To illustrate the problem, let’s begin by examining net debt flows in the private nonfinancial and government sectors over the last 10 years. As can be seen in Chart 1, borrowing by the  2  BIS central bankers’ speeches  private nonfinancial sector rose rapidly from 2003 to 2006 and remained high until the crisis hit. Then borrowing turned negative as new loans were more than offset by repayments and write-offs. Only recently has borrowing turned weakly positive. Chart 2 illustrates how the stock of net debt in different sectors of the economy evolved throughout this period. It shows that much of the credit boom was concentrated in the household sector. The business sector only experienced a surge from 2006 onward. During the boom, leverage also increased in the financial sector. As the boom proceeded, credit losses were low and earnings strong. But once the bust began, this dynamic reversed. Credit losses at financial institutions surged and the sector was forced to deleverage rapidly and raise new capital. This resulted in a significant contraction in the availability of credit and was a major direct shock to the global economy. Crucially, this tightening of credit standards exacerbated how much many households and firms had to deleverage. It also crimped demand, inhibiting economic, employment and income growth, which in turn made the deleveraging process more challenging.
The origins of the crisis are complex, but it had its roots in the bursting of a credit bubble that had grown to great size during the middle part of the last decade. Prior to the onset of the crisis, a combination of rapid financial innovation and unbalanced global economic integration resulted in a mispricing of risk worldwide. This was particularly extreme in certain markets such as U.S. housing and housing finance. This mispricing of risk led to a misallocation of resources and an excessive build-up of debt in many parts of the global economy. Many – though not all – U.S. households responded to the easy availability of credit and rising home prices by taking on more debt. When the housing boom lost steam and began to burst, expectations about housing prices and wealth were disappointed. The bursting of the credit bubble also created instability within the global  BIS central bankers’ speeches  1  financial system, and this in turn resulted in a sharp constraint in the availability of credit for households and businesses. The result was what is now called the “Great Recession.” Over the period from late 2007 through mid-2009, real gross domestic product (GDP) declined more than 5 percent, making this recession the longest and deepest recession of the postwar period. The recession manifested itself in many ways, but one of the most painful was the severe impact it had on the labor market.