by: Alex G. (Grade 11)

The main cause behind the 2008 Great Recession was that banks loaned out subprime mortgages. Typically, banks want to loan mortgages out to people with good credit, as this means that they are more likely to pay back the loan. Subprime loans are riskier loans that are given to people with bad credit. Banks would take these loans and pool them together as Collateralized Debt Obligations (CDOs). Then the banks would pull these CDOs and sell them to investors. To further exacerbate the situation, companies like American International Group (AIG) would provide insurance for these CDOs without having the money to back them up. This insurance was known as Credit Default Swaps. When the crash happened in 2008, the government had to step in and bail out banks such as Fannie Mae and Freddie Mac, and insurance companies like AIG. 

Understanding the main cause of the crisis begs the interesting question: “Why were the banks taking so many risks?” The answer that is most often given, and the main lesson that is taught, is that the banks got too greedy. Capitalism and deregulation are to blame, and the government should step in to regulate the banks. I believe that this view of the Great Recession is partially wrong, and ignores who is really responsible for the crisis. With that being said, I do not condone the risky actions of the banks. I think they should have been allowed to fail and not have their losses socialised due to the excessive risks they took. I believe that Federal Reserve Chairman Alan Greenspan is the person responsible for the crisis for two important reasons:

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#1 – Interest rates

When the Dot-Com bubble burst, there was a brief recession. One of the Fed’s tools for dealing with this is lowering the interest rates. Interest rates refer to the cost of borrowing money. Lower interest rates boost consumer spending because it is easier to borrow money. This approach is useful during recessions, however it is important that interest rates aren’t too low for too long. Demand for housing was boosted, causing a housing bubble. This happens when demand for a good or service is high, and supply is constant. As a result, firms raise prices to keep up with this demand.

Unfortunately, Alan Greenspan kept the interest rates too low for too long, which contributed to the housing bubble. Eventually, the Fed had to raise interest rates, a move usually done during an economically prosperous time. Because interest rates were too low for too long, this made it harder for those who took subprime loans to repay them.

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#2 – The Greenspan/Fed Put

When Alan Greenspan was chairman of the Fed from 1987-2006, he was known for the Greenspan put – the idea that Alan Greenspan and the Fed would enable banks and investors to take excessive risks. Banks and investors could score high profits, and any losses would be absorbed by the Fed or the government. This created a government failure known as a Moral Hazard, meaning that one party engages in risky behaviour knowing that another party will be responsible for the risk. Assuming that there was deregulation in the financial market before the recession, I do not believe that it is the real cause of the financial crisis. If the financial markets were deregulated, they would not have the incentive to act irresponsibly by loaning subprime mortgages because they would suffer the consequences of their losses. However, they are aware that the Fed has enabled the banks to act risky by setting up a moral hazard situation.

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The main lesson here is that deregulation was not the real cause of the Great Recession. The real cause of the recession was Alan Greenspan fuelling the housing bubble and using the Greenspan Put to allow the banks to become irresponsible. To prevent a financial crisis in the future, the Fed needs to learn from the mistakes of Alan Greenspan to prevent moral hazards and bubbles.

Do you agree with this report? Leave a comment below!