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Why did the economy crash in 2008?

Updated on :  

08 min read.

All of us are aware of the financial crisis, also known as the recession, that occurred in 2008.

The Global Financial Crisis of 2008 is widely regarded as the worst financial catastrophe since the 1930s Great Depression.

It started in 2007 with the subprime mortgage crisis in the United States. The collapse of the major investment bank Lehman Brothers on September 15, 2008, developed into a full-fledged international banking crisis.

Origin of crisis

The collapse of the US housing bubble, which peaked in FY 2006-2007, was the primary and immediate cause of the financial crisis.

But it all began after the terrorist attacks of September 11, 2001. As a result of the US economy entering a recession, the Federal Reserve System (Fed) reduced its interest rate to 1%.

Since 1% is such a low-interest rate, fixed income investors who used to buy US Treasury bills became dissatisfied with the rates they were receiving and began searching for other investment options.

Investment banks in the United States became aware of the situation and began to apply some of their financial wizardries to mortgages.

Mortgages were first securitised into Mortgage-Backed Securities (MBS), a form of asset-backed securities, by investment banks in the United States.

An MBS is a series of various mortgages geographically scattered to increase diversification and thereby lower risk.

Investment banks use MBS to keep future returns from such investments as high as possible while lowering risk.

World-wide effects

Almost no nation in the world, developing or developed, has been spared the effects of the US financial crisis.

In August 2007, it became clear that the stock system alone could not overcome the US subprime crisis, and the problems had spread beyond the country’s borders.

The inter-banking market fully shut down, owing to widespread fear of the unknown among banks worldwide.

Due to a liquidity shortage, Northern Rock, a British bank, had to approach the Bank of England for emergency funding.

At that time, central banks and governments all over the world had begun to band together to avert a global financial crisis.

At the end of 2008, all of the world’s major economies were either in or fighting to stay out of recession.

The World Bank predicts a 0.9 per cent rise in global economic activity in 2009, the slowest growth rate since records began in 1970.