Opening
HOST
Welcome back. Today we are on two great shocks to the world economy: the financial crisis that began in 2007, and the Covid-19 pandemic. Let's start with a puzzle.
ECONOMIST
After 2005, U.S. house prices fell by more than a third, even after taking out the general rise in prices. Compared with the wealth of the whole country, the losses on home loans were small. Yet by the autumn of 2008, some of the biggest financial firms had failed or needed a rescue.
HOST
And twelve years later came the pandemic.
ECONOMIST
Yes. In the spring of 2020, output, meaning everything the economy produces, fell further and faster than in 2008. But this time, output came back within about a year, and jobs within a little over two years.
HOST
So here is today's question. How did a fall in house prices break the banks, and how was the pandemic slump different?
ECONOMIST
A slump, or a recession, is a time when output and jobs fall. The one after the financial crisis is called the Great Recession. By the end of this episode, you'll be able to do three things. First, describe how the crash of 2007 to 2009 shows up in house prices, an interest rate, the fear between banks and the stock market. Second, explain why a bank that borrows most of its money can be wiped out by a small fall in what it owns, and how the damage spreads. Wiped out means the owners lose all their money. Third, explain why the pandemic slump, the deeper of the two, cost less output in total.
HOST
And we'll follow the chapter's mind map part by part?
ECONOMIST
Yes. Part one tells the story of the crash, part two looks inside a bank, and part three compares the two recessions. Each part has four or five leaves, small topics we take in order.
The crash of 2007–09
HOST
Part one of the map: the crash of 2007 to 2009. The first leaf is real house prices. Why real?
ECONOMIST
Real means adjusted for the general rise in prices: we divide house prices by the level of consumer prices. U.S. house prices rose fast, to a peak in December 2005. From there to February 2012, they fell by 35.7 percent, the largest fall since 1953, when our data begin.
HOST
So the rise before it was a bubble?
ECONOMIST
Many economists call it that: prices rise far above what can last, because buyers expect them to keep rising.
HOST
Next leaf: the Fed rate. Who is the Fed?
ECONOMIST
The Federal Reserve, the central bank of the United States. Its main tool is the Fed funds rate, the interest rate that banks charge one another for overnight loans. In 2004, it was low, about 1 percent.
HOST
And then it went up?
ECONOMIST
Step by step, to above 5 percent in 2006. So home loans, called mortgages, got more expensive. Many borrowers had mortgages whose low starting rate later jumped. More of them stopped paying, which is called a default. Defaults pushed house prices down, and lower prices led to more defaults.
HOST
So the Fed raised rates just as house prices peaked. And after the crash?
ECONOMIST
It cut the rate, and quickly. By December 2008, the rate was close to zero, and it stayed there for seven years.
HOST
Next leaf: the TED spread. That sounds technical.
ECONOMIST
It's a measure of fear. A spread is a gap between two interest rates. This one is the rate banks charged one another for three-month loans, minus the rate on safe three-month loans to the U.S. government, called Treasury bills. So the gap is the extra interest banks asked for, in case the borrowing bank failed.
HOST
How big was the gap?
ECONOMIST
Before 2007, it was small and calm: about 0.33 percentage points on average. A percentage point is the plain difference between two rates, so that's about a third of one percent of interest.
HOST
And in the crisis?
ECONOMIST
The spread jumped in the summer of 2007, when banks first began to doubt one another. In October 2008, it reached 3.35 points, ten times its calm level.
HOST
What happened just before that peak?
ECONOMIST
In September 2008, the financial giant Lehman Brothers went bankrupt. No bank knew which banks held the bad mortgages. It was like ten bottles of water with one poisoned: if nobody knows which one, nobody drinks.
HOST
The last leaf of this part: the real S and P 500.
ECONOMIST
It's an index, one number that follows the stock prices of 500 large U.S. companies, again divided by consumer prices. From its peak in 2007, it fell by 51.7 percent. That's about half.
HOST
About half. Then I'd guess a rise of about 50 percent brings it back.
ECONOMIST
That's the natural guess, but it's wrong. Say a stock is worth 100 and falls by half, to 50.
HOST
So to get back to 100, it must gain 50.
ECONOMIST
Right, and 50 is as big as everything that is left. So the stock must double: a rise of 100 percent, not 50.
HOST
And the real fall was a bit more than half.
ECONOMIST
So it needed a bit more than a doubling, a rise of about 107 percent.
HOST
But stocks had crashed before. Why was this crash so dangerous?
ECONOMIST
The crash of 2000 to 2003 was almost as deep. But it caused no banking crisis, because its losses fell on shareholders who had not borrowed. In 2008, the losses fell on banks that held many mortgages and had borrowed heavily.
HOST
So in part one we saw the trouble start in housing, spread as fear between banks, and hit the whole stock market. And unlike in 2000, the losses landed on banks that had borrowed most of their money.
ECONOMIST
Exactly. Next branch: why those banks broke.
Why a housing bust broke banks
HOST
Part two of the map: Why a housing bust broke banks. A bust is a sudden fall in prices. The first leaf says that assets equal debt plus equity, and it defines leverage.
ECONOMIST
These are the words of a balance sheet, which lists what a bank owns, its assets, like loans, and what it owes, its debts, like deposits. Equity is the assets minus the debts: the owners' own money in the bank, also called net worth or capital. Careful: here capital means money, not machines.
HOST
Can we make that concrete?
ECONOMIST
Take Islandia, the imaginary island country we use as our example. Its biggest bank owns 2,000 billion dollars of assets. It owes 1,800 billion. So its owners' money is 200 billion.
HOST
And leverage?
ECONOMIST
Leverage is the debt divided by the owners' money. Here, that's 1,800 divided by 200, which is 9.
HOST
So of every 10 dollars the bank owns, 9 are borrowed and 1 is the owners'. Next leaf: the percent change in equity equals the sum of one and leverage, times the percent change in assets. In plain words?
ECONOMIST
Leverage makes gains and losses bigger for the owners. The bank owes the same amount whatever its assets are worth, so every dollar gained or lost goes to the owners. Say the assets rise in value by 1 percent.
HOST
1 percent of 2,000 billion is 20 billion.
ECONOMIST
And all of it goes to the owners, who had 200 billion. So their money grows by 10 percent. That's ten times as much, because the assets are ten times the owners' money: nine borrowed dollars plus their own one. That's the sum of one and leverage, and it works for losses too.
HOST
Next leaf: the fall that wipes out the owners, one divided by the sum of one and leverage. How big a fall makes a bank fail? I'd guess it has to lose something like half of what it owns.
ECONOMIST
That's the tempting answer, but the true number is far smaller. Let's build that number step by step. Islandia's bank has assets of 2,000 billion, and its owners can take a loss of up to their 200 billion. What share of the assets is that?
HOST
One tenth. So 10 percent.
ECONOMIST
Right. A 10 percent fall in the assets is a loss of 200 billion, exactly the owners' money. So a fall of 10 percent wipes the owners out. Any bigger fall makes the bank insolvent: its assets are worth less than its debts.
HOST
So the fall that wipes them out is just the owners' share of the assets.
ECONOMIST
Yes. Here it's one tenth: one divided by 10, and 10 is the sum of one and the leverage of 9.
HOST
And the 2.8 percent on this leaf?
ECONOMIST
That's Bear Stearns, a large U.S. investment bank that collapsed in the crisis. Its leverage was about 35.
HOST
So one plus 35 is 36, and the owners' money was one part in 36 of the assets.
ECONOMIST
Exactly, about 2.8 percent. A fall that small was enough to wipe out its owners.
HOST
Next leaf: for every 1 dollar lost, the bank must sell as many dollars of assets as its leverage. Why must it sell?
ECONOMIST
After a loss, the owners' money is smaller, so leverage jumps. The bank, or its regulators, the agencies that set rules for banks, want it back down. More leverage means a thinner cushion, that is, less owners' money to take losses. Say Islandia's bank loses 10 billion and can't find new owners' money. Its owners now have 190 billion. To keep the old leverage, its assets can be only ten times that: 1,900 billion.
HOST
But it started with 2,000 and lost only 10, so it still holds 1,990. That's 90 too many.
ECONOMIST
Right. So it must sell 90 billion and repay debt. If every bank does this at once, they all sell the same assets in a hurry, at low prices. That's a fire sale. Prices fall, the banks lose again, and they must sell again.
HOST
And a bank run? I'd assume a bank that faces a run must have made bad loans.
ECONOMIST
A lot of students think that, but it isn't always true. In a run, many depositors want their money back at once. The bank has little cash, so it must sell loans in a hurry, at a discount, and each sale costs the owners money. So even a healthy bank, one whose loans are good, can fail. The first people in line get paid, and the last may not, so if you think others will run, you run too.
HOST
Last leaf of this part: the spread is roughly equal to the probability of default. Is that our TED spread again?
ECONOMIST
Yes. Probability means chance. A lender can buy a safe Treasury bill, or lend to a bank that might fail. Say it expects 3 out of every 100 such banks to fail and repay nothing. Then it lends only if the loan pays about 3 points more than the bill.
HOST
So the spread shows how likely lenders think a failure is. Before 2007, a third of a point meant a risk of a third of one percent.
ECONOMIST
Exactly, per year. At the peak in October 2008, lenders saw a risk of about 3 percent a year, ten times as much. That's why we call the spread a thermometer of fear.
HOST
So in part two we saw that a bank owns a big pile of assets, paid for mostly with debt. The owners' money is a thin layer on top, the cushion. A small fall in the value of the pile wipes out that layer, and then losses force sales.
ECONOMIST
Exactly. Next branch: what all this did to jobs and output, and how the pandemic was different.
Two recessions compared
HOST
Part three of the map: Two recessions compared. The first leaf gives two numbers for the United States: 1 in 306 died, and a GDP loss of 3.3 percent of a year's output.
ECONOMIST
When the virus spread, governments closed shops and schools, and people stayed home out of fear. On Islandia, it shut the shops and the ferries for a season. By March 2023, about 1 in every 306 Americans had died of it.
HOST
And how do we measure the GDP loss?
ECONOMIST
GDP is a country's total output. Start from GDP at the end of 2019, just before the virus. Add up the output lost in each quarter, or three months, until GDP is back at that old level. Compare the total with one year's GDP. If output stayed 4 percent below for a whole year, the loss would be 4 percent of a year's GDP.
HOST
I'd guess countries with more deaths per person also lost more output. More deaths, more fear, more closed shops.
ECONOMIST
That's a reasonable guess, but the data show almost no link. Spain lost the most output, about 17 percent of a year's GDP, but other countries had more deaths. The United States had many deaths, but lost only 3.3 percent. Deaths depended more on health systems and age, and lost output depended more on lockdowns and government support.
HOST
Next leaf: jobs.
ECONOMIST
In the Great Recession, the United States lost 8.7 million jobs. In the pandemic, it lost 21.9 million, more than twice as many, in just two months.
HOST
So which took longer to get the jobs back? My guess is the pandemic. A bigger hole takes longer to fill.
ECONOMIST
That's the natural guess, but the opposite is true. After the Great Recession, it took 77 months, more than six years, from the old peak until jobs were back at that level. After the pandemic, it took only 28 months, a little over two years.
HOST
Why so different?
ECONOMIST
A likely reason links to part two, though it's an interpretation. After 2008, banks and families spent years repaying debts instead of lending and spending. In 2020, few balance sheets were broken, and many jobs were only paused.
HOST
Next leaf: short-run output. Remind me what that is.
ECONOMIST
Potential output is what the economy would produce with its workers and machines in normal use, and it keeps growing. Short-run output is the gap between actual GDP and potential, in percent. In the Great Recession, output fell to about 5 percent below potential. It stayed below potential for most of the years from 2010 to 2019.
HOST
And in the pandemic?
ECONOMIST
It fell to 8.8 percent below potential, but it was back above potential within about a year.
HOST
Then the pandemic slump must have cost more output in total. It was deeper.
ECONOMIST
That's what most people guess, but the total depends on depth and length together. The Great Recession was a bit more than half as deep, but it lasted about nine times as long. So, counted against potential output, it cost about 21 percent of one year's output. That's about six times as much as the pandemic slump. The rough rule gives about five, and the exact sum gives about six.
HOST
So the lost output is like an area: depth times length. Next leaf: inflation. I remember prices jumping as soon as the pandemic hit.
ECONOMIST
Many people remember that, but the data say no. Inflation is how much consumer prices rose over the past year. In 2020, it fell. In the United States, it first passed 3 percent only in April 2021, a year after the pandemic began. So something that came later pushed prices up, and Chapter 12 looks at what.
HOST
And how high did it go?
ECONOMIST
In the United States, it peaked at 8.7 percent in June 2022.
HOST
This leaf also says core, 6.4 percent. What is core inflation?
ECONOMIST
Core inflation leaves out food and energy, whose prices move up and down a lot. U.S. core inflation peaked at 6.4 percent, not far below the 8.7 percent for all prices, so most of the rise was broad.
HOST
The last leaf: policy, in four words: capital, rescues, jobs and lives. Capital first.
ECONOMIST
Capital is the owners' money again. Regulators set a minimum for it, as a share of what the bank owns, and that share is the cushion. After 2008, the minimums went up. Next, rescues. In a panic, a central bank can lend to banks, so they need not sell in a hurry. That makes it the lender of last resort. On Islandia, that's the Bank of Islandia.
HOST
Doesn't that reward banks for taking risks?
ECONOMIST
That's the worry. But letting Lehman Brothers fail was followed by the peak of fear between banks. So the usual answer is more owners' money before a crisis, not refusing help in a panic.
HOST
And jobs?
ECONOMIST
Some countries, like Germany, paid firms to keep workers on shorter hours. The United States let firms cut jobs and paid unemployment benefits. The first path suits a short shock, like the pandemic.
HOST
And lives? Wait, how can anyone put a price on a life?
ECONOMIST
It's what people as a whole are willing to pay, on average, to avoid one death. U.S. agencies use about 10 million dollars. Spread over the roughly 40 years a middle-aged American has left, that's about 250,000 dollars a year.
HOST
And the pandemic cut U.S. life expectancy, the years people live on average, by about 3 years.
ECONOMIST
Three years at 250,000 dollars each is about 750,000 dollars per person. The lost output was only about 3 percent of one year's income. So the human cost was many times larger.
HOST
So how should governments choose?
ECONOMIST
That was the hard question of 2020: how to weigh lives saved against output lost. The right balance is still debated.
HOST
So in part three we saw two very different slumps. The pandemic hit harder but was over quickly. The Great Recession was not as deep, but it lasted far longer, so it cost much more.
ECONOMIST
And inflation came back only a year after the pandemic began. Let's sum up.
Wrap-up
HOST
Let's go back to our three goals. First, the crash of 2007 to 2009 in the data.
ECONOMIST
Real house prices fell by more than a third. The Fed raised its rate, then cut it to zero. Fear between banks became about ten times as large, and stocks lost half their value.
HOST
Second, why a small fall can wipe out a bank.
ECONOMIST
The owners' money is only a thin layer on top. The fall that wipes them out is their share of the assets: 10 percent for Islandia's bank, under 3 percent for Bear Stearns. Then losses force sales, and fear stops the lending.
HOST
And third, the two recessions.
ECONOMIST
The pandemic slump was deeper but lasted about a year. The Great Recession, deep by the standards of earlier recessions, lasted most of a decade, so it cost about six times as much output. So here is the big message. Because banks had borrowed so much, a fall in house prices became a banking crisis and a long, deep recession. The pandemic hit harder but more briefly, and inflation came back only a year later.
HOST
Here's a question to think about. An islander family buys a house. It pays only 10 percent of the price itself and borrows the rest. Then house prices fall by a third. What happens to the family's own money, and why?
ECONOMIST
Pause the episode and think about it for a moment.
HOST
Okay, we're back. What's the answer?
ECONOMIST
The family's own money is gone. Its cushion is the 10 percent it paid itself, like Islandia's bank. So a fall of just 10 percent wipes it out. A fall of a third goes far beyond that: the house is now worth less than the loan. Families in that position are poorer, which helps explain why spending fell in the Great Recession.
HOST
Where can students try all this themselves?
ECONOMIST
Open the chapter's Colab notebook to rebuild every number from the data. The Data Apps show every chart without code.
HOST
And next time?
ECONOMIST
In Chapter 11, we start building the short-run model that explains slumps like these. We ask: how does the real interest rate move output in the short run?
HOST
That's it for today. Thanks for listening, and see you next time.