Transcript | 1. lecture: What Happened - University for modern Slovakia

The global financial crisis reached Slovakia in late 2008, when its consequences already affected Slovak economy. The fact that something serious is going on was evident earlier, in September 2008, after the collapse of one of the largest investment banks Lehman Brothers, which the U.S. government let go bankrupt on 15.09.2008. Subsequently a panic spread out in financial markets, cash flows were blocked and the financial crisis became the global financial crisis and affected the real economy.

Governments began to organize rescue operations (bailouts), and together with central banks they began to inject huge amounts of new money into banks and economy to avoid freezing of financial flows and collapsing of so-called real economy. This, however, was only a culmination of problems, it started much earlier. Let us have a look at how and why.

The immediate cause of the global financial crisis was the bursting of mortgage real estate bubble in the United States. The previous stock market crisis in the U.S. in 2000 was connecting with the bursting of internet bubble (dot-com bubble). What exactly are the bubbles? Basically they represent an inflated, artificial and unsustainable growth in prices and turnover in some markets, which inevitably, sooner or later, collapses leading to price drops and crises.

The internet bubble was being inflated between the years 1995 and 2000, when it burst. Share prices of internet companies in this period rocketed; it seemed as if it was permanent. When the bubble burst, prices of all shares on the New York Stock Exchange fell by an average of 40%. And here are the beginnings of the new, real-estate bubble.

Fed Chairman Alan Greenspan, in order to prevent recession, right from the beginning of 2001, decided to significantly lower interest rates, which he lowered eleven times in a row to a level of 1% between years 2003 and 2004. It appeared that Greenspan's policy was successful; the recession was very mild and lasted only eight months. At the same time, it was the only recession in recent decades, during which there was no decline in real estate prices.

However, today it is clear that the recession was so short because the internet bubble was replaced by a new, real estate bubble. The real estate bubble was being inflated between the years 1998 and 2006. Real estate prices rose unprecedently. The ratio between real estate prices and rental prices had increased in this period by 65% and it is estimated that real estate prices were overestimated on average by about 50% and in some regions (e.g. Florida) even twice as much.

In July 2006, real estate prices stopped to grow and then slowly began to fall down, first slowly, but then the drop accelerated. Until the first half of 2007, the prices drop only by 3%, over the next year, however, they dropped by additional 15%. And then came the fall of the first banks. It is interesting to point out the fact the first banks that went bankrupt were banks from Europe, not from the U.S. In the second half of the year, it launched worldwide and in full extent. The global financial crisis was here and hit with full force.

What were the causes of the real estate bubble in the U.S. and why the bursting of this bubble turned into a global financial crisis will be said in the following lectures. Now let us take a look at what Keynesians and Austrian school has to say on the causes of the crisis.

Krugman argues that the main causes of bubbles are mostly psychological. He calls them "irrational exuberances on asset markets" and if he is critical about something at FED, specifically Greenspan in relation to the dot-com bubble and real estate bubble, it is that Greenspan underestimated these irrational exuberances and not corrected them adequately. Krugman considers the main causes of dot-com crisis to be the excessive optimism about profit potential of information technologies and the belief that deep recessions are already a thing of the past (excessive optimism about real estate prices and end of recession), and the mismanagement of regulation of new banking products.

He argues that if share prices or real estate prices are growing rapidly for several years, people see that anyone who purchased the shares or invested in real estate earned a lot of money, thus they also begin to invest, regardless of rational risks and arguments. Thus, the Ponzi scheme (here known as a pyramid game) is a good analogy for this situation, which works until you can find enough fools who are willing to join this game. In other words, Krugman and Keynesians argue that the bubbles are inevitable, they arise from inherent limitations of human knowledge and the desire for profit.

The Austrian school sees the main cause of bubbles somewhere else. They do not deny the psychological aspects of the bubble growth, however they consider the fundamental cause of crises to be the central bank policy. Strictly speaking, not only the policies, but rather its entire existence. The Austrian school thinks of the central bank as a planning authority for the monetary policy and it is the state regulation and manipulation with the amounts of money that the Austrian school considers to be the main cause of bubbles and crises.

Specifically, a major cause of bubbles, such as dot-com or real estate bubble, is the fact that FED released too much cheap money into the economy, leading to bubbles and excessive, disproportionate and unsustainable growth in stock prices and real estate prices and subsequently to collapses and crises. The Austrian school does not deny the strong psychological dimension and its impact on the inflation of bubbles; however, they say this is the main cause. As Mises wrote, "without credit expansion, the mere psychological mania could not start an economic boom by itself".