VoxEU Column Financial Markets

Reflections on the International Dimensions and Policy Lessons of the US Subprime Crisis

We may just have started to feel the pain. Asset price drops – including housing – are common markers in all the big banking crises over the past 30 years. GDP declines after such crises were both large (-2% on average) and protracted (2 years to return to trend); in the 5 biggest crises, the numbers were -5% and 3 years. This column, based on the author’s testimony to the Congress, picks through the causes and consequences. It argues that when it comes to ‘cures,’ it would be far better to get the job done right than get the job done quickly.


“There is nothing new except what is forgotten.” - Mlle. Rose Bertin

The financial press has often characterised the 2007-2008 United States subprime mess as a new breed of crisis. Indeed, this view often points to the international repercussions of the US-based crisis as evidence that the globalization of financial portfolios has introduced brand-new channels for spillovers.  At present, there is also considerable confusion in academic and policy circles as to whether the shaky predicament of the global economy owes to contagion or to shared (common) economic fundamentals. I address these issues, in turn, and discuss some of the questions, as regards regulation of financial institutions, that the current crisis has raised.


Financial Crisis: the setting

Across countries and over the centuries, economic crises of all types follow a similar pattern. An innovation emerges.  Sometimes it is a new tool of science of industry, such as the diving bell, steam engine, or the radio.  Sometime it is a tool of financial engineering, such as the joint-stock company, junk bonds, or collateralised debt obligations.  Investors may be wary at first, but then they see that extraordinary returns appear available on these new instruments and they rush in.  Financial intermediaries—banks and investment companies—stretch their balance sheets so as not to be left out. The upward surge in asset prices continues, and that generation of financial market participants concludes that rules have been rewritten. Risk has been tamed, and leverage is always rewarded.  All too often, policy makers assert that the asset-price boom is a vote of confidence for their regime—that “this time is different”. Seldom, to my knowledge, do they protest that perhaps the world has not changed and that the old rules of valuation still apply.

But the old rules do apply. The asset price rise peters out, sometimes from exhaustion on its own or sometimes because of a real shock to the economy. This exposes the weaknesses of the balance sheets of those who justified high leverage by the expectation of outsized capital gains. Many financial firms admit losses, and some ultimately fail. All those financial firms hunker down, constricting credit availability in an effort to slim their balance sheets. With wealth lower and credit harder to get, economic activity typically contracts. Only after the losses are flushed out of the financial system and often with the encouragement of lagging monetary and fiscal ease does the economy recover.

The role of the real estate market

This sorry spectacle repeats itself in the various types of crises, but the most relevant to the present situation is the aftermath of banking crises. In recent work with Kenneth Rogoff, I documented eighteen such episodes in industrial economies over the past thirty years.  Declines in assets, including those of both houses and equities that the US has experienced over the past year, are common markers of the onset of banking crises. In the worst five banking crises (The Big Five) in industrial countries over the past thirty years, the value of houses fell about 25 percent on average from their peak (Figure 1)

Sources: Reinhart and Rogoff (2008) and sources cited therein
The fallout of banking crises

The cautionary lesson for today’s situation in the United States is that the decline in output after a banking crisis is both large and protracted (Figure 2). The average drop in (real per capita) output growth is over 2 percent, and it typically takes two years to return to trend. For the five most catastrophic cases, the drop in annual output growth from peak to trough is over 5 percent, and growth remained well below pre-crisis trend even after three years.

Sources: Reinhart and Rogoff (2008) and sources cited therein.

The international repercussions of the US crisis: contagion or confusion?

Swift international spillovers are not a new phenomenon. In this regard, the panic of 1907, which began in the US and quickly spread to other advanced economies (particularly, Denmark, France, Italy, Japan, and Sweden), serves as an illustrative historical benchmark for modern-day financial contagion. Like in the present episode, emerging markets were mostly spared in 1907; the only casualty in that episode was Mexico.

There is little doubt that the US crisis has spilled over into other markets. Two major advanced economies, Japan and Germany, have been singled out by the financial press as being particularly hard-hit. There is no denying that German and Japanese financial institutions sought more attractive returns in the US subprime market, perhaps owing to the fact that profit opportunities in domestic real estate were limited at best and dismal at worst (Figure 3). Indeed, after the fact, it has become evident that financial institutions in these countries had nontrivial exposure to the US subprime market.  This is a classic channel of transmission or contagion, through which a crisis in one country spreads across international borders. In the present context, however, contagion or spillovers are only a part of the story

If other countries are experiencing economic difficulties at the same time as the US, it is due to the fact that many of the features that characterised the run-up to the subprime crisis in the US were also present in many other advanced economies. Specifically, many countries in Europe and elsewhere (New Zealand, for example) were having their own home-grown real estate bubbles (Figure 3). This, in and of itself makes, these countries vulnerable to the usual nasty consequences of asset market crashes—irrespective of what may be happening in the United States. This cannot be pinned on the US subprime fiasco or on contagion. The odds of a correction were already present.  

Sources: Shiller, and Bank of International Settlements.
Policy Lessons: the banana republic approach to banking supervision

As Venezuela’s worst banking crisis unfolded in 1994-1995 (conservative estimates of the bailout costs of that crisis are at around 18 percent of GDP), no one in that country seemed to know whose responsibility it was to supervise the financial institutions. As is usual in most banking crises, lending standards had become lax, there was interconnected lending, and there was plenty of plain old-fashioned graft. The central bank blamed the main regulatory agency (SUDEBAN), the regulatory agency blamed the deposit insurance agency (FOGADE), and everyone else blamed the central bank.

At the time of that crisis, the received wisdom was that such supervisory disarray could only happen in an emerging market; advanced economies had outgrown such chaos. We now know better.

For starters, part of the supervisory responsibilities in the US is delegated to the states, which is to say that 50 emerging markets agencies were partially responsible for the oversight of real estate lending. Supervisors failed to caution depositories as they offered potential borrowers unsuitable mortgages.   They also acquiesced as complicated structures were booked off the balance sheet, even though, in the event, they were not treated as such by corporate headquarters at the first sign of stress. And after the fact, they have pointed to the other guy as responsible for the problem. 

In the private sector, mortgage brokers often sought no more assurance of future repayment than a signature. That act of faith was made easier because their own compensation came from originating loans rather than how the loans played themselves out. And underwriters took that raw material of mortgages and somehow convinced themselves that the law of large numbers would make the whole better than the sum of its parts, even though many of those pieces needed double-digit house price growth to make economic sense. Credit rating agencies, encouraged by their own fee structure, listened attentively to underwriters’ assurances of the power of pooling and their ability to predict despite a limited track record. And final investors substituted the judgment of the rating agencies for their own due diligence, perhaps abetted by regulation and accounting rules that imparted special significance to those judgments.

No doubt, change is needed in both the private and public sectors. My immediate fear is that, as in most prior episodes, the initial reaction will be overdone and inefficient. Financial institutions are already tightening the terms and standards for new lending at a ferocious clip. Rating agencies, following their pro-cyclical tendencies, will overreact as well in the effort to distract the investing public from their laxness of the past few years by strict standards going forward. Similarly, bank examiners will interpret the regulations narrowly, reinforcing the natural tendencies of depositories to tighten credit availability. 

And last but not least, politicians have already turned their focus toward the financial industry. If the regulation of financial institutions needs to be revisited, there are compelling arguments to pare the multitude of regulators of depository institutions and insurance companies and to restructure the supervision of rating agencies. But the outcome of hurried debate in the heat of the moment is more likely to be legislative overreach than informed policy making. It would be far better to get the job done right than get the job do

Michael D. Bordo ( 2007), “The Crisis of 2007: The Same Old Story Only the Players have Changed”. At Michael Bordo’s webpage.

Carmen M. Reinhart and Kenneth S. Rogoff (2008), “Is The 2007 U.S. Subprime Crisis So Different? An International Historical Comparison,” forthcoming in American Economic Review, May.


The Five Big Five Crises: Spain (1977), Norway (1987), Finland (1991),Sweden (1991) and Japan (1992), where the starting year is in parenthesis.

Other Banking and Financial Crises: Australia (1989), Canada (1983), Denmark (1987), France (1994), Germany (1977), Greece (1991), Iceland (1985), and Italy (1990), and New Zealand (1987), United Kingdom (1974, 1991, 1995), and United States (1984).


See , Reinhart and Rogoff (2008).

Owing to the opaqueness of balance sheets in many of these financial institutions in these countries the full extent of exposure is, as yet, unknown.

Superintendencia de Bancos y Otras Instituciones Financieras (SUDEBAN) ; Fondo de Garantías de Depósitos y Protección Bancaria (FOGADE) .


See Carmen M. Reinhart (2002), “Sovereign Credit Ratings Before and After Financial Crises,”  and other chapters in Richard Levich, Giovanni Majnoni, and Carmen M. Reinhart, eds. Ratings, Rating Agencies and the Global Financial System, (New York: Kluwer Academic Press, 2002).

See Richard Portes (2008) “Rating Agencies Reform” http://www.voxeu.org/index.php?q=node/887 

for an insightful discussion.

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