The 2008 Financial Crisis: Where Did All the Money Go?
A Story of Liquidity and Fear
On September 12, 2001, just hours after the devastating 9/11 attacks, the CEO of a major Spanish financial institution made an early morning call to his treasury secretary. The treasurer was on vacation, and his deputy, despite her long tenure, had never received a call from the CEO. He asked a simple question: “How is our liquidity?” Her response was reassuring: “We’ve never been so liquid all year.” (A statement, it should be added, that was purely coincidental.)
The CEO, hearing the positive numbers, ordered the bank to maintain its liquidity, refraining from lending or investing. This seemingly prudent decision, driven by a natural reaction to uncertainty, would soon prove to be a costly mistake. Interest rates plummeted globally, and the money that could have been earned through loans or investments sat idle.
The Ripple Effect of Fear
This story illustrates a common human response to perceived trouble: the desire to hold onto cash. This same instinct drove individuals, corporations, and banks in 2008 to sell assets—homes, stocks, bonds—converting them to cash and driving down prices across the board. Deflation swept through asset markets, seemingly vaporizing billions of euros in value.
The question many asked then was: where did all the money go? Was it destroyed? The answer is both complex and simple: it never existed.
The Illusion of Money: Basel II and the Debt Bubble
The Basel II international treaty established a relationship between a financial institution’s equity and its assets, mandating that banks hold eight cents of equity for every euro invested. This essentially allowed banks to finance investments with over 92% debt. This 8% equity requirement, while legal, was arguably insufficient. A mere 8% default rate (common during crises) could lead to bankruptcy, which is precisely what happened to many banks that had pushed this leverage to the legal limit.
However, the allure of economic growth and high profits silenced any concerns. This system, fueled by non-existent money, inflated asset prices. The rush to convert these inflated assets into liquidity triggered the 2008 crisis. It became a crisis of confidence. As long as people believe asset values will rise, they hold onto them. But when fear takes over, and everyone rushes to sell, the market crashes.
Confidence and the Fragility of the System
Despite the dramatic fall in asset prices, confidence, though shaken, did not completely disappear. While there wasn’t enough actual money to cover all existing assets, the economy avoided complete collapse. The system relies on the continuous accrual of debt and the belief that there’s no better place for our capital. This is why governments rushed to guarantee bank deposits—a mathematically impossible promise, but one that served its psychological purpose.
The Stock Market: A Leading Indicator
The stock market, due to its liquidity, often provides early warning signs of a crisis. It’s a stark reminder of the illusory nature of money, where a single day’s trading volume, representing a tiny fraction of a company’s actual value, can cause massive swings in market capitalization. This volatility tends to only cause concern during downturns.
It’s important to remember that not everything valued outside the real economy is necessarily mispriced. A privately held company might have a theoretical value based on assets and profits, but its actual sale price in a down market could be significantly lower. Price is relative.
The Debt-Backed System
Our current financial system is inherently built on debt—debt backed not by physical money, but by the perceived value of assets, which is itself determined by the available money supply. Imagine a house bought for 40 with a 35 loan. If the house’s value drops to 20, the owner loses everything. If the value rises to 60, they can borrow more. The house remains the same; only our perception of its value changes.
We tend to only question the artificiality of this system during times of crisis, despite its historical success. Is there a better system? More importantly, is there a better system that wouldn’t negatively impact our current standard of living in the developed world?