US Economic Crises: Dot-Com Bubble & 2007 Housing Crash

A Brief History of US Economic Crises

The Dot-Com Bubble (Pre-2001)

Before 2001, interest rates were high, which was reasonable given the economic cycle. High interest rates typically control economic growth and appreciate the currency. The dot-com bubble was a speculative bubble that inflated the stock prices of technology companies. These companies had significant know-how, but many lacked profitability. Venture capital firms fueled this bubble, seeing a promising future in the tech sector. While their vision was correct, the returns were not immediate. Companies like eBay and Amazon were in their early stages and not yet profitable, some not even generating revenue.

As investors began to question the future profitability of these companies, the bubble burst, creating a cascade effect that impacted the entire sector. When investment dried up, many companies faced severe financial problems, leading to bankruptcies or acquisitions.

The 2007 US Financial Crisis

The global crisis began with the collapse of the American housing bubble. Similar to Spain, the US experienced readily available credit, fueled by large inflows of foreign funds and low interest rates. These low rates were intended to support the American economy after 9/11 and the dot-com bubble.

This easy credit led to increased lending for housing, with less stringent loan requirements. Rising housing prices made it seem like a good investment, with the assumption that prices would not fall. These mortgages were not held by the banks but were packaged into complex financial products that transferred the risk.

This issue quickly spread to banks that had acquired these financial products, which were rated as safe but ultimately were not. Many banks were at risk. This crisis not only severely impacted the financial sector but also individuals who had taken out mortgages and could no longer afford to pay them.

Some of these mortgages were second mortgages (refinancing), allowing people to borrow for consumption using their homes as collateral. Government-sponsored companies like Freddie Mac and Fannie Mae played a significant role in the US mortgage business. Driven to increase market share, they relaxed their standards and assumed more risk, which was then passed on to insurance companies. These companies created investment products that included these “subprime” mortgages.

This situation was irresponsible for individuals, and there has been much criticism of the companies involved and the deregulatory practices that enabled it.

This raises questions about the freedom of financial institutions and how far they can go if they can endanger the entire economic system.

The majority report of the U.S. Financial Crisis Inquiry Commission, composed of six Democratic and four Republican appointees, reported its findings in January 2011. It concluded that “the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.“

The crisis resulted in a $7 trillion loss in the U.S. stock market and $6 trillion in housing wealth. These losses led to declining demand, with GDP and employment shrinking at some of the most rapid rates since World War II; 4.4 million jobs were lost by 2009.

While the crisis started in the US, it hit Europe harder. The US was able to address the crisis with expansive monetary and fiscal policies. The congress passed a bill allocating $700 billion to buy troubled assets from banks.

The US response was more solid and coordinated. They not only set up a credit plan but also enhanced acquisitions and protected banks. For example, they helped facilitate the purchase of Merrill Lynch by Bank of America and lent AIG $85 billion to avoid its collapse.