Causes and Consequences of the Financial Crisis of 2007-2009

By Poole, William | Harvard Journal of Law & Public Policy, Spring 2010 | Go to article overview

Causes and Consequences of the Financial Crisis of 2007-2009


Poole, William, Harvard Journal of Law & Public Policy


By the early fall of 2009, the business contraction that began in December 2007 appeared to be ending, (1) but the outlook, remained hazy. Despite a number of "green shoots," as Federal Reserve Chairman Ben Bernanke liked to put it, (2) the data were not decisive enough to declare the end of the contraction. Employment was still falling through September 2009. (3) Although in October 2009 it certainly seemed that the economy was near the bottom, it was not safe to say that the crisis was history. (4) Nevertheless, much is already known about the causes of the financial crisis and government responses to it, permitting a much more than speculative review. David Wessel has provided a superb blow-by-blow account of events during the crisis; (5) there is no point in repeating that account here.

Nevertheless, a brief chronology of the phases of the financial crisis should help to organize the discussion.

I. CHRONOLOGY OF THE FINANCIAL CRISIS

The crisis broke in mid-August 2007, when the market suddenly cut off funding to several financial entities. (6) The Federal Reserve's initial response in August was to reduce the discount rate--the interest rate the Fed charges on loans to banks--in the hope that banks could provide funds to firms cut off by the market. (7) In mid-September 2007, the Fed began to cut its main policy interest rate, the federal funds rate. The rate had stood at 5.25% from June 2006 through August 2007. (8) Although the Fed ordinarily changes its fed funds rate target in steps of twenty-five basis points, the first reduction in September was by fifty basis points. (9) As financial strains grew and the economy gradually weakened, the Fed continued to reduce its fed funds target rate, reaching 3% in late January 2008. (10)

In mid-March 2008, financial strains intensified as the market cut off funding to Bear Stearns, a large New York investment bank. (11) To prevent Bear Stearns from failing, the Federal Reserve provided an emergency loan and assumed the credit risk on some Bear Stearns assets, which persuaded JP Morgan Chase to buy Bear Stearns. (12) A few days later, the Federal Reserve cut its federal funds rate target by seventy-five basis points, down to 2.25%. (13) The Bear Stearns bailout marked the end of the first phase of the financial crisis.

In April the Fed lowered its funds rate target another notch to 2%, which it held until September. (14) During this second phase of the crisis, the economy was drifting downward, but not at an alarming pace. This phase ended with the Lehman crisis. The Fed did not bail out Lehman Brothers, an investment bank twice the size of Bear Steams, and Lehman declared bankruptcy on September 15. (15) Lehman's collapse marked the beginning of phase three of the crisis, when market strains went from serious to calamitous. The Fed bailed out American International Group (AIG), a huge insurance company, the day after Lehman failed. (16) In October 2008, the Fed cut its target funds rate in two steps to 1% and further to near zero in December. (17)

The flight to safety was so intense that in November and December 2008 the market bid the yield on Treasury bills literally to zero on some days. (18) Credit strains were severe and economic activity declined sharply. There is no particular date or event to mark the end of phase three of the crisis; markets gradually improved and the economy transitioned to phase four, in which credit conditions became more settled and credit began to flow again.

The financial crisis was worldwide, with European banks and markets as severely affected as those in the United States. (19) Asian banks were stronger than U.S. and European banks, but Asia could not escape the effects of the crisis. (20) Output and employment fell around the world.

II. CONDITIONS LEADING TO THE CRISIS (21)

After the stock market peak in 2000 and to resist the 2001 recession, the Fed reduced its target federal funds rate in steps, eventually reaching 1% in 2003. …

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