Causes Of The Great Recession Of 2008

INTERPRETING THE CAUSES OF THE GREAT RECESSION OF 2008 This paper places the onus for the crisis on failures in the financial system, including its flawed incentives and models. The regulators should have recognized the risks posed by the pervasive failures in the financial system and the growing bubble. The paper identifies other factors that may have contributed to the magnitude of the crisis,such as low interest rates (both as a result of Fed policy and global imbalances) and inadequate risk assessments by investors. It argues that particular actions (such as the mishandling of the Lehman Brothers collapse) may have also contributed to the magnitude of the crisis and affected the timing, but that the crisis would have occurred in any case. It argues, moreover, that low interest ratesare neither necessary nor sufficient for the existence of bubbles and that low interest rates could have been a boon to the economy if the funds had been well allocated and risks well managed by the financial system. It dispenses with other attempts to shift blame away from the central failures of the financial system. Joseph E. Stiglitz Abstract

It seeks to explain the failures of thefinancial system, including the incentives for shortsighted behavior and excessive risk taking, identifying too-big-to-fail institutions and deficiencies in corporate governance as key.

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INTERPRETING THE CAUSES OF THE GREAT RECESSION OF 2008 The Great Recession of 2008 is both complex and simple. In some ways, beneath the complexity of CDS’s, sub-prime mortgages, CDO’s, and a host of new termsthat have entered the lexicon is a run-of-the-mill credit cycle. As banks lent money freely on the basis of collateral, prices increased, allowing more and more lending. Real estate bubbles are a dime a dozen. Bubbles break, and when they break, they bring havoc in their wake. Perhaps the most unusual aspect of this bubble was the conviction of key policymakers (including two Chairmen of the FederalReserve) that there was no bubble (perhaps a little froth), and the bald assertions (a) that one could not tell a bubble until it broke; (b) that the Fed didn’t have the instruments to deflate the bubble, without doing untold damage to the economy; and (c) that it would be less expensive to clean up the mess after it broke than to take preventive action. Joseph E. Stiglitz 1

These assertionswere made presumably on the basis of the “accepted” wisdom of the economic profession. Such views were reinforced by the belief in rational expectations and the belief that with rational expectations there couldn’t be bubbles. Few would hold to these views today. But even before the crisis there was little basis for these beliefs. Brunnermeier (2001) had shown that one could have bubbles withrational expectations (so long as individuals’ have different information). 2 Decades ago, economists had shown that there could be dynamics consistent with capital market equilibrium (rational expectations, with the noarbitrage condition being satisfied across different assets) for arbitrarily far into the future, but not converging to the long run “steady state,” so long as there were not futuresmarkets extending infinitely far into the future. 3 Such paths look very much like “bubbles.” There has been, in addition, a large literature on rational herding. Standard results on the stability of market equilibrium with rational expectations employed representative agent models with infinitely lived individuals (where the transversality condition replaced the necessity of having futures marketsextending infinitely far into the future). But as soon as the assumption of infinitely lived individuals was dropped, there was no assurance of convergence; the economy could oscillate infinitely, neither converging nor diverging. 4 Other models in the same vein emphasized the possibility of multiple rational expectations equilibria. 5
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Lecture to have been delivered at BIS Conference,...