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The 18-month recession that lasted from December 2007 to July 2009 was dubbed the Great Recession, not because of its length, which was not much longer than the typical recession, but rather for its severity and the impact it had on so many industries and countries. Further, the economic recovery that took place after the recession was slow, requiring many years for economic indicators to return to their prerecession levels. This section presents the factors that led to the Great Recession and the macroeconomic policies used to mitigate its effects.

Owning a home is a dream shared by most people. During the first few years of the 21st century, a glut in worldwide savings and the Fed’s aggressive expansionary monetary policies following the 2001 recession led to low mortgage rates, helping many to achieve that dream of home ownership. Renters bought their first homes. Existing homeowners moved into larger homes or bought second homes. The resulting higher than normal demand drove up the price of housing. After a few years of rising prices, people started to think prices could only go up. This led some people to become speculators, which led to house “flipping”—purchasing a home with the intention of selling it as soon as possible for a tidy profit.

Builders provide homes, but usually a third party brings the transaction to a close. A financial intermediary provides the financing for home buyers in the form of a mortgage. Traditionally, the standard is a 30-year mortgage with a fixed interest rate. The person taking out the mortgage to purchase the home made monthly payments, which consisted of interest on the loan and some payment toward the loan amount (the principal). Financial intermediaries, such as banks, usually had high standards that would-be home buyers had to meet.

This changed at the beginning of the new century, as banks eager to cash in on the lucrative housing market made loans easier to obtain. And, as long as housing prices kept rising, the borrower’s collateral (the house) would protect the bank from losing money if the loan could not be repaid. Financial intermediaries encouraged home buying by offering adjustable-rate mortgages (ARMs). These mortgages offered a below-market interest rate for a short period (usually three or five years); the rate would then adjust based on the market interest rate. From a buyer’s point of view, a below-market rate, at least in the short term, was an inducement to buy. From a bank’s point of view, below-market rates generated business: They could expect ARM holders to seek out fixed interest rate mortgages after the initial period ended, which meant a second round of origination fees (paid whenever a mortgage is taken out).

The housing boom of 2003 to 2007 saw even more innovations in the mortgage market, as financial intermediaries felt competitive pressure from new mortgage brokers and Wall Street firms that were only too happy to meet the growing demand. Two key things happened: Mortgage credit standards fell, and the market for collateralized debt obligations (CDOs) developed.

Subprime Mortgages and Collateralized Debt Obligations Subprime mortgages are loans made to borrowers with poor credit. These loans carried high interest rates that were profitable for the banks as long as borrowers made payments on time. Because the economy was strong, defaults were minimal. Further, many financial institutions reduced their risk by selling these loans to other investors in the form of CDOs, also know make up most CDOs).

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CDOs are essentially bonds backed by a collection of mortgages: prime, subprime, home equity, and other ARMs. Banks holding mortgages found they could offset the risk of default by selling them to consolidators who put together enormous packages of CDOs, with the mortgaged homes standing as the collateral behind the security offered. Wall Street then sold off slices of these mortgage pools to investors interested in the steady income from mortgage payments. Mortgages to subprime borrowers—those with higher credit risks—could be combined with solid mortgages, a little like diluting poison in a large lake to dissipate its effects.

Banks and mortgage companies now were evaluating mortgage clients for loans that they did not intend to keep. They were simply collecting an origination fee and then immediately selling the mortgage to Wall Street. What in the past had been a long-term investment for banks and mortgage companies became nothing more than a business of advertising and selling loans quickly. Because Wall Street could package and sell as many loans as mortgage brokers could provide, banks had less incentive to keep high lending standards. Risk was being transferred elsewhere.

Trouble started in 2007 when some of the people who took on subprime mortgages started to default. These people were stretched too thin. When their ARMs reset, they faced higher payments, sometimes double or triple the original monthly payments. Worse, the spike in foreclosures as well as homeowners trying to sell their homes to escape rising mortgage payments caused the value of houses to fall, which meant that borrowers wishing to refinance their homes (to make mortgage payments affordable again) were being turned away because the amount they were seeking to borrow exceeded the value of their now lower-value home.

Compounding this, another problem arose. Risk ratings by bond rating agencies whose job it is to rate packages of mortgages turned out to be faulty. Wall Street knew the minimum requirements needed for a rating agency to assign a AAA rating to a CDO, and they manipulated the components to get that all-important rating. Also, rating firms were paid 6 times their normal fee to give the AAA rating to the mortgage packages, and were only paid if the CDO got the AAA rating, giving ratings agencies an incentive to lower standards. Investors wanted bonds with the security of a AAA rating, which gave the appearance of high-yield, low-risk investments. The bond packages sold well all over the world. The risk of each CDO was underestimated because of the overly rosy ratings.

Two more problems would make this a growing house of cards. Because the mortgage packages were seen as low-risk investments, many investors borrowed money at the low prevailing interest rates to purchase greater quantities. They leveraged their capital to earn greater returns. But with leverage comes additional risk: A small drop in prices can easily wipe out a highly leveraged account. Table 1 shows how a leveraged investment magnifies the risk of losing money. In this case, a 10% drop in value of the security wipes out the leveraged account, while the nonleveraged account sees its value drop by just 10%. A leveraged account magnifies both gains and losses.

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To protect against this risk, investors purchased credit default swaps, an instrument developed by the financial industry to act as an insurance policy against defaults. The biggest issuer of credit default swaps, the American International Group (AIG), sold several trillion dollars of these swaps with only a few billion dollars in capital to back them up. Here again, we see risk underestimated and therefore mispriced.

Collapsing Financial Markets This brings us to the central event that brought down the financial system. By 2007, $25 trillion of American CDOs were in investment portfolios of banks, pension funds, mutual funds, hedge funds, and other financial institutions worldwide. The rate of subprime mortgage defaults skyrocketed, and because investors did not know what exactly was in their CDOs, they panicked.

Consequently, buyers of CDOs evaporated, and prices fell as people began dumping CDOs at fire-sale prices. AIG could not cover the losses it had insured and went bankrupt. For banks, this was a catastrophe. Their CDOs were virtually worthless, and an important part of the banks’ capital was wiped out. To raise capital, banks called in loans and reduced lines of credit to businesses, which reduced the money supply, contracted the economy, caused job losses, and deepened the recession.

In sum, the financial crisis was caused by a savings glut that led to low interest rates, which fueled a housing boom that led to new financial instruments and investment securities that depended on the value of housing staying high. A financial house of cards was created, and when one card at the bottom (subprime loans) lost strength, the entire edifice fell. Because all types of financial institutions worldwide were investors in CDOs, credit dried up, creating a credit crisis that precipitated a worldwide recession.

As long as the financial system takes on risks that it misperceives, we will have financial crises. Let’s look at the government’s policy response to the financial crisis:

These extraordinary efforts prevented the widespread bank failures that had plagued the economy during the Great Depression and during the savings and loan crisis in the 1980s. For the Fed, it was crucial to maintain public confidence and keep the recession from becoming a full-blown depression. The Fed stepped far outside of its usual role of managing the money supply, interest rates, inflation, and unemployment, and took extraordinary, lender-of-last-resort measures to prevent a financial sector meltdown.

This brief summary of the government’s response during the financial crisis outlines the breadth and depth of fiscal and monetary policies designed to avert a catastrophe. They have succeeded, but the cost may not be known for a decade.

The financial crisis that resulted in the 2007–2009 recession was the most serious downturn in the economy in over a generation. And the speed by which the economy deteriorated was alarming. The recession began at the end of 2007 and accelerated in 2008 until the middle of 2009. Real GDP declined by over 4% and unemployment reached 10% of the labor force.

At the onset of the financial crisis, jobs were cut as consumers reduced their spending. They tightened their belts in an effort to reduce household debt levels and hunkered down for what they perceived as a severe recession on the way. As a result, 7 million people lost their jobs during this two-year period. Job losses reduced consumer confidence, further reducing consumer spending and aggregate demand. As demand dropped, businesses reduced their production capacity through layoffs and plant closings, shifting short-run aggregate supply leftward.

Toward the end of the recession, prices began to fall as deflation set in for most of 2009. We have spent a considerable time in this book studying the harmful effects of inflation, yet now the economy faced deflation. Deflation can be a problem because it increases the real value of existing debt, making the debt more burdensome and requiring more purchasing power to make interest payments or pay off the debt. Policymakers faced the problem of preventing debt from becoming a more serious burden on households, which would further reduce aggregate demand and deepen the recession.

The tools we learned about in previous chapters helped us to understand how the government managed the last financial crisis and the accompanying recession. Let’s take a further step, adding some challenges to the effective use of policy to smooth the business cycle. The next section focuses on the effectiveness of macroeconomic policy by considering the Phillips curve, which proposes a tradeoff between unemployment and inflation. If this tradeoff exists, policymaking becomes simple: Pick some rate of unemployment and face a corresponding rate of inflation. We also look at how the rational expectations model questions whether using macroeconomic policy to correct fluctuations in the business cycle can ever be effective at all.

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