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Economic Monthly Report

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From subprime mortgages to a world recession: two anxious years

Tue, Jul 21 2009, 12:20 GMT
by La Caixa Economic Research Dept.

La Caixa

In the summer of 2007, just two years ago, it became clear that a small segment of the US mortgage market, subprime mortgages, was presenting a disturbing anomaly. With the real estate recession already under way and interest rates that had gone up relatively fast, it was no wonder there was a notable increase in default of such mortgages that had been granted to customers of doubtful solvency. The most troubling was that this phenomenon quickly set off a chain reaction in terms of risk aversion, a collapse of liquidity and widespread distrust that put the financial system on the edge of an abyss. This affected not only the United States but also Europe and Asia.

As the public has become aware of the series of errors, incompetence and even rather unethical behaviour that led to the present financial crisis, it has become possible to understand the phenomenon and move on to the design of mechanisms to avoid any repetition. To some extent, the origin of the disaster has a lot to do with the dynamic of bubbles, both real and financial. A very long period of easy monetary policies, which sharpened with the dot-com crisis in 2000 and the terrorist attacks in 2001, set the bases for a liquidity bubble along with an expansionist credit bubble that led to exceptional world growth in the period 2003-2007. This growth rested on very weak bases and was boosted by low interest rates and over-leveraging of the private sector along with persistent world imbalances. Prudence was greatly eased and investors ignored risk more and more. It was claimed that economic cycles had passed into history and it seemed that the good times would last forever.

As often happens in times of excessive speculative euphoria, a quite banal event, on this occasion the matter of subprime mortgages, suddenly turned around the trend, emphasizing the fragility of the financial system and the excesses that had taken place. It was only a relative surprise. Year after year, the Bank for International Settlements had been warning of the risks facing the international economy. Nearer home, the Bank of Spain had repeatedly warned of the excesses in the real estate sector. However, if a posteriori it is tempting to point to possible culprits and lay blame, when a bubble is in full swing and irrational exuberance is the order of the day, going against the current becomes a thankless task.

The crisis puts in question many important principles that up until now have been considered as givens as, for example, the degree of regulation and supervision that should be applied to the financial system or, on the other hand, the degree of self-regulation that is acceptable. The paradigm of the efficiency of the markets, the standard of inversion models based on pure rationalism, stands in doubt. The response to the financial crisis also raises major questions. The initial reaction of economic policies, the massive injection of government funds into the economy, is not without its risks. The rapid worsening of the public sector accounts threatens the stability of the economy and could mean a serious problem if recovery is not rapid. International coordination, both in the financial sphere and the real economy, could be greatly improved. Meanwhile, the crisis continues. The worst is probably behind us but one has to be very optimistic to believe that the road ahead is clear. The times of anxiety may perhaps be over but the days of tranquillity are not yet in sight.

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Published on  Tue, Jul 21 2009, 12:25 GMT