From Paul Krugman's MasterClass

How ‘08 Happened

Learn about the market patterns and unregulated financial activities that led to our worst financial crisis since the Great Depression, and how to prepare yourself for the uncertain economic future.

Topics include: The Economics of a Bank Run • The Shadow-Banking Run • Bubbles and Wile E. Coyote • The Subprime Doomsday Machine • Debt Deflation • Crimeless Victims

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Learn about the market patterns and unregulated financial activities that led to our worst financial crisis since the Great Depression, and how to prepare yourself for the uncertain economic future.

Topics include: The Economics of a Bank Run • The Shadow-Banking Run • Bubbles and Wile E. Coyote • The Subprime Doomsday Machine • Debt Deflation • Crimeless Victims

Paul Krugman

Teaches Economics and Society

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There was a period not that long ago, when people were very complacent about things like financial crises. There's an infamous address to the American Economic Association saying the problem of the business cycle has been solved-- that was in 2003. Well, actually, no. It turns out recession crises still happen. And we haven't found it that easy to deal with them. When did they begin? No one really knows, but there was, in fact, a recognizably modern banking crisis in Scotland, in the 1770s. Scotland had led the way in the introduction of paper money, which was, at that time, issued by private banks, which had gold and silver in reserve. But it could go bad. You could have bank runs. You could have a crisis of confidence. And left to themselves, banks can create risks that can then spread out and disrupt the economy as a whole. [MUSIC PLAYING] Banking is a very clever institutional thing that, like many clever institutional arrangements, is extremely useful. But sometimes goes really wrong. The trick about banking is that the bank takes your money. And from your point of view, your money is sitting at the bank and I can withdraw it whenever I want. But the bank doesn't actually keep your money there. They put it to work. They lend it out. They make it available so it can be used to build businesses. Or finance other people's purchases of homes. And that's good. You want wealth to be put to work, but how can they do that? Because since I'm free to take my money out of the bank, how can they guarantee that when the money isn't actually there? And the answer is there's a lot of customers. And on any given day, only some people will be withdrawing money. But suppose I have reason to suspect that my bank has actually lost a lot of money? Suppose I have a reason to think that they've made a lot of bum loans. Then I might want to pull my money out while it's still there. So will everybody else. And if everybody tries to take their money at the same time, well, the bank doesn't have the money. And if they try and raise it by selling their loans to somebody else, it's going to be fire sale. They're going to be trying to sell it at speed and they're go lose a lot of money. Which means that if people believe that a bank is going to fail, that can be a self-fulfilling prophecy-- that's a bank run. Everybody is trying withdraw their money at the same time. That actually dries the bank out of business, even if it was fundamentally sound. [MUSIC PLAYING] The Great Depression was, pretty much-- it started as a recession, which was bad. It turned into the Great Depression because of a wave of bank runs. As each bank failed, that made people nervous about the next bank. And so over the course of 1930, 1931-- huge numbers of banks failed. There was panic. People wanted to put cash under their mattresses. The banks that survived pulled back from lending and just accumulated big reserves of cash, just in case. And that is re...

Think like an economist

For Nobel Prize-winner Paul Krugman, economics is not a set of answers—it’s a way of understanding the world. In his economics MasterClass, Paul teaches you the principles that shape political and social issues, including access to health care, the tax debate, globalization, and political polarization. Heighten your ability to read between the lines and decipher the underlying economics at play.

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Comments

Pisko

Paul, ur work has earned u a great reputation as an economist, please help me understand why don't u tell 2008 the way it was!! People here is paying 2 learn, n u come out with "crimeless victims", what!!! We do live in a strange world, where a nobel prize missinforms people that is investing on their education, on a major subject: Bank boards at wall street are responsible, they created the CDO's, they deliverately dodged regulation n created da bubble, n they have the power 2 force the government 2 rescue them with the taxpayers money, works, savings n even lives. That's one lesson people actually has 2 learn from 2008. This is not my opinion but a fact, anybody can learn more by watching the "Inside job" documental or even "The big short" movie. U r one of the few instructors at Masterclass with zero replies, so PAUL PLEASE ANSWER

Mark B.

I would assume all of the folks at the NY financial firms and government and private economists who were looking at the US economy during this time put together are very, very, very, smart people. So why were the factors listed below so hard to grasp: 1. Mean wages had been stagnate since 1973 2. First, families first coped by having both spouses working in dramatically greater numbers than in the 50's and 60's 3. Second they coped by increasing personal debt mostly in form of credit card debt. 4. Finally they used their house as an ATM by refinancing etc, This of course worked as long as as housing values increased. But has there ever been a period in the history of the country where housing prices never dipped? So it is hard to imagine that the brilliant folks described above could not see the storm clouds gathering as we entered the new millenium. I have thought for awhile that a lot of folks did see the storm clouds but just did not have an answer as to how to avoid them and just hoped they would dissipate before they reached our shores. Can someone smarter than me explain why this scenario is not true? Mark Brown, MD

Jan C.

The true cause of financial bubbles is commercial banks ability to create money "out of thin air" when lending to households and businesses. I have Masters in Economics but for some reason, our professors never taught us the truth about how MONEY IS CREATED EVERY TIME COMMERCIAL BANKS ISSUE A LOAN and destroyed when loans are repaid. I'd love to hear Paul explain money creation process and bust the myth of "money multiplier" still taught at universities! Here's how the money system really works POSITIVE MONEY ORG London, U.K. www.positivemoney.org If you want to get involved, find money reform organization in your country https://internationalmoneyreform.org/members/ Thanks.

Norm C.

I love it. This is a very kind, no fingers pointed, generous to the guilty explanation of what happened. It is an explanation people can kind of grasp. I would love to hear Paul explain why the US went off the gold standard and why mortgage interest rates in Canada went to 20% in the late 70's early 80's. Even more I would love to hear why the Canadian government insisted high interest rates were necessary to "protect the Canadian dollar" even though unemployment was high. My opinion is the interest rates were kept extraordinarily high to protect the Canadian banks who had lost mega bucks on bad domestic and overseas loans and the average Canadian was made to pay for it. Once the bad loans were wrote off, interest rates fell.

kristi K.

Where is the workbook? I see the pdf, but it's simply a print version of the lecture. I'm thinking there's more??????

Gordon

Back in the palmy days of 2006, Jimmy Cayne, the Bear Stearns Chairman and CEO revealed the secret of the firm's success at a senior managing directors' quarterly meeting: "Everyone needs a house" ! that's policy on a postage stamp

Joshua P.

His fundamental premise on the Great Depression is incorrect. Every economy goes through economic cycles, booms and busts if you will, but the Great Depression was ultimately caused by a failure in government, not the market. After the crisis began, the federal reserve over the next several years decreased the money supply by roughly 1/3rd. It was this decrease in the money supply that triggered the Great Depression to the record high levels of unemployment accompanied by nearly every other form of human misery we can name. The scarcity of money inevitably made the bank runs of the early 1930s much worse than they would have been if the federal reserve had expanded the supply of money. If we expand to the crisis of 2008, we find much of the same. It wasn't financial innovations that caused the 2008 Great Recession. In the 1990s, we find that the federal government expanded the subprime mortgage lending program that lent money to individuals that were not financially stable enough to purchase a home. Again, every economy goes through booms and busts as a result of the leverage cycle. After all, economic cycles at the most fundamental level are driven by debt. The question we should be asking is what actions turned the bust into a crisis and what actions prolong the crisis. Sure, financial institutions were engaging in risky mortgage-backed securities, but when you begin to probe on what the driving factors of the housing crisis were, we again see the hands of government intervention gone wrong.

Mia S.

"The financial crisis of 2008 in the United States had a lot to do with something that was 'financial innovation' that turns out to have been a really destructive new idea, which was lending to dubious borrowers, subprime. People who you might not have been willing to grant the mortgage before. We used to talk about 'ninja loans' - no income, no job, no assets. The bright idea was, Take loans to a lot of people like that, and merge them - create an asset which is claimed on all of these people, and even though any individual might end up defaulting, what are the odds that all of them are going to default? So this is probably a pretty safe asset, right? Well actually not - when housing prices crashed, they all default. In a way, the subprime fallacy or subprime problem was the same as the bank run problem. That is, in normal times, the law of averages can make things pretty predictable. Normal times, any individual might decide to withdraw his money from a bank, but not everybody at once. If you average out the risk of defaulting on a mortgage, it's pretty predictable - a certain fraction will default, that's predictable and you can create a pretty safe asset by pooling them. But in abnormal times, they all become correlated. House prices are falling, everybody is defaulting at once. Something that worked fine as long as the economy was moving on an even keel suddenly turned into a doomsday machine. There's another one of those great economists - not nearly

Mia S.

"Often, financial innovation is actually clever ways of avoiding the guard rails that we've put up. Looks like a good idea, because you can make a little bit more money. So people will come up with clever ways of evading the rules, call it innovation, and then it turns out that what they've done is set things up for destruction. So we have - alongside bank runs - there is the issue of bubbles. Bubbles - on average, assets tend to be priced at what they're fundamentally worth, but it's not always. And sometimes you get into situations where people are buying something, basically because other people are buying it. The price is going up, so you say, 'Oh look, I see other people have made money by buying that. I'm going to buy some too.' If you look at an asset price that's heading for the sky, it's kind of like a Ponzi scheme - the people who bought in early make a lot of money because the price goes up. More people come in because they see that other people made lots of money and the keep on coming in until you eventually run out of people to pull in - that's what happened to dot.com stocks in the 90s, and it is pretty much what happened to housing prices in the 2000s. House prices were rising, everybody started to think housing - 'What can go wrong? I should buy housing.' And sooner or later there was going to be - actually we use a common phrase now, we had a 'Wile E. Coyote' moment. By the laws of cartoon physics, you run off the edge of a cliff and you don't actually fall until you look down and realize there's nothing under you. So there was going to be a Wile E. Coyote moment, the housing bubble burst; but the worst thing is that when the bubble applies to a big enough part of the economy - and housing is a pretty darn big piece of the economy - then it can really bring the whole economy down. And when it burst, it brought down a lot of the shadow banks with it. So all of a sudden there we were with a souped up, high-tech financial crisis which was, however, in its fundamentals, the same thing that had happened in 1930. We just managed it - we didn't have long lines of people outside banks waiting, screaming for their cash, it was all taking place in cyberspace. But the functional effects were the same - you had a complete collapse of credit markets, companies couldn't borrow money, asset prices were plunging, people saw their life savings evaporate. Economy plunged, and it plunged so hard that the Fed didn't have the ammunition to fight it."

Mia S.

"The Great Depression was pretty much - it started as a recession, which was bad; it turned into the Great Depression because of a wave of bank runs. As each bank failed, it made people nervous about the next bank, and so over the course of 1930, 31, huge numbers of banks failed, there was panic - people wanted to put cash under their mattresses. The banks that survived pulled back from lending and just accumulated big reserves of cash, just in case. And that is really what drove the US economy into the ditch in the 1930s. We thought we'd solved that problem - we created deposit insurance. In fact, if you have money in a bank, an ordinary bank, then it's guaranteed by a federal program, even if the bank goes bust - you'll get your money back. If the federal government's going to guarantee your deposits, it's also going to insist that banks not abuse that privilege, so you combine deposit insurance with regulation. And pretty much everybody thought, 'These are '30s things, we created deposit insurance, regulated banks, it can't happen again.' What we forgot was - What is a bank? A bank is not defined by what it looks like.What really defines a bank is the fact that it takes your cash, tells you you can have access to the cash whenever you want it, but in fact uses that cash to lend out to other purposes. We had developed a whole set of institutions that were doing that that were not called banks, were not subject either to regulation or the protections that regular banks have. We collectively call all of this 'shadow banking,' it wasn't officially banking but in economic terms it was banking, and it turned out that by 2007, most of our banking system was actually shadow banking, not traditional banking, and it was the Wild West - it was completely unprotected. Which meant that when something started to go wrong, all of the old problems came back. We managed to recreate the conditions that made the Great Depression possible by having created this unregulated shadow banking system in parallel with - and in many way overtaking - traditional banking."