Deciphering the Liquidity and Credit
Crunch 2007–2008
Markus K. Brunnermeier
T he financial market turmoil in 2007 and 2008 has led to the most severe
financial crisis since the Great Depression and threatens to have large
repercussions on the real economy. The bursting of the housing bubble
forced banks to write down several hundred billion dollars in bad loans caused by
mortgage delinquencies. At the same time, the stock market capitalization of the
major banks declined by more than twice as much. While the overall mortgage
losses are large on an absolute scale, they are still relatively modest compared to the
$8 trillion of U.S. stock market wealth lost between October 2007, when the stock
market reached an all-time high, and October 2008. This paper attempts to explain
the economic mechanisms that caused losses in the mortgage market to amplify
into such large dislocations and turmoil in the financial markets, and describes
common economic threads that explain the plethora of market declines, liquidity
dry-ups, defaults, and bailouts that occurred after the crisis broke in summer 2007.
To understand these threads, it is useful to recall some key factors leading up
to the housing bubble. The U.S. economy was experiencing a low interest rate
environment, both because of large capital inflows from abroad, especially from
Asian countries, and because the Federal Reserve had adopted a lax interest rate
policy. Asian countries bought U.S. securities both to peg the exchange rates at an
export-friendly level and to hedge against a depreciation of their own currencies
against the dollar, a lesson learned from the Southeast Asian crisis of the late 1990s.
The Federal Reserve Bank feared a deflationary period after the bursting of the
Internet bubble and thus did not counteract the buildup of the housing bubble. At
the same time, the banking system underwent an important transformation. The
y Markus K. Brunnermeier is the Edwards S. Sanford Professor of Economics, Princeton
University, Princeton, New Jersey. His e-mail