As we’ve just seen, banking crises have typically been followed by major economic problems. How did the aftermath of the financial crisis of 2008 compare with this historical experience? The answer, unfortunately, is that history has proved a very good guide: once again, the economic damage from the financial crisis was both large and prolonged. And aftershocks from the crisis continue to shake the world economy today.

Figure 32-6 shows real GDP during the crisis and aftermath in the United States and the eurozone—the group of countries using the euro as a shared currency, which together form an economy roughly the same size as that of the United States. For both economies real GDP is shown as an index with the peak pre-crisis quarter—the last quarter of 2007 for the United States, the first quarter of 2008 for the eurozone—set equal to 100. What you can see is that the United States experienced a steep downturn followed by a relatively slow recovery, and Europe did even worse, sliding back into recession in 2011.

The severe slump and the slow recovery in the United States were very bad news for workers, since a healthy job market depends on an economy growing fast enough to accommodate both a growing workforce and rising productivity. Figure 32-7 shows two indicators of unemployment in the United States—the overall unemployment rate and the percentage of the unemployed who had been out of work 27 weeks or more. Both measures shot up during the crisis and remained very high years later, indicating a labor market in which it remained very hard to find a job.

This outcome was, sad to say, about what one should have expected given the severity of the initial financial shock and the historical experience with such shocks. Look back at Figure 32-2: compared with either the Panic of 1893 or the aftermath of the Swedish banking crisis of 1991, the U.S. experience after 2008, the Great Recession, has if anything been better. The United States, observed Kenneth Rogoff (whose work we cited earlier), has experienced a “garden variety severe financial crisis.”

One important factor bedeviling hopes for recovery was the emergence of special difficulties in several European nations—difficulties that repeatedly raised the specter of a second financial crisis.

The 2008 crisis was caused by problems with private debt, mainly home loans, which then triggered a crisis of confidence in banks. In 2011 and 2012, there were fears of a second crisis, this one arising from concerns about whether Southern European countries as well as Ireland could repay their burgeoning public debts.

Europe’s troubles first surfaced in Greece, a country with a long history of fiscal irresponsibility. In late 2009 it was revealed that the previous Greek government had understated the size of the budget deficits and the amount of government debt. This prompted lenders to refuse further loans to Greece. To prevent a default on Greek public debt, other European countries provided emergency loans to the Greek government in return for harsh cuts to the Greek government budget. But these cuts depressed the Greek economy, and by late 2011 there was general agreement that Greece would be unable to pay back its public debt in full.

By itself, this was a manageable shock for the European economy since Greece accounts for less than 3% of European GDP. Unfortunately, foot-dragging and finger-pointing by European officials in confronting Greece’s problems and the effects of the harsh budget cuts on the Greek economy spooked the markets for public debt of other European countries. So by the fall of 2011, the crisis had spread beyond the Greek borders, hitting two major European economies, Spain and Italy, which found themselves forced to pay much higher interest rates on their public debt.

Figure 32-8 shows a measure of pressure on Italy and Spain during the 2008 and 2011 crises: the difference between interest rates on 10-year bonds issued by the governments of Spain and Italy, and the interest rate on German public debt, which most people consider a safe investment. Because all three countries use the same currency, the euro, these interest rates would all be the same if Italian and Spanish government debt were considered as safe as German government debt. The rise in the spreads—the differences between the interest rates on Spanish and Italian public debt versus the interest rate on German public debt—therefore indicated a growing perception of risk that the Spanish and Italian governments could not repay their debts in full. As you can see from Figure 32-8, the spreads were virtually zero in 2007, indicating investors felt that German, Spanish, and Italian public debt were equally risky. However, this changed in 2008 as the spreads began to rise.

Spain’s fiscal problems were mainly fallout from the 2008 crisis. Before that crisis, Spain seemed to be in very good fiscal condition, with low debt and a budget surplus. However, Spain, like Ireland, had a huge housing bubble between 2000 and 2007. When the bubble burst, the Spanish economy fell into a deep slump, depressing tax receipts and causing large budget deficits. At the same time, there were worries that the Spanish government might eventually have to spend large amounts bailing out banks. As a result, investors began worrying about the solvency of the Spanish government and a possible default.

Italy’s case was somewhat different. Italy has long had high levels of public debt as a percentage of GDP, but it has not run large deficits in recent years; as late as the spring of 2010 its fiscal position looked fairly stable. At that point, however, investors began to have doubts about the Italian government’s solvency, in part because in the aftermath of the 2008 crisis the Italian economy was growing very slowly—too slowly, it was feared, to generate enough tax revenue to repay its public debt. These doubts drove up interest rates on Italian public debt, and this in turn created a vicious circle: higher interest payments, caused by fears about Italian government solvency, worsened Italy’s fiscal position even further and pushed it closer to the edge.

Some economists argued that the problems of Spain and Italy were exacerbated by the fact that, having adopted the euro, their debts were in effect in a foreign currency. Why does this matter? Governments like those of the United States, Britain, or Japan, which borrow in their own currencies, can’t run out of money—they can just print some more. True, this may have bad side effects, such as inflation; but a cash crunch, in which the government literally can’t pay its debts, is ruled out. The governments of Spain and Italy, however, can run out of money—and bond investors, it was argued, worried that this made them vulnerable to something like a bank run, in which a loss of investor confidence produced a liquidity crisis—a lack of available cash—that forced them into default.

This argument gained a lot of credibility in 2012, when the European Central Bank declared that it would become a lender of last resort for the eurozone by buying directly the bonds of troubled governments in that area if necessary, greatly reducing the fears of a liquidity crisis for these governments. As you can see in Figure 32-8, spreads on Spanish and Italian debt fell sharply after the announcement. Although immediate fears of government defaults in the eurozone had been greatly eased, at the time of writing Europe’s economic difficulties remain grave.

The persistence of economic difficulties after the 2008 financial crisis led to fierce debates about appropriate policy responses. Broadly speaking, economists and policy makers were divided as to whether the situation called for more fiscal stimulus—expansionary fiscal measures such as more government spending and possibly tax cuts to promote spending and reduce unemployment—or for fiscal austerity, contractionary fiscal measures such as spending cuts and possibly tax increases to reduce budget deficits.

The proponents of more stimulus pointed to the continuing poor performance of major economies, arguing that the combination of high unemployment and relatively low inflation clearly pointed to the need for expansionary policies. And since monetary policy was limited by the zero bound (a concept we discussed in Chapter 31) for interest rates, stimulus proponents advocated expansionary fiscal policy to fill the gap.

The austerity camp took a very different view. Strongly influenced by the solvency troubles of Greece, they argued that the common source of all the problems were high levels of government deficits and debts. In their view, countries like the United States that continued to run large government deficits several years after the 2008 crisis were at risk of suffering a similar loss of investor confidence in their ability to repay their debts. Moreover, austerity advocates claimed that cuts in government spending would not actually be contractionary because they would improve investor confidence and keep interest rates on government debt low.

Each side of the debate argued that recent experience refuted the other side’s claims. Austerity proponents argued that the persistence of high unemployment despite the fiscal stimulus programs adopted by the United States and other major economies in 2009 showed that stimulus doesn’t work. Stimulus advocates argued that these programs were simply inadequate in size, pointing out that many economists had warned of their inadequacy from the start. Stimulus advocates further argued that warnings about the dangers of deficits were overblown, that far from rising, borrowing costs for Japan, the United States, and Britain—nations that, unlike the troubled European debtors, still had their own currencies with all the flexibility that implies—had fallen to record lows. And they dismissed claims that spending cuts would raise confidence as mainly fantasy.

By 2014, the intellectual debate seemed to have gone mostly against the advocates of austerity. Research at the International Monetary Fund and elsewhere seemed to support warnings that austerity policies depress output and employment, especially when there is little room for interest rates to fall. Interest rates in countries that borrow in their own currencies remained low despite years of high budget deficits—and as we saw in Figure 32-8, even eurozone governments with high levels of public debt saw their borrowing costs drop sharply once the European Central Bank moved to end fears of a cash crunch. The shift in the intellectual debate did not, however, lead to much change in actual economic policies.

Almost all major economies had great difficulty dealing with the aftermath of the 2008 financial crisis—high unemployment, low growth and, for some, solvency concerns, and high interest rates on public debt.

Clearly, then, the best way to avoid the terrible problems that arise after a financial crisis is not to have a crisis in the first place. How can you do that? In part, one might hope, through better regulation of financial institutions. We turn next to attempts at regulatory reform.