the 2008 us financial crisis
TRANSCRIPT
Philip Pledger Marcio Sierra
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TABLE OF CONTENTS
Introduction ..........................................................................................................................3
Causes of the Credit Boom and the Housing Bubble ..........................................................3
The Deregulation and “laissez-faire” of the Financial Sector .................................3
Deregulation of the Financial Sector through Legislation ...........................4
The Credit Boom and the Housing Bubble ..............................................................5
Global Liquidity and Low Interest Rates .....................................................5
The Sub-Prime Mortgage Boom and Flawed Expectations .........................7
The Magnification of Systematic Risk through Financial Engineering in
the Capital Markets ....................................................................................11
The Burst of the Housing Bubble ......................................................................................14
The Market Freeze and its Effects on the Economy ..............................................14
TARP and other Governmental Responses ............................................................17
The General Effects in the Economy .....................................................................18
America Today .......................................................................................................19
The Federal Funds Rate .............................................................................20
Money Supply ............................................................................................21
Inflation ......................................................................................................22
Conclusion .........................................................................................................................23
References ..........................................................................................................................25
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INTRODUCTION
In this paper we will analyze the causes and effects of the 2008 United States financial
crisis that almost brought the global economy to a collapse. Due to the extent of literature
on the topic, we will focus our analysis on the causes of the credit boom and the housing
bubble and on the effects on the US financial sector. We will provide an overview on the
behavior that led to a burst in the housing bubble and give insight on the US
governmental response to the financial crisis.
CAUSES OF THE CREDIT BOOM AND THE HOUSING BUBBLE
After the Dot.com bubble burst in the early 2000’s, the US economy started to experience
a boom in its economy. Gross Domestic Product (GDP) was growing around a 3-4% per
year. The financial sector of the US was recording record breaking transactions and
compensations. Little did the population new that the high-risk business transactions
taken by the financial sector would lead to the deepest recession since the Great
Depression. “A financial crisis developed with remarkable speed starting in the late
2008, as mortgage-related securities that had spread through the U.S. and global financial
system suddenly collapsed in value” (Kotz 2009). The following sections give insight
into the several factors that contributed to the credit boom and housing bubble that
triggered the 2008 US Financial Crisis also known and referred to as the Great Recession.
The Deregulation and “laissez-faire” of the Financial Sector
Prior to the direct actions caused by the Shadow Banking System that led to the credit
boom and housing bubble burst, a framework for such possibilities had to be created.
This framework was created through the deregulation and lack of control of the Shadow
Banking System throughout the years leading to the Great Recession started in 2008.
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Deregulation of the Financial Sector through Legislation
The US commercial sector has been protected by legislators and government entities at
extreme levels since the Great Depression. As a response and in order to avoid another
stock market meltdown or securities crisis from affecting commercial banks, the Glass
Steagall Act was legislated in 1933. This brought the separation of commercial banking
from all other financial sectors like investment banking, securities and insurance banking.
In the Deregulation and bank supervision (1989), "it was felt that banks should be
insulated as much as possible from the risks of the stock and other securities market."
The Glass Steagall Act would separate commercial and shadow banking for almost 70
years until the Gramm-Leach-Billey Act of 1999 under Bill Clinton’s administration was
created. The new act in place deregulated banking, insurance, securities and the financial
service industry and overrode the separation of commercial and shadow banking from the
Steagall Act of 1933 as said by Gramm-Leach-Bliley Act (2015). Coincidentally,
Citicorp had merged illegally with insurance company Travelers and turned into Citi
Group. Under the new Gramm-Leach-Billey Act, Citi’s merger would become legal and
it would mark the start of an interconnected financial system in which commercial and
shadow banking would be tied up together in multiple, complicated links and forms.
Furthermore, 106th Congress (2000) says a new set of deregulatory laws came into place
with the Commodity Future’s Modernization Act of 2000 were the regulation of
derivatives and other securities was banned. Furthermore, banks wanted to extend their
privileges and manage their operations with further liberty. “Investment banks added
leverage the old-fashioned way by persuading the SEC in August of 2004 to amend the
net capital rule of the Securities Exchange Act of 1934. This amendment allowed a
voluntary method of computing deductions to net capital for “large” brokers and dealers.
This alternative approach allowed the investment banks to use internal models to
calculate net capital requirements for market and derivatives-related credit risk. It
effectively allowed “big” investment banks to lever up as much as they wanted”
(Acharya, Philippon, Richardson, & Roubini, 2009). With this new framework, the
shadow banking system would financially engineer new ways to boost short-run
performances by exploiting the derivatives and securities market.
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Finally, economist found that there had been a weak federal regulation and supervision of
the shadow banking system, including lax oversight of the capital markets. “There were
several specific problems with regulation and oversight. These include the adequacy of:
(1) capital requirements for investment banks, CDS issuers, and the GSEs
(2) measures to ensure transparency
(3) oversight of rating agencies
(4) oversight and regulation of CDS markets and capital standards for CDS
protection writers
(5) assignment of liability for defects in loan originations
(6) underwriting standards
(7) oversight of compensation. (
The deregulation of the shadow banking system, weak federal regulation and supervision,
and lax oversight of the capital markets would set the framework necessary for a credit
boom and the creation of a housing bubble that would later lead to the Great US
Recession of 2008.
The Credit Boom and the Housing Bubble
Upon a change in regulations in favor of the Shadow Banking system, historically low
interest rates, a deterioration in loaning standards, and a high demand for short-term
profits and performance led to a credit boom, followed by a housing bubble during the
years before the Great Recession of 2008. The following subsections will analyze the
three main factors behind the credit boom and the housing bubble after the financial
sector was deregulated to a great extent during and before the decade of the 2000’s.
Global Liquidity and Low Interest Rates
According to economists, “the driving force behind the boom in nonprime lending was
the excess liquidity created in the 1990s by rapid growth in the United States and other
large economies, particularly China, Brazil, and India” (Belsky & Richardson, 2010).
This excess liquidity led to historically low interests in the United States that opened up
the possibility for an increase in lending, especially when it came to home mortgages.
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Figure #1: The Effective Federal Funds Rate
SOURCE: Board of Governors of the Federal Reserve System
As seen in Figure #1, historically low interest rates came in place after the Dot.com
bubble burst at the start of the millennium. As a result, a remarkable amount of cash
began to look for opportunities for high returns and “unrestrained competition put
pressure on each institution to constantly seek new, more profitable activities” (Gelain et
al., 2015). These benign macroeconomics conditions, like “Historically low real interest
rates helped foster increased leverage across a wide range of agents—notably financial
institutions and households—and markets” (Claessens, Kose, Laeven & Valencia, 2013).
The housing market became the target of financial institutions that were looking to boost
their short-term performances and profits. Their pressure led to a decrease in lending
standards. Easy credit prolonged and extended the boom, which would otherwise have
run out of steam due to affordability constraints. Furthermore, lower interest rates,
improved mortgaged terms and increased availability of mortgage finance. Those who
once were unable to lend, were now offered mortgages at low interest rates and low down
payment. Low interests and excess liquidity would pave the way to a boom in the Sub-
Prime Mortgage market.
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The Sub-Prime Mortgage Boom and Flawed Expectations
With historically low interest rates, and excess liquidity, financial institutions found in
the housing market a market from which they could easily profit with a couple of new
lending and securitization methods. “Increased competition among mortgage lenders has
led to an expansion of the range of mortgage products available to consumers and the
capacity to make demand effective in the market” (Kotz 2009). Financial institutions
believed that by lowering their lending standards, they would be able to reach an
untapped market. Thus, the sub-prime mortgage boom was born. The goal of lenders was
to create as much mortgages possible, with little or no importance at all for the
borrower’s ability to pay, and then sell the mortgages throughout the shadow banking
system. The system of compensation of bankers and agents within the financial system is
characterized by moral hazard in the form of “gambling for redemption”. Because a large
fraction of such compensation is in the form of cash bonuses tied to short-term profits,
managers/bankers/traders had a huge incentive to take larger risks than warranted by the
goal of shareholders’ long-run value maximization. “Much of the run-up in U.S. house
prices and credit during the boom years appears to be linked to an influx of
unsophisticated homebuyers. Given their inexperience, these buyers would be more likely
to employ simple backward-looking forecast rules for future house prices, income,
lending standards, etc. One can also make the case that many U.S. lenders behaved
similarly by approving subprime and exotic mortgage loans that could only be repaid if
housing values continued to trend upward.” (Gelain et al., 2015). Thus, the following
loan features became common in the housing market:
1) Low- or no-down payment loans (often in the form of piggyback loans that lifted
combined LTV to high levels).
2) Loans with balloon or negative amortization features.
3) Loans to borrowers with credit scores below 620.
4) Loans with little or no income verification or documentation, or payments
(Belsky & Richardson, 2010).
These new requirements for house mortgages became so popular because owning a house
was associated with the basis of the American Dream, as said by President George W.
Bush. Many Americans were willing to take these risks because they wanted to own a
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home, or wanted to speculate in real estate, or saw opportunities to buy a better home in a
more desirable location than if they limited themselves to more traditional products.
Figure #2: The Quality of New Debt Issuance
Figure #2 depicts the growth of of New Debt Issuance from 1993-2007. The Credit Boom
can be easily visualized in Figure #2. “Investors in search of higher yields kept increasing
their demand for private-label mortgage-backed securities (MBS), which also led to sharp
increases in the subprime share of the mortgage market (from around 8% in 2001 to 20%
in 2006) and in the securitized share of the subprime mortgage market (from 54% in 2001
to 75% in 2006)” (Demyanyk & Van Hemert, 2011), as seen in Figure #3. Sub-prime
mortgages and their securitization were fueled by each other. As the yield for
Collaterized Debt Obligations (CDOs) and MBS increased, so did the demand for sub-
prime mortgages and as the supply of sub-prime increased, the demand for their
securitization also increased. Figure #3 illustrates the increase in the sub-prime share of
the entire mortgage market and with it the increase in the percentage of mortgages that
became securitized simultaneous to the decrease in lending standards throughout the US
mortgage market.
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Figure #3: Subprime Mortgage Originations
Apart from easy credit, the expectation that home prices would keep increasing misled
many, including bankers, into the buying and selling of sub-prime mortgages without
little regard for the systematic risk these practices could cause. On the other hand, houses
in the US kept appreciating in value as seen in Figure #4 and Figure #5.
Figure #4: Real house price increases in selected OECD countries: 1995-2006
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Figure #5: All Transactions House Price Index for the United States
SOURCE: US Federal Housing Finance Agency
The credit boom and the housing bubble were going hand by hand in a vicious circle that
increased each other the more and more mortgages were given. In broad terms, house
prices are determined by demand and supply (Gelain et al., 2015). Changes in
demographics, especially the increases in household formation, income and the
availability, as well as terms of mortgage financing, are the most important factors on the
demand side. Also, increased competition among mortgage lenders has led to an
expansion of the range of mortgage products available to consumers and the capacity to
make demand effective in the market. Another key driver of the house price boom was
the expectations of house price increases. Both Wall Street and Main Street believed that
house prices would continue to appreciate for an indefinite time, leading to more and
more sub-prime loans. These flawed expectations and lending methods brought the
economy to the brink of collapse because of how mortgages were sold and resold within
the shadow banking system.
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The Magnification of Systematic Risk through Financial Engineering in the Capital
Markets
With a credit boom, and appreciating house prices, bankers and other financial
institutions financially engineered new ways to make profit through the securitization of
sub-prime mortgages. Investment banks, like Lehman Brothers, Goldman Sachs, and
Merrill Lynch would then buy these sub-prime mortgages and bundle them into
Collaterized Debt Obligations (CDOs). These CDOs were then insured, mainly by AIG.
Because the loans were risky, they were always backed by collateral, in this case the
appreciating prices of houses tied to each sub-prime mortgage. “Financial engineering on
the capital markets, for its part, resulted in large amounts of nonprime securities receiving
AAA ratings that increased demand for risky nonprime loans and kept credit flowing to
them” (Belsky & Richardson, 2010). Standard and Poor, Moody’s and Fitch would rate
give these CDOs a AAA rating, the highest possible rating. Then, other investors, like
pensioner funds would invest in these AAA backed CDO’s. At the same time, speculators
were able to bet on whether or not the CDO’s would default or not. Problems would arise
when the house prices started to decrease because the shadow banking operations and
mortgage performances were all supported by the expectation that house prices would
continue to appreciate. “On the back of buoyant housing and corporate financing markets,
favorable conditions spurred the emergence of large-scale derivative markets, such as
mortgage-backed securities and collateralized debt obligations with payoffs that
depended in complex ways on underlying asset prices. The corporate credit default swap
market also expanded dramatically due to favorable spreads and low volatility. The
pricing of these instruments was often based on a continuation of increasing or high asset
prices” (Claessens, Kose, Laeven & Valencia, 2013).
But the whole point of securitization is precisely that by transferring credit risk from
lenders to investors, the risks will be spread throughout the economy with minimal
systemic effect. Investors and holders of such securities believed that by selling them to
another entity, they would get rid of the effect of a CDO going default. “Although the
originate-to- distribute model in the U.S. seemed a good template for risk allocation, it
turned out to undermine incentives to properly assess risks and led to a buildup of tail
risks. The model also made it much more difficult to know the true value of assets as the
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crisis unraveled. This lack of understanding quickly turned a liquidity crisis into a
solvency crisis” (Claessens, Kose, Laeven & Valencia, 2013). In reality, the risks being
taken in the primary mortgage market were multiplied on the secondary market by
financial engineering and by leveraging the investments. In sum, the push to extend more
and more credit emanating from the capital markets—as well as what was done to the
credit when it was bundled and sold as securities on these markets—helped to magnify
risks and increase the exposure of the financial system to deterioration in mortgage loan
performance (Belsky & Richardson, 2010).
Furthermore, why were financial institutions taking the risk of managing, buying and
selling sub-prime mortgages turned into MBS and CDOs? “In the securitization food
chain for US mortgages, every intermediary in the chain was making a fee; eventually the
credit risk got transferred to a structure that was so opaque even the most sophisticated
investor had no real idea what he/she was holding. The mortgage broker, the home
appraiser, the bank originating the mortgages and repackaging them into MBSs, the
investment bank repackaging the MBSs into CDOs, CDOs of CDOs, and even CDOs
cubed, the credit rating agencies giving their AAA blessing to such instruments – each of
these intermediaries was earning income from charging fees for their step of the
intermediation process and transferring the credit risk down the line. The reduction in
quality of the loans and lack of transparency of the securitized structure added to the
fragility of the system.” (Acharya, Philippon, Richardson, & Roubini, 2009). Private
conduits (investment banks and other originators selling directly into private
securitizations) issued nearly all the securities backed by subprime loans, although both
Fannie Mae and Freddie Mac ended up purchasing significant amounts of the highly
rated tranches of those securities. As of 9/30/2009, they reported owning a total of $86
billion of subprime private label securities. Private conduits also issued most of the Alt-A
MBS, though Fannie Mae and Freddie Mac stepped up their issuances of securities
backed by Alt-A loans 2000-2007. As of August 30, 2009, they reported guarantees
outstanding on Alt-A loans in their credit books of business of $415 billion.
Some portfolio lenders also loaded up on nonprime debt. Lehman Brothers and other
investment banks increased their purchase of these CDOs in order to boost their short
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term performances. Little did they know that when house prices depreciated, their
mortgages would default and they would be left with billions of dollars worth of toxic
and illiquid assets.
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THE BURST OF THE HOUSING BUBBLE
As trillions of dollars in risky mortgage-related securities spread through the U.S.
financial system, and into much of the global financial system, in the mid 2000s, the
financial system became ever more vulnerable to a deflation of the housing bubble. Once
the housing bubble burst, the effects on the shadow banking system were devastating.
Unluckily, Main Street was also affected and thus, the Great Recession of 2008 started.
The following sections give insight to the freezing of the financial markets and its effects
on the economy. Furthermore, the policies and responses on behalf of the government are
analyzed and detailed.
The Market Freeze and its Effects on the Economy
Credit markets froze nearly solid in the fall of 2008, the stock market went into a freefall,
and job losses accelerated sharply. The interconnectedness of the global financial system
became apparent as problems emanating from residential debt in the United States and in
the derivatives used to hedge and trade mortgage risk prompted a global credit crisis.
After this market freeze, the next several months became a series of announcements
about subprime lenders going bankrupt, or massive write-down by financial institutions.
Figure #6: Magnitude of accounting write-downs per quarter during the 2007-08 crisis
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“By now, banks had stopped trusting each other as well and were hoarding significant
liquidity as a precautionary buffer; unsecured inter-bank lending at three-month maturity
had largely switched to secured overnight borrowing; the flow of liquidity through the
inter-bank markets had frozen; and lending to the real economy had begun to be
adversely affected” (Acharya, Philippon, Richardson, & Roubini, 2009). The erosion of
nonprime loan performance then reverberated through the global financial system for at
least four reasons:
1) the sheer size of the US mortgage market and the heavy amounts of foreign
capital invested in it, especially from nations with which the United States had
large trade deficits
2) the magnification of risk through the issuance of credit default swaps referencing
nonprime securities
3) the lack of transparency in the CDS market and the difficulty in assessing the
performance of the loans underpinning collateralized debt obligations
4) the amount of leverage financial institutions used to warehouse or purchase
nonprime securities with short-term liabilities, together with and the lack of
adequate reserves against the risk in the underlying subprime securities and the
CDS referencing them.
(Belsky & Richardson, 2010).
The burst of the housing bubble was felt in the US financial markets to a greater extent.
The effects of the burst in the housing bubble were felt throughout the major financial
institutions managing the housing mortgage market. With the depreciation in housing
prices, Fannie Mae and Freddie Mac entered into governmental conservatorship because
they had a combined loss of $14.9 billion and market concerns about their ability to raise
capital and debt threatened to disrupt the US housing financial market. More detail of the
conservatorship will be given in the following section. “The two government-sponsored
enterprises had more than US$ 5 trillion in mortgage-backed securities (MBS) and debt;
the debt portion alone is $1.6 trillion” (Kopecki, 2008). The second phase of the shadow
banking system’s demise was the collapse of the entire system of Structured Investment
Vehicles (SIVs) and conduits that started when investors realized that they had invested
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in very risky and/or illiquid asset. These risky or illiquid assets were toxic CDOs based
on mortgages and other credit derivatives that had been profoundly affected by the burst
in the housing bubble. Following Fannie Mae and Freddy Mac came Lehman Brothers,
the fourth biggest investment bank in the US. On September 15, 2008, Lehman Brothers
filed a Chapter 11 bankruptcy petition in federal court. The market realized that there was
no company “too-big to-fail” and that it could become true for other major investment
bankers. “It resulted in a classic run on the other institutions, irrespective of the fact that
they were most likely more solvent than Lehman Brothers. This led to Merrill Lynch
selling itself to Bank of America” (Acharya, Philippon, Richardson, & Roubini, 2009).
Furthermore, Lehman’s bankruptcy caused inter-bank markets to truly freeze as no bank
trusted another’s solvency and the entire financial intermediation activity was at a risk of
a complete collapse. Lehman became an example of systemic risk that could have
actually materialized because Lehman hold considerable systemic risk and its bankruptcy
led to a near collapse of the financial system. Lehman’s systemic risk and domino effect
on other investment banks was halted thanks to the efforts of the Federal Reserve, which
will be discussed in the following sections. Either way, the crisis faced by the shadow
banking system translated into “a significant credit crunch that exacerbated the asset price
deflation and led to lower real spending on capital goods – consumer durable and
investment goods – which, in turn triggered an overall economic contraction” (Acharya,
Philippon, Richardson, & Roubini, 2009). The burst of the housing bubble led to a near
collapse of the US financial sector, its economy and the global economy. When the credit
and housing boom turned into a bust and banks deleveraged through contraction of credit,
the global economic meltdown occurred (Kalemli-Ozcan et al., 2012). The combined
efforts of the US Federal Reserve, and other US entities, as well as other governmental
intervention from around the world, were able to mitigate the losses and prevent a total
meltdown of the global economy.
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TARP and other Governmental Responses
The TARP (Troubled Asset Relief Program) initiative, authorized by Congress in
October 2008, was implemented by the US Treasury as a stabilization measure in
response to the 2008 financial crisis. Initially slated as a $700 billion initiative, the Dodd-
Frank Wall Street Reform and Consumer Protection Act cut this number down to $475
billion (“TARP Programs”). TARP funds were distributed among five program areas.
The bulk of TARP funds, at about $245 billion, went to programs stabilizing banking
institutions. These included the Asset Guarantee Program (AGP), the Supervisory Capital
Assessment Program (SCAP) and Capital Assistance Program (CAP), the Capital
Purchase Program (CPP), Community Development Capital Initiative (CDCI) and the
Targeted Investment Program (TIP). The AGP focused on purchasing risky assets from
financial institutions, the SCAP and CAP provided a market stress test, and the CPP,
CDCI and TIP simply provided capital to various banking institutions (“TARP
Programs”). The second largest recipient of TARP funding, at around $80 billion, was an
effort to stabilize the American automotive industry. About $68 billion went to
stabilizing AIG, an insurance provider deemed “too big to fail,” $46 billion to foreclosure
assistance for needy families and finally $27 billion to restart credit markets. The TARP
initiative contained programs and bailouts across a wide range of and institutions and
made up a large portion of the government’s efforts to repair the damage dealt to the
economy by the 2008 financial crisis. As with most proposals of its size and cost,
however, TARP has proven relatively divisive.
Perhaps due to TARP being a recent initiative, or perhaps due to its highly politicized
nature, opinion on the initiative’s effectiveness is largely split. The Treasury itself
defends TARP as being a complete success, both preventing a second Great Depression
and being “currently projected to cost approximately $37.2 billion” instead of the $475
billion allotted through the Dodd-Frank Act (“TARP Programs”). On the other hand, an
article published in an April 2013 issue of the Journal of International Financial
Markets, Institutions and Money noted a drop in operating efficiency for banks that
received TARP funding, attributing this trend to moral hazard stemming from the TARP
bailouts (Harris 85). The authors argued that bank managers who received TARP funding
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had “abated incentives…to adopt best practices that improve asset quality” (Harris 85).
The truth of TARP’s effectiveness is likely somewhere in between either depiction.
Indicators of economic health have been largely trending upwards since TARP was
instituted, although there are still indications of work yet to be done.
The General Effects in the Economy
The 2008 financial crisis heralded a significant drop in American economic output. The
damage done to output is most visible when comparing real GDP in 2008 Q3 (14,891.643
billion chained 2009 dollars) to real GDP in 2009 Q1 (14,375.018 billion chained 2009
dollars) (Real Gross Domestic Product, 3 Decimal [GDPC96]). This brief period alone
saw American real GDP drop by more than 3.469%, declining at a notably faster rate
than it had been growing before the financial crisis. Real GDP hit its lowest point for the
crisis in 2009 Q2, at 14,355.558 billion chained 2009 dollars. This was down from 2008
Q2, where real GDP was 14,963.357 billion chained 2009 dollars. However, since hitting
the floor in 2009 Q2, real GDP has been rising steadily. Real GDP for 2015 Q3 is
16,394.200 billion chained 2009 dollars as seen in Figure #7.
Figure #7: Real Gross Domestic Product (GDP), 3 Decimal
SOURCE: US Federal Housing Finance Agency
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The 2008 financial crisis came with an extremely visible impact on US civilian
unemployment. In December 2007, the civilian unemployment rate was at 5% (Civilian
Unemployment Rate [UNRATE]). Unemployment continued to rise sharply until about
May 2009, where it hit 9.4%. Civilian unemployment still continued to rise at a
somewhat diminished pace until its peak of 10% in October 2009. From there,
unemployment remained within the 9.8%-10% range until May 2010, where
unemployment dropped to 9.6%. After that, with some minor exceptions (November
2010, for example) the unemployment rate has been declining fairly steadily. The
downward slope of the unemployment level has grown increasingly smooth (as opposed
to an initial drop/plateau pattern), and unemployment for September 2015 was at 5.1%,
which is close to that before the 2008 recession. In summary, unemployment rose sharply
for the duration of the crisis, and has been falling at a relatively slower pace ever since as
seen in Figure #8.
Figure #8: Civilian Unemployment Rate 2000-2014
SOURCE: US Federal Housing Finance Agency
America Today
While effects of the 2008 financial crisis still linger, the US economy is no longer
experiencing the recession that followed in its wake. Many indicators of economic health
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are painting a fairly positive picture. Real GDP has been increasing steadily, and current
real GDP is higher than pre-crisis real GDP by a wider margin than pre-crisis real GDP
exceeded real GDP during the recession (Real Gross Domestic Product, 3 Decimal
[GDPC96]). Indeed, real GDP has been growing at a constant positive rate since it hit its
floor in Q2 of 2009. Additionally, the civilian unemployment rate for September of this
year (5.1%) is only slightly higher than the lowest rate of this past decade (4.4%, during
certain months in 2006 and 2007) (Civilian Unemployment Rate [UNRATE]).
The Federal Funds Rate
While the American economy is no longer in a period of recession, it is still strongly
affected by the 2008 financial crisis and the relief methods employed by the government.
The Effective Federal Funds Rate (interest rate) in particular has been extremely low ever
since the recession. As of October 2015, the Effective Federal Funds Rate is only 0.12%
(Effective Federal Funds Rate [FEDFUNDS]). This is opposed to 4.76% on October
2007, before the crisis, and is the same rate as October 2009 after the crisis. No month
between July 1954 (the earliest recorded in the FRED Figure) and the end of the 2008
financial crisis has had an Effective Federal Funds Rate as low as we have currently, as
seen in Figure #9.
Figure #9: Effective Federal Funds Rate 2000-2014
SOURCE: US Federal Housing Finance Agency
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US Money Supply
This is a result of a dramatic increase in the money supply. Supply of M1 currency in the
United States in 2014 was nearly double that of 2008, jumping from
$1,434,733,333,333.30 in 2008 to $2,806,208,333,333.30 in 2014 (M1 for the United
States [MANMM101USA189S]). With such a dramatic increase in money supply, it is
only natural that interest rates have dropped accordingly. The Federal Open Market
Committee (FOMC) set its interest rate target to these low levels in December 2008 in
order to encourage investment in capital goods, recapitalize the banking system and raise
asset prices (increasing household wealth and lowering the cost of business capital
purchases) (Kliesen). Both the extremely low federal funds rate and sharp upward trend
in money supply are current effects of the financial crisis on today’s economy, despite
other indicators being positive, as seen in Figure#10.
Figure #10: M1 for the United States 2000-2002
SOURCE: US Federal Housing Finance Agency
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Inflation
Interestingly enough, the US economy is not experiencing certain predicted effects from
its recession, namely high inflation rates. According to the Federal Reserve Bank of St.
Louis,
“During normal times, for each 1 percent increase in the growth of money,
inflation increases by 0.54 percent…money supply (MO) increased 40.29 percent
between December 2008 and December 2013, or about 8 percent per year on
average. Under this pace of annual growth, we would have seen inflation of 4.3
percent per year, or a price level increase of at least 40 percent in 2013 compared
with the price level in 2008” (Arias).
Figure #11: Inflation, consumer prices for the United States
SOURCE: US Federal Housing Finance Agency
The inflation rate in the United States, however, has behaving in a way that starkly
contradicts such forecasts. Despite M1 supply nearly doubling from 2008 to 2014, the
inflation rate actually dropped from 3.83910% in 2008 to 1.62222% in 2014 (Inflation,
consumer prices for the United States [FPCPITOTLZGUSA]). With the exception of
2011 (which had an inflation rate of about 3.16%), inflation after this dramatic surge in
M1 supply began has been at its lowest since 2003 (2.27% inflation). The Federal
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Reserve Bank of St. Louis argues that this curious pattern of low inflation despite sharp
money supply increases may be the result of a liquidity trap (Arias). Under normal
circumstances, an increase in the supply of money will lead to a decrease in its worth,
manifesting in higher inflation and higher price levels. In a liquidity trap, however,
demand for money is so great as to effectively “absorb” the increase. With the nominal
interest being held near zero, there is little opportunity cost to holding on to cash instead
of spending or investing it. This decrease in willingness to spend keeps prices from
rising. More money is entering the economy, certainly, but, in the event of a liquidity
trap, that money is not necessarily circulating in the economy. If a liquidity trap is
responsible for the US’s unusually low inflation, then inflation will not increase by much
until money demand decreases.
CONCLUSIONS
The US Financial Crisis of 2008 was the greatest recession since the Great Depression in
the 1930’s. We saw that an excess in global liquidity led to a credit boom that was fueled
by sub-prime mortgages and appreciating houses. This led to financial engineer within
the derivatives market. Once the home depreciation started, the financial sector lost
hundreds of billions in the derivatives market. This revealed the high level of systemic
risk spread through the trade of CDOs and MBS and many financial institutions
collapsed. Thanks to the effort of the Federal Reserve through TARP and their other
policies, the economy survived and refueled with an injection of capital through billions
in bailouts.
The crisis may have ended years ago but its ghost still haunts the fears of America. Still,
the idea that the US may be in a liquidity trap is certainly a worrying prospect. The
Federal Reserve is currently holding its interest rate target at around zero as a means of
encouraging spending and investment. However, in a liquidity trap, lowering interest
rates and increasing the money supply will have exactly the opposite effect. According to
the Federal Reserve Bank of St. Louis, “more monetary injections during a liquidity trap
can only reinforce the liquidity trap” (Arias). If the US is in a liquidity trap, the proper
24
monetary policy would be to raise the nominal interest rate, rather than keeping it at near
zero levels. The Fed could sell financial assets in the marketplace to decrease money
supply, which would in turn raise the nominal interest rate. Should the Fed do so,
investors would have more of an incentive to hold interest-generating assets instead of
cash in their portfolios. If the US economy is experiencing a liquidity trap, a reversal of
the Fed’s current monetary policy may be enough to remedy the situation.
25
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