[Expert Analysis] Lessons from the 2008 Financial Crisis

What I Hope from Choo Kyungho’s Team II

Let us look back on the 2008 global financial crisis. Around the time the dot-com bubble burst in the 1990s, then-Federal Reserve Chairman Alan Greenspan pursued an expansionary monetary policy with low interest rates, setting off a boom in the housing market.

However, artificially low interest rates brought about by monetary expansion lead entrepreneurs to mistakenly believe that savings available for investment have increased, even though no such increase in real savings has actually occurred, causing them to undertake misguided investments simultaneously on a broad scale.

Such malinvestment creates a short-term boom, but in a situation where the resources made available through real savings do not actually exist, competition to secure the resources needed to complete those investments drives their prices sharply upward. When that in fact happened, the Federal Reserve raised its policy rate in order to cool an “overheated economy.”

At the time, amid artificially ultra-low interest rates, banks were making mortgage loans even to subprime borrowers because government-sponsored investment finance institutions such as Fannie Mae would purchase those loan claims. As a result, home loans were in fact extended even to borrowers with poor credit.

These loans were securitized into securities, and various derivatives were developed based on those securities, into which investment banks around the world invested heavily. When the bubble in the housing market burst following the Federal Reserve’s rate hikes, it put not only the U.S. housing mortgage market but also the entire U.S. financial market and the global financial market into crisis.

This was the so-called global financial crisis. Unlike past crises, such as the Asian financial crisis, which occurred in underdeveloped or emerging countries, this one was distinctive in that it originated in the United States, the very center of global finance.

However, unlike the United States or Europe, which can issue international settlement currencies when needed, once the crisis erupted, emerging countries were exposed not only to credit risk—the risk of simply being unable to repay debts on time—but also to currency mismatch (foreign exchange) risk, under which they could face bankruptcy if they did not possess sufficient dollars, the international settlement currency, even if they otherwise had money on hand.

In the United States, during the period when housing prices were rising sharply, bonds expected to generate profits and the various derivatives based on them became certain to bring enormous losses once the housing bubble collapsed.

As large financial companies holding massive amounts of these derivatives faced the possibility of default, the U.S. government ultimately provided them with bailout funds. Under the principles of a market economy, financial firms are supposed to invest at their own responsibility, and providing such bailouts creates so-called moral hazard. But the U.S. government could not simply stand by and watch major financial institutions fail when that would have led to the failure of so many investors.

Difficult to Resolve an Economic Crisis through Bailouts and Deficit-Financed Spending

The U.S. government sought to stimulate the economy by both supporting distressed financial institutions so they would not collapse—through bailouts, recapitalization, and other measures—and by carrying out enormous fiscal spending. At the same time, Ben Bernanke, the new Federal Reserve chairman, could no longer lower interest rates further under the zero interest rate policy, so he implemented the so-called unconventional policy of “quantitative easing” (QE).

That is, in the past, when the Federal Reserve conducted open market operations, it purchased Treasury bonds and excluded corporate bonds. The reason was that allowing a specific company facing funding difficulties to survive with Federal Reserve support could itself amount to a kind of favoritism. Bernanke, however, paid no heed to such concerns.

In fact, these policies can be seen not as solving the problem of simultaneous malinvestment induced by artificially lowered money-market interest rates, but rather as concealing and postponing it, thereby making the problem worse.

What long-term outcome would have followed if the U.S. government had resolutely refused to bail out the financial firms that had made bad investments and had let them go bankrupt? The only way to answer that is for economists analyzing the situation to imagine the result based on the economic theory they believe to be correct and on past experience. In that sense, this is also an exercise in evaluating Bernanke’s unconventional quantitative easing.

For the time being, economic stimulus through massive fiscal spending, together with zero interest rates and the Federal Reserve’s direct purchases of corporate bonds to increase the money supply, would indeed keep unemployment and similar consequences from becoming too conspicuous when the simultaneous malinvestments are revealed to be failures. But that does not solve the problem. The reason for saying this lies precisely in the experience of the Great Depression in the United States.

Even when a situation similar to the 1929 stock market crash occurred, the economy in most cases recovered after one or two years. But in the case of the 1929 crash, despite Hoover and Roosevelt’s New Deal policies—similar to the bailout policies used during the global financial crisis—and despite public works programs carried out through aggressive fiscal spending, the downturn instead deepened and lasted for 12 years.

This can be seen even without examining the statistics if one listens to the following confession, almost a cry of anguish, from Treasury Secretary Henry Morgenthau Jr. (1891–1967), who implemented the New Deal under the Roosevelt administration during the Great Depression: “We have tried spending money. We are spending more than we have ever spent before, and it does not work. I have just one interest.… I want to see people have enough to eat. We have not kept our promises.… After eight years of this Administration, we have just as much unemployment as when we started.… And an enormous debt to boot!” (Murphy, Understanding the Great Depression and the New Deal, 142; quoted in Kim Iseok, “Deputy Prime Minister Hong, Do You Know Secretary Morgenthau’s Confession?” Asia Today, 2020.5.22.)

In any case, the core of the problem is that artificially lowered interest rates through monetary expansion caused a mismatch between consumers’ decisions on the allocation between present and future consumption and producers’ production plans, leading producers to undertake simultaneous misguided investments on the assumption that real savings existed when in fact they did not. Because these investments were not liquidated, economic stimulus through bailouts and deficit-financed spending effectively produced the Great Depression.

Just as the authorities were about to begin withdrawing the enormous amount of money released after the global financial crisis, the COVID-19 pandemic struck, and countries including the United States began printing money again. After creating bubbles in real estate and stock markets, that money is now driving consumer prices sharply upward. In response, the Federal Reserve is now pulling back the dollars it released through quantitative tightening, along with policy rate hikes in the form of big steps, giant steps, and ultra steps.

In this situation, the Choo Kyungho economic team says it will end the Moon Jae-in government’s loose fiscal spending policies and restore fiscal soundness, while also pursuing tax cuts. So while it does not appear that the Choo Kyungho economic team will repeat the mistakes of the U.S. government during the Great Depression and the global financial crisis, one cannot be completely reassured when policies are being proposed to restructure the debts incurred through borrowing to the hilt and debt-financed investing.

Iseok Kim, Director, Center for Market Economy Institutions

---

Original title: [전문가 진단] 2008 금융위기의 교훈

Author: I-seok Kim

Date: 2022-09-29

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&idx=24988