The credit crunch: "It's a story of hubris followed by a fall"
Ten years ago this month, the world was rocked by a financial crash that still reverberates today. We asked three economic historians to reflect on the events of 2008 and consider how history will remember the crisis
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They're among the most enduring images of the 21st century: shell-shocked market traders looking on in horror as trillions are wiped off share prices; people queuing round the block to withdraw savings from Northern Rock; Lehman Brothers employees streaming out of Canary Wharf, boxes of possessions in hand, now effectively jobless. Behind those images lay the greatest jolt to the global financial system in almost a century – a jolt that pushed the world's banking system towards the edge of collapse.
The 2008 financial crash had long roots but it wasn't until September 2008 that its effects became apparent to the world. Within a few weeks, Lehman Brothers, one of the world's biggest financial institutions, went bankrupt; £90bn was wiped off the value of Britain's biggest companies in a single day; and there was even talk of cash machines running empty.
In the short term, an enormous bail-out – governments pumping billions into stricken banks – averted a complete collapse of the financial system. In the long term, the impact of the crash has been enormous: depressed wages, austerity and deep political instability. Ten years on, we're still living with the consequences, as our experts make clear.
Martin Daunton is emeritus professor of economic history at the University of Cambridge and co-editor of The Political Economy of Public Finance (Cambridge, 2017)
Scott Newton is emeritus professor of modern British and international history at the University of Cardiff and author of The Reinvention of Britain 1960–2016: A Political and Economic History (Routledge, 2017)
Dr Linda Yueh is an economist at Oxford University and London Business School and author of The Great Economists: How Their Ideas Can Help Us Today (Viking, 2018)
What do you see as the main causes of the 2008 crash?
Scott Newton: The immediate trigger was a combination of speculative activity in the financial markets, focusing particularly on property transactions – especially in the USA and western Europe – and the availability of cheap credit. There was borrowing on a huge scale to finance what appeared to be a one-way bet on rising property prices. But the boom was ultimately unsustainable because, from around 2005, the gap between incomes and debt began to widen. This was caused by rising energy prices on global markets, leading to an increase in the rate of global inflation.
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This development squeezed borrowers, many of whom struggled to repay mortgages. Property prices now started to fall, leading to a collapse in the values of the assets held by many financial institutions. The banking sectors of the USA and the UK came very close to collapse and had to be rescued by state intervention.
Martin Daunton: The crisis had two major causes – weak regulation of financial interests and institutional flaws. Excessive financial liberalisation from the late 20th century, accompanied by a reduction in regulation, was underpinned by confidence that markets are efficient. This replaced the scepticism of [influential interwar economist] John Maynard Keynes that economies are intrinsically unstable.
There was a complacent assumption that financial crises were a thing of the past, and that volatility had declined
The crash first struck the banking and financial system of the United States, with spill-overs into Europe. Here, another crisis – one of sovereign debt – arose from the flawed design of the eurozone; this allowed countries such as Greece to borrow on similar terms to Germany in the confidence that the eurozone would bail out the debtors. When the crisis hit, the European Central Bank refused to reschedule or mutualise debt and instead offered a rescue package – on the condition that the stricken nations pursued policies of austerity.
Was the crash a natural continuation of previous global trends, or a decisive break from them?
Linda Yueh: Crises occur fairly regularly throughout history, but this one was unusual in that it threatened the entire system.
MD: I see the crisis as a culmination of previous trends. In many ways, it arose from the overly confident belief that markets are preferential to regulation. Such an assumption was a major feature of the last quarter of the 20th century, both at the International Monetary Fund and the US Treasury.
It is difficult to give a precise date for the transformation, but it arose from a combination of a reliance on commercial banks to recycle petrodollars after the oil shock of 1973; the confidence of the Thatcher and Reagan governments in markets; a transformation in economics; structural changes in the world economy with the rise of multinational corporations; and the growth of transnational banks, leading to greater flows of capital around the world.
The speed and savagery of the crash appeared to take the world by surprise. Was it unusual in being so sudden and so unexpected?
SN: The crash caught economists and commentators cold because most of them have been brought up to view the free market order as the only workable economic model available. This conviction was strengthened by the dissolution of the USSR, and China's turn towards capitalism, along with financial innovations that led to the mistaken belief that the system was foolproof.
It was more sudden than the two previous crashes of the post-1979 era: the property crash of the late 1980s and the currency crises of the late 1990s. This is largely because of the central role played by the banks of major capitalist states. These lend large volumes of money to each other as well as to governments, businesses and consumers. Given the advent of 24-hour and computerised trading, and the ongoing deregulation of the financial sector, it was inevitable that a major financial crisis in capitalist centres as large as the USA and the UK would be transmitted rapidly across global markets and banking systems. It was also inevitable that it would cause a sudden drying up of monetary flows.
MD: There was a complacent assumption that crises were a thing of the past, and that there was a 'great moderation' – the idea that, over the previous 20 or so years, macroeconomic volatility had declined. The variability in inflation and output had declined to half of the level of the 1980s, so that the economic uncertainty of households and firms was reduced and employment was more stable.
In 2004, Ben Bernanke, a governor of the Federal Reserve who served as chairman from 2006 to 2014, was confident that a number of structural changes had increased economies' ability to absorb shocks, and also that macroeconomic policy – above all monetary policy – was much better in controlling inflation. In congratulating himself for the Fed's successful managing of monetary policy, Bernanke was not taking account of the instability caused by the financial sector (and nor were most of his fellow economists). However, the risks were apparent to those who considered that an economy is inherently prone to shocks.
How closely did the events of 2008 mirror previous economic crises, such as the Wall Street Crash of 1929?
SN: There are some parallels with 1929 – the most salient being the reckless speculation, dependence on credit, and grossly unequal distribution of income. However, the Wall Street Crash moved across the globe more gradually than its counterpart in 2007–08. There were currency and banking crises in Europe, Australia and Latin America but these did not erupt until 1930–31 or even later. The US experienced bank failures in 1930–31 but the major banking crisis there did not occur until late 1932 into 1933.
There are parallels with 1929 – reckless speculation, dependence on credit, and unequal distribution of income
LY: Every crisis is different but this one shared some similarities with the Great Crash of 1929. Both exemplify the dangers of having too much debt in asset markets (stocks in 1929; housing in 2008).
MD: Crises follow a similar pattern – overconfidence succeeded by collapse – but those of 1929 and 2008 were characterised by different fault lines and tensions. The state was much smaller in the 1930s (constraining its ability to intervene) and international capital flows were comparatively tiny.
There were also differences in monetary policy. By abandoning the gold standard in 1931 and 1933, Britain and America regained autonomy in monetary policy. However, the Germans and French remained on gold, which hindered their recovery.
The post-First World War settlement hampered international co-operation in 1929: Britain resented its debt to the United States, and Germany resented having to pay war reparations. Meanwhile, primary producers were seriously hit by the fall in the price of food and raw materials, and by Europe’s turn to self-sufficiency.
How successfully did policy makers apply the lessons of those previous crises to the events of 2008?
LY: My recent Great Economists book details how, in 2008, Ben Bernanke and other central bankers drew on the wisdom of economists like Milton Friedman (1912–2006), who stressed the importance of utilising monetary policy in such episodes. Policymakers also applied the insights of economists such as Irving Fisher (1867–1947) to avoid the debt-deflation spiral. This spiral was a hallmark of the 1930s and is still plaguing Japan after its early 1990s crash.
SN: Initially, policymakers reacted quite successfully. Following the ideas of Keynes, governments didn't use public spending cuts as a means of reducing debt. Instead, there were modest national reflations, designed to sustain economic activity and employment, and replenish bank and corporate balance sheets via growth. These packages were supplemented by a major expansion of the IMF's resources, to assist nations in severe deficit and offset pressures on them to cut back which could set off a downward spiral of trade. Together, these steps prevented the onset of a major global slump in output and employment.
By 2010, outside the USA, these measures had been generally suspended in favour of ‘austerity’, meaning severe economies in public spending. Austerity led to national and international slowdowns, notably in the UK and the eurozone. It did not, however, provoke a slump – largely thanks to massive spending on the part of China, which, for example, consumed 45 per cent more cement between 2011 and 2013 than the US had used in the whole of the 20th century.
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How far was the crisis responsible for the political, social and economic uncertainty we are experiencing now?
SN: The crisis was the immediate cause. But the social tensions, economic difficulties and political instability evident across much of the developed world have been long in the making. During this era, governments, supported by cheerleaders in the universities and the media, have prioritised free markets and private profit above the reduction of inequality, the welfare of the community and the pursuit of growth for social purposes.
The fallout from the crash offers an opportunity to refashion the market economy for the requirements of the 21st century
LY: It has certainly added to the economic uncertainty. Just as in the aftermath of previous serious economic downturns, we are now worrying about a slow growth future. The term secular stagnation, which was first used in the 1930s, when economist Alvin Hansen warned about a slow growth path after the Great Depression, has been revived by the economist Larry Summers when discussing economic growth today,
But we can harness this uncertainty. A serious episode that breeds doubts about the economic consensus is also an opportunity to refashion the market economy for the requirements of the 21st century.
How do you think historians in 50 years' time will look back on the financial crisis of 2008?
MD: They will see a story of hubris followed by a fall. Quantitative easing worked in stopping the crisis becoming as intense as in the Great Depression. The international institutions of the World Trade Organisation also played their part, preventing a trade war. But historians might then look back and point to grievances that arose from the decision to bail out the financial sector, and the impact of austerity on citizens' quality of life.
What we cannot tell now – but historians in 50 years’ time will know – is whether Donald Trump sparks an all-out trade war and destroys multilateral institutions. Or will his brand of nationalist populism be rejected as a problem and not the cure, followed by a turn to more sensible policies aimed at removing both greed and grievance?
SN: To quote [former Chinese premier] Zhou Enlai, "it's too early to say". Much will depend on the unfolding development of China. It seems possible that the crisis is the prelude to the disintegration of the neoliberal order. But, if so, will its replacement be characterised by economic conflict between unstable nations governed by nationalist demagogues? Or, following an interlude of instability, will it spawn a new social and economic golden age, akin to the 30 years of economic prosperity following the end of the Second World War? Currently, the former seems more probable. But history can play tricks on those attempting to predict the future.
Financial crisis glossary
Asset markets refer to classes of assets – houses, equities, bonds – each of which is traded with similar regulations and behaviour.
Debt-deflation is the process by which, in a period of falling prices, interest on debt takes an increasing share of declining income and so reduces the amount of money available for consumption.
The Gold Standard fixed exchange rates by the amount of gold in their currencies. As a result, it was not possible to vary exchange rates to solve a balance of payments (the difference between payments into and out of a country) deficit, and instead costs were driven down and competitiveness restored by deflationary policies.
The International Monetary Fund is an organisation created in 1944 which now concentrates on structural reform of developing economies and resolving crises caused by debt.
Macroeconomics refers to the behaviour and performance of the economy as a whole, by considering general economic factors such as the price level, productivity and interest rates.
Monetary policy uses the supply of money and interest rates to influence economic activity. This is in contrast to fiscal policy which depends on changes in taxation or government spending.
Mutualisation of debt entails moving from a government bond that is the responsibility of a single member of the eurozone to make it the joint responsibility of all members.
Petrodollars are the dollars received by oil producers. Particularly after the increases in prices during the oil shocks of 1973 and 1979, and again after 2003, their earnings – the petrodollars – led to the growth of international financial flows through commercial banks.
Quantitative easing is the process by which a central bank purchases government bonds and other financial assets from private financial institutions. The institutions selling assets now have more money and the cost of borrowing is reduced. Individuals and businesses can borrow more, so boosting spending and increasing employment – though it is also possible that, when this process was employed, money went into buying equities, so boosting the gains of richer people.
Reflation refers to the use of policies that are employed to boost demand and increase the level of economic activity by increasing the money supply or reducing taxes, and so breaking the debt-deflation cycle.
Secular stagnation describes a long period of no or very slow growth in contrast to a short-term cyclical downturn. It assumes that the economy is trapped by a lack of demand and fails to achieve full employment.
Sovereign debt is the debt of national governments, with interest and repayment secured by taxation. If debt was too high, the country might default. This became a risk in 2010, above all in Greece.
This article was first published in the October 2018 edition of BBC History Magazine
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