Question

how can such a crisis as the 2008 recession in the future be avoided?

Answer 1

To understand the crisis of 2008, we need to look back at the period of 1998 to 2007.

It was in 1998 that Long-Term Capital Management Fund was bailed out since a collapse of the firm might have caused a bigger crisis in the financial system. This created a moral hazard that banks and financial institutions can engage in risk taking and if there is a crisis, the government and federal reserve are there to bail out such institutions.

Further after the TMT stock market bubble in 2000 and the subsequent recession, the federal reserve reduced interest rates and kept it artificially low for an extended period. This resulted in easy credit, increased speculation across asset classes and to add to the crisis, banks had slack lending standards. It is this easy money, excessive risk taking and asset bubbles that created the financial crisis of 2008.

Therefore, if such crisis needs to be avoided, the following measures are important -

1. Easy money or low interest rates for an extended period should be avoided

2. Banks and financial institutions need to be more regulated to avoid excessive risk taking

3. By having adequate policies to support the financial system, banks and financial institutions engaging in excessive risk taking should be allowed to fail instead of bailout using tax payer money. This will eliminate the moral hazard and make financial institutions more responsible

4. Another good idea would be break-up the "too big to fail" banks so that the risk is spread across institutions than being concentrated in one or few institutions