This paper examines the origins, development, and global consequences of the credit crisis that began in the third quarter of 2007. Drawing on peer-reviewed, scholarly, and business literature, the paper defines the concept of a credit crisis, surveys historical precedents from the Depression of 1807 through the Great Depression of 1929, and analyzes the subprime mortgage lending practices and regulatory failures that precipitated the modern crisis. The paper then assesses the distinct impact of the crisis on three major economies — the United States, the European Union, and the Russian Federation — highlighting differences in severity, policy responses, and economic resilience. The conclusion synthesizes key findings, noting that the crisis shares many characteristics with prior downturns and underscores the systemic risks of insufficient regulatory oversight in an increasingly globalized financial system.
In retrospect, the warning signs were visible for all to see, and many observers today are questioning how regulators could allow the economic meltdown to reach such critical levels. After all, the United States fields a veritable army of regulators in the Securities and Exchange Commission and federal banking agencies tasked with overseeing financial markets, and comparable agencies exist in Europe and the Russian Federation. Not surprisingly, the impact of the credit crisis on the United States and major European economies has produced ripple effects for consumers all over the world, including those who have not traditionally been affected by such trends.
Despite the fact that these issues have been at the forefront of media coverage for quite some time, many observers may remain uninformed concerning the origins and consequences of a credit crisis. To this end, this paper provides a review of the peer-reviewed, scholarly, and business literature to develop a working definition of a credit crisis, an overview of previous global credit crises and concomitant depressions, and an analysis of how the current credit crisis began in 2007 and what key factors precipitated it. An assessment of the impact of the credit crisis on the United States, Europe, and the Russian Federation is followed by a summary of the research and important findings in the conclusion.
In order to discuss the current credit crisis meaningfully, a clear operationalization of the term is in order. According to Black's Law Dictionary (1991), credit is "the ability of a business or person to borrow money, or obtain goods on time, in consequence of the favorable opinion held by the particular lender as to solvency and past history of reliability" (p. 367). Therefore, a so-called "credit crisis" — alternatively referred to as a "credit crunch" or "credit squeeze" — occurs in situations where there has been a significant reduction in the availability of loans. For the majority of consumers, a credit crisis is represented primarily by an increase in the requirements needed to obtain a secured loan from a bank, rising interest rates, or a fundamental lack of funds available for unsecured loans such as credit cards and personal loans (Thomas, 2009). Given the importance of credit to an enormous range of organizations and consumers, it is little wonder that its effects have been felt around the world. According to Sinai (2008), "The current credit crisis encompasses a wide range of bank and nonbank financial intermediaries, all of which provide credit and invest in the U.S. and global economies" (p. 25).
Complicating the analysis of what went wrong is the fact that an increasing number and variety of financial institutions have become lenders of first choice for a growing number of consumers and businesses alike. In this regard, Sinai adds that "the traditional major sources of credit — commercial banks — no longer are so, with a wide range of nonbank financial intermediaries that have grown in size and number now taking up the lion's share of credit" (2008, p. 25). The nonbank financial institutions that have become major players in the credit-issuing arena may surprise casual observers, because these institutions have not traditionally been viewed as credit-issuers; however, they have assumed an increasingly important role in the current economic crisis and must therefore share much of the blame for what has transpired. For instance, Sinai concludes that "these nonbank financial institutions include investment bank/brokerage firms, hedge funds, private equity funds, venture capital, insurance, and the mutual funds that now provide a totality of credit and finance that dwarfs that of traditional banks" (2008, p. 25).
The impact of the credit crisis has been severe in some parts of the world while its effects have been less significant elsewhere. Global economic growth decreased from 4.7 per cent in 2007 to just 4.2 per cent in 2008; however, the resiliency of the major Asian economies helped to buffer the full impact of the crisis worldwide (The world economy, 2008). Analysts at the National Institute of Economic Review emphasize that "as the most serious credit crisis since the early 1930s unfolds, an extreme outcome in braking the global economy, including a recession in the Organisation for Economic Co-operation and Development (OECD), cannot be excluded" (The world economy, 2008, p. 2). These analysts add, however, that increasingly aggressive interventions and support by the world's main central banks have helped in some ways to cushion the impact, meaning that current economic projections indicate that global economic growth will decline in relatively modest ways (The world economy, 2008).
Notwithstanding an overall positive global economic outlook, there remains a very stark difference between the impact of the credit crisis on developed and emerging economies. Analysts at the National Institute of Economic Review project that growth in the OECD group — comprised primarily of developed nations — will experience a slowdown from their 2007 rate of 2.7 per cent to just 2.0 per cent in 2009 (The world economy, 2008). By sharp contrast, economic growth remained strong in China, which continued to enjoy a GDP growth rate of a remarkable 10.4 per cent in 2008 (The world economy, 2008). According to these analysts, "The Asian upswing is being buoyed by lax monetary policy, which is keeping short-term interest rates well below the rate of nominal GDP growth in several countries, including China and India. The downside is an upsurge in inflation, which now poses the most serious risk to the economic stability of the region" (The world economy, 2008, p. 2).
The current credit crisis and global economic downturn is certainly not a unique occurrence; such events have taken place throughout history in one form or another. According to Dattel (2008), "The subprime crisis is yet another episode in the continuing historical saga of financial debacles. Each crisis occurs in a different context and time, but is a variation on the same theme" (p. 24). The primary theme that has characterized most previous credit crises and resulting depressions has been insufficient regulatory oversight in virtually all countries, regardless of the type of central banking system in place. Dattel adds that "financial institutions chase a relatively high yield without regard to risk until a real or anticipated default happens. Then the extent of the problem dribbles out and governments assess the possibility of a more generalized impact upon their respective economies" (2008, p. 24).
A timeline and descriptions of previous credit crises and depressions over the past two centuries are provided below.
This economic downturn was different from those that would follow in that it was likely caused or exacerbated more by the trade embargo imposed by President Thomas Jefferson — intended to keep the U.S. from becoming involved in European wars involving the United Kingdom and France — than by financial irregularities or mismanagement. At the time, U.S. exports to either nation were subject to interdiction, which would have precipitated a military response the U.S. could ill afford (Watkins, 2008).
A number of different factors contributed to this depression. Perkins and Van Deusen (1962) report that "the Specie Circular drew gold and silver into the West, made money tight in the East, forced western banks to curtail discounts, and spread doubt as to the soundness of banks in general. Rumors that all was not well with the nation's economic situation began to circulate as early as April 1836 and multiplied as the year went on" (p. 406). In addition, the United Kingdom was experiencing a depression of its own that reduced its demand for American cotton, precipitating a drain of specie abroad as foreign investors began to sell their holdings in American canal and bank stocks (Perkins & Van Deusen, 1962). A number of American companies also defaulted on loans from European financial institutions, making lenders wary of further investments in the U.S. (Hacker, 1940).
The Depression of 1873 followed the failure of the Great Northern Railroad (Green, 1939) and had ripple effects throughout Canada and Europe, though Canada managed to weather this economic storm better than the U.S. (Winder, 2002). According to Winder, "Ontario manufacturers suffered in the period 1870–1900, but so did those in New York and Ohio. These states were industry leaders in 1870, employing 36 percent of the continental industry workforce" (p. 292).
Following closely on the heels of the depression that had taken place just two decades earlier, the precise causes of this economic downturn remain unclear. Steeples and Whitten (1998) advise that "there is no adequate account of the causes of the depression of 1893–1897 or, by implication, of the crisis itself" (p. 6). These authors cite fundamental shifts in demographics in the U.S., as well as innovations in technology and manufacturing that caused a reevaluation of traditional institutions and the role the U.S. was going to play in global economic affairs in the 20th century (Steeples & Whitten, 1998).
The stock market crash of 1929 is frequently cited as the precipitating factor for the Great Depression, but Rothermund (1996) emphasizes that other economic forces also fueled the crisis. According to Rothermund, "This depression upset many assumptions concerning the working of market forces in the 'real economy.' Credit was suddenly contracted, prices fell to such an extent that the law of supply and demand seemed to be irrelevant, the international exchange of goods dwindled, and many nations returned to the policy prescriptions of the mercantilists who had interpreted trade as a zero sum game in which gains in one place must invariably lead to losses elsewhere" (p. 2). Rothermund nevertheless places primary blame for this economic downturn on the United States: "All major factors contributing to the depression can be traced back to the United States of America: the handling of war debts, the sterilisation of gold, a deflationary monetary policy after an expansionist period, protectionism and the overproduction of wheat. All these factors were due to long-term developments, but they were accentuated by the sudden crash of the stock market in October 1929 which undermined the world credit system and thus was the proximate cause of the depression" (p. 48). The external causes of the Great Depression were amplified by various internal factors as well, including a highly disparate distribution of income, a concentration of capital, and a scarcity of prospects for productive investment. In their place, there was an increase in stock market speculation that placed enormous strains on a system of financial intermediation that remained relatively disorganized and unregulated (Rothermund, 1996).
According to an analysis by Pomerantz (2008), the credit crisis that rocked the world's financial markets began during the third quarter of 2007, resulting at least in part from the failure of governmental regulators to monitor the situation and take timely action. Thomas (2009) reports that "typically central banks regulate the availability of credit by raising or lowering interest rates and reserve requirements. The Federal Fund Rate is the rate that is mandated for short-term loans between banks to cover their minimum reserve requirements" (p. 2).
When the Federal Reserve (the "Fed") tightens credit, the intended effect is to increase interest rates and reserve requirements, thereby increasing the amount of money a bank must keep on hand and the costs associated with borrowing to satisfy that objective; these requirements combine to minimize the total amount the bank is able to loan (Thomas, 2008). According to Thomas, however, the Fed failed to act in a meaningful fashion in the months leading up to the credit crisis, and by the time it recognized what was happening, traditional credit management approaches could no longer positively affect the situation. As Thomas emphasizes, "To loosen credit, [the Fed] would do the reverse. In a credit crisis, however, the connection between interest rates and the availability of credit is weakened or broken by other factors, curtailing the ability of a central bank to intervene" (2009, p. 3).
As noted in the background and overview above, credit crises are typically the result of a combination of factors, though in some cases — such as the Great Depression of 1929 — the crisis may be primarily caused by a single event. In still other cases, a credit crisis can result when a national government seeks to tighten credit by a small amount but, given the conditions at the time, this proves sufficient to trigger a larger financial crisis. Thomas advises that a small increase in interest rates may "precipitate one through an overzealous hike in interest rates and reserve requirements. However, the main culprits are usually either a steep decline in the value of assets used by banks to secure collateral, an increased perception on the part of the financial system as a whole that particular banks or banks in general are at risk of insolvency, or both" (2009, p. 3).
In the most recent instance, a common theme that quickly emerges from the literature is greed on the part of lenders and mortgage companies seeking to maximize profits. These factors are frequently the end result of a long-term period of speculative and ill-conceived lending practices, and financial institutions and their stakeholders bear the brunt when subprime or speculative loans go unpaid (Thomas, 2009). Moreover, the same type of panic that causes runs on banks can cause multiple financial institutions to experience adverse effects, even those that practiced more stringent loan requirements. Thomas notes that "as the extent of the bad loans becomes known, a crisis of confidence in one or more banks arises. Banks in general will then reduce the availability of credit. They will stop loaning each other money to meet reserve requirements or for other purposes, because no one really knows how bad a bank's balance sheet will be six months from now" (2009, p. 4). In addition, many financial institutions adopt a "wait and see" attitude before returning to business as usual. As Thomas emphasizes, "Banks will also restrict loans to the public and to commercial enterprises in order to retain capital and shore up their balance sheets, and also because of an irrational 'snapback' response, from reckless lending to overly conservative lending" (2009, p. 5).
The basis for the current credit crisis can be directly traced to the 2006 subprime mortgage crisis that rocked the U.S. and then the rest of the world. The years prior to the crisis were marked by mortgage companies seeking to capitalize on the explosion in the U.S. housing industry, and real estate values skyrocketed in a number of regions to unrealistically high levels (Thomas, 2009). Mortgage companies ruthlessly competed with each other to maximize profits while conditions remained favorable, and these practices — combined with unsustainably high real estate values — ultimately broke the camel's back. As Thomas explains:
"Reckless lending to prospective home buyers grew to a widespread practice, injecting more capital into the real estate bubble and driving home values ever higher. In the meantime, a booming business in mortgage-backed securities had grown up. These securities were based on the payments from a package of mortgages bundled together, and traded around the world as foreigners invested in the U.S. housing market." (2009, p. 6)
The resulting downturn in the housing industry, together with interest rates that continued to creep upward, sounded the death knell of the real estate boom. Many Americans found themselves holding mortgages on homes worth far less than what they owed, and foreclosures skyrocketed as mortgage holders were unable to meet their obligations, leaving banks holding the empty bag. This trend ultimately affected the value of mortgage-backed securities and triggered a domino effect that extended around the world. According to Thomas, "As things became worse, banks became increasingly suspicious of each other, as no one could be sure what the value of these mortgage-backed securities were, or just how many of these 'toxic' securities were held by their colleagues" (2009, p. 5). As Thomas concludes, two primary external causes led to the current crisis: "Reckless lending practices and a crisis of confidence in financial institutions. The result was that, despite low interest rates, a general reluctance on the part of financial institutions to lend to anyone" (2009, p. 6).
"GDP slowdown, bank failures, and TARP response"
"EU and Russian economic effects and policy responses"
The research showed that the current credit crisis began in the third quarter of 2007 and continued to worsen over the next several months as financial institution after financial institution was forced to pay the price for speculative high-risk loans and subprime mortgage investments. This economic downturn was further exacerbated by high energy prices and decreases in demand for exports, though some countries managed to weather the downturn better than others, most notably China and Russia. The research also showed that the current credit crisis shares many characteristics that have marked previous depressions, including being the result of both external and internal factors that combined in ways regulators and investors were unable to foresee.
You’re 65% through this paper. Sign up to read the remaining 2 sections.
Sign Up Now — Instant Access Already a member? Log inAlways verify citation format against your institution’s current style guide requirements.