The idea that markets self-regulate, or come close to self-regulation, is a surprisingly robust proposition. Practical experience and simple reflection would seem to run contrary to this notion, but for a period of time from the 1980s forward, the idea that markets worked best if left to their own regulatory efforts seemed to gain support, particularly in the financial services industry. The key to making it sound reasonable is to not carry it too far and to support it with the right kind of story. It also helps if the story is buttressed with a large dose of cynicism regarding the ability of governments to get things right.

The story goes like this: Financial markets are places where firms and individuals can gain or lose enormous sums of money; reasonable people will not venture into those markets without doing all the necessary background checks and research; and financial firms that do business with one another will not establish relationships if their potential partner’s corruption or incompetence will hurt their own reputation and profitability.

During the Subprime Crisis and its aftermath, the US federal debt ratcheted up dramatically. By 2012 it was equal to almost 100 percent of GDP and in the next year it crossed that symbolic level. While the ratio of debt to GDP was climbing before the crisis, the increase in both deficits and debt during the crisis created a political backlash. Conservatives and deficit hawks opposed any further increases in spending and tried to cut both discretionary spending and mandatory entitlements.

Relative to the size of the economy, the largest debt in recent US history was just over 118 percent of GDP in 1946. Most observers probably justified wartime expenditures as warranted given the existential threat of Nazism, but the debt accumulated during the Subprime Crisis did not have a similar rationale, particularly when it was assumed that it was largely due to bailouts of financial institutions, auto companies, and other private enterprises.

With the exception of the common currency, the euro, all members of the European Union are required to follow the rules and regulations of the economic union. To date, nineteen of the current twenty-eight members of the European Union have given up their national currencies. The incentive to adopt the euro is the belief that a common currency will increase prosperity and promote deeper integration and closer political ties. A common currency reduces costs by eliminating the need for travelers to change their money when they cross borders, and for businesses to keep multiple accounts or currencies for receipts and payments. A further benefit for business is that a common currency eliminates exchange rate risk. The most important trading partners for EU countries are other EU countries so the elimination of exchange rate fluctuations provides an added degree of stability in payments and receipts. In the 1990s, as the euro project was negotiated and developed, proponents also hypothesized that it would cause there to be more trade and investment between member countries and that the ties binding together EU countries would strengthen.

It is too soon to know if the financial controls implemented in the wake of the recent Subprime Crisis are as robust as the reforms put into place after the Great Depression. It seems unlikely, however, that the next seventy-five years will be free from a systemwide crisis like the seventy-five years from the Great Depression to the Subprime Crisis. The complexity of finance, together with its international linkages, rapid development of new technologies such as blockchain and risk models, and institutional innovations such as the various forms of shadow banking, seem to argue against another long period of relative quiet.

There are plenty of possibilities for another crisis. China has accumulated massive amounts of internal debt in its shadow banks and state owned enterprises. The Eurozone will continue to create divergences between weak and strong economies, along with pressures to implement austerity in countries already suffering from slow or negative growth.

The institutional origins of the European Union began with the signing of several treaty agreements by a handful of European countries in the 1950s. These were important but not comprehensive, covering coal and steel trade, peaceful development of atomic power, and a six-nation free trade agreement. The original goals of the founders were motivated by a desire for deeper political integration as a means to end the “frequent and bloody wars between neighbors” (European Union, 2018). The movement toward political integration required countries to cede some sovereignty to a federal European authority but that proved to be beyond the reach of political leaders. It was possible to reduce economic barriers, however, and movement toward economic integration encouraged the belief that trade agreements could serve as a platform for approaching deeper political ties. Today, the original six countries have expanded into twenty-eight and the free trade area is an economic union of more than 500 million people and nearly $20 trillion in GDP. Perhaps more importantly, it has helped to bring peace and prosperity to a region with a long history of war and deep cultural and linguistic divisions. The EU is one of the world’s great institutional achievements of the second half of the twentieth century.

Financial crises are a normal feature of contemporary market economies. They are analogous to diseases or natural disasters and, like some diseases and most natural disasters, are currently beyond the ability of science to prevent or to accurately predict. In part this because most of the preconditions of financial crises also occur in situations that do not develop into a crisis. Nevertheless, it is possible to minimize the risks of a crisis and to mitigate the damage when they do happen.

While financial crises usually do not kill people directly, the economic damage can lead to numerous indirect deaths, with monetary costs that are comparable to wars and that are far greater than the largest natural disasters. Compare the Subprime Crisis to recent natural disasters such as Hurricanes Katrina or Harvey.

Financial crises are rarely the result of a single causal factor or a single set of circumstances. In the lead-up to a crisis, economic, psychological, social, and other variables interact in ways that lead to vulnerabilities and increase the probability that a wrong turn of events will trigger a crisis in the financial system. Sometimes crises are triggered by recessions and related economic pressures, while at other times they are the causes of recessions. Crises sometimes involve fraud in a significant way, but most frequently and in very general terms, they are more likely to result from simple human errors compounded by well-intentioned but inadequate rules and organizations. During economic expansions, overconfidence bias expands and when reinforced by the social phenomena of herd behavior, the result can be too much risk, too much debt, and increasingly fragile economies.

As the United States descended into the Great Depression of the 1930s, economic advice was contradictory and confused. The business community, politicians, and academics called for a variety of different policies: Some wanted government to do nothing, believing that there was not much that government could do, that recessions had to work their way through the economic system, like a poison that has no antidote; others thought government should encourage firms to invest, that they should be allowed to form cartels to control prices and wages and output; and still others favored public works that would put the unemployed back to work. To a large degree, Roosevelt was more successful than Hoover because he kept trying one thing after another. He did not have a comprehensive economic model, or even much of any kind of model, but focused on humanitarian relief as something government could do even if it did not understand how to systematically counter the recession. At least government could aid those who lost their jobs, their homes, and their farms. Roosevelt did not end the Great Depression and we now know that many of his policies and those of his contemporaries were counterproductive and prolonged the recession.

Banks take deposits – other people’s money – which they use to fund their own activities. Bank deposits are loans by depositors and a form of bank debt, even if most people with checking accounts probably do not think about the fact that they are loaning money to a bank. Deposits are the primary source of funding for most retail banks, which also have other sources of funding, including capital invested by the bank owners or shareholders, and loans from sources other than depositors. Taken together, deposits, other borrowed money, and capital, make up the liabilities side of the bank balance sheet.

The emergence of modern economic life with amenities such as electricity, sanitation and indoor plumbing, modern medicine, and transportation and communication networks, is a recent development in human history. In 1800, someone living in New York, London, or Shanghai experienced conditions that were closer to ancient Rome or Greece than to a mid-twentieth century city. Candles were the primary source of artificial light, modern medicines did not exist, food storage was primitive, and animals, wind, water, and humans supplied all the available power. The vast changes in living conditions since 1800 are the result of nearly two centuries of economic growth that came after several millennia of little or no cumulative progress in living standards. Significant changes did not begin until the 1800s and after approximately 1870 they accelerated further (Gordon, 2016: 1–18; Maddison, 2006: 29).

The literature on the Subprime Crisis is voluminous and spans a range of different approaches, from popular accounts to technical analysis to memoirs by first responders at the Federal Reserve and in the executive branch of the federal government. This chapter provides an overview and chronology of the main developments and turning points and describes the vulnerabilities present at the onset of the crisis. Chapter 7 examines the contagion effects of the crisis in Europe and how it deepened into a worse slump than the Great Depression of the 1930s.

Perhaps the most surprising fact about the financial crisis that engulfed several East Asian countries in 1997 and 1998 was that it happened. Their long-run economic successes and stability did not place them on anyone’s list of countries likely to suffer major financial crises. The focus of East Asian specialists was on the reasons for the region’s economic growth and when or if it might slowdown. Sometimes the debate was heated, particularly about the longevity of high growth rates and whether there was a new Asian model of economic success, but no one was thinking that a major financial meltdown would begin in East Asia and spill over into other parts of the world.

It is easy to tell a story about the benefits of capital flows and open capital markets. The free movement of financial capital lets the receiving countries obtain more resources for investment while businesses and individuals in the sending countries earn higher returns. History is full of examples. In the nineteenth century, the United Kingdom invested its savings in infrastructure projects around the world, but especially in its colonies and former colonies where British savings were used to build the railroads, seaports, mines, urban sanitation systems, and other major projects. British investors were not alone in investing in the Americas, Asia, and Africa, but were joined by German, French, Dutch, and others lenders and investors.