While its underlying causes are varied and still subject for debate, it is widely acknowledged that the global financial crisis was triggered by the surge and collapse of United States housing prices during the 2000s.
US Housing Market
The US economy had gone into recession in 2001, and the US Federal Reserve — the country’s central banking system — reduced interest rates as a counter-cyclical measure (see Monetary Policy). Lower interest rates made it easier for households to carry larger amounts of mortgage debt, and so the demand for US housing increased. The resulting increase in prices stimulated residential construction activity, and the resulting increase in employment and output in the housing sector was an important factor in the recovery in the US economy.
A contributing factor behind the surge in housing investment was a massive inflow of foreign investment into the United States, notably from China: by 2006, the US current account deficit reached 6 per cent of GDP (see Balance of Payments). Much of this foreign capital was subsequently channeled into the US housing sector, offering larger pools of savings for households seeking mortgage financing.
The housing market is well-known for its cycle of booms and busts, and it became apparent in the mid-2000s that US housing prices showed many of the signs characteristic of a “bubble.” Asset-price bubbles occur when investors make purchases based on the expectation of being able to sell the asset later at a higher price, and not on the inherent qualities of the asset itself.
US housing prices finally peaked in early 2006. Activity in the housing sector slowed, and the US economy began to undertake a transition of investment and employment to other sectors. This transition was not seamless, however, and the United States fell into recession in December 2007.
Initial concerns were focused on how declining housing prices affected household wealth: lower levels of wealth are generally associated with lower levels of spending. On its own, the wealth shock was generally viewed as manageable: estimates for the losses were less than those suffered during the dot-com stock market crash of a few years earlier. But the more fundamental problem proved to be structural weaknesses in the financial systems of the United States and other countries. (Canada was an exception, as noted below.)
One contributor was the deterioration in the mortgage underwriting standard: an increasing share of loans was made to high-risk borrowers. When housing prices eventually fell, these “sub-prime” mortgages were more likely to go into default.
The increased securitization of mortgage assets, and most notably the development of Collateralized Debt Obligations (CDOs), amplified the underlying risk. A CDO gave its owner a claim on the flow of mortgage payments made by households. CDOs that offered higher-priority claims were considered to be safe assets, and traded at a premium. The development of CDO and related instruments provided a further incentive to offer sub-prime loans: purchasers of CDOs had little way of verifying the quality of the underlying mortgages upon which the assets were based.
When US housing prices fell, many homeowners found themselves underwater: their mortgage debts exceeded the value of their homes and went into default. It soon became apparent to financial institutions and other investors that many of the supposedly “safe” mortgage-based assets were worth much less than their book values. Financial market liquidity dried up as institutions became less willing to make loans, out of fear that the counterparties might go bankrupt in the near term. These fears came to a head with the collapse of Lehman Brothers, the fourth-largest US investment bank, in September 2008.
DID YOU KNOW?
Liquidity describes the ease with which an asset can be converted to cash. Liquid assets are easiest to convert to cash and lose little to no value when converted because they are valued by a broad market, such as currencies and commodities. Illiquid assets, such as real estate and collectibles, are harder to convert to cash because the market in which they are sold has fewer buyers. Illiquid assets may have a reduced value when quickly converted to cash.
Transmission to Canada
Oil prices continued to surge during the first months of 2008, and the Canadian economy was at first little affected by the US recession: employment and output continued to expand. But the US financial crisis in the fall of 2008 affected global financial markets, and Canada was not exempt from its effects. The collapse of the prices of oil and other Canadian commodity exports compounded the effects of the financial crisis, and the Canadian economy fell into recession in October 2008 (see Commodity Trading).
Canadian Policy Responses to the Recession of 2008–09
Stabilization of Financial Markets
The immediate priority of policy-makers in the United States and other countries was dealing with banks and other financial institutions that had suddenly become insolvent. Financial institutions play a key intermediary role in the economy, and governments acted to minimize the disruptions caused by bank failures. Banks that were sufficiently large were considered “too big to fail,” and had to be bailed out. Indeed, the fact that banks were aware that they were too big to fail produced a moral hazard problem: the belief in an eventual rescue by governments encouraged large banks to engage in risky behaviour.
Canadian policy-makers were spared this problem. Though all of the “Big Six” chartered banks — National Bank of Canada, Royal Bank of Canada, Bank of Montreal, Canadian Imperial Bank of Commerce, Bank of Nova Scotia and Toronto-Dominion Bank — were considered “too big to fail,” Canada’s regulatory regime prevented them from engaging in the sort of risky behavior observed elsewhere (see Bank Act). In particular, Canada’s banks were obliged to maintain lower debt-to-equity ratios than most of their counterparts abroad. Higher debt-to-equity ratios offer the possibility of higher profits rates, but highly leveraged banks are also more vulnerable to negative shocks to the value of their assets. After the 1985 collapse of Northland Bank and Canadian Commercial Bank, Canadian regulations were further tightened (see Estey Commission). Partly because of this stronger regulatory environment, Canada’s banks were not in danger of insolvency in the crisis.
Instead, the immediate priority of Canadian policy-makers was to restore stability and liquidity to financial markets (see Stock and Bond Markets). While Canadian investors and financial institutions were not as exposed to the sort of losses seen in the United States, Canadian holdings of asset-backed commercial paper dropped sharply in value. (The term commercial paper describes short-term, unsecured loans that companies issue in order to finance their accounts and inventories. They are usually sold at a discount but pay out at full value.) In order to avoid the sort of “fire sale” price collapses observed elsewhere, Canadian authorities persuaded investors to accept and write off short-term losses. In addition, measures such as the Insured Mortgage Purchase Program (IMPP) allowed banks to exchange illiquid mortgage assets for bonds issued by the Canadian Mortgage and Housing Corporation (CMHC). Since CMHC debt is backed by the federal government, these assets were more readily accepted as collateral for short-term lending. This exchange did not affect the government’s risk exposure to the mortgage market: only mortgages that were already insured by the government were eligible for the IMPP.
The failure of Lehman Brothers made it clear that the scale of the financial crisis would soon affect the real economy. On 8 October 2008, the Bank of Canada — in concert with other leading central banks — reduced its target for the overnight rate from 3 per cent to 2.5 per cent (see Interest Rates in Canada). This action was followed by a series of rate cuts until the Bank’s policy rate was reduced to its lower bound of 0.25 per cent on 21 April 2009. (The Bank allows a 0.25 per cent deviation above or below its target rate, so a target of 0.25 per cent implies a lower bound of 0 per cent; see Bank Rate.)
Since the Bank of Canada could not reduce its policy rate any further, it felt obliged to make use of “unconventional” monetary policy instruments. Other central banks, including those in the United States and United Kingdom, had also reached the lower bound of their policy rates and began to use unconventional monetary policy tools. The reduction of the interest rate to its lower bound in Canada was accompanied with a “conditional commitment” to maintain the Bank’s policy rate at its lower bound until the middle of 2010. This was the extent of Canada’s experience of unconventional monetary policy instruments; unlike in the US and the UK, the Bank of Canada did not see fit to engage in quantitative easing.
DID YOU KNOW?
The term quantitative easing describes the unconventional monetary policy whereby a central bank buys government securities, or other securities, in order to lower interest rates and increase the money supply.
The Conservative government of Stephen Harper remained in power with an increased minority after the federal election of 14 October 2008. During the campaign, the Conservatives promised to keep the federal budget in balance, and its fiscal update of 27 November outlined measures to restrain spending in order to avoid going into deficit. Subsequent economic and political developments — including an attempt by opposition parties to form a coalition government — forced the Conservatives to back away from this position. The Harper government introduced a budget on 27 January 2009 that included a two-year stimulus program, mainly on infrastructure spending (see Fiscal Policy).
Auto Sector Bailout
The North American auto sector was troubled and in decline even before 2008, and the recession pushed General Motors (GM) and Chrysler into bankruptcy (Ford was able to withstand the crisis). Chrysler was eventually purchased by the Italian automaker Fiat and was able to continue operations.
GM, on the other hand, had no such saviour, and it was “too big to fail.” The risk of a catastrophic collapse of GM’s network of suppliers and associated industries forced governments in the United States and Canada to take an equity stake in GM. This injection of capital gave GM time to restructure and continue its operations. The federal government and the government of Ontario sold the last of their GM holdings in 2015.
Factors Contributing to Recovery
The efforts of Canadian policy-makers were not the only — or even the most important — factors driving the eventual recovery from recession. The Canadian dollar had been trading near par with the US dollar in mid-2008, but it depreciated sharply as the crisis deepened. By March 2009, the Canadian dollar had depreciated by more than 20 per cent, to less than US$0.80. This depreciation encouraged Canadian exports (see Exchange Rates).
A more decisive factor was the continued strength of the Chinese economy during the global financial crisis, which supported a recovery in the price of oil and other resource commodities. Oil prices rebounded from a trough of US$30 per barrel in December 2008 to more than US$60 per barrel in May 2009.
Turning Point and Recovery
The US recession was severe enough to draw comparisons with the Great Depression of the 1930s, but the Canadian recession of 2008–09 was milder than the downturns of 1981–82 and 1990–92. The main Canadian business cycle indicators rebounded in the spring and early summer of 2009. Monthly GDP attained its trough that May, and the unemployment rate peaked in June. Monthly GDP recovered its pre-crisis peak in October 2010, and employment losses were absorbed in January 2011. US employment did not recover its pre-crisis peak until May 2014.
Aftermath and Legacy
Recovery was slower in the United States and in Europe, and the sluggish growth of the world economy acted as a drag on Canadian economic growth after 2011. The Bank of Canada and other central banks were obliged to maintain their policy interest rates at low levels, as inflation remained weak. It was not until 2017 — almost 10 years after the United States moved into recession — that Canada and the US began to return to pre-crisis monetary policy stances.