* Boom in World Economy and Surge in Asset Prices
The years that preceded the turbulence saw an exceptionally strong performance of the world economy – another phase of what has come to be known as the “Great Moderation”.
Following the global slowdown of 2001, the world economy had recovered rather rapidly, posting record growth rates in 2004, 2005 and 2006. The long period of abundant liquidity and low interest rates prior to the crisis led to a global search for yield and a general under-pricing of risk by investors. Across a wide spectrum of asset classes, volatilities and risk premia looked exceptionally low compared with fixed income credit, equity and foreign exchange markets.
– Growth in the US Economy
There were ‘global imbalances’, the phenomenon of huge current account surpluses in China and few other countries coexisting with the unsustainably large deficits in the US. This imbalance was caused by the propensity of the countries with high saving rate to park their savings often at low yields, in the US. The flood of money from these countries into the US kept interest rates low, fueled the credit boom and inflated real estate and other asset prices to unsustainable levels.
– Rapid increase in credit
Against the backdrop of the historically low interest rates and booming asset prices, credit aggregates, along side monetary aggregates, had been expanding rapidly. Despite the rapid increase in credit, however, the balance-sheets and repayment capacity of corporations as also the households did not appear to be under any strain. The high level of asset prices kept the leverage ratios in check while the combination of strong income flows and low interest rates did the same with debt service ratios.
-- Failure of the US Leadership in anticipating the crisis
During the housing boom, most of the US authorities failed to comprehend the problem. Alan Greenspan, the then head of Federal Reserve, in his book 'The Age of Turbulence', recalled what he used to say about the housing boom: "I would tell audiences that we were facing not a bubble but