The 2008 Financial Crisis: How It Changed the World Forever and What You Need to Know Today
The 2008 Financial Crisis: How It Changed the World Forever and What You Need to Know Today
Have you heard of the financial crisis of 2007–08? How old were you when it happened? Did you know the crisis was so big that it made people think of the need for an alternative system of banking?
Yes, it was a devastating event. The economy of the entire world came to a standstill. Millions and millions of people, the world over, lost their jobs, their investments and their homes.
If you didn’t know what led to the crisis and why the rules of investing have changed, read on.
Early 2000’s — Centralised finance on high gear
In the late ’90s, the US economy was trying to get out of a downturn due to a stock market crash.
A lot of people had bought shares in tech companies. The share prices kept growing and growing for about 5 years till one day when it all crashed.
Then the terrorist attack on the World Trade Centre happened on September 11, 2001. This plunged the American economy into more trouble. So, the Central Bank of the US, the Federal Reserve (Fed), tried to revive the economy in the early 2000s.
This is the characteristic of a centralised financial system. The central bank of a nation takes decisions based on its own idea of how things ought to be. In a way, it can run the lives of the citizens.
If you’ve studied a little economics, you’ll know that for an economy to grow two things need to happen. People should buy more stuff and businesses have to produce more stuff and create jobs.
Fractional reserve banking allows banks to keep only a tiny portion of the money deposited in them and give away the rest as loans. So, by reducing the interest rate of borrowing, you can make loans attractive to people and businesses. This would naturally put money in the hands of people to spend and businesses to grow and expand.
Obviously, this is what the Fed did. It reduced the borrowing rates to a bare minimum persuading people to take loans.
Banks on high gear
As people take more loans, banks earn more interest. Banks sensed the opportunity and started making loans to anyone who walked in. Plus due to the relaxation of some lending norms banks didn’t care to check if the borrowers were creditworthy people who even bother to repay their loans.
All the focus turned to buying houses. Prior to this only trustworthy people with a good credit history could get loans. Hence buying a house was reserved for a select minority of the population.
Now, with lax regulation, banks dished out loans like a spray of bullets out of a machine gun. And all this was legitimate from the viewpoint of the Federal Reserve. The logic was that if people couldn’t repay, they could return the house they purchased and there won’t be a loss to the bank.
Consequently, the demand for houses skyrocketed and this in turn caused the prices of houses to shoot up. Banks had no problem lending more loans because they didn’t have to storehouse the entire amount of their deposits.
All these things turned into a dangerous cycle. Banks giving loans to people, people buying houses in hope that they could sell them off at higher prices and the prices of houses going up into space.
Banks on an even higher gear
Banks got greedier. If it wasn’t enough that banks were already making risky loans, they found a way to make even more loans.
Because the prices of houses were on the rise, banks started giving more loans on the same house. So now you could take a loan to buy a house and then use the house as collateral to take another loan!!!
The big crash — the big tragedy
Finally, the lending spree became unsustainable. People started defaulting on their loans because they were never creditworthy to start with. Banks couldn’t recover loan payments and started making huge losses.
Then the prices of houses dropped because now people were just returning the keys to the banks and walking away. There was an excess supply of houses and no one to buy them.
Next, the stock market collapsed. Investments of people came tumbling down and firms started laying off employees because they couldn’t pay salaries to them. So, many lost their livelihood and were pushed down into poverty.
Banks couldn’t bear the losses anymore and started to close down. Over 150 banks went bankrupt taking with them people’s money and the jobs of their employees. The crisis soon spread to Europe and then to the rest of the world.
Ultimately, it became the biggest financial crisis in almost eight decades since the Great Depression.
Nations that were exporting to Europe and the US suffered because there was no one to buy their goods. The crisis affected exchange rates too and several developing countries were hit.
Overall, the crisis completely shook the faith that humankind had in the financial system of the world.
Centralised finance tries to rescue
At the peak of the crisis, what did the Federal Reserve do? People were out of money. Firms were unable to pay their workers and meet their business expenses.
The Fed brought the interest rate of borrowing to almost zero making people take more loans. On the one hand, banks were closing down one after the other and on the other hand, people were being persuaded to borrow more.
The Fed also took over some of the large housing loan lenders and some very large banks were taking over the other ones and became even bigger! Basically, greedy lenders were rescued with tax payer’s money and the rich got even richer.
Central Banks exploit fiat money
Central banks did another very important thing that would make you question the very nature of money.
Money of the modern world is fiat money. This means that it has value only because the government says it has value. Money works based on the trust people have on the government and the central authorities. It’s not backed by any commodity.
Meaning, if you’ve a $100 note, it doesn’t mean the government has $100 worth of gold stashed away in the treasury. A $100 note has worth only because the government says so.
This makes it possible for central banks to print money whenever they want, how much ever they want. They can print money out of thin air and deposit it in other banks so that these banks can make loans on their deposits! And this is exactly what the Fed and other central banks did.
World over, more than $9 trillion was printed from 2008 to 2014 and deposited in banks in a bid to resuscitate and stimulate the economy to grow.
This form of money creation may be allowed as long as it resolves crises. Unfortunately, it comes with a terrible consequence — inflation. When money is created in this way by a central authority, it may seem like accounts are being settled on paper. But in reality, this will raise the price of goods and services drastically.
So your $1000 of today won’t buy you the same amount of stuff tomorrow. You’re now poorer even though you’ve $1000.
Nevertheless, this is how central banks all over the world dealt with the crisis. The period after 2008 was a difficult time for everyone. Somehow with no alternative option things did stabilise in the last decade until the pandemic struck.
Money printing to fire up after Covid19
The Coronavirus sprang out of nowhere and shut the whole world down. All business activity came to a standstill. People needed money but without work, everyone was hit.
To restart the economy what did the Fed and other central banks do? They gave tax cuts to people and businesses in hope that they’d spend their money and increase the demand for things. This would in turn push businesses to produce more stuff thereby getting the economy going again.
And of course, central banks printed money and put them as deposits so that everyone could borrow. Also, they reduced the interest rate of borrowing. There was no other option. Increase the money supply to make people spend.
What was the consequence? Inflation. Prices of goods and services increased due to the expanded money supply. Owing to this people’s savings have reduced in value and most of the world has made a loss. The sad part is, firms didn’t take loans as the central banks hoped. Now the world has gone into an economic downturn since the pandemic.
The effects of the pandemic and the measures that were taken to restart the economy will be felt in the coming years.
Cryptocurrencies: the solution to the mess
After the 2008 crisis, faith in the financial system dwindled. Too many people had suffered too much for no fault of theirs but due to the inherent flaw in the financial system and also the blunder made by central banks.
Money and the economy were controlled too much by central authorities and the government. If this continued there’d only be more crises. There was a need more than ever to relieve the financial system from the clutches of a few people in authority.
They may be honest people who genuinely seek the good of the population. But their hands are tied by the shortcomings of the system. Plus, they’re also capable of making mistakes which can be too big that they can make or break everything.
The answer to this came in the form of cryptocurrency.
What if money creation could be done in a scientific and rational manner and not at the whim of a few experts? What if the financial system could be changed to a trustless mechanism? You don’t have to trust the government to back the value of money. What if there was no central authority running the whole show? The entire system runs on a zero-bias, zero-guesswork platform.
These are all the things that cryptocurrencies do. In 2009 the first crypto, bitcoin, was introduced.
The trustless way of functioning happens through blockchain technology. Blockchain allows the data to be stored in such a way that all the information, every transaction, right from the year dot, is recorded and publicly accessible!
Blockchain allows you to buy and sell things using cryptocurrencies which are basically computer programmes. Instead of paying a seller in banknotes you just send them these programmes.
And whenever a new transaction happens on the blockchain new money is created and awarded to the person whose computer processed the transaction. So the money supply is increased in a stable way and technology runs the entire show.
You too can earn cryptocurrencies if you get those special computers and connect to the blockchain network. That’s why the system is decentralised.
Money runs on technology. Money is created and given to those offering processing power to the network. And anyone on the network can buy and sell without any hassle.
The government cannot increase the money supply and make banks give loans. Consequently, even banks become redundant because on a blockchain you can borrow directly from a lender rather than going to the bank. So you eliminate the commission you pay to banks. Here you can see the idea of a decentralised financial system (DeFi) taking root.
Perhaps now how the 2007 crisis and the efforts taken by central banks have led the world to exasperation.
With the advent of DeFi the current investment environment is drastically different from the world prior to cryptos.
As an investor, you need to consider this paradigm shift in the world of finance. A lot of rules of traditional investing are going to break down with DeFi.