The 2008 Financial Crisis: A Global Interplay of Economic Forces and Flow of Money
The 2008 Financial Crisis: A Global Interplay of Economic Forces and Flow of Money
A broader picture of what led to one of the greatest financial catastrophes.
The 2008 financial crisis stands as a stark reminder of the vulnerabilities inherent in global financial systems, much like a World War in the economic sphere. It reshaped economies, affecting tens of millions of jobs, industries, and livelihoods worldwide. Often viewed as a blemish on track record of capitalism, the crisis is frequently attributed to its principles. However, a closer examination reveals that it stemmed more from a dissonance between financial systems and the principles of free market economies.
This article is an attempt to analyse the manner in which the flow of money and capital interacted with each other for almost two decades leading up to the 2008 meltdown. It is a summarisation of various accounts on the same to try and develop a more grassroot understanding of the numerous forces (visible and invisible) at play that all worked in collusion with each other to result in the event. While many reviews available are extremely detailed and technical in their interpretation (often loaded with dry and rather unnecessary economic jargon), this narrative is aimed at developing a simple yet comprehensive framework of what led to the event in a manner that helps all readers understand. That being said it is no way exhaustive in nature.
Origins of the Crisis
The causes of the financial crisis are multifaceted, with debates tracing back decades. While the immediate catalysts—rampant securitization of assets (mortgage-backed securities in particular), unhealthy speculation, unchecked risk and the eventual collapse of Lehman Brothers—are well-documented, the roots of the crisis go deeper. Some analysts point to the abolition of the Gold Standard, which altered global currency valuations, while others highlight the Plaza Accord's effects and its reversal. Ultimately, the crisis emerged not from a single event, but rather from a convergence of numerous factors and policies that unfolded over time.
For me, a pivotal starting point could be the Parade of Sovereignties in 1988 USSR and its subsequent, formal dissolution in 1991, which solidified capitalism as a global force and facilitated globalization. Emerging economies, particularly in Asia, began integrating into the world economy, adopting free-market principles that propelled rapid manufacturing growth. China, Japan, South Korea and India were able to produce inexpensive goods and services in much larger quantities. This sudden and large influx of cheap labour and products into the world economy meant it was cheaper for richer countries (US and EU) to import these goods. The wide variety and easy availability of goods caused them to spend more. On the other side of the world, emerging economies began growing at high rates supported by increased exports. GDPs began converging with developed economies. Asian economies that led this growth saw a parabolic rise in incomes and subsequently higher savings. Lack of a social safety net in these countries, coupled with the natural tendency of individuals to save more only pushed these numbers higher. Furthermore, policies such as the one child policy in China, meant that families saved more as parents had one less child that they could depend on in retirement. South East Asian economies such as Japan, Thailand and South Korea began accumulating large foreign reserves (US dollars in particular) from increased exports as insurance against any currency shock or shortfall in domestic banking systems (as seen in the 1997 Asian Financial Crisis). As former Federal Reserve Chairman Ben Bernanke said, it was a classic case of a “savings glut.” The availability of inexpensive goods and services led wealthier nations, especially the US and EU, to import more, fuelling consumer spending.
Imbalances, Increased Debt and Bank Balance Sheets
Meanwhile, the Western world became more liberal with spending; they were enjoying the lower priced goods by virtue of cheaper imports. This increased spending on imported goods and services meant these countries ran large and persistent trade deficits which in the long run is not optimal. During this time, economies such as the US and UK turned to their respective Central Banks to stimulate economic growth. Expansionary policies were undertaken and short-term interest rates were reduced to boost the growth of money supply, credit and domestic demand in an attempt to reduce trade imbalances. This resulted in a perilous situation: burgeoning debt in the West coexisted with rising savings in emerging markets, leading to macroeconomic disequilibrium. The 90s and early 2000s was a period of relative economic stability. During such times, capital investment sees a huge rise, generally flowing from mature economies to the emerging economies. But the savings in emerging economies coupled with growing debt in the developed economies saw capital flowing in the opposite direction. This influx manifested in the banking systems of the US, UK, and EU, leading to inflated bank balance sheets. With low real interest rates, borrowing became cheaper and asset prices—especially real estate—soared. Older generations cashed in on their properties at elevated prices, while younger buyers took on debt to finance purchases. Both parties looked to banks for their requirements; the former to put their sales proceeds to productive use while the latter for borrowings. Consequently, bank assets in the US grew from an average of around 25% of GDP to 100%, while in the UK, the figure surged to nearly 500%. Other developed economies too experienced similar situations with even higher numbers. With large amount of funds at their disposal, banks and financial institutions were under increasing pressure to deliver higher and more attractive returns.
The Perfect Storm of Risk
This undue rapid expansion of bank balance sheets was allowed by Central Banks, partly owing to the political climate while at the same time regulators also believed that there was no particular irrationality in the situation, provided interest rates remained lower. Newer, more sophisticated and riskier vehicles of investment were developed and promoted in chase of higher returns. One such instrument was asset backed securities, particularly mortgage-backed securities. In simple terms, this was an instrument bundling various individual mortgages at different rates and varying levels of risk, which was then sold as a security to prospective buyers. Extreme optimism in markets led to large scale speculation of these derivative instruments, much like how NFTs and DeFi took the investing community by storm in the post-Covid era.
The combination of a savings glut and the unchecked expansion of bank balance sheets created a precarious economic environment. While trade deficits remained manageable relative to GDP, the levels of internal and external debt became unsustainable. The attempts to boost domestic spending in various economies could not be sustained in the long run. Low interest rates meant households brought future expenditures to the present. A correction was almost certain to bring balance back in the economic system. It was not a matter of if, but a matter of when. Policy makers probably believed that the situation would solve itself; investors would either lose confidence in the stability of banks or would lose confidence in the US Dollar. Confidence in the US Dollar showed no signs of weakening given that export driven emerging economies such as China continued stockpiling the currency. As a result, the fragility of bank balance sheets and credit risks were exposed first. The unsustainable pile of bricks of credits and debits that were piled on top of each other began being noticed by investors and the public.
This precarious situation was exacerbated when French banking giant BNP Paribas halted redemptions on funds invested in asset-backed securities, a pivotal event that triggered a chain reaction. The collapse of Lehman Brothers soon followed, sending shockwaves through the financial system and culminating in the crisis. What happened afterwards is pretty much well known and was even more so felt throughout the world. Several comprehensive documentaries, biopics and books are available that give great insights into the events leading up to the event and its consequences.
Conclusion
The 2008 financial crisis serves as a cautionary tale about the complexities of global finance and the potential consequences of imbalances. It underscores the necessity for ongoing vigilance and reform to ensure that the principles of capitalism and the realities of financial systems align harmoniously. It is almost 100% likely that the world would face more financial crises of varying magnitudes in the future. It could be 5 years down the line, could be 20 years; its an inherent quality of economic and financial systems. Timing its precipitation and the subsequent effects is near impossible, practically a fool’s game. But analysing past events helps draw our attention to data points which otherwise would’ve gone unnoticed. In the end, such understandings are what could help us as individuals improve our perception of the financial matrix that exists and governs the working of all economies.
Display Photo by Christine Roy on Unsplash