcapacity in world manufacturing as Germany and Japan, the northeast Asian newly industrialising countries such as Korea, the southeast Asian Tigers and finally China entered the world market one after another. Faced with insufficient demand, the authorities encouraged borrowing, and from the mid-1990s the Federal Reserve nurtured one asset bubble after another, in shares and then in housing. Brenner called this replacement of public deficits by private ones "asset price Keynesianism". For him this was a "Marxian crisis", rooted in a long-term fall of the rate of profit and its failure to recover. 44

In The Failure of Capitalist Production (2011) Kliman sought to put back at the centre of explanations of the Great Recession the fall in the rate of profit, which Marx called "the most important law of motion". He argued that the US economy never fully recovered from the slumps of the 1970s and early 1980s and that policymakers held off the resulting stagnation by injecting more and more debt, creating the artificial booms of the 1990s and 2000s. He criticised other researchers' calculations showing a recovery of profitability after 1982 for failing to distinguish cyclical swings from long-term trends. Michael Roberts likewise wrote that the fall in the rate of profit "eventually triggered the credit crunch of 2007 when credit could no longer support profits". 43 4

In a winter 2008 interview with International Socialism, Lapavitsas said that today's crises differ both from the nineteenth-century crises Marx analysed and from those of the 1970s. Banks used to lend to productive enterprises and receive part of the surplus value those firms produced as interest. As big business came to fund investment more and more from its own profits and relied less on the banks, the banks sought profit in areas not directly connected with the production of value and surplus value, above all lending to workers' households. In Profiting Without Producing (2013) he called this "financial expropriation" and the transformed system "financialised capitalism". When the bubble bursts, indebted workers are the first to lose their homes, and the fall in their consumption spreads to real accumulation. 45 42

In "The Right to the City", published in New Left Review in the autumn of 2008 as the crisis broke, Harvey wrote that because capitalists must keep reinvesting surplus value, they must perpetually find profitable terrains to absorb surplus capital, and that this need shapes the politics of capitalism; urbanisation and real estate were one such outlet. In The Enigma of Capital (2010) he took a long view of how capitalism came to dominate the world and why that led to the 2008 crisis, arguing that to talk of a regulated, ethical capitalism is a fundamental error. The debate has not been settled, but its strands share a point that separates them from mainstream accounts: they look for the cause of the crisis not in the greed of a few bankers or in regulatory mistakes but in the limits that capital accumulation ran into. 46 47