What Caused The Great Recession?

A few days ago a friend mentioned to me that he was interested in learning more about the financial crisis of 2007, and it got me thinking. Identifying one singular cause of a phenomenon as complex as a financial crisis is impossible, because there are many factors operating and interacting between many levels of analysis. That said, we can attempt to simplify a little bit. There are many explanations that don't dig very deep and reveal simple causal relationships. To say that the Great Recession was caused by excessive debt fits this type of explanatory category. But such a simplistic explanation neglects too much: what caused businesses, financial institutions, and households to take on the excessive debt in the first place?

To answer this question, we need a richer model of causal relationships that includes big forces like political and economic context. But we must be wary: too much emphasis on context and structural forces leaves us with an explanation distant and divorced from the reality of the crisis. To say that the Great Recession was caused by capitalism or human psychology, while interesting, is meaningless to policymakers developing solutions. The best explanation should therefore occupy some middle zone, and depend on the ability of policy to influence things within that zone.

With that in mind, three big "causes" of the Great Recession stick out to me as deserving special attention:

1. Massive influx of savings from China: Leading up to the financial crisis, a ridiculously large amount foreign savings were deposited in the U.S. This kept interest rates down and meant credit was more accessible to U.S. consumers than ever before. Put another way, China was sending us tons of money, and it had to go somewhere, leading to the expansion of credit and rise in asset prices. (note: clever readers might be tempted to ask: but why does China save so much? There are many reasons, not least China's lack of a social safety net, its rapidly aging population, or its extremely competitive marriage market (due to gender imbalances). But keep in mind the comments above about finding explanations that fit within policymakers' realm of influence. Restricting capital inflows we can do; Chinese social policy we can't.)

2. Shadow Banking & Regulation: Most financial crises have followed a similar path concerning the cat-and-mouse game between businesses and government regulators. Following a crisis, populist outrage results in political incentives for new regulation in the industry or sector most at fault. Typically, such regulation reduces the leverage (or risk/reward) of that industry or sector. Over time, smart business innovators develop new tools to make money that are outside the purview of the most recent regulations. These new tools develop into massive unregulated industries and markets, subject to the economic original sin of unfettered capitalism: boom and bust business cycles. For the 2007 crisis, this periodic pattern manifested itself as the so-called "shadow banking system." More and more financial activity was being conducted on unregulated markets: derivatives trading, collateralized-debt obligations, credit-default swaps, auction-rate mortgages, mortgage-backed securities, etc. These all exploded in a big way.

3. Inequality: To blame the financial crisis on inequality is to tread a risky path. But I believe the extremely high income and wealth inequality leading up to the financial crisis (and still rising today) did more to cause the Great Recession than any other single factor. Whatever the reason for inequality and middle-class wage stagnation (liberals blame social and tax policy, conservatives blame global competition and labor-replacing technology), it has the pernicious effect of decreasing household savings and increasing debt-fueled consumption. The U.S. economy grew a lot between 1980 and 2007, yet most Americans' incomes stayed flat or declined--economic gains went to those at the top. With the rich getting richer and quality-of-life increases a resilient norm, the middle-class turned to three mechanisms to keep consumption high: 1) women moving into the workforce, 2) work longer hours, and 3) draw down savings and borrow. With the gains from 1) and 2) all but spent (Americans work longer hours than anybody), only option 3) remained: debt. And as they say, the rest is history. (note: for more on this idea, check out Aftershock by Robert Reich.)