A Brief Note of the Financial and Economic Crisis in 2008

Proximate and other causes of the Global Financial Crisis of 2007-2008

By the time this book is in your hands, the global financial crisis of 2008 (GFC) might sound like a distant memory. At least, the memory of the crisis must be fading. But, it is important to recall the s salient elements of this crisis.

Global Explanations with the US being the intellectual leader

Any US-centric explanation of the crisis would, of course, fail to explain the global nature of the crisis. The crisis was not confined to the US alone. That tells us a few things. One is that global financial markets are integrated to a much larger degree than we acknowledge. Among other things, it is partly due to the relatively unrestricted capital flows that characterise global financial markets. Second, it reflects the herd mentality that prevails among investors. Institutional investors and their consultants – pension funds, mutual funds and pension fund advisors – would rather be part of the crowd than stand out and expose themselves for being wrong. This herd mentality gives rise to correlated trends in global financial markets as it accentuates both buying and selling frenzies. The third reason for the global nature of the crisis was the intellectual framework that most countries have adopted, whether full or partial, is imported from the United States. Hence, policies - regardless of whether they succeed or fail - are mostly made in the United States.

Fourth, exchange rate arrangements of most countries in the world would not be called fixed exchange rate systems.  But, in truth, most countries operate on a formal or informal dollar standard. When US dollar strengthens due to restrictive monetary policies in the US, these countries tighten policies to avoid excessive currency weakness. They accentuate US tightening. When the US has a loose monetary policy, the US dollar weakens and their currencies appreciate. They counter it by following loose policies of their own. Thus, they accentuate US easing. This is what happened between 2002 and 2007. As the US adopted looser policies in this period, most countries followed suit. Therefore, what happened was that the US housing bubble became a global housing bubble. When that bubble burst, it created a global crisis.

Fifth and perhaps, most importantly, globally there was the perception that risk did not matter or that risks had been conquered. Conventional wisdom was that the financial sector had learnt to diversify risk and even eliminate it. Policymakers had learned to handle business cycles. They had convinced themselves and the rest of the world, by sheer dint of repetition that it was their skilful handling of monetary policy in the 1980s and 1990s that had ushered in a period of non-inflationary growth (it was called ‘The Great Moderation’). They dismissed the possibility that a serendipitous confluence of one-off factors could have brought about favourable growth and inflation outcomes. Hence, policymakers and financial market participants had become confident that there was no crisis that could not be handled by fine-tuning policy. It was easy to clean up after the crisis than to lean against the wind, beforehand.