What Caused The 2008 US Stock Market Crash?

Summary: This page looks at some of the causes of the US stock market crash in 2008 and their impacts. These of course include the monetary problems caused by a banking crisis.

In his book, "The Return of Depression Economics", 2008 Nobel Prize winner Paul Krugman looks at the financial crisis from the perspective of the banking and credit crises that went before in Argentina, Mexico, Asia and then LTCM. In other words, he questions the notion from the early 2000s made by US economists that recessions, depressions, banking and credit market problems were 'fixed' and a thing of the past.

In his way, he is telling us that our confidence was misplaced - as confidence often is - and that we need a still greater understanding of monetary policy.

He describes the 2008 crash thus, "I'm tempted to say that the crisis is like nothing we've ever seen before. But it might be more accurate to say it's like everything we've seen before, all at once: a bursting real estate bubble comparable to what happened in Japan at the end of the 1980s; a wave of bank runs comparable to those of the 1930s (albeit mainly involving the shadow banking system rather than the conventional banks); a liquidity trap in the United States, again reminiscent of Japan; and, most recently, a disruption of international capital flows and a wave of currency crises all too reminiscent of what happened to Asia in the late 1990s."

Each of the factors mentioned above was enough to pull the country or region metioned into a downward economic spiral including recession, unemployment, currency devaluation and banking crisis. The real difference is that in the US in 2008, all of these factors seemed to be converging. The hopes for a 'quick fix', a 'soft landing' or a 'shallow recession' seem to be quite limited.

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As Krugman describes it, the impact of Alan Greenspan's policies (blowing bubbles) and hedge fund managers and their use of short-term financing for long-term trades and commitments, caused much of the problems. But of course, that was not all. We can only recommend that you read the book for a full description - it is very readable for a book about economics.

How high is high?

Of course, none of the factors explain the 2009 stock market recovery. In a period of worsening financial statistics, rising unemployment / bankruptcies and reposessions, currency devaluations, bailouts, quantitative easing and much more, any positive stock market progress seems rather foolish. At the time of writing, many major world stock exchanges seem to be showing David Blaine-like levitational abilities. Time will tell...

(As a footnote, in early February 2013 this page was edited and a few days before the Dow Jones had passed 14,000! This is an incredible number for the US stock market today considering the current global financial problems (the postponement of the US fiscal cliff, eurozone problems in Greece, Spain and Italy (amongst others) and rising unemployment around the world). 

Krugman does not look into the elements of interconnectivity and the notion that some financial institutions are 'too big to fail', instead he spends time discussing the 'shadow banking system' and the 'Masters of the Universe' (hedge fund managers) and the impact each had when it failed to operate and their borrowed money could no longer be re-borrowed. Fascinating.

Needless to say, the impact - as we all know - was not contained to the United States or the S&P, far from it. The positive correlation between many major bourses around the world, when combined with the global nature of most major financial companies and investment banks, and the use of global diversification of investment funds, meant that the problem was felt virtually everywhere and by the majority of people on earth in one way or another.

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Krugman was famous for calling the problems "Great Depression 2" and the "Mother of all recessions" in 2008/9. While the world has continued to turn and life has mostly continued, the problems being faced by the world economy are still very large.

There have been many other books - and even a few films - written about this precarious moment in Wall Street history. Each depicts a different element of the crisis unfolding. The sad reality is that the world of investment banking, mortgage lending and pension fund investing had altered significantly but the old models of risk management were still being applied. This led to huge risks being taken by American borrowers, companies, pension funds, investment banks and insurance companies. Alas, many did not understand the risks properly.

Previously...

The 2008 problems were not, of course, the first time that the Dow Jones has seen large falls. There was a significant downturn in 2000 at the end of the TMT / tech boom. That was a raging bull market that sucked a great many in, looking for fast rewards and big profits.

In October 1987 the US stock market (information here) fell dramatically for a few days and even caused the suspension of trading. At the time, the height of risk management involved computerised fund management technology that would sell holdings at specific prices relative to the rest of the portfolio. The concept was good. However, once prices started to drop, the NYSE was flooded with automated sell orders that forced prices sharply lower. Within a few hours Wall Street seemed to be in a death spiral. Another lesson learned...

With hindsight, the falls of October 1987 were not a bear market, simply a pause for breath and a brief wobble in the longest bull market in history. It provided an excellent long-term opportunity to buy stocks. Of course at the time it did not feel like this at all.

To read more about related subjects, please visit the following pages:

Understanding Bull And Bear Markets

Bear Market Definition

What Is A Bear Market?

Bear Market Investing Strategies

What Is Short Selling?

Secular And Cyclical Bear Markets

The Great Crash 1929 by J.K Galbraith

What Caused The 2008 Financial Crisis?

What Caused The Fall Of Lehman Brothers?