Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Facing the failure of financial institutions

The big question on everyone’s mind in 2007 was ‘who owned all these super risky mortgage-backed securities?’. Any financial institution that did would suffer potentially huge losses. The thing is, putting your hands up and admitting to owning this junk would be suicide: people would immediately doubt whether your company could weather the storm and stop doing business with you. Predictably, everyone kept schtum.

The result was much anxiety and uncertainty. The bank or financial institution that you were dealing with could be on the brink of collapse and you wouldn’t know! This situation stopped banks lending to one another and made their problems even worse. To add insult to injury, most banks were highly leveraged, which meant that any losses would be multiplied many times over. The highly interconnected nature of the global financial system meant that problems at one bank were quickly transmitted to others. Economists call this situation contagion (see Chapter 14 for a detailed look at leverage, systemic risk and contagion).

Many banks and financial institutions did collapse or had to be bailed out during, or in the aftermath of, the 2008 crisis, including: in the US, Lehman Brothers, AIG, Bear Stearns, Fannie Mae and Freddie Mac; and in the UK, RBS, Lloyds TSB and Northern Rock. It was one big mess that caused much suffering for people throughout the world: the effects are still around today.

Asking Why Economists Didn’t Predict the Crisis

The events that we describe in the preceding section raise an intriguing question: were economists partly to blame for the 2008 crisis? Gasp!

Being an economist at a dinner party used to be a fun experience. People readily asked for our opinions on the state of the economy, inflation, house prices, you name it, and usually listened with respect to the answers. Since the financial crisis, people are noticeably more sceptical about economists and economics generally. A standard question is: ‘How can we trust you guys and your models if you couldn’t even predict the financial crisis?’

In this section we look at whether this criticism is fair. We discuss why averages don’t work for financial investments and introduce one of the most important results in financial economics: the Efficient Market Hypothesis (EMH).