Question

Evaluate critically, as a classical or Keynesian economist, what caused the 2007 to 2009 financial crisis.

Examine the causes that aggravated the financial crisis during the period?

Answer 1

Banks, consumers, and the government all contributed to improper borrowing and lending, which in turn created a downward spiraling economy.

The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, was borne of the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to homeowners into a falsely ‘safe’ investment. To simplify this, banks pushed mortgages on prospective homeowners who could not afford to repay them. Then they combined and packaged varying mortgage-backed securities based off of these loans and sold them as highly dependable and safe investments, either through a lack of due diligence (negligence) or lack of ethical consideration. This created an economic meltdown, starting with the United States, that spread across the global markets.

The inherent complexity of the causes and dramatic repercussions (most of which are still ongoing) require a great deal of context. It is a fiercely debated and widely discussed issue in the field of economics (and in mainstream media), providing a real-life case study for many of the critical concepts of economic theory.

The inputs to the 2007-2008 economic collapse, briefly touched upon above, are complex and still evolving. That being said, there are a few key talking points from an economic perspective that should be discussed. A useful perspective to take is the various stakeholders and their contributions:

• Banks: Simply put, the banks made two critical errors. First, they lent money to people who could not pay it back (to buy homes). They pursued what is referred to as ‘predatory lending,’ or lending to individuals they knew could never pay it back. Secondly, banks knowingly grouped these loans into bundles called collateralized debt obligations (CDOs) and sold them as extremely safe derivative investments. They were not safe.
• Consumers: Consumers played their role as well, acting as easy prey for the banks predatory practices. Individuals bought homes they could not afford utilizing loans they could not pay back. This drove them into debt, to the extent at which they had to default. This meant that the capital banks expected to get back did not arrive, it simply was not there.
• Government: The government did not regulate the housing market, as a result of the elimination of two critical legal clauses that required the verification of income and a 20% down payment. In short, the U.S. government used to ensure that prospective home buyers could put down 20% of the their borrowing in addition to verify that their income could cover their mortgage payments. Without such verification, it became easier for people to get mortgages they could not afford.

The 2007-2009 economic crisis has had far-reaching and profound effects on both the domestic and global markets, primarily as a result of the sub-prime mortgage disaster originating in the United States. Addressing these economic ramifications to induce recovery has been the focal point of global governments and global agencies such as the International Monetary Fund (IMF). The objective of economic recovery when in crisis is to stabilize the economy, and from there recapture the value lost through economic stimulus strategies while addressing the factors which contributed to the collapse in the first place.

One of the key components to the crisis recover in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA), put into place by the Obama administration just as the first days of his term were beginning. This act has seen substantial debate, both positively and negatively, as to the efficacy and overall implementation of the program. Understanding the inputs, and expected outcomes, is critical to understanding the economics behind reacting to economic crises (particularly from a Keynesian perspective).

The stimulus package can be broken down via the attached figure in regards to monetary investment in specific places, totaling $831 billion (USD) between 2009 and 2019. The goal of investing or providing tax relief and subsidies for individuals and companies is to drive up purchasing behavior and offset the positive feedback loop attributed to economic crises. This is largely based on the Keynesian concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further. President Obama’s administration was criticized by classical economists for employing this as well as Keynesian economists (such as Paul Krugman) for not employing it enough. That being said, the efficacy in the attached figure demonstrates that it was likely a strategic reaction to the economic crisis.

From the end of the Great Depression until the early 1970s, Keynesian economics provided the main inspiration for economic policy makers in Western industrialized countries. The influence of Keynes's theories waned in the 1970s, due to stagflation and critiques from Friedrich Hayek, Milton Friedman, Robert Lucas, Jr. and other economists, who were less optimistic about the ability of interventionist government policy to positively regulate the economy or otherwise opposed to Keynesian policies. From the early 1980s to 2008, the normative consensus among economists was that attempts at fiscal stimulus would be ineffective even in a recession, and such policies were only occasionally employed by the governments of developed countries.^{[citation needed]}

In 2008, a rapid shift of opinion took place among many prominent economists in favour of Keynesian stimulus, and, from October onward, policy makers began announcing major stimulus packages, in hopes of heading off the possibility of a global depression. By early 2009 there was widespread acceptance among the world's economic policy makers about the need for fiscal stimulus. Yet by late 2009 the consensus among economists began to break down. In 2010 with a depression averted but unemployment in many countries still high, policy makers generally decided against further fiscal stimulus, with several citing concerns over public debt as a justification. Unconventional monetary policy continued to be used in attempts to raise economic activity. By 2016, increasing concerns had arisen that monetary policy was reaching the limit of its effectiveness, and several countries began to return to fiscal stimulus.

The financial crisis was primarily caused by deregulation in the financial industry. That permitted banks to engage in hedge fund trading with derivatives. Banks then demanded more mortgages to support the profitable sale of these derivatives. They created interest-only loans that became affordable to subprime borrowers.

In 2004, the Federal Reserve raised the fed funds rate just as the interest rates on these new mortgages reset. Housing prices started falling as supply outpaced demand. That trapped homeowners who couldn't afford the payments, but couldn't sell their house. When the values of the derivatives crumbled, banks stopped lending to each other. That created the financial crisis that led to the Great Recession.