So here it goes. I contend that the puncturing of the subprime bubble in 2007 set offthe explosion of a super-bubble, much as an ordinary bomb sets off a nuclear explosion. Thehousing bubble in the United States was the most common kind, distinguished only by thewidespread use of collateralized debt obligations and other synthetic instruments. Behindthis ordinary bubble there was a much larger super-bubble growing over a longer period oftime which was much more peculiar.
The prevailing trend in this super-bubble was the ever increasing use of credit and leverage.
The prevailing misconception was the belief that financial markets are self correcting and shouldbe left to their own devices. President Reagan called it the magic of the marketplace, and I call itmarket fundamentalism. It became the dominant creed in the 1980s when Ronald Reagan wasPresident of the United States and Margaret Thatcher was Prime Minister of the United Kingdom.
What made the super-bubble so peculiar was the role that financial crises played inmaking it grow. Since the belief that markets could be safely left to their own devices wasfalse, the super-bubble gave rise to a series of financial crises. The first and most serious onewas the international banking crisis of 1982. This was followed by many other crises, the mostnotable being the portfolio insurance debacle in October 1987, the savings and loan crisisthat unfolded in various episodes between 1989 and 1994, the emerging market crisisof 1997/1998, and the bursting of the Internet bubble in 2000. Each time a financial crisisoccurred, the authorities intervened, merged away or otherwise took care of the failing financialinstitutions, and applied monetary and fiscal stimuli to protect the economy.
These measures reinforced the prevailing trend of ever increasing credit and leverage, butas long as they worked, they also reinforced the prevailing misconception that markets can besafely left to their own devices. It was a misconception, because it was the intervention of theauthorities that saved the system; nevertheless these crises served as successful tests of a falsebelief, and as such, they inflated the super-bubble even further.
Eventually the credit expansion became unsustainable and the super-bubble exploded. Thecollapse of the subprime mortgage market led to the collapse of one market after another inquick succession because they were all interconnected, the firewalls having been removed byderegulation. That is what distinguished this financial crisis from all those that preceded it.
Those were successful tests that reinforced the process; the subprime crisis of 2007 constitutedthe turning point. The collapse then reached its climax with the bankruptcy of LehmanBrothers, which precipitated the large-scale intervention of the financial authorities.
It is characteristic of my boom-bust model that it cannot predict in advance whether a testwill be successful or not. This holds for ordinary bubbles as well as the super-bubble. I thoughtthat the emerging market crisis of 1997/1998 would constitute the turning point for the superbubblebut I was wrong. The authorities managed to save the system and the super-bubblecontinued growing. That made the bust that eventually came in 2008 all the more devastating.
After the bankruptcy of Lehman Brothers on September 15, 2008, financial markets had to be puton artificial life support. This was a shock not only for the financial sector but also for the real economy.
International trade was particularly badly hit. But the artificial life support worked, and financial marketsstabilized. The economy gradually revived. A year later, the whole episode feels like a bad dream andpeople would like to forget it. There is a widespread desire to treat the crisis as just another crisis and returnto business as usual. But reality is unlikely to oblige. The system is actually broken and needs to be fixed.
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