How the 2008 Financial Crisis Supports the Theory of Coordination Failure

The financial crisis of 2008 is a textbook case of an endogenous coordination failure, meaning that the economic crash was caused by a failure of shared expectations within the system rather than by an external shock.

The pre-crisis boom was characterized by a homogeneous belief system that supported macroeconomic expansion. Households, banks and investors all operated under the assumption that housing assets would continue to appreciate. This common expectation increased the supply of credit that supported demand for housing, keeping the economy in a high-activity equilibrium.

But everyone holding that very same outlook was what stability depended upon. At the time of slowing down the growth of housing prices, the market agents began to interpret the data differently. It led to informational fragmentation. The common coordination regime broke down because borrowers, lenders, and investors could no longer agree on the risk of default or the value of assets. Diverse expectations also meant that complex financial instruments, such as mortgage-backed securities, lost their value as coordination devices, because they could not be priced correctly.

This mis-alignment of expectations triggered an endogenous contractionary feedback loop. As uncertainty increased, financial institutions tightened credit constraints and curtailed lending sharply. This credit crunch lowered aggregate demand, which lowered incomes and raised default rates. The negative results confirmed the initial pessimistic expectations, resulting in further credit tightening and a self-reinforcing downward spiral for the system. The crisis was not due to an exogenous loss of physical productive capacity, but to a rapid rearrangement of beliefs.

In the panic, the price system failed completely to aggregate information. Standard economic theory says falling prices help markets to adjust but in the crisis the falling prices only added to the severe signal noise. The falling price could be interpreted as a temporary correction or as a systemic solvency crisis, and agents responded with different and conflicting strategies that caused further destabilization in the market.

The breakdown of this information led to a systemic market failure in the banking industry. Counterparty risk could no longer be assessed by institutions and the assumption of financial stability collapsed. The opacity of this information created massive hoarding of liquidity that completely froze the interbank lending markets.

In the end, the 2008 crisis demonstrates that macroeconomic stability is not an automatic attractor to which decentralized markets are naturally drawn. Rather equilibrium is a delicate state of mutually consistent expectations. When this alignment breaks down, the economy makes a regime switch, from a healthy state into a long-lived, self-sustaining equilibrium of underperformance.

R E F E R E N C E S

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4. Gorton, Gary B. Slapped by the Invisible Hand: The Panic of 2007. Oxford University Press, 2010.
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7. Financial Crisis Inquiry Commission. The Financial Crisis Inquiry Report. U.S. Government Printing Office, 2011.