Introduction
The Great Recession, which began in late 2007 and officially ended in mid-2009, is considered the most severe economic downturn since the Great Depression. This period of economic decline affected not only the United States but also countries worldwide, leading to a global recession. The last recession in the U.S. was from February to April 2020.
Understanding the causes, impact, and subsequent recovery efforts provides critical insights into how interconnected and fragile the global financial system can be. The most recent significant recession in the U.S. was the Great Recession, which lasted from December 2007 to June 2009.
Defining a Recession
Traditionally, a recession is characterized by a decline or stagnation in economic growth. However, the specific economic indicators used to define a recession have evolved. According to the International Monetary Fund (IMF), a global recession is marked by a decline in real per-capita world gross domestic product (GDP), along with other macroeconomic indicators such as industrial production, trade, oil consumption, and unemployment for at least two consecutive quarters.
Causes of the Great Recession
The Subprime Mortgage Crisis
The roots of the Great Recession in the United States and Western Europe are closely tied to the subprime mortgage crisis. Subprime mortgages are high-risk loans granted to borrowers with poor credit histories. During the housing boom of the early to mid-2000s, mortgage lenders, eager to profit from rising home prices, became less stringent in approving loans for high-risk borrowers.
As housing prices soared, financial institutions purchased large quantities of these risky mortgages, often bundled into mortgage-backed securities (MBS). This investment strategy was based on the assumption that home prices would continue to rise, allowing for quick and substantial profits. However, this proved to be a catastrophic miscalculation.
The Bursting of the Housing Bubble
The first signs of trouble appeared when New Century Financial, a leading subprime mortgage lender, declared bankruptcy in April 2007. Earlier, in February, Freddie Mac announced it would no longer purchase subprime mortgages or related securities. These developments signaled the beginning of the end for the housing bubble. As the crisis unfolded, housing prices plummeted, leaving millions of homeowners underwater, meaning their homes were worth less than their mortgage loans.
The Financial Crisis and Credit Freeze
The collapse of the subprime mortgage market had a domino effect on the broader financial system. Banks and financial institutions, heavily invested in MBS, faced significant losses. The complexity and opacity of these securities made it difficult for institutions to assess their value, leading to a severe contraction of liquidity in global financial markets. Banks began to doubt each other’s solvency, resulting in an interbank credit freeze. This credit freeze impaired the ability of banks to extend credit to businesses and consumers, exacerbating the economic downturn.
The Stock Market Crash
On October 9, 2007, the U.S. stock market reached its all-time high, with the Dow Jones Industrial Average surpassing 14,000 points. However, over the next 18 months, the Dow lost more than half its value, plunging to 6,547 points. This dramatic decline wiped out substantial portions of Americans’ life savings, leading to a significant reduction in household wealth. The net worth of American households and non-profits fell by over 20 percent, from $69 trillion in 2007 to $55 trillion in 2009.
Government and Federal Reserve Interventions
Lowering Interest Rates
In response to the crisis, the U.S. Federal Reserve (Fed) took several measures to stabilize the economy. One of the first steps was to lower the national target interest rate, which influences loan rates. From a rate of 5.25 percent in September 2007, the Fed reduced the target interest rate to zero percent by the end of 2008, hoping to encourage borrowing and investment.
Economic Stimulus Packages
In February 2008, President George W. Bush signed the Economic Stimulus Act into law. This legislation provided taxpayers with rebates, reduced taxes, and increased loan limits for federal home loan programs to stimulate the economy. Despite these efforts, the economic challenges persisted.
The Collapse of Major Financial Institutions
The economic interventions were insufficient to prevent the collapse of major financial institutions. In March 2008, Bear Stearns, a significant investment bank, failed due to its exposure to subprime mortgages and was acquired by JP Morgan Chase at a cut-rate price. The bankruptcy of Lehman Brothers in September 2008 marked the largest bankruptcy filing in U.S. history and further destabilized the financial system. To prevent further collapse, the Fed lent $85 billion to insurance giant AIG, deeming it “too big to fail.”
The Troubled Asset Relief Program (TARP)
In October 2008, President Bush approved the Troubled Asset Relief Program (TARP), allocating $700 billion to purchase the assets of struggling companies. This move aimed to stabilize the financial system by allowing the government to sell these assets later, hopefully at a profit. TARP funds were used to support nine U.S. banks, automakers General Motors and Chrysler, and banking giant Bank of America.
The Obama Administration’s Response
When President Barack Obama took office in January 2009, the financial crisis remained a pressing issue. One of his first actions was to sign a second stimulus package into law, earmarking $787 billion for tax cuts and investments in infrastructure, schools, healthcare, and green energy. These measures aimed to bolster the economy and mitigate the effects of the recession.
Global Impact and European Debt Crisis
The Great Recession’s effects were not confined to the United States. The economic downturn quickly spread to other countries, particularly in Western Europe. Many European nations, including Ireland, Greece, Portugal, and Cyprus, faced severe economic challenges, leading to sovereign debt crises. The European Union, along with the IMF, provided bailout loans and imposed austerity measures to help these countries stabilize their economies.
Long-Term Social and Economic Consequences
Increased Poverty and Wealth Inequality
The recession had profound social consequences. In the United States, the poverty rate increased from 12.5 percent in 2007 to over 15 percent in 2010. Federal legislation, such as the 2009 American Recovery and Reinvestment Act (ARRA), helped mitigate the impact by funding job creation, extending unemployment insurance, and expanding safety net programs. Despite these measures, poverty among children and young adults increased significantly.
The wealth disparity in the United States also worsened. While the wealthiest households recovered relatively quickly, middle and lower-income families experienced more prolonged economic hardship. Between 2009 and 2011, the net worth of the richest 7 percent of households increased by 28 percent, while the lower 93 percent saw a 4 percent decline in their net worth. This trend exacerbated existing wealth inequalities.
Financial Regulation Reforms
The Dodd-Frank Act
The Great Recession prompted significant reforms in financial regulation. The repeal of the Glass-Steagall Act in the 1990s, which had previously separated commercial and investment banking, was seen as a contributing factor to the crisis. In response, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in 2010. This legislation aimed to restore regulatory oversight, prevent predatory lending, and provide the federal government with the authority to manage failing financial institutions.
Conclusion
The Great Recession of 2007-2009 was a period of significant economic turmoil that highlighted the vulnerabilities of the global financial system. The crisis was precipitated by the collapse of the subprime mortgage market, leading to a severe financial crisis and a global recession. Government interventions, including lowering interest rates, stimulus packages, and financial bailouts, helped stabilize the economy but could not prevent long-term social and economic consequences. The recession also led to increased financial regulation aimed at preventing future crises. Understanding the causes and effects of the Great Recession provides valuable lessons for managing economic stability in an interconnected global economy.