A simple model of the financial crisis of 2007‐2009, with implications for the design of a stimulus package

Abstract

PurposeThe aim of this paper is to provide a grammar for dissecting the financial crisis that began in the housing finance market of industrialized nations in 2007, rapidly becoming a general credit crisis and spreading to all parts of the world and causing a global recession of gigantic proportions. The unexpectedness and force of the crisis has had experts floundering for an explanation and the policy response has been an ad hoc collection of stimulus interventions by governments and central banks around the world, akin to scatter shots in the hope that some will hit the target whatever it be.Design/methodology/approachThe paper is based essentially on a static equilibrium model. The author chose the assumptions carefully to capture some of the features of dynamics in this static model. Also, a static model does not have to mean one period but the infinite repetition of the same kind of world. The aim here is to draw on some existing ideas concerning equilibria where group behavior influences individual preferences, and which give rise to multiple equilibria. Unlike several other works, the model in this paper does not try to explain the collapse in terms of the bursting of a bubble.FindingsAs more and more lenders indulged in sub‐prime lending, the share of risky borrowers rose. With a little lag, defaults rose. More and more houses came back on the market, and the value of houses declined. So the value of F (value of the mortgaged property), with which individual lenders had begun their calculations, declined. Clearly, the value of F depends on how many others were indulging in sub‐prime lending. If this aggregate supply was forecast wrongly, some firms would end up discovering that their asset position had weakened since the foreclosed property did not have the value originally calculated.Originality/valueThe model developed is a new frame for conceptualizing the crisis. While there has already been some theorizing on this, the model has the advantage of novelty and simplicity. It provides a stark characterization of how a small credit correction can escalate into a major equilibrium shift with large changes in behavior, in this case, a sudden collapse in the supply of and demand for loans. It is distinct from existing models of collapse in lending, which are based on the idea of bubbles bursting. Despite the model's simplicity, it turns out to be a useful structure addressing policy questions.