The Lazy Economist: Why the 2008 US financial crisis impacted the world

Part two of a three-part series on the ups and downs of the economic cycle

Examining the 2008 recession is important for understanding what a recession is and how it can be avoided in the future.

When the United States financial system crashed more than a decade ago, its impact wasn’t contained to the domestic economy. It was felt worldwide.

In 2008, the US experienced one of the worst financial crises it’s ever seen. This resulted in the economy becoming slow-moving, culminating in a recession that some have argued started off worse than the Great Depression of the 1930s.

Banks went bankrupt, businesses suffered, and life savings were drained. It was a scary time for anyone in the US, whether you were a company dependent on dwindling domestic customers, a factory worker getting laid off, or a parent wondering how you’d pay for food.

However, what was perhaps the most unprecedented effect was not the country’s swift economic downfall, but the extent to which it took much of the world along for the ride. Many other countries, including Canada, were hit by the crisis—meaning that even well across the border, you or your parents may have felt the shock of the 2008 crash.

To understand the crash, the best place to start is with the subprime mortgages. In the time leading up to the crash, the US was operating with low interest rates. An interest rate is basically the cost of money, since money is either borrowed or lent.

High interest rates mean the cost of borrowing money is higher, so people want to save it, make interest on it, and spend less. As such, rising interest rates causes the economy to slow down.

The opposite is also true, where lowering interest rates makes the cost of borrowing cheaper, so people borrow more, buy more, and the economy ramps up.

In the mid-2000s before the crash, people mostly spent their cheaply-borrowed money on mortgages: everyone and their mother was buying a house, whether or not they could afford it.

People wanted homes, but the main motive was that investing in a house could be really profitable. This is because for your primary residence in the US, capital gains up to $500,000 for a couple are untaxed. Capital gains occur when the value of something you bought, whether a stock or a house, rises from the price you bought it at, so when you sell it, you make the difference in profit.

All of this meant that many people who shouldn’t have been able to were buying houses—someone working a minimum-wage job could be approved for a mortgage on a big house when realistically, they’d never be able to pay it back. Therefore, the term “subprime mortgages” lent itself to describing the mortgages of these poor-credit buyers.

What banks and insurance companies did was combine many of these mortgages into one package, creating the infamous mortgage-backed security. It was through these securities that the rest of the world was pulled in: investors worldwide ate up these packages, drawn in by the meaninglessly high ratings the securities were assigned by ratings agencies.

The sellers of the securities were able to market them as profitable by downplaying their associated risk, either by combining them with mortgages more likely to be paid off, or by operating under the mindset that all housing markets across the country would not rise or fall in unison.

They were wrong about that.

In 2006, the US began to raise its low interest rates, meaning mortgages became more expensive. People began to be unable to pay them back, so it ended up making more sense to just sell their houses. Many people whose mortgages combined to make up these security packages began doing just that, leading to an influx of homes on the market.

With more houses on the market, each individual house was worth less, due to basic supply and demand: as the supply of a good rises above demand, its price falls. It became more expensive to keep paying off a mortgage than to sell the house because the houses were worth less than the debt from these mortgages.       

This left investors around the world high and dry, with no one able to pay back the loans they were promised with these packages.

However, it wasn’t only these mortgages that led to the worldwide economic slowdown. Given what we now know about recessions, the US' hampered ability to buy what others were selling was another hit to the worldwide economy.

If American workers were making less, they were also spending less. Given the US’ economic size, it’s not surprising that countries and businesses dependent on American citizens’ consumption also suffered.

All in all, the 2008 financial crisis was a scary time for the world.

It wasn’t all about the subprime mortgages, but they were a good symbol of the lack of oversight in the financial system as a whole.

After experiencing what can happen to an economy without adequate oversight (like letting the housing bubble grow as long as it did thanks to low interest rates), more stringent regulations exist today in both the US and across the world, in hopes of mitigating any future crashes that severe.

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