Before COVID, the Great Financial Crisis (GFC) of 2008 was the most severe economic downturn since the Great Depression of the 1930s. Also known as the Global Financial Crisis, the GFC caused a nationwide recession, as well as causing global trade to decrease by 15% between 2008-2009. Nearly every country in the world was affected by the decline of economic growth, the loss of jobs, as well as the unprecedented number of bankruptcies and bank failures. So what caused this economic disaster? Why were the impacts so severe? 

In the years leading up to the GFC, the United States and other countries experienced high rates of economic growth alongside low and steady inflation and unemployment rates. As a result, many people speculated that the future value of housing would increase, (known as speculative buying), causing people to borrow excessively in order to purchase and build houses, hoping to make short term profits. The increase in speculative demand caused house prices to increase, creating a ‘housing bubble’. This brought about the risk of the bubble bursting, which would cause a heavy drop in real estate prices, which eventually did occur. 

In order to capitalise on the booming real estate market, banks and other lenders were willing to make increasingly large volumes of risky loans in the hope of receiving large returns on investment. Many of these lenders loaned amounts close to or even greater than the general price of a house. As a result, there were a large share of ‘subprime’ borrowers (borrowers unlikely to be able to repay their loans, due to relatively low incomes/wealth). Furthermore, due to mortgage loans being costly, lenders presumed that it would take some time before their loans were repaid, which reflected the widespread presumption that favourable conditions for lenders would continue. They usually sold loans in the form of ‘mortgage-backed securities’ (MBSs), which consisted of thousands of individual mortgage loans of varying quality. Many investors mistakenly believed MBSs to be a safe investment, unaware that if the borrowers of mortgage loans defaulted, there was no way to compensate MBS investors. These investors included large US banks, as well as many other foreign banks that were looking for higher returns than what they could achieve locally. These banks and investors in the US were borrowing increasing amounts in order to expand lending of MBS products. This was extremely risky, as it magnified both potential profits and losses. As a result, when house prices began to fall, many banks went bankrupt, such as ‘Lehman Brothers’, the 4th largest US bank, with 25000 employees worldwide, which went bankrupt in September 2008. 

Another major cause was the lax regulation of subprime lending. Many individuals borrowed excessively, to the point where it was unlikely for their loans to be repaid. Fraud also became more common; many lenders over-promised on MBS safety which encouraged more investors to borrow what they believed to be ‘low-risk’ loans. 

So how did the economic collapse unfold? Housing prices in the US peaked in early 2006, before a 24% decrease in value by 2008 due to a rapid increase in supply of newly built houses. The fall in house prices caused an increase in subprime loans; borrowers were unable to repay their debt and began defaulting, as many of the houses had fallen below the value of the loans themselves. This left banks with unwanted homes, which they then sold to recover their losses. Relatedly, investors became less willing to purchase MBS products, and aimed to sell their holdings, causing MBS prices to decline, due to a decrease in demand and an excess of supply. Trillions of US dollars were invested in subprime mortgages, which became almost worthless by the beginning of 2009. 

Furthermore, foreign banks were also active participants in the US housing market during the boom, meaning that on top of the 25 US bank failures in 2008, several other banks around the world suffered heavy losses and bankruptcies. The shortage in bank funds reduced lending, causing a huge decrease in consumer spending, and therefore a massive decrease in the total demand for goods and services all over the world. In fact, Bank lending decreased by 47% in just 9 months, from October 2007 through to July 2008. Many individual investors faced heavy losses, costing them their jobs, savings and homes. So how did this effect global economies on a macroeconomic scale? 

The decrease of demand of goods and services due to shortages in bank funds resulted in a decrease of real GDP per capita, especially in the US. As a result, world trade faced a decline, and a decrease in exports reduced aggregate demand even further. The collapse of the banking sector was well publicised, and so consumer confidence decreased, causing more saving and less spending. 

A decrease in inflation causes an increase in unemployment, so the decrease in inflation caused by the fall in aggregate demand resulted in over 30 million jobs lost in the US alone. High unemployment further reduced spending, due to fewer people having stable incomes, which further reduced aggregate demand. The combination of these factors reducing economic growth caused a worldwide 18 month recession. In the United States, real GDP contracted by 6.3% in late 2008, and by 5.7% in early 2009. Even after the recession many countries were still affected; it took the UK 5 years to recover sustainably, and median household incomes in the US only stabilised 8 years later, in 2016. 

Until September 2008, the main policy response to tackle the crisis came from central banks lowering interest rates in order to encourage spending and to stimulate economic activity. After many banks faced bankruptcies in late 2008, this policy was ramped up further to tackle the downturn in economic growth. Governments increased their spending in an attempt to stimulate a demand increase, to support employment and to shore up confidence in financial firms. The ‘Economic Stimulus Act’ was put into place by the government in 2008, which significantly reduced taxes for low and middle income taxpayers, in the hope that consumer spending would increase. Although the global economy faced the largest economic downturn since the Great Depression, government and central bank policies prevented a second depression and greatly dampened the impacts of the worldwide recession. 

In summary, the 2008 Financial Crisis began with cheap credit and lax lending standards that fuelled a housing bubble, and when that bubble burst, trillions of dollars were lost in subprime mortgages and worthless investments. The recession after caused millions to lose their jobs, homes and life savings on a global scale due to foreign bank investment, and it took around 10 years to fully recover from the economic downturn.