Financial Crisis That Emerged in 2008 Came

Financial crisis that emerged in 2008 came about because of a number of different factors that all contributed something to the problem. Ostensibly, this was a credit crunch. A credit crunch occurs when lender either no longer have money to lend or they are prohibited or unwilling to do so.

Mussa (2008) notes a truth that Adam Smith recorded that while money is an essential part of an economy's capital stock, it was not directly useful but rather indirectly useful through consumption or production. So what we saw with the credit crunch was that lenders were not lending. This brought about conditions where firms did not have access to the capital that they needed in order to grow. Then, of course, this became a contagion. Worries about the economy slowing down due to a lack of credit had otherwise healthy companies cancelling projects and money that otherwise could have been lent was held back by banks worried about their liquidity going forward.

The problems that led to the credit crunch were myriad. In essence, mortgage lenders grew more aggressive in the mid-90s for a number of different reasons, but the outcome was that they were able to take on added risk in their mortgage portfolios -- so they thought -- by bundling some of the mortgages into securities known as MBS, mortgage-backed securities. These were billed as having a high credit rating, but they were still risky because though there was diversification of individual assets all of the mortgages within a given security were susceptible to a sharp increase in interest rates, which is exactly what happened.

Smith had noted that credit and money can become opaque when passed through multiple financial institutions and that is what was happened with the securitization of the mortgages. They were bought and sold, and structured in an arcane manner so that when the underlying mortgages started to become subject to default, nobody really knew what their exposure was. This caused the people holding these securities to stop lending altogether, unsure if their assets were ever going to pay. The result was the credit crunch. Financial institutions had been pursuing better returns with these securities, not realizing the risk and when those securities started becoming worthless the banks were still uncertain of their value.

The government responded first by orchestrating a bailout of Lehman Brothers as a move to stabilize the financial system. Over time, it would invest in buying back these "toxic assets" to free up capital on the balance sheets of the affected institutions. Furthermore, the Federal Reserve flooded the economy with low interest money in order to increase the supply of money in the economy, in the hopes that this would stimulate the banking system to begin lending again. It did not, because by that point the businesses were laying off workers due to the credit crunch -- it was a negative feedback and the government's response was ultimately too little, too late to prevent a recession.