Great Recession: What It Was and What Caused It

What Was the 2008 Great Recession?

The Great Recession was the sharp decline in economic activity that started in 2007 and lasted several years, spilling into global economies. It is considered the most significant downturn since the Great Depression in the 1930s.

The term “Great Recession” applies to both the U.S. recession, officially lasting from December 2007 to June 2009, and the ensuing global recession in 2009. The economic slump began when the U.S. housing market went from boom to bust, and large amounts of mortgage-backed securities (MBS) and derivatives plummeted in value.

Understanding the Great Recession

The term “Great Recession” is a play on the term “Great Depression” of the 1930s, when gross domestic product (GDP) declined more than 10% and unemployment hit 25%.

While no explicit criteria exist to differentiate a depression from a severe recession, there is a near consensus among economists that the downturn of 2007–2009 was not a depression. During the Great Recession, U.S. GDP declined by 0.3% in 2008 and 2.8% in 2009, while unemployment briefly reached 10%.

Causes of the Great Recession

According to a 2011 report by the Financial Crisis Inquiry Commission, the Great Recession was avoidable. The appointees, which included six Democrats and four Republicans, cited several key contributing factors that they determined led to the downturn.

First, the report identified failure on the part of the government to regulate the financial industry. This failure to regulate included the Federal Reserve’s inability to stop banks from giving mortgages to people who subsequently proved to be a bad credit risk.

Next, too many financial firms took on too much risk. The shadow banking system, which included investment firms, grew to rival the depository banking system but was not under the same scrutiny or regulation. When the shadow banking system failed, the collapse impacted the flow of credit to consumers and businesses.

Other causes that the report identified included excessive borrowing by consumers and corporations, along with lawmakers who did not fully understand the collapsing financial system. This created asset bubbles, especially in the housing market, as mortgages were extended at low interest rates to unqualified borrowers who subsequently could not repay them. The ensuing selloff caused housing prices to fall and left many other homeowners underwater. This, in turn, severely impacted the market for the mortgage-backed securities (MBS) that banks and other institutional investors held, and demand for which allowed lenders to give mortgages to risky borrowers.

Origins and Consequences

The 2001 dotcom bubble implosion, followed by the terrorist attacks of Sept. 11, 2001, hammered the U.S. economy. The Fed responded by cutting interest rates to the lowest levels since Bretton Woods to stimulate the economy. The Fed held interest rates low through mid-2004.

Combined with federal policy to encourage homeownership, low interest rates helped spark a boom in real estate and financial markets and a dramatic expansion of the volume of total mortgage debt. Financial innovations, such as new types of subprime and adjustable mortgages, allowed borrowers—many of whom otherwise might not have qualified—to obtain home loans on generous terms based on the expectation that interest rates would remain low and home prices would continue to rise.

However, from 2004 through 2006, the Federal Reserve raised interest rates to control inflation. As interest rates rose, the flow of new credit through traditional banking channels into real estate slowed. More seriously, rates on existing adjustable mortgages and exotic loans began to reset at much higher rates than many borrowers expected (or were led to expect by lenders). As monthly mortgage payments rose beyond borrowers’ ability to pay (and they could not simply refinance, as prices had stopped steadily rising), many borrowers started to sell. The increase in supply burst what was later widely recognized to be a housing bubble.

During the U.S. housing boom, financial institutions sold mortgage-backed securities and complex derivative products at unprecedented levels. When the real estate market collapsed in 2007, these securities declined precipitously in value. The credit markets that had financed the housing bubble quickly followed housing prices into a downturn as a credit crisis began unfolding in 2007. The solvency of over-leveraged banks and financial institutions hit a breaking point with the collapse of Bear Stearns in March 2008.

Things came to a head later that year with the bankruptcy of Lehman Brothers, the country’s fourth-largest investment bank, in September 2008. The contagion quickly spread to other economies around the world, most notably in Europe. As a result of the Great Recession, the United States alone lost more than 8.7 million jobs, according to the U.S. Bureau of Labor Statistics, doubling the unemployment rate. Further, U.S. households lost roughly $19 trillion in net worth as the stock market plunged, according to the U.S. Department of the Treasury. The Great Recession’s official end date was June 2009.

Response to the Great Recession

The aggressive monetary policies that the Fed took, along with other central banks around the world, was widely credited with preventing even greater damage to the global economy. However, some also criticized the moves, claiming they made the recession last longer and laid the groundwork for later recessions.

Monetary and Fiscal Policy

For example, the Fed lowered a key interest rate to nearly zero to promote liquidity and, in an unprecedented move, provided banks with a staggering $7.7 trillion of emergency loans in a policy known as quantitative easing (QE).

Along with the inundation of liquidity, the U.S. federal government embarked on a massive program to stimulate the economy in the form of $787 billion in spending under the American Recovery and Reinvestment Act. These monetary and fiscal policies reduced immediate losses to major financial institutions and large corporations.

The Dodd-Frank Act

Not only did the government introduce stimulus packages, but new financial regulation was also put into place. In the 1990s, the U.S. repealed the Glass-Steagall Act, a Depression-era regulation that separated investment from retail banking to reduce systemic risk. Some economists say this move helped cause the crisis. The repeal allowed some large U.S. banks to merge and form larger institutions, many of which later failed and had to be bailed out.

In response, in 2010, the U.S. Congress passed and then-President Barack Obama signed the Dodd-Frank Act, which gave the government expanded power to regulate the financial sector, including greater control over financial institutions that were deemed on the cusp of failing. It also created consumer protections against predatory lending.

However, critics of Dodd-Frank note that the financial-sector players and institutions that actively drove and profited from predatory lending and related practices during the housing and financial bubbles were also deeply involved in both the drafting of the new law and with the agencies charged with its implementation. 

Recovery From the Great Recession

Following these policies, the economy gradually recovered. Real GDP bottomed out in the second quarter of 2009 and regained its pre-recession peak in the second quarter of 2011, 3½ years after the initial onset of the official recession. Financial markets recovered as the flood of liquidity washed over Wall Street.

The Dow Jones Industrial Average (DJIA), which had lost over half its value from its August 2007 peak, began to recover in March 2009 and, four years later—in March 2013—broke its 2007 high.

For workers and households, the picture was less rosy. Unemployment was at 5% at the end of 2007, reached a high of 10% in October 2009, and did not recover to 5% until 2015, nearly eight years after the beginning of the recession. Real median household income did not recover to pre-recession levels until 2016.

Critics of the policy response and how it shaped the recovery argue that the tidal wave of liquidity and deficit spending propped up politically connected financial institutions and big business at the expense of ordinary people. It also may have delayed recovery by tying up economic resources in industries and activities that deserved to fail, when those assets and resources could have been used by other businesses to expand and create jobs.

The Bottom Line

The Great Recession lasted from roughly 2007 to 2009 in the U.S., although the contagion spread around the world, affecting some economies longer. The root cause was excessive mortgage lending to borrowers who normally would not qualify for a home loan, which greatly increased risk to the lender.

Lenders were willing to take this risk, as they could simply package the loans into an instrument they sold, passing the risk on to investors. Low interest rates and poor regulatory oversight following the repeal of the Glass-Steagall Act compounded the problem, as credit was cheap and lending institutions had been freed from regulations that would have hampered their ability to mix commercial and investment banking, which Glass-Steagall had separated.

As the economy imploded and financial institutions failed, the U.S. government launched a massive bailout program, which included assistance for consumers and the many unemployed people via the $787 billion American Recovery and Reinvestment Act (ARRA). Most credit the bailouts and the ARRA with providing much-needed relief to the public and with saving the financial industry (along with other industries) from total failure; however, some assert the money used to bail out insolvent institutions could have been directed to more productive enterprises rather than using it to save failed ones.