Page 27 - Accelerating out of the Great Recession

ACCELERATING OUT OF THE GREAT RECESSION

in the pressure to deleverage. When this led to a further decline
in asset prices, the whole cycle repeated itself.
It was inevitable that such enormous financial dislocation would
lead to significant collateral damage to the real economy. Falling
asset prices and the prospect of an economic slowdown dented
consumer confidence. Lower demand and a shortage of credit—
because of the liquidity squeeze—combined to drive companies
toward conserving cash, reducing output, lowering capital expen-
diture, and laying off workers. Small and medium-sized enterprises
were particularly affected as banks cut back their lending in an
effort to stabilize their balance sheets, which, in turn, made a bad
situation worse and drove some companies into bankruptcy.
The bottom line: the subprime crisis led to a solvency crisis
in the financial sector. This, in turn, led to a recession in the real
economy, which further amplified the problems for the finan-
cial sector as credit losses increased. And as losses continue to
increase and credit tightens, the constraints in the financial sys-
tem collide with an increasing number of personal and corpo-
rate loan defaults that naturally follow when economic condi-
tions deteriorate. The two cycles feed off each other.
If there is one phenomenon that best characterizes the irra-
tional behavior that underpins the crisis, it is the history of home
values in the United States. As Robert Shiller, an economics
professor at Yale University, has demonstrated, U.S. house prices
in any given year up to 1997 had virtually always been within
about 15 percent of house prices in 1890, when adjusted for
inflation (the only exception being the 25 percent drop between
the two world wars). In 1997, though, U.S. house prices started
to rise dramatically. In just 10 years, the inflation-adjusted price
of a U.S. house doubled. In 2006, at the peak of the bubble,
Shiller’s index reached 202.9 (in 1890, the index stood at 100). 2

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