Did the financial crisis really start in late 2000?

However since 2000 economic growth was only possible with the help of low interest rates (way too low) and huge tax breaks. This delayed the financial crisis, because key financial indexes and commodity prices went up, enabling the investment banks to post staggering profits. But this growth wasn’t sustainable.

I think in the least the process of irresponsible leadership in the financial/borrowing sector began before that time….. Because coming into 2002 there were problems even before 9/12. the housing initiatives by the Bush government to lend to people who really had no business borrowing was part of the problem.

It is difficult to pinpoint the exact beginning of the subprime meltdown, however, I wouldn’t say that it began right after the burst of the IT bubble either. Also, the period from 1980 to 2000 was not “undeniably a period of economic boom”. As you mention, this was when we witnessed the burst of the IT bubble which was preceded by the savings and loans crisis of the 1980s.

Although interest rates and tax breaks are worthy of mentioning, it is important to note that asymmetric information and financial innovation piloted the economic expansion of this bubble rather than anything else. Before jumping into this particular situation, I feel that it is necessary to examine the dynamics underlying financial crises in general. Hopefully, this approach will illustrate the characteristics of the crises incurred during the 1980-2000 period as well.

Mishkin, and other notable economists, identifies three main stages that lead to the development of a full swing financial crisis. Such framework outlines the series of events that result in a collapse of a financial market.

First, the initiation of a financial crisis is primarily aroused by misconduct of financial liberalization/innovation, asset-price bubble, spikes in interest rates, and an increase in uncertainty. Abolition of regulation and the development of new technologies, if handled improperly, eventually lead to unwarranted risk taking. The financial institutions go into a period of credit boom where managers, who may not have the required expertise and knowledge to properly undertake operations in the new lines of business, rapidly extend their lending. Also, the existence of a government safety net further exacerbates the problem. It creates potential for moral hazard, a type of asymmetric information. With their deposits insured by the FDIC, the depositors will be less willing to monitor the activities of their banks and, thus, less willing to pull out their funds if the bank takes on excessive risk. Sooner or later, loan losses and defaults decrease the value of bank assets, in this manner reducing the bank’s net worth. An asset-price bubble is usually kicked off by a credit boom where large purchases of assets artificially bloat their prices. This is often followed by a realignment of prices to their true market value. The effect is a decline in net worth, a possible deterioration of financial institutions’ balance sheets, and a resulting increase in asymmetric information. Interest-rate volatility reduces the number of players who are good credit risks, thereby slowing down economic activity and leading to further asymmetric information problems. While these factors contribute to the overall increase in uncertainty, bank panics and the breakdown of important financial institutions also play a prominent role in this effect.

The uncertainty that plays into effect worsens banking conditions and leads investors to refrain from making potentially lucrative investments. Unsure of the bank’s health, the depositors begin to remove their funds from their banks. This triggers the second stage, known as the “banking crisis”. Due to asymmetric information, a collapse of one of the major banks can lead to a contagion effect. Hence, anxious depositors may begin to withdraw their funds from healthy banks because, in the view of a depositor, these banks are potentially prone to be next in the default line.

The final stage is labeled as “debt deflation” and is ushered in response to an unanticipated decline in the price level. This simultaneously decreases the net worth of financial institutions through an amplified burden of debt. Debt deflation was an especially prominent feature during the Great Depression and various financial crises abroad.

As you mention, we did enter a crisis around 2000 followed by the 2000-2001 recession, yet this was not the same crisis that erupted over us during the 2007–2008 period. The IT bubble and the expansionary boom of the 1990s were largely characterized by asset-price bubbles. Companies saw an almost instant increase in their stock prices as they added an e- before their name and/or a .com after, what later became known as “prefix investing”. Moreover, the subprime mortgage bubble began to originate not with George W. Bush implementing large tax cuts, but rather through financial engineering. (I hope that it will become somewhat easier to dissect the causes and the effects after having analyzed the underlying structure of U.S. financial crises.) As a result, innovation in computer technology enabled financial firms to perform statistical inference on a new level allowing for the lauded “democratization of credit”. This gave birth to subprime and alt-A mortgages and structured credit products such as collateralized debt obligations (CDOs). These financial innovations created undesirable levels of structural risk in asset management.

Along with cash inflow from emerging economies as India and China, these risky assets laid the foundation for the housing price bubble. The constantly appreciating prices allowed subprime customers to take out further loans on their houses and, since these houses served as collateral, the lenders were in no particular worry. Thus, the subprime market launched off. However, not everything was going great. The market, structured on an originate-to-distribute model, was heavily undermined by the principal-agent problem that created various conflicts of interest. For instance, the mortgage broker, paid through commission on each sale, had little incentive to make sure that the subprime customers were “good” credit risks. The selected customers were able to make profit if the housing prices appreciated and could just “walk away” if prices fell.

It became hopelessly difficult to determine the true market value of the various securities being traded, id est the collateralized debt obligations. Moreover, with the widespread decline in housing prices, these subprime customers found themselves no longer able to pay on their loans. As a result, the mortgage bubble burst in more than one million foreclosures and a rapidly spreading financial crisis leading to massive deterioration in banks’ balance sheets. Hence, I would say that the bubble was initiated around 2001 and further mismanagement oscillated the various problems arising. In effect, the financial crisis was not “delayed”, but rather just began spreading and coming into maturity years later.

I hope that the structural analysis laid forth helped you examine the crisis from a more analytic point of view. Good luck!