Unit 8 Economic dynamics: Financial and environmental crises

8.1 Collapse of Lehman Brothers (2007–2009)

asset

Something that is owned, and has value.

In the early morning hours of 15 September 2008, Lehman Brothers filed for bankruptcy after 164 years in business. Lehman’s owners had reaped extraordinary profits from the housing boom of the early 2000s, but a sharp downturn in house prices beginning in 2007 had generated substantial losses on its assets, which were ultimately linked to the price of houses. Three days earlier, New York Federal Reserve Chairman Timothy Geithner and US Treasury Secretary Henry Paulson had met with others at the New York Federal Reserve Bank to consider options.

liquidity, liquid, illiquid

An asset is described as liquid if it can easily be sold (exchanged for money). Savings at a commercial bank are highly liquid if you can instantly withdraw them in cash, but less so if you have to give notice to the bank several weeks or months before a withdrawal. Housing is a relatively illiquid asset (that is, not liquid): it can take months or even years to complete the sale of a house.

balance sheet

A record of all the current assets and liabilities, and the net worth, of an economic actor such as a household, bank, firm, or government. See also: net worth, liability.

equity

Shares (stocks) in a business are known collectively as equity. The total value of the equity held by the shareholders is equal to the net worth of the business, and an individual shareholder’s equity in the business is the total value of the shares they own. The term equity is also used more generally for a share of ownership of any asset, and for the net worth of any household, business, or project. There is a second entirely different use of the term, meaning fairness, as in ‘an equitable division of the pie’. See also: net worth.

This was a decisive moment for the global financial system. Like other banks, Lehman had suffered large losses on real estate investments. Its share price fell and short-term funding dried up. Because the market was not willing to roll over Lehman’s short-term debt, the bank faced a liquidity crisis within a very short period of time. Illiquidity describes a firm that has insufficient funds available to meet its debt obligations that are due. This can happen to a bank that in principle has a solid balance sheet, but struggles to secure enough liquid finances due to difficult market conditions. But Lehman was also insolvent: an insolvent firm has asset values which would not be sufficient to cover its outstanding debt. Hence, the valuation of its net worth (or equivalently, its equity capital) was negative.

At the time, Lehman was not viewed as ‘too big to fail’. In terms of its sheer size, it was considered of relatively little importance for the entire global financial system. Geithner and Paulsen decided not to organize a rescue for Lehman. The bank therefore went into regular insolvency proceedings. Yet it turned out it was ‘too connected to fail’ without devastating consequences for the global economy. Interconnectedness can take the form of direct links through lender–borrower relationships or indirect links through the prices of the same type of assets.

When Lehman filed for insolvency, financial market participants suspected that banks around the world with similar business models and interconnectedness could be in trouble. Even before Lehman failed, just as the global financial crisis unfolded, the leading French bank BNP Paribas announced on 9 August 2007 that it could no longer pay back its depositors, pointing to an entirely new problem for a bank: it had become impossible for them to value certain assets on their balance sheet. It dawned on people that the bank had no idea what their assets were worth.

This, in turn, provoked an unwillingness of banks to lend to each other, and the short-term funding banks required to function dried up. Hence, the Lehman failure triggered large-scale disruptions in the entire global financial system, threatening a cascade of bank failures around the world.

Banking crises have long-run consequences

Despite government attempts to prevent them, occasionally recurring banking crises are a characteristic of capitalist economies. And they can have long-lasting effects when compared with ordinary recessions. Banking crises usually result from a preceding pattern of growth that is built on excessive borrowing, which is often linked to housing. The global financial crisis, for example, which began in the US, was brought on by extraordinary household borrowing in the form of mortgages and by banks themselves borrowing huge amounts to make those loans to households.

The lasting impact of the credit boom and banking crisis in the US is clear from data on the growth of real GDP per capita. The data from 2000 is shown in Figure 8.1, where the vertical axis scale is a ratio scale (also termed a logarithmic scale). This means that the slope of a line is the growth rate of the series. The dashed line shows a constant growth rate equal to the average annual growth rate over the period 2000–2007.

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https://www.core-econ.org/macroeconomics/08-financial-environmental-crises-01-lehman-brothers-collapse.html#figure-8-1

Figure 8.1 US real GDP per capita (2000–2023), ratio scale.

Note: For each year in the blue shaded area, the shortfall of GDP per capita compared with its level had the economy grown in line with the trend from 2000–2007 is shown. The trend line uses previous peaks from 2000 to predict the next peak. This chart uses a ratio scale on the vertical axis, with GDP growing by 7% between each of the gridlines.

The shaded bars in the chart indicate recessions. A recession in the early 2000s was followed by the US housing credit boom. This credit-fuelled housing boom was unsustainable because of the lending and borrowing behaviour of banks. Banks lent to households who would be unable to meet their repayments and borrowed to fund this risky behaviour, believing that the government would bail them out if they were threatened with bankruptcy.

The housing credit boom was the precursor to the banking crisis in the US that led to the global financial crisis. For now, we draw attention to the fall in GDP per capita shown in the chart that occurred following the bankruptcy of Lehman Brothers, and the failure of output to return to the trend line over the subsequent years. The banking crisis appears to have had a long-lasting effect on US growth.

Figure 8.1 also shows that GDP fell by more in 2020 than it did in the financial crisis. The fall in 2020 was caused by the COVID-19 pandemic when much face-to-face economic activity ceased. But GDP bounced back very quickly to its previous level once the worst of the pandemic was over. It was a V-shaped recovery. It seems that it is not the size of the fall in GDP that determines its long-term effects, but the cause. What is it about banking crises that produces such lasting damage to the economy?

A recession caused by a banking crisis has long-lasting effects because it reduces the wealth of households, firms, and banks. These economic actors respond by saving more to repair their balance sheets, which reduces aggregate demand. The destruction of wealth in the banking crisis had more long-lasting economic effects than the threat to people’s health arising from the COVID-19 pandemic.

In the case of a bank, as explained in Section 6.4, if the value of its assets falls—as it does in a financial crisis—this shrinks the bank’s equity. With their damaged balance sheets, banks contract their lending and increase the cost of credit to borrowers in order to rebuild their net worth (equity). Less lending means less investment spending by firms.

wealth

The stock of things owned, or value of that stock; it may generate income, or contribute to the owner’s well-being in some other way; it includes the market value of a home, car, any land, buildings, machinery, or other capital goods that a person may own, and any financial assets such as shares or bonds. To calculate wealth, debts are subtracted—for example, the mortgage owed to the bank. Debts owed to the person are added.

marginal propensity to consume (MPC)

The change in consumption when disposable income changes by one unit.

Turning to households, the global financial crisis began with falling house prices, which reduced the wealth of households, leading to a long period of abnormally high savings as they sought to rebuild their wealth. Low-income households which had taken on mortgage debt in the run-up to the crisis were hit hardest. These households have the highest marginal propensity to consume (Unit 3), which explains the depth of the recession as they even cut back on spending on non-durable consumption goods. In short, households saved more and their demand for loans fell and in response the supply of loans by banks declined. When they occur together, high saving and low investment produce low growth.

And when a financial crisis is global, the effects of low aggregate demand at home are amplified because selling goods and services abroad is also harder than usual.

New problems require new tools: Economic dynamics

The concept of equilibrium plays an important role in economics. An equilibrium is self-perpetuating: in an equilibrium, none of those involved wish to change their behaviour. Away from equilibrium, actors will want to change their actions. Typically, disequilibrium is self-correcting: if a shock moves the economy away from equilibrium, buyers, sellers, or other actors will find it in their interest to act in such a way that will restore the equilibrium situation (even if this was not part of their intentions). This is why we say that an equilibrium is self-perpetuating.

For example, the multiplier model explains how a negative shock to business confidence (exogenous to the model) that leads firms to reduce investment produces a new equilibrium at lower output and employment as illustrated in Figure 3.15. The economy converges to the new equilibrium through successively smaller steps because the marginal propensity to consume is less than one. When aggregate demand recovers either because business confidence revives or because the policymaker uses monetary or fiscal stimulus (Section 5.4), the multiplier process explains how the economy returns to the previous level of output.

In microeconomics, in the model of a price-taking market such as the market for apples, if the price rises because of temporary bad weather putting apples in short supply, farmers’ response to the high prices will increase supply to the market (keeping fewer for cold storage) and the price will fall back to equilibrium. In both examples—the macroeconomy and the apple market—the economy converges to the equilibrium defined by the model. It will return to the equilibrium unless something outside the model changes.

But sometimes a disequilibrium situation is not self-correcting. Sometimes a disequilibrium creates forces that push the economy away from an equilibrium.

Consider the market for houses: if there is an upward blip in house prices, a self-correcting process would be a feedback mechanism that brings prices back down. For example, people might buy smaller houses or postpone buying. But, instead, an increase in the price of houses can produce a rise in the demand for houses if people think prices will be higher in the future. If the price were to be higher in the future, the house could be sold with a capital gain. So a rise in house prices may encourage rather than discourage house buying. This can lead to a runaway process of price increases taking the housing market further away from the initial equilibrium.

economic dynamics

Economic dynamics refers to the process of change in an economy, especially changes occurring when the economy is not in equilibrium.

If disequilibrium is not self-correcting, then we need to expand our toolbox so that we can understand not only equilibria, but also the processes of change that occur when the economy is not in equilibrium, termed economic dynamics.

In this unit, we explain what happens when the mechanisms that usually restore equilibrium instead work in reverse, so that the economy moves further away from the initial equilibrium. This allows us to consider the problem of instability—that is, a situation in which the structure of the economy makes it likely that we will experience unusual and possibly catastrophic out-of-equilibrium developments. Here we illustrate these disequilibrium processes by:

• the case of housing price booms and crashes that set off the global financial crisis
• the case of climate change via an acceleration of warming, and the disruption of life and livelihoods on the planet.