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KEITH HENNESSEY, DOUGLAS HOLTZ-EAKIN, AND BILL THOMAS 

kets that made it difficult for some to access additional capital and liquidity
when needed.
VII. Risk of contagion. The risk of contagion was an essential cause of the crisis.
In some cases, the financial system was vulnerable because policymakers
were afraid of a large firm’s sudden and disorderly failure triggering balance-
sheet losses in its counterparties. These institutions were deemed too big and
interconnected to other firms through counterparty credit risk for policy-
makers to be willing to allow them to fail suddenly.
VIII. Common shock. In other cases, unrelated financial institutions failed be-
cause of a common shock: they made similar failed bets on housing. Uncon-
nected financial firms failed for the same reason and at roughly the same
time because they had the same problem: large housing losses. This common
shock meant that the problem was broader than a single failed bank–key
large financial institutions were undercapitalized because of this common
shock.
IX. Financial shock and panic. In quick succession in September , the fail-
ures, near-failures, and restructurings of ten firms triggered a global financial
panic. Confidence and trust in the financial system began to evaporate as the
health of almost every large and midsize financial institution in the United
States and Europe was questioned.
X. Financial crisis causes economic crisis. The financial shock and panic
caused a severe contraction in the real economy. The shock and panic ended
in early . Harm to the real economy continues through today.

We now describe these ten essential causes of the crisis in more detail.

THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS,
UNDERPRICED RISK, AND FEDERAL RESERVE POLICY

The financial and economic crisis began with a credit bubble in the United States and
Europe. Credit spreads narrowed significantly, meaning that the cost of borrowing to
finance risky investments declined relative to safe assets such as U.S. Treasury securi-
ties. The most notable of these risky investments were high-risk mortgages.
The U.S. housing bubble was the most visible effect of the credit bubble but not
the only one. Commercial real estate, high-yield debt, and leveraged loans were all
boosted by the surplus of inexpensive credit.
There are three major possible explanations for the credit bubble: global capital
flows, the repricing of risk, and monetary policy.

Global capital flows

Starting in the late s, China, other large developing countries, and the big oil-
producing nations consumed and invested domestically less than they earned. As