What really precipitated the global financial crisis?
Since 2007, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we face.
The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion. A 25% decline in housing value would generate a paper loss of $5.75 trillion. With an estimated 1%-3% of housing wealth gains going into consumption, this could generate about a $60-$180 billion reduction in total consumption — a modest amount compared to U.S. gross domestic product of $15 trillion. We should have seen a serious impact on consumption, but there was no a priori reason to believe we were embarking on a crisis of the current scale.
Leverage did increase the riskiness of the system, but it did not by itself turn a housing downturn into a global financial crisis. How leveraged a bank can be depends on many factors — most notably, the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit was overextended, this financial crisis was not a foregone conclusion.
There are two possible paths to resolving an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending and raise underlying capital. This can occur over many years, without much harm to the economy. The second path is more dangerous. If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices. These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to declines in their value.
A Similar Crisis in the 1990s
We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets in 1997 and 1998. For countries then, substitute banks (or markets) today. Both then and now, a crisis of confidence among short-term creditors caused them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.