NRPLUS MEMBER ARTICLE {T} he Lehman Brothers and AIG failures are often considered causes of the stock-market crash and recession, but the week of those failures, the stock market actually rose. The benign market reaction at the time suggests they may be more accurately considered as markers of the real-estate crisis that, by September 2008, had been unfolding for over a year.

The fundamental cause of the Great Financial Crisis (GFC) can be seen as too much finance, too much debt. The chart below illustrates that private-sector debt nearly doubled over the 40 years preceding the crisis, rising by over 80 percentage points of GDP:

There was an initial increase in debt equal to about 30 percent of GDP in the 1980s, followed by a decade-long stability, coinciding with the “Great Moderation,” a period of healthy growth with minimal inflation. Beginning in the late 1990s through the commencement of the GFC, outstanding private-sector debt grew by an amount equal to 50 percent of GDP. This was an inauspicious time to lay on debt as it marked the beginning of a period during which, in the words of former Fed chairman Ben Bernanke, “Financial disruptions . . . played an increasingly important role in economic downturns.” Since the GFC, this credit measure has shrunk by about 25 percent of GDP, much lower but still well above the Great Moderation levels.

So, what caused the enormous debt build-up? Many observers blame the growth of the “shadow” banking sector, non-bank financial intermediaries such as mortgage companies, finance companies, investment banks (under pre-crisis regulation), and hedge-fund lenders. As shown in the chart below, shadow-bank lending grew rapidly by about 60 percentage points of GDP in the run-up to the GFC:

Credit growth equal to another 20 percent of GDP came from increased bank lending. These statistics represent only lending to the domestic non-financial sector. When total bank investments, including financial lending, are analyzed, the banking system grew every bit as fast as the shadow banking system, as reflected in the following chart:

The ratio between total credit and invested bank assets (excluding cash) is constant throughout the GFC run-up. Shadow banking did not grow faster than banking, and, considering the reliance of shadow banks upon banks for credit and transaction processing, it is likely bank credit growth spurred non-bank growth. As the chart below displays, after remaining stable throughout the Great Moderation and before, bank balance sheets took off in the late 1990s, increasing by nearly 30 percentage points of GDP:

So why did the banks grow their assets so quickly? In an easy credit environment, it stands to reason that banks took in their share of financing. Borrowing by banks increased by about 18 percentage points of GDP, most of which began in the mid 1990s:

Deposits, the other main source of bank financing, also grew excessively. After drifting downward from the 1970s to the mid 1990s by the equivalent of over 10 percent of GDP, starting in the mid 1990s, deposits grew by about 12 percentage points of GDP leading up to the GFC.

A curious thing about deposit growth in this period was that bank reserves were shrinking, both relative to the economy and in absolute terms. Those receiving an economics education before the GFC can recall the classical model of banking growth in a fractional-reserve system whereby the central bank purchases securities in the market and deposits the proceeds in bank reserve accounts. Banks then lend out these funds, increasing credit and monetary aggregates.

In the period preceding the GFC, banks were required to hold reserves only against their checking deposits. To obtain a full return on checking-accounts funds, which had to be partially offset by reserves with no interest, banks began providing “sweep” accounts to large customers in which the daily checking balance was swept overnight into a savings account with no reserve requirements. The banks could earn money on funds that otherwise would be required to be held as no-interest reserves.

The shift of funds from checking accounts to other deposits meant reserves no longer served as a brake on the growth of deposits and bank lending. Even though reserves were stable or falling, bank deposits grew. The chart below shows how declining checkable deposits led to increases in the ratio of deposits relative to reserves, which then spurred overall deposit growth beginning in the mid 1990s:

Autonomous shifts within the banking system contributed to easy credit, which contributed further to excess growth of bank assets. So, how did the excess asset growth become a real-estate crisis? Because that’s what banks do — they lend to real estate, and these loans were favored under the prevailing risk regulations. The next chart shows how direct lending on real estate grew before the GFC from 16 to 34 percent of all bank assets:

Just this growth in real-estate lending amounted to 11 percent of GDP. These figures don’t include bank investment in agency (such as Fannie Mae and Freddie Mac) real-estate securities, which weren’t separately recorded until after the GFC and currently amount to 10 percent of U.S. GDP.

This massive amount of financing pouring into real estate had predictable results. As we now know all too well, there was a tremendous house-price bubble, illustrated below:

Home prices grew by a measured 31 percent in the ten years preceding 1997. In the ten years before January 2007, the increase was 120 percent.

Conventional monetary-policy measures did not reflect the emerging crisis. For five years through the end of 2007, the core PCE index rose a benign 2.1 percent annually. Headline prices were more concerning over that period at a 2.7 percent rate and became alarming as the less-noticed headline figure topped 3 and even 4 percent heading into the crisis. While M2 is little used by the Fed, it wouldn’t have helped. The five years through mid 2007 saw average M2 growth of 5.6 percent, consistent with expected growth and inflation at the time. Meanwhile, invested bank assets were galloping along at a 10 percent clip. While not a policy target for the Fed, the dollar’s value offered useful information before the GFC, having fallen by over a third from 2002 to 2008, propelling headline inflation and presenting the clearest indication monetary policy was too lax.

Given the disparity between soaring home prices and seemingly sluggish conventional inflation measures, statistics reflecting current housing-market conditions would have been helpful. Official inflation statistics include a housing component with a built-in twelve-month lag, which means annual statistics include two-year-old data. The chart below substitutes current house-price data from Zillow for lagged official housing statistics in a manner similar to the way car-price inflation is computed:

In this chart, coming right out of the 2001 recession, adjusted inflation takes off above 2 percent in 2002, is around 2.5 percent in 2003 when the Fed was still cutting rates, is over 3 percent when the Fed first begins a slow climb, and is near 4 percent in 2005 with the federal funds rate at a mere 2.25 percent. Incorporating current housing-market data into inflation measures would have provided timelier warning. (Current disinflation also would have been evident earlier with these adjustments.)

While the Fed wished to spur sluggish growth amidst benign official inflation data, its easy-money policies didn’t help. With official headline inflation at 4 percent when the Fed was confronted with the Lehman and AIG crises, the central bank needed to provide liquidity to the financial system but still wished to control inflation. Initial liquidity for various credit facilities was obtained by selling from the Fed’s securities portfolio. Then the Treasury sold debt securities to finance the Fed’s liquidity facilities. Selling these securities drains overall liquidity and so, roughly speaking, mimics a normal Fed tightening.

It was this financing of the Fed through the Treasury’s Supplemental Account that appears most consistent with the stock market’s plunge following its initial steady response to the Lehman/AIG failures. The chart below depicts the stock market’s dive from mid September to November 2008. At that point quantitative easing began, which added to the Fed’s balance sheet and thus to liquidity, and the market reacted positively:

The Fed’s concern about inflation in the midst of the crisis was an attempt to do the right thing, but hindsight being so wonderful, it was misplaced. The priority in a crisis must be liquidity. Providing liquidity with one hand while taking it away with the other didn’t work.

Countless factors played a role in the GFC’s development and severity, among them regulation of banks and homebuilding, the reliance by financial institutions on short-term “runnable” funding, and, certainly, human foibles and shortcomings amidst rapidly changing conditions. While at various times, alternative actions might have ameliorated some of the crisis, at the end of the day, there is no possibility that the U.S. private sector could virtually double its debt by about 80 percent of GDP and emerge without a crisis. That was the root cause of the GFC.