The financial crisis and the Great Recession

The US stock market experienced a spectacular growth between July 2006 and July 2007. In just one year, the Dow Jones increased by 30%; the value of US corporations rose from $11.5 trillion to $15 trillion. Yet the fundamentals increased at their normal rates; nominal GDP in the United States increased by only 5% ($650 billion).

What happened to the US economy in 2006? As pointed out by De Grauwe (2010), the answer is almost nothing, apart from a change in the “animal” spirits of investors, who somehow began to believe that the US economy had entered a new era characterized by a permanent growth path for an indefinite future. In fact, the US economy entered in to a speculative bubble instead that soon bust and led the United States and the entire world to the most dramatic recession since the 1930s.

Within a year, between 2007 and 2008, stock prices dropped by 30%. The economy experienced a sudden sharp reduction in the availability of credit from banks and other lenders (a credit crunch) and trade and industrial activity reduced dramatically. Millions of Americans lost their homes and jobs; many more saw their retirement and education investments dwindle in value. Soon the US crisis turned global, spreading to Europe and to the rest of the world. Almost 12 million workers had lost their jobs in the Organisation for Economic Co-operation and Development (OECD) countries up to mid 2014.

Bubbles (and crashes) are not a special feature of recent years. They are endemic in capitalist systems; bubbles have existed since capitalism started and usually result from uncertainty, herd behavior, positive feedback, or bandwagon effects (Kindleberger and Aliber, 2005; Reinhart and Rogoff, 2009). A bubble occurs when investors believe in increases in an asset price independently of its fundamentals; asset prices then increase because the surge of demand fuels expectations of further rises, which then become self-fulfilling. However, as soon as the misalignment in prices becomes clear and investors change their beliefs, buyers become sellers. The bubble explodes and prices fall dramatically. Investors lose money and often, as a consequence, market confidence evaporates in all sectors of the economy.

Although bubbles are not special, they are not “white noise.” Their explosion and consequences are strongly related to the institutions (in particular, to financial sector regulation).