Causes of the Global Financial Crisis (Financial Economics)

This study note looks at some of the root causes of the global financial crisis that exploded in 2007-08. Before reading through these notes, have a look at the short video from Core Economics featuring Professor Joseph Stiglitz.

What were the main causes of the global financial crisis?

The global financial crisis of 2008, also known as the Great Recession, was caused by a combination of factors. Some of the main causes of the crisis include:

1. Loose monetary policy: Low interest rates and a large increase in the money supply in the years leading up to the crisis made it easy for individuals and institutions to borrow and invest heavily in real estate and other assets.
2. Lack of regulation: There was a lack of oversight and regulation of the financial industry, particularly in the areas of mortgage lending and securitization. This allowed risky practices to go unchecked, such as lending to borrowers with poor credit or packaging and selling risky mortgages as securities. This is a good example to use of regulatory failure.
3. Subprime mortgages: The widespread use of subprime mortgages, which are home loans given to borrowers with poor credit, was a significant contributor to the crisis. These mortgages had a higher likelihood of default and were often packaged and sold as securities to investors.
4. Housing market bubble: The rapid increase in housing prices in the years leading up to the crisis, particularly in the United States and parts of Europe created a housing market bubble. When the bubble burst, many homeowners found themselves with mortgages that were worth more than their homes, leading to a wave of foreclosures and a decline in housing prices.
5. Leverage: Many financial institutions had high levels of leverage, meaning they had borrowed a large amount of money to invest in assets. When the value of those assets declined, they were unable to meet their financial obligations and faced bankruptcy.
6. Complex financial products: The use of complex financial products, such as collateralized debt obligations (CDOs) and credit default swaps (CDS), made it difficult for investors and regulators to understand and manage the risks in the financial system.
7. Global interconnections: The financial crisis quickly spread globally due to the interconnectedness of the global financial system, as institutions had large exposures to the US housing market and the crisis had a domino effect on other countries.

These were some of the main causes of the global financial crisis of 2008.