NATIONAL LAW UNIVERSITY

ASSIGNMENT WORK IN HISTORY OF ECONOMIC THOUGHT

TOPIC:
2008 FINANCIAL CRISIS

SUBMITTED BY: Samvid Shetty , B.A- L.L.B (Hons.)IIIrd SEMESTER

ROLL NO: 1238

TABLE OF CONTENTS
INTRODUCTION......................................................................................................................3
CAUSES OF THE CRISIS........................................................................................................4
HOW THE 2008 GLOBAL FINANCIAL CRISIS LED TO REVIVAL OF KEYNESIAN
ECONOMICS............................................................................................................................6
Background on Keynes..............................................................................................................6
Why did popularity of Keynes decrease?...................................................................................6
Displacement by Monetarism and New Classical economics....................................................6
Partial Return to Keynesian Economics.....................................................................................7
Proper Resurgence of Keynesian Economics.............................................................................8
HOW AUSTRIAN SCHOOL OF THOUGHT PREDICTED AND COULD HAVE
PREVENTED THE CRISIS....................................................................................................10
How they predicted the crises?................................................................................................10
How Recession could have been prevented.............................................................................11

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1. INTRODUCTION
The financial crisis of 200708, also known as the Global Financial Crisis and 2008 financial
crisis, is considered by many economists to have been the worst financial crisis since
the Great Depression of the 1930s1. It threatened the collapse of large financial institutions,
which was prevented by the bailout of banks by national governments, but stock markets still
dropped worldwide. In many areas, the housing market also suffered, resulting
in evictions, foreclosures and prolonged unemployment. The crisis played a significant role in
the failure of key businesses, declines in consumer wealth estimated in trillions of U.S.
dollars, and a downturn in economic activity leading to the 20082012 global recession and
contributing to the European sovereign-debt crisis2. The active phase of the crisis, which
manifested as a liquidity crisis, can be dated from August 9, 2007, when BNP
Paribas terminated withdrawals from three hedge funds citing "a complete evaporation of
liquidity".
The bursting of the U.S. (United States) housing bubble, which peaked in 20043, caused the
values of securities tied to U.S.real estate pricing to plummet, damaging financial institutions
globally4. Many major financial institutions such as Lehman Brothers and Meryll Lynch
collapsed which triggered a collapse in the stock market itself . Many other major financial
institutions such as American Bank and JP Morgan were on the brink of collapse and had to
be bailed out by the .US Federal Bank. Worldwide over $2 trillion dollars was pumped in by
central banks and governments around the world to revive the economy. Collapse of these
many major financial institutions triggered a liquidity crisis in the market which led to lack of

1Reuters.com<
http://www.reuters.com/article/pressRelease/idUS193520+27-Feb2009+BW20090227>, last viewed on 2nd October 2015.
2Brooklings.com<http://www.brookings.edu/~/media/Files/rc/papers/2009/0615_economic_c
risis_baily_elliott/0615_economic_crisis_baily_elliott.pdf>, last viewed on 4th October 2015.
3usgovcensus.org < https://www.census.gov/housing/hvs/data/charts/fig06.pdf>, last viewed
on 4th October 2015.
4 Pri.com,<http://www.pri.org/business/giant-pool-of-money.html>, last viewed on 3rd October 2015.

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money supply in the market which led to many businesses having to shut shop which led to
large loss of jobs and thus a substantive increase in unemployment.

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2. CAUSES OF THE CRISIS

2.1 Easy Availability of Credit
The immediate cause or trigger of the crisis was the bursting of the U.S. (United
States) housing bubble, which peaked in 2004, Already-rising default rates on "subprime"
andadjustable-rate mortgages (ARM) began to increase quickly thereafter. As banks began to
give out more loans to potential home owners, housing prices began to rise.
Easy availability of credit in the U.S., fueled by large inflows of foreign funds after
the Russian debt crisis and Asian financial crisis of the 19971998 period, led to a housing
construction boom and facilitated debt-financed consumer spending. Lax lending standards
and rising real estate prices also contributed to the real estate bubble. Loans of various types
(e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an
unprecedented debt load5.
2.2 Effects of such easy availability of credit
As part of the housing and credit booms, the number of financial agreements
called mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which
derived their value from mortgage payments and housing prices, greatly
increased. Such financial innovation enabled institutions and investors around the world to
invest in the U.S. housing market. As housing prices declined, major global financial
institutions that had borrowed and invested heavily in subprime MBS reported significant
losses6.
Falling prices also resulted in homes worth less than the mortgage loan, providing a financial
incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in
the U.S. continues to drain wealth from consumers and erodes the financial strength of
banking institutions. Defaults and losses on other loan types also increased significantly as

5Nytimes.com<,http://www.nytimes.com/2008/09/24/business/economy/24text-bush.html?
_r=2&pagewanted=1&oref=slogin>, last viewed on 2nd October 2015.
6
Bllomberg.com,http://www.bloomberg.com/apps/news?
pid=20601170&refer=home&sid=aGT_xTYzbbQE, last viewed on 3rd October 2015.
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the crisis expanded from the housing market to other parts of the economy. Total losses are
estimated in the trillions of U.S. dollars globally7.

2.3 Lack of Government Regulation

While the housing and credit bubbles were building, a series of factors caused the financial
system to both expand and become increasingly fragile, a process called financialization. U.S.
Government policy from the 1970s onward has emphasized deregulation to encourage
business, which resulted in less oversight of activities and less disclosure of information
about new activities undertaken by banks and other evolving financial institutions. Thus,
policymakers did not immediately recognize the increasingly important role played by
financial institutions such as investment banks and hedge funds, also known as the shadow
banking system. Some experts believe these institutions had become as important as
commercial (depository) banks in providing credit to the U.S. economy, but they were not
subject to the same regulations8.
2.4 Inability of Banks to absorb the losses
These institutions, as well as certain regulated banks, had also assumed significant debt
burdens while providing the loans described above and did not have a financial cushion
sufficient to absorb large loan defaults or MBS losses. These losses impacted the ability of
financial institutions to lend, slowing economic activity. Concerns regarding the stability of
key financial institutions drove central banks to provide funds to encourage lending and
restore faith in the commercial paper markets, which are integral to funding business
operations. Governments also bailed out key financial institutions and implemented economic
stimulus programs, assuming significant additional financial commitments.
The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It
concluded that "the crisis was avoidable and was caused by: widespread failures in financial
7Imf.org, < http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/exesum.pdf>, last viewed
on 3rd October 2015.
8
Newyorkfeed.org,
<http://www.newyorkfed.org/newsevents/speeches/2008/tfg080609.html>, last viewed on 4th
October 2015.
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regulation, including the Federal Reserves failure to stem the tide of toxic mortgages;
dramatic breakdowns in corporate governance including too many financial firms acting
recklessly and taking on too much risk; an explosive mix of excessive borrowing and risk by
households and Wall Street that put the financial system on a collision course with crisis; key
policy makers ill prepared for the crisis, lacking a full understanding of the financial system
they oversaw; and systemic breaches in accountability and ethics at all levels9.

3. HOW THE 2008 GLOBAL FINANCIAL CRISIS LED TO REVIVAL OF

KEYNESIAN ECONOMICS
To understand how Keynesian economics has become relevant again in the modern world we
have to first understand how Keynes first came to the forefront, what led to its demise the
first time and what has lead to its revival.
3.1 Background on Keynes
Keynes was the first economist to popularize macroeconomics and also the notion that
governments can and should intervene in the economy to alleviate the suffering caused by
unemployment. Before the Keynesian revolution that followed Keynes's 1936 publication of
his General Theory, the prevailing orthodoxy was that the economy would naturally
establish full employment. So successful was the revolution that the period spanning the
aftermath of World War II to about 1973 has been labelled the Age of Keynes. From the end
of the Great Depression until the early 1970s, Keynesian economics provided the main
inspiration for economic policy makers in Western industrialized countries10.
3.2 Why did popularity of Keynes decrease?
The stagflation of the 1970s, including Richard Nixon's imposition of wage and price
controls on August 15, 1971, and in 1972 unilaterally cancelling the Bretton Woods
system and ceasing the direct convertibility of the United States dollar to gold, as well as
the 1973 oil crisis and the recession that followed, unleashed a swelling tide of criticism for
9 FinancialTimes.com, <http://www.ft.com/cms/s/0/9c158a92-1a3c-11de-9f91-0000779fd2ac.html>,
viewed on 4th October 2015.

last

10 Mtpredictor.com, http://www.mtpredictor.us/1061/impact-of-quantitative-easing-on-thestock-market/, last viewed on 3rd October 2015.

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Keynesian economics, most notably from Milton Friedman, a leading figure of monetarism,
and the Austrian School's Friedrich von Hayek. This eventually lead to Keynesian economics
becoming less and less popular.

3.3 Displacement by Monetarism and New Classical economics

In 1976, Robert Lucas of the Chicago school of economics introduced the Lucas critique,
which called into question the logic behind Keynesian macroeconomic policy making and
leading to New classical macroeconomics. By the mid-1970s policy makers were already
beginning to lose their confidence in the effectiveness of government intervention in the
economy. In 1976 British Prime Minister James Callaghan went on record saying the option
of spending our way out of recession no longer exists. In 1979, the election of Margaret
Thatcher as UK prime minister brought monetarism to British economic policy. In the US,
the Federal Reserve under Paul Volcker adopted similar policies of monetary tightening in
order to squeeze inflation out of the system11.
In the world of practical policy-making as opposed to economics as an academic discipline,
the monetarist experiments in both the US and the UK in the early 1980s were the pinnacle of
anti-Keynesian and the rise of Perfect Competition influence. The strong form of monetarism
being tested at this time taught that fiscal policy is of no effect, and that monetary policy
should purely try to target the money supply with a view to controlling inflation, without
trying to target real interest rates; this was in contrast to the Keynesian view that monetary
policy should target interest rates, which it held could influence unemployment.
Monetarism succeeded in bringing down inflation, but at the cost of unemployment rates in
excess of 10%, causing the deepest recession seen in those countries since the end of the
Great Depression and severe debt crises in the developing world. Contrary to monetarist
predictions, the relationship between the money supply and the price level proved unreliable
in the short- to medium-term. Another monetarist prediction not borne out in practice was
that the velocity of money did not remain constant, in fact it dropped sharply. The US Federal
11Whatonedu.com,<http://knowledge.wharton.upenn.edu/article.cfm;jsessionid=a830ee2a1f1
8c5f62020347bf11442669617?articleid=2234>, last viewed on 2nd October 2015.
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Reserve began increasing the money supply above Monetarist-advised thresholds with no
effect on inflation, and discarded monetarism in 1984, and the Bank of England likewise
abandoned its sterling M3 money targeting in October 198512.
3.4 Partial Return to Keynesian Economics
By 1999, the 1997 Asian Financial Crisis and the harsh response by the International
Monetary Fund (IMF) had already caused free market policies to be at least partially
discredited in the eyes of developing world policy makers. The developing world as a whole
stopped running current account deficits in 1999, largely as a result of government
intervention to devalue their currencies, which would help build foreign reserves to protect
against future crises and help them enjoy export led growth rather than rely on market forces .[
But only after the dotcom bubble burst in 2000 that there was a significant shift away from
free market policies. In America there was a return by the Bush government to a moderate
form of Keynesian policy, with interest rates lowered to ease unemployment and head off
recession, along with a form of fiscal intervention with emergency tax cuts to boost
spending. In Britain, Gordon Brown as Chancellor had gone on record saying "the real
challenge was to interpret Keynes's insights for the modern world.
Yet American and British policy makers continued to ignore many elements of Keynesian
thinking such as the recommendation to avoid large trade imbalances and to reduce
government deficits in boom years. There was no general global return to Keynesian
economics in the first 8 years of the 2000s. European policy became slightly more
interventionist after the start of the 21st century, but the shift in a Keynesian direction was
smaller than was the case for the US and UK, however Europeans had not generally
embraced free market thinking as whole heartedly as had the Anglosphere in the 1980s and
1990s.Japan had been using moderate Keynesian policies in the nineties, and switched to neo
liberalism with the Koizumi government of 2001200613.
For the first half of the 2000s, free-market influences remained strong in powerful normative
institutions like the World Bank, the IMF, and in prominent opinion-forming media such as
12 Ibid.
13Projectsyndicate.org, < http://www.project-syndicate.org/commentary/bubble-trouble>, last
viewed on 3rd October 2015.
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the Financial Times and The Economist. The Washington consensus view that current account
imbalances do not matter continued even in the face of a ballooning US deficit, with
mainstream academic opinion only turning to the view that the imbalances are unsustainable
by 2007. Another notable anti Keynesian view that remained dominant in US and UK policy
making circles was the idea that markets work best if they are unregulated.
In the world of popular opinion, there had been an upsurge in vocal but minority opposition
to the raw free market, with anti-globalization protests becoming increasingly notable after
1998. By 2007 there had been bestsellers promoting Keynesian or at least pro mixed
economy policies: in the Anglosphere, Naomi Klein's The Shock Doctrine; in China and
south east Asia, Song Hongbing's Currency Wars.
In the academic world, the partial shift towards Keynesian policy had gone largely unnoticed.
3.5 Proper Resurgence of Keynesian Economics
In the wake of the financial crisis of 20072012 the free market consensus began to attract
negative comment even by mainstream opinion formers from the economic, leading to a
reassessment or even reversal of normative judgments on a number of topics. The Keynesian
view receiving most attention has been fiscal stimulus. Against the prevailing economic
orthodoxy at the time, then IMF managing director Dominique Strauss-Kahn had been
advocating for global fiscal stimulus from as early as January 2008.
Gordon Brown built support for fiscal stimulus among global leaders at September's UN
General Assembly, after which he went on to secure George Bush's agreement for the first
G20 leaders summit. In late 2008 and 2009 fiscal stimulus packages were widely launched
across the world, with packages in G20 countries averaging at about 2% of GDP, with a ratio
of public spending to tax cuts of about 2:1. The stimulus in Europe was notably smaller than
for other large G20 countries. Other areas where opinion has shifted back towards a
Keynesian perspective include:

Global trade imbalances. Keynes placed great importance on avoiding large trade
deficits or surpluses, but following the Keynesian displacement an influential view in the
West was that governments need not be concerned about them. From late 2008
imbalances are once again widely seen as an area for government concern. [35][36] In
October 2010 the US suggested a possible plan to address global imbalances, with targets

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to limit current account surpluses similar to those proposed by Keynes at Bretton Woods.
[37]

Capital Controls. Keynes strongly favoured the use of controls to restrain international
capital movement, especially short term speculative flows, but in the 1970s and 1980s
opinion among Western economists and institutions swung firmly against them. During
2009 and 2010 capital controls once again came to be seen as an acceptable part of a
government's macroeconomic policy toolkit, though institutions like the IMF still caution
against overuse.[38][39] In contrast to stimulus policies, the return to favour of capital
controls still had momentum as of late 2012.[40][41][42]

Skepticism concerning the role of mathematics in academic economics and in

economic decision making. Despite his degree in mathematics, Keynes remained
skeptical about the usefulness of mathematical models for solving economic problems.
Mathematics, however, became increasingly central to economics even during Keynes
career, and even more so in the decades following his death. While the resurgence has
seen no general reversal of opinion on the utility of complex math, there have been
numerous calls for a broadening of economics to make further use of disciplines other
than mathematics. In the practical spheres of banking and finance, there have been
warnings against overreliance on mathematical models, which have been held up as one
of the contributing causes of the 20082009 crises14.

4. HOW AUSTRIAN SCHOOL OF THOUGHT PREDICTED AND COULD

HAVE PREVENTED THE CRISIS
4.1 How they predicted the crises?
Countless economists who belong to the Austrian School of economics saw it coming.
Investment mavens Jim Rogers, Peter Schiff and James Grantall proponents of the Austrian
Schoolwere among the very few who predicted the economic meltdown. To understand
how they managed to predict the recession we have to look at the boom and bust cycle
propounded by the economists of the Austrian school of thought.

14
Pbs.org,
<http://www.pbs.org/wnet/wideangle/uncategorized/how-global-is-thecrisis/3543/>, last viewed on 4th October 2015.
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To explain the boom and bust cycle economist Peter Schiff draws a perfect analogy between
an artificial boom and a circus that comes to a small town for a couple weeks. During this
time, the circus attracts a large crowd, which is a boom to local businesses. Now imagine that
a local businessman mistakenly believes that the upturn in his business will endure
permanently. He then responds by greatly expanding his business by hiring new workers or
opening a second location. Ludwig von Mises called this malinvestment instead of
overinvesting. All is well until the circus leaves town and the businessman is left with a large
surplus of workers and capacity. He finds out he miscalculated when all the wasteful
malinvestments are exposed. This is an example of the boom and bust cycle15.
The last decade in America has been a textbook example of a boom and bust cycle. Between
2001 and 2004, the Federal Reserve injected new credit into the economy, pushing interest
rates to their lowest level since the late 1970s. As a result, the economy was booming just a
few short years ago. This sent out false economic signals to businesses with respect to
demand for their products. These businesses responded by hiring more staff, buying more
resources, investing in capital, and so forth.
If we have to look at it in figures then we can see that between September 2003 and
December 2007 United States had uninterrupted Job growth as well as the Dow Jones was at
an all time high in 2007 but as stated before the growth was fuelled by people taking on more
debt they could afford which led to them to default on their loans which eventually lead to the
recession.
4.2 How Recession could have been prevented
1) Raised interest rates. Austrians generally charge that central banks controlling fiat
currency are dangerous because they have strong temptations to run lax (i.e. inflationary)
monetary policy, which they believe leads to malinvestment in unprofitable sectors of the
economy. Fed funds rate were indeed kept very low for an extended period after the dot com
bubble burst.
2) Eliminated homeownership tax incentives. Most notably, they would recommend
eliminating the home mortgage interest deduction and related subsidies for home-ownership
versus renting. Such incentives further distort economic activity by making home ownership
artificially cheap relative to the true economic costs of constructing and maintaining homes
15Missies.org, < https://mises.org/journals/qjae/pdf/qjae13_1_1.pdf>, last viewed on 4th
October 2015.
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and using that land (as well as building roads, sewers, etc. to support new developments). On
their own distortionary tax incentives probably would not have caused a housing bubble but
they may have made an existing bubble worse by incentivizing buying houses by taking on
debt.
3) Ended

implicit

federal

guarantees

for

government-sponsored

mortgage

underwriters. Fannie Mae and Freddy Mac underwrote or guaranteed a large majority of
US mortgages; they also purchased a large number of mortgage-backed securities packaged
and sold by private underwriters. They were able to borrow money at very low rates to fund
these activities due to the expectation that the federal government would absorb losses if one
of the institutions found itself underwater. This made for even more easy money flow into
market.
4) Overhauled financial accounting, reporting, and oversight requirements. A common
media narrative is that the late 1990s were a period of "deregulation" of financial institutions.
In one sense this is true - the range of financial activities in which banks were allowed to
participate was broadened (e.g. through the repeal of Glass-Steagall, though that was a
symbolic move more than anything else). But in a broader sense it is false - the regulatory
structure was changed but not eliminated; and the presumption of federal oversight was still
very much there. Federal standards still dictated how profits and losses are recorded on
balance sheets, as well as what disclosures needed to be made to potential investors interested
in purchasing various financial products. Further, the SEC and CFTC monitored for financial
fraud. And for commercial banks, federal regulations dictated required capital ratios.
Austrians would argue this regulatory web led to a false sense of security - investors assumed
government regulations protected them, so they didn't dig deeply enough into balance sheets
and potential conflicts of interest. Austrians would prefer to strip away all such requirements
as much as possible (other than penalties for fraudulent statements) and force investors to
think for themselves about what information they need to make an informed decision; what
accounting standards they feel account for complex, often illiquid financial assets
appropriately; and what capital levels a safe bank should be holding. As one example,
Lehman might not have been able to use the "repo 105" maneuver to manipulate its financial
reporting. This would have led to much more caution in the markets
5) Eliminated the tax break on carried interest. "Carried interest" is the term used to
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describe profits accrued by investment managers from capital gains on their investments. As
has been well-publicized, these capital gains are taxed at 15% rather than the usual top
marginal rate of 35%. Austrians would argue that this distorted the labor market by
encouraging top talent to flock to private equity groups and hedge funds, and into the
financial sector in general. This "brain drain" would certainly have harmed other
"productive" sectors losing that talent at the margin, possibly leading to a slow-down in "real"
growth at the expense of paper financial gains. (I put terms in quotes because I want to avoid
an ideological stand on whether these assertions are correct.) It may also have encouraged
excessive speculation and risk-taking, as a swollen financial sector competed more fiercely
for profits with more clever and talented players. Some blame financial innovation in part for
the crisis. Austrians do not (they would say that the market should be free to produce and test
new ideas), but they would argue that distorted incentives led too many people to enter the
financial market and attempt to produce those innovations, with whatever consequences that
might have entailed when coupled with the other distortions named previously.
6) Ended an expectation of government support for the financial sector. Whether the
federal government can ever commit in advance to not bailing out troubled financial
institutions is a difficult question. However, if anybody could credibly commit to it, it would
have been the Austrians. If banks and lenders truly felt that the government would sit by and
allow the financial sector to collapse following a calamity, Austrians argue that they would
have behaved much more conservatively beforehand. If Lehman and Bear Sterns knew there
was going to be no government backstop, they would have not taken such large positions in
the mortgage market. Banks such as Lehmann Brothers were shocked when the government
decided not to bail them out16.

16 Supra at 15.
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