REVISITING THE GREAT RECESSION.

• Author: Van Overtveldt, Johan
• Position: ECONOMICS

"The world held its breath as surprise, bewilderment, desperation, and outright panic dominated.... Levels of nervousness, discomfort, and... suspicion shot through the roof." HOW did the crisis that led to the Great Recession develop? The news in summer 2007 that Bear Stearns, three German financial institutions, and BNP Paribas were facing massive losses related to real estate set the crisis events in motion. On learning of the problems at BNP Paribas, Jean-Claude Trichet, then-president of the European Central Bank, immediately sensed that he must act. Within hours, the ECB announced it would provide "unlimited" liquidity to the markets. This was the first clear indication that the lessons of the Great Depression had been learned, and that the lender of last resort advice of 19th-century discretionary monetary policy advocates Henry Thornton and Walter Bagehot would be taken seriously this time around.

The ECB promptly made available [euro]95,-000,000,000 in emergency lending, and the Fed stepped in with $64,000,000,000. Immediately, a problem arose for central bankers, especially in the U.S.: How could they get funds to the shadow banking system (investment banks, hedge funds, money market mutual funds, and so on), which had no direct access to central bank financing? Levels of nervousness, discomfort, and outright suspicion shot through the roof. The growing uneasiness and uncertainty in the markets were illustrated clearly by a pronounced hike in LIBOR (London Inter-Bank Offered Rate), the rate at which international banks make loans to each other. Distrust and uncertainty predominated throughout the financial system.

The next domino to fall was the British bank Northern Rock, which was highly leveraged and up to its ears in mortgage financing. Moreover, most of Northern Rock's financing was very short term. For the first time in 150 years, a British bank run made news; people stood in line for hours to get their money out. Some observers regard the September 2007 bank run on Northern Rock as the event "that heralded the global financial crisis." In February 2008, the British government nationalized Northern Rock.

In the meantime, unease and worries about the evolving situation escalated around the world. A precipitous drop in real estate prices in many parts of the U.S. accelerated the concerns. Central banks drastically lowered their policy rates and provided ample liquidity where it was needed. They also showed a clear awareness of the international nature of the troubles and provided each other with substantial credit lines. The Fed recognized the worldwide need for dollar financing and acted accordingly through extensive swap agreements with other central banks, a step that proved to be crucial in fighting the...