Skip to 0 minutes and 2 seconds What was the cause of the great recession that started in 2008? Some blame it all on greedy Wall Street bankers and some on subprime mortgage lenders. Others say it’s what Keynes called “animal spirits.” What is clear is that the trigger for the recession was the boom and eventual bust of the housing market. But what caused this bust? Why did so many homebuilders get it wrong at the same time all across the country? A simple answer is that the home builders responded to a false price signal in the economy. That false signal was the interest rate, set artificially low by the Federal Reserve.
Skip to 0 minutes and 39 seconds The Federal Reserve began lowering interest rates from 6.5% in late 2000 all the way down to 1% in November of 2003 and held it there until June of 2004. These artificially low interest rates encourage consumers to buy houses and builders to produce more houses. However, the low interest rate was not an accurate reflection of the true demand for houses in the marketplace. At the same time, Congress amended the Community Reinvestment Act, encouraging banks to offer mortgages to lower-income borrowers who would ordinarily not qualify for a loan. In addition, the federal government required Fannie Mae and Freddie Mac, the two now infamous government-sponsored lenders, to provide over half their mortgages to low-income buyers. These are known as subprime mortgages.
Skip to 1 minute and 28 seconds Essentially, this meant that banks and other mortgage lenders were told to relax their lending standards and provide mortgages to people who really couldn’t afford them. Then in July of 2004, the Fed began to increase interest rates to counter the growing inflation. But by May of 2006, the higher interest rates began to cause housing prices to fall. Millions of homeowners soon found that they owed more on their mortgages than their homes were worth. This led to a wave of foreclosures and defaults, further depressing housing prices and shrinking the capital of financial institutions, whose mortgage-backed securities were now worth much less.
Skip to 2 minutes and 8 seconds This was all made much worse by a 2007 change in the federal accounting standards, which required that these institutions write down losses before they occur. This is called mark-to-market accounting. This drastically reduced the capital of these financial institutions and led to the collapse of investment banks, such as Lehman Brothers. The best analysis of the Great Recession focusing on the unintended consequences of government intervention is the Austrian business cycle theory, as developed by such economists as Ludwig von Mises and Friedrich Hayek. If you’d like to know more about Austrian business cycle theory and this explanation of the Great Recession, watch lecture number 9 of Econ 101.
The Great Ressession
In this video, Gary will discuss more about the cause of the great recession in 2008.