Topic:

The 2008 recession, bailout and conclusion

CONTENT:
Abstract
1. Follow up to the crisis and recession in US
1.1. Forms of financial crisis
1.2. Causes of the collapse
1.3. The Minsky crisis
1.4. Financialization and liquidity
2. Failing the bail out
Conclusion

Abstract
This paper talks about the most recent economic crisis. Through the paper it is attempted to
encompass in short form the important moments prior and with the crisis and consequent
bailout. As a finale a conclusion is added that best describes the writers stance on the topic and
most important issues on causes and consequences of the most recent Great Recession

1. Follow up to the crisis and recession in US

Prerecession period following up to 2008 recession already known as The Second Great
Recession, second to the first one which happened in 1930s, was the time of great
expansion. This expansion was short lived but very intensive, especially in years 2006 and
late 2007. At the heart of the expansion was the banking sector in both financial and
economic sense. Banking activity followed the growth of the expanding economy and
growth of GDP, but in two years prior to the recession the banking activities became too
risky and due to the lack of regulative policies it has, along with other factors that led to
2008 recession.
The question of financial stability is central to the assessment of the financial development
and growth of any country. The crisis are in most cases signals of financial instability and
failure of the system to work properly, which very often can have serious economic and
financial consequences leading to recessions and depressions. These phenomena are also
very expensive as they lead to many bankruptcies among households, companies, and
financial institutions, which again lead to social deadweight loss and debt incurred by the
fiscal costs from necessary government interventions, known to reach over 10% of GDP. (The
Ascent After Decline 2012)
For this reason especially it has become important to review the banking practices and
implement new reforms that are supposed to bring better results with financial stability and
economic stability. The reforms will be presented later in the text with a specific chapter.
1.1.

Forms of financial crisis

Financial crisis can take different forms. In recent history most crisis have been classified in
the following categories: (The Financial Development Report 2012)
a. Currency crisis the crisis that occurs when a fixed or semi fixed exchange rate
regime becomes unsustainable and the peg, or the effective peg has to collapse
b. Sovereign debt crisis the crisis that occurs when a sovereign government is unable
to service its debt obligations in time and in full, and thus formally or informally
defaults on its debt
c. Systematic or financial crises occurs when a significant number of financial
institutions become financially strained and need to be either closed down, merged
or restructured
d. Systemic corporate crises occurs when a significant portion of the corporate sector
is financially strained
e. Systematic household debt crises occurs when large number of households become
unable to service their debt in form of mortgage and customer credit

1.2.

Causes of the collapse

According to the Financial Crisis Inquiry Report which is the final report that the National
Commission issues on the causes of the financial and economic crisis, the crisis itself was
foreseeable and avoidable. It also states that crisis as such does not happen in a short run
with only few events, but rather takes time and deliberate lasting behavior. The crisis was
mainly caused by the largest banks under lack of supervision by the public institutions hired
to regulate the banks activities. (FCIR 2011) Furthermore it is clear, according to the William
Black, that this crisis represents a dramatic failure of corporate governance and risk
management, which is in large part resulted by the unwarranted and unwise focus on high
risk trading, which can also be marked as gambling, and could strongly indicate fraud.
(William Black 2005) During the time, banks attained to the regulators that they push to
lower regulation and supervision and allow for more self-regulation and self-supervision.
1.3.

The Minsky Crisis

Minsky Crisis or how it is also called the Minsky Moment, named by the economist Hyman
Minsky who had developed a famous financial instability hypothesis. His hypothesis
describes the transformation that is necessary to be done in order to make a robust
economy strongly structured financially, into a fragile one. He has introduced a term run of
good times where he describes that a run of good times would encourage ever greater risk
taking and growth in instability which will have to be solved by an emergency government
intervention. Minsky also stated that stability is destabilizing which meant to say that last
decade of stable growth, progress and expansion of US lead to lower risk awareness, which
consequently made the coming crisis even more severe.
Minskys theory went even further, where he developed stages to approach to describe the
long term process of transformation of the financial system from the late 19 th century to
present. In this part Minsky described three main stages of financial system, first the
financial capitalism named by Rudolf Hilferding, which was market by financial speculation
and pyramid schemes speculating in mainly close to worthless shares similar to those of
Charles Ponzi or Bernie Madoff. The second stage was the New Deal reforms which included
reforms of the financial sector and much bigger role of the government. The central bank
(FED) and the US government (Treasury) at this time promoted slow and stable growth, with
high employment rate and rising wages, which was latter market as US economic golden
age. This lasted from WW2 to 1970s. The third stage came with 1970s where many
identified it as casino capitalism or financialization, where it was also characterized by
shadow banks which deal as non-bank financial intermediaries providing similar services as
commercial banks. (hedge funds, money market funds etc) (Kregel Jan 2008)

The problem with the latter is the following and can be best described through the example
of the mentioned transformation. What would happen was that respectable banks like
Goldman Sachs would go from partnership to become publically held firms. They would hire
management that would be richly paid. The case of what would happen was very similar to
that of 1929 Great Crash or the pump and dump scenario. The incentives would be created
to pursue a scenario where management would artificially raise the asset and equity prices
of the company, and then just before the crash they would sell out their position due to the
speculative bubble that was created. For this reason exactly they are called pump and
dump scenarios. For this reason regulatory commissions and other responsible regulatory
institutions have shown an increased effort to develop precise and strict policies and
reforms after the latest 2008 recession, so such reform could be prevented. The kind of
behavior prior to the recession is market as one designed for fraud and rip-offs of banks
customers and shareholders, change of ownership organization from partnerships to
corporate form, hence increasing agency problems, and last but not the least, the excessive
executive compensation which was dependent only on short-run performance, hence
increasing pressure for fabricating the results in order to gain large bonuses.
1.4.

Financialization and liquidity

By the time of the recession in late 2007 and early 2008, the US ratio of debt to GDP reached
an all-time peak of 500%, which means that for each one dollar of income, there was 5
dollars of debt to be serviced. Moreover the financial sectors debt reached 125% of GDP.
(Ascent after Decline 2012b) This kind of debt incurred by one financial institution to
another is highly unusual, especially because of the fact that it was incurred as debt on debt.
Basically what happened with the last recession was that financial institutions chose to shift
the source of financing from deposits made by household checking and savings accounts, to
financing positions in assets, by issuing short term and long term, non-deposit liabilities held
by financial institutions. In example, banks purchase mortgage backed securities (MBS) by
issuing commercial paper; this paper in turn is bought by money market mutual funds
(MMMF) that based on this issue deposit like liabilities to firms and households. As
household bank deposits are insured by FDIC insurance by government, meaning backed
with unrestricted access to Fed to make necessary withdrawals to avoid bank runs. At the
point when mortgage backed securities were plenty and their market values started to drop,
households had no need to worry because they were backed by the FED. However, as
commercial paper was issued by banks based on mortgage backed securities, and bought by
MMMFs, it meant panic with MMMFs, as it also meant that commercial paper was bad as
the MBS. This led to run out of commercial paper, which meant that banks will have trouble
refinancing their positions, because there was no market for mortgage backed securities.
This logically has led to liquidity crisis and a run to most liquid and safe assets. Now, because
of great level of interdependence and the fact that financial institutions relied one to
another through borrowing from each other, the entire global financial system came to a

halt. Consequently, in lack of government intervention all financial institutions had to try to
sell their assets as they no longer had the ability to finance them.
2. Failing the Bail out
The bail outs are performed by the government intervention and its stimulus package.
However I will not go in lengths to analyze the government fiscal stimulus packages, but
rather will address the Feds response to the escalating crisis.
2.1.

Was it liquidity or a solvency issue?

Since the Great Recession of 1929, it has become clear that the central bank of a country
needs to operate as the lender of the last resort, in order to prevent an escalating crisis and
stop an emerging bank run. This opinion has been confirmed by many economists of which
in my opinion the leading role in analyzing such behavior has been taken by prof. Milton
Friedman in his book and on the same topic based TV series Free to Choose. The case is
such that when Fed steps in with sufficient amount of newly printed money to satisfy the
emerging withdrawals the bank run stops. (Free to Choose 1980) Also, once the deposit
insurance is added to the assurance of emergency lending, runs on demand deposits stop
also. But in the recent crisis banks have increasingly financed assets by issuing a combination
of both uninsured deposits and non-deposit liabilities like commercial papers. Having in
mind that the financial crisis started as a run on non-deposit liabilities which were largely
held by other financial institutions, it is clear that this behavior led to insolvency which again
led these institutions to sell their assets in order to remain liquid. However all their assets
put together, couldnt have covered the incurred debts, due to the risky and fraudulent
practices, which made this crisis not just a liquidity crisis, but rather a solvency crisis.
The case was at first that big banks began to fail, including handful of financial institutions,
big investment banks and few big mortgage lenders and MMMFs. Great majority of US banks
were not holding the bad assets, except for the part of having risky home equity loans and
commercial loans. For the most cases of banks the depth of the recession caused the
problems with their loans rather than their riskiness in the first place.
Improper government response to a failing and insolvent bank is very much different than a
response to a liquidity crisis of a bank. To put it shortly, the government was supposed to
step in by seizing the insolvent institution, get rid of management and begin a resolution of
the issue. In ordinary case, the stockholders lose as their investment/deposit was uninsured.
However at the time of crisis the Treasury Secretary Henry Paulson asked the Congress for
funds necessary to deal with the crisis. Congress approved funds in amount of $800 billion.
(FCIR 2011b) Now, instead of using the funds for resolving bad institutions that were
rather insolvent than illiquid, the funds were used for recapitalization of those bad
institutions by buying stocks in them, mainly in the troubled banks.

3. Conclusion
Today it is clear that there were many mistakes done in period prior to the economic
recession of 2008 and in its aftermath. Most economic recessions that happened in the last
century were able to happen not only due to unavoidable behavior in the market and
supposed invisible hand that failed to do the job properly. Rather most times great
economists who manage to explain the causes of each, become great just as did John
Maynard Keynes, John Kenneth Galbraith, Milton Friedman, Paul Krugman, Joseph Stieglitz
and many others to whom I have most respect. Still, in my opinion which is largely based on
the opinions of above mentioned economists and their respective works, the largest cause
of the economic recession was not merely in the fact that certain activities were allowed to
happen and certain regulations were missing to prevent such banking behavior, but rather
the core issue lies with the fact that we are even still addressing the consequences rather
than the causes of our recessions.
Here is to say that we need to be prepared to collectively pinpoint the causes of our
recessions in a manner that we prevent the interests of powerful to gain advantage over the
society and be ready to set things straight even after we realize that unfair has happened. In
future we are not to allow entire societies to be indebted for the causes and interests of
individuals who seemingly in a legal way and through legal procedures have gained great
amounts of capital and withholding it have monopolistically enslaved the rest of the
countrys population.
The economic science is expecting great change, with the emerging issues of internet and
free communication, renewable energy sources like sun and electrically powered vehicles,
issues with rising gas prices, ideas of one world currency etc. All this is about to impact the
rules in the financial world and economies as a whole. World is moving towards freedom
and transparency, even if in some cases this freedom is restricted by regulation, or misused
by individual interests. It is in our sole consciousness and moral behavior to make things
right and protect our common interests embedded within the stability of our economies and
our financial system.

REFERENCES:
1. Otaviano Canuto and Danny M. Leipziger (2012). Ascent after Decline. Washington
D.C.: The World Bank - . p87-150.
2. World Economic Forum (2012). The Financial Development Report 2012. New York:
World Economic Forum Geneva Switzerland. p1-47.
3. US National Commission (2011). FCIR - Financial Crisis Inquiry Report. Washington
D.C.: US Government Printing Office. p27-127.
4. William Black (2005). The Best Way to Rob a Bank is to Own One, How Corporate
Executives and Politicians Looted the S&L Industry. Texas: University of Texas Press.
p12-33.
5. Kregel Jan (2008). Minsky's cushions of safety. New Jork: The Levy Economics
Institute. p7-29.
6. Milton Friedman (1980). Free to Choose. Chicago: The University of Chicago Press.