Financial stability is based on the balance between supply and demand. Equilibrium can accommodate swings in the levels of supply vs. demand, but there normally is a balancing factor, such as price, that re-balances. If demand exceeds the supply of gasoline, the price of gasoline will rise, discouraging some people from driving their cars for unnecessary trips. When gasoline prices rise, producers have incentive to produce more. As more gasoline enters supply, prices decline and drivers become less careful about their consumption. Equilibrium is restored.
Credit Crisis of 2008
The credit crisis of 2008 created unstable financial situations on many levels because the instability spread to all sectors of the economy. The equilibrium between the demand for money and the supply was upset by stringent credit restrictions that locked out all but the very largest, most credit-worthy companies. The Federal Reserve Board of Minneapolis conducted a study in 2008 that indicated companies with the ability to borrow increased their borrowing and hoarded cash whether they needed it or not. This produced a shortage in funds available to lower-tier companies, so the demand for money exceeded its ready supply. When small businesses tried to borrow money, they couldn't compete with corporate giants, so many of them either went out of business or cut back employees and operations. Those companies had suppliers and their employees had favorite places to spend money -- and they all suffered. When the financial system became unstable, action and reaction spread the instability further by destabilizing industries outside the financial industry.
Business Financial Instability
On the business level, the failure of Bear Sterns, Lehman Brothers and AIG occurred because they held mortgage securities that were defaulting, causing other financial products based on those mortgage securities to also default. Those financial institutions failed because other companies feared that if they invested money in them, they would not be paid back. Indeed, many companies did lose money as a result of those failures. The credit markets froze because they had become extremely out of balance and fearful lenders raised their credit quality requirements. Commercial banks failed because they could not sell their loans into the securities markets and companies could not get bank financing because the banks had less money to loan. Companies such as General Motors failed, as did their smaller suppliers and so did companies that supplied the suppliers.
Personal Financial Instability
People lost their jobs or had their hours cut back and were unable to pay their mortgages, so many houses were put up for sale and the number of people able to buy houses declined. This happens in any economic downturn and is usually just a temporary imbalance between the supply of houses and demand. In this case, it was more than a temporary imbalance because it had so many different components -- problems reaching to the very highest levels of the financial system and back down to the smallest businesses. It was a perfect storm. More demand than supply in the housing market had in previous years driven house prices to record highs. This was because Federal Reserve monetary policy had driven interest rates to record lows, making it possible for more people to buy houses. Mortgage products were created to allow even previously unqualified buyers to purchase houses, and because of the high prices and appealing mortgage terms, many people bought houses they couldn't afford even in booming economic times. The burgeoning defaults on mortgages by over-extended homeowners caused the defaults that brought big securities firms and insurance companies to financial failure.
When the recession hit, normal things happened. Business slowed and overtime hours were cut, resulting in declining income for many people who depended on the extra income to support their bill payments. This instability in the financial system was so large and widespread that it exceeded the ability of normal adjustments in supply and demand to bring back equilibrium.
Geopolitical Financial Instability
The unstable financial situation in the United States was mirrored in other countries. Recession in the U.S. resulted in fewer imports from foreign countries. Ireland's growing technology industry faltered as did Greece's tourist industry. As jobs were lost in those countries, ordinary people began defaulting on their bills. In areas where housing had experienced a boom similar to the U.S., housing markets collapsed. Governments that had over-spent during the economic boom were in danger of going bankrupt as a result of the economic bust. Financial instability had spread to most places around the globe.
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