Macroeconomic Perspectives on the Financial Crisis and Its Aftermath

This chapter deals with the macroeconomic roots and consequences of the financial crisis. The roots of the crisis go back to the preceding period of low interest rates, excessive risk appetite and inadequate regulation. The combination of cheap finance and new financial products, including zero amortization loans, made it possible to buy real estate without any equity capital.1 New home owners also often entered the market in the anticipation that house prices would continue to rise. The problem with this model became particularly obvious in the US subprime market in late 2006 and early 2007 when house prices began to flatten out and subsequently decline. At that time delinquency rates started to increase to levels not seen in many years and financial institutions began to report their first significant losses. This marked the beginning of the financial crisis. Once the crisis had struck, high leverage was the key to understanding why it became the worst crisis since the Great Depression. Following Lehman’s crash on September 15, 2008, financial markets froze and highly leveraged financial institutions, including hedge funds, embarked on massive fire sales which led to plummeting stock markets and a fast contraction in real economic activity. Had policymakers not intervened and undertaken the necessary firefighting the crisis could very well have led the world into the Great Depression II since world industrial production, trade and stock markets were diving faster from April 2008 to early spring 2009 than during 1929–30, see Eichengreen and O’Rourke (2009).2