The Great Recession of 2008-2009: Causes ... - Index of - IZA

What then is the link between the global financial crisis and the imbalances leading up to
2007? It is argued that the flows of capital from China and other exporting countries fed into
the US housing bubble and credit boom along with its depressing effect on bond yields. For
this reason, mortgage rates remained low in the US even after the Federal Reserve started
tightening monetary policy in 2004 (Baily et al. 2008). In addition, foreign borrowing directly
funded both investment in US companies and the mortgage debt instruments that were at the
centre of the sub-prime disaster. Overall, during the decade preceding the crisis, credit indeed
grew most strongly in deficit countries, which was only possible to maintain through the
ever-increasing flows of capital from surplus economies (Astley et al. 2009).
The search for higher yields, misperception of risk and lax financial regulation
Low interest rates and yields on government bonds ultimately encouraged investors to search
for higher-yielding assets. Yields on emerging market or corporate bonds also narrowed
relative to T-bills thus leading investors to search for higher returns; hence, the demand for
mortgage-backed securities. In the United States, lenders took advantage of low interest rates
to expand activities but, having exhausted credit-worthy borrowers, they turned to riskier
segments of the market (sub-prime, alt-A and other non-standard loans). 21 These efforts at
financial innovation were enabled by lax regulation of the financial system, which had begun
in the 1990s and culminated in the Gramm-Leach-Bilely Act of 1999, which over-turned the
restrictions on banks posed by the Glass-Steagall Act of 1933. On top of this regulatory
aspect, lending was encouraged by political authorities who sought to enhance home
ownership rates among disadvantaged and low-income groups (though the role of legislation
in promoting sub-prime lending has been disputed). 22
The combination of perverse incentives in the financial sector and goals of increasing
homeownership rates created the setting for the emergence of so-called ‘sub-prime’ housing
market in the US. Such ‘sub-prime’ borrowers who would not be regarded as credit-worthy
under normal prudential standards were deemed to be profitable and worthy business targets
by yield-seeking lenders and investors. Aggressive lending and a drop in lending standards
during the period resulted in rapid growth in “non-prime” loans. By 2006, 48 per cent of all
21 See Baily et al. (2008) for a detailed description of these issues.
22 See the discussion on the role of the Community Reinvestment Act in the sub-prime crisis; for example,
http://www.federalreserve.gov/newsevents/speech/kroszner20081203a.htm#f6.
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