By Zachary Zhu We all remember the 2008 recession. The stock market crashed, unemployment skyrocketed, and murder rates went through the roof. But what really caused the financial crisis of 2008? Many people can cite the housing bubble and the subprime lending, but few know the root cause of the issue. To fully understand the causes of the most recent economic downturn, we need to go back a century. In 1929, the US experienced the worst economic contraction in its history: the Great Depression. The Great Depression was one of the most influential events in US history: one out of four people were left unemployed, capitalism itself had failed. To prevent a repeat of another such event, the Glass-Steagall Act was passed in 1933. For most Americans, big banks were to blame for the Great Depression in the twentieth century. In theory, a commercial bank is supposed to manage the deposit accounts of individuals and businesses, while an investment bank would be free to purchase and sell bonds, stocks, and other investments. However, in the beginning of the twentieth century, no line was drawn between commercial banks and investment banks, so banks that managed the deposits of citizens were free to make risky investments. As a direct consequence of the Great Depression, the public came to believe that commercial banks and investment banks needed to be separated. Consequently, at that time, an artificial distinction between investment banks and commercial banks was created. The intention of the act was to prevent banks from taking impractical risks, but the Glass-Steagall Act enabled banks to grow exponentially bigger by providing a false sense of security that often accompanies reform that ultimately set up the financial collapse over a century later. Another historical precedent that helped precipitate the financial crisis of 2008 was the Community Reinvestment Act of 1977. In the twentieth century, redlining laws were passed which legalized discrimination against members of low-income minority neighborhoods for receiving loans. However, in 1977, the Community Reinvestment Act was passed, which encouraged banks to provide more loans to low-income neighborhoods. The act aimed to provide loans that were less secure in order to enable low-income individuals to have greater opportunities. In theory, this law was well-intentioned: to rectify the discrimination against minorities, laws were passed to provide incentive for banks to give loans to members of underprivileged communities. However, this originally well-meaning law was eventually perverted to make a profit. Banks realized that by providing loans willy-nilly, they could receive the monetary benefits under the Community Reinvestment Act. Thus, eventually more and more loans were granted to individuals that could not afford to pay back the loan. This practice of subprime lending eventually resulted in massive defaults, which culminated in years long economic recession. Now, this does not mean that people should think that giving people loans will just have universally negative effects, but the 2008 recession does tell us that a law can have lasting unintended consequences if we do not do our due diligence. Speculation lies at the core of almost all panics and recessions. In the 1930s, the Great Depression occurred, to a large extent, because of stock market speculation. In 2000, the dot com speculative bubble popped. In 2008, the housing bubble burst. In the early twenty-first century, housing prices continued to soar. For many homeowners, an appreciation of 15-20% per year for their houses was not an uncommon phenomenon. The vast majority of people expected this trend to continue. This expected growth in housing prices encouraged more people to take mortgage loans that they would not be able to pay back, simply because they expected their houses to keep increasing in value. Of course, once the housing bubble burst, these people could not pay back their loans, and were forced to default and go bankrupt. Another effect of increasing house prices was the growth in home equity loans. To illustrate what this means we can use a hypothetical scenario. Let’s assume you want to buy a house that costs a million dollars. To buy the house, you get a loan from the bank for a million dollars, and you use that loan to buy the house. While you owe a million dollars to the bank, you also have a million dollar asset-the house. In essence, your equity is equal to zero, since you have the same amount of assets as liabilities and equity is defined as assets minus liabilities. However, let’s say after a year, your house’s value appreciates to $2 million. Suddenly, you have a $2 million dollar asset, and $1 million in liability, so your net equity is positive $1 million. You can’t do anything with that extra $1 million in the house, but you can get a home equity loan to convert that $1 million in equity to cold, hard cash. Now, you have a $2 million asset, $1 million in cash, but you owe the bank $2 million. After that, you spend that one million dollars however you please, but suddenly, the housing bubble burst, and your house is only worth $1 million again. You now owe $2 million to the bank, only have a $1 million asset, and you have to default. The bank takes back your house; you are crushed under a mountain of debt; the bank harasses you; you go bankrupt. Congratulations! You’re one of the millions of people who have lost their homes from 2007-2009. More than anything, the 2008 recession reminds us that our economy is not perfect. Capitalism can fail. Regulation can fail too. Banks that are “too big to fail” can fail and have failed. Even so, the recession reminds us that the American economy is resilient. Even if the housing bubble bursts and century old legislation can wreak havoc on our economy, we eventually recovered. The Dow Jones dropped a third of its value from 2006-2009, but it has reached record highs in recent years. Perhaps this grisly recession was the wake-up call that the United States needed to reform its financial sector, setting itself on the path of economic prosperity in recent years. CITATIONSBeattie, Andrew. “Market Crashes: Housing Bubble and Credit Crisis (2007-2009).” Investopedia, 7 Mar. 2017, www.investopedia.com/features/crashes/crashes9.asp. Lim, Paul J. “A Recession’s Impact Is All in the Timing.” The New York Times, The New York Times, 19 Jan. 2008, www.nytimes.com/2008/01/20/business/20fund.html. Rich, Robert. “The Great Recession.” Federal Reserve History, 22 Nov. 2013, www.federalreservehistory.org/essays/great_recession_of_200709. sUGGESTED READINGS"What is Glass-Steagall? The 82-Year-Old Banking Law That Stirred The Debate":
https://www.nytimes.com/2015/10/15/upshot/what-is-glass-steagall-the-82-year-old-banking-law-that-stirred-the-debate.html "The Origins of the Financial Crisis: Crash Course": https://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article
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