Definition of Financial Terms

Economic Essay on Global Financial Crisis

Global Financial Crisis

Introduction

Generally, the global financial or economic crisis (GFC/GEC), is believed to have begun in august 2007 (Gale & Allen, 2007). GEC was marked with the start of credit crunch after United States investors lost confidence in the sub-prime mortgages value resulting from liquidity crisis. As a result, this the Federal Bank was forced to instill huge capital amounts in the financial markets. By 2008, the crisis worsened, following global markets crash and increased volatility. Gale and Allen (2007) stated consumer confidence experienced a drastic stop also as every individual became cautious as a result of the uncertainties regarding the future. The United States housing market, following these events suffered greatly as a large percentage of homeowners had already taken sub-prime loans making them incapacitated to make the payments. The borrowers went through negative equity as the value of homes plummeted. With the rising number of default loans, banks experienced a state where repossession of houses and lands was of far less value compared to loans they had originally rendered (Detragiache et al, 2008). The banks therefore, similarly suffered a crisis of liquidity such that giving and obtaining loans proved to be a challenge following bursting of subprime lending bubble or currently is known as credit crunch. The GEC, according to et al Allen et al (2009) affected almost all countries across the globe but the impact was felt strongly in the United States. The crisis also led to high rate of unemployment with majority of people losing jobs. There are others who lost property like land and houses. Thus, this paper, is going to demonstrate theoretical implementation, a thorough study of the effects and causes related to the happenings of 2007 and 2013.

Credit Crunch

Credit crunch refers to economic state that makes it quite a challenge to acquire capital for investment. Such a state makes it close to impossible for organizations or firms to get loans as a result of fears related to bankruptcy among leaders. According to Whalen (2008), credit crunch involves economic state where loans and investment capital are difficult to acquire. During these seasons, banks and other lenders are cautious of giving out loans thus making the cost of borrowing to increase to levels where deals do not materialize. Lehman Brothers was among the first largest financial institution to suffer bankruptcy in 2008 (15th September). The experience of the bank was due to the fact it could not obtain any bail out from the Federal government. Bear Streams, on the contrary was bailed out regardless of being a smaller competitive investment bank. Though the assumption was Lehman Brothers was never bailed out due to their huge size which provided the advantage of survival, this was not the case since every financial institution has its own risk. Western governments made high investment funds into banks at the risk of suffering bankruptcy as a result of ‘domino effect’ fears. The United States statistics indicate that approximately 8.8 million people lost their jobs as a result of the financial crisis, which made the duration from 2007 to 2009 to record the low level of GDP of about -5 percent.

As early as the start of 2007, analysts and other scholars already had issued warnings that the United States financial markets were going to get into a credit crunch. By August 2007, the announcement was made that the business sector had been hit by the crunch. By September the same year, the confirmation was made that households or consumers had already been affected by the crunch. As a matter of fact, 70 percent of the home loans from mortgage brokers never closed in august as the brokers were not in the position to purchase the loans. Previously, banks were enthusiastic to offer loans to buyout companies as the institutions could not resell the loans to investors. However, the financial sector, experienced a problem during the month of July 2007 in that the existing and new market for buyout loans shrank at a drastic rate. Certainly, investors with portfolios for existing loans found out they were not able to sell the loans at whatever price. Investors were therefore caught up having loans, which were losing high value each hour yet, they did not have any exit. On the other hand, since the investors feared getting stuck in similar circumstance, the buyout deals were abandoned. Other dimensions included commercial paper and hedge funds role (Whalen, 2008).

Cause and Effect

To a great extent, GFC is attributed to extended periods of extreme loose monetary policy in the United States between 2002 and 2004. Very low IRs during the period promoted aggressive hunt for yield and a substantial compression upon risk of premia globally. Abundant liquidity in the developed economies resulted from slack of the monetary policy in form of massive capital flows into developing economies. All these factors served as a boost to the asset and commodity prices like oil prices across the range, offering a boost to consumption and investment. Global imbalances also served as manifestations of the accommodative monetary policy and the concomitant aggregate demand boost while also outstripping the domestic aggregate supply in the United States. Detragiache et al (2008) stated the period coincided with lax standards of lending, credit ratings, excessive leverage, financial engineering and inappropriate use of derivatives. As inflation begun edging up to high levels, it raised the need to tighten the monetary policy (Mohan, 2009). Prices of housing began to experience challenges while excessive lax lending rules, leverage and bank risks model weaknesses were exposed. As such, bank’s losses became excessive and they wiped out capital key of financial institutions.

Therefore, there are a couple of factors that led to emergence of GFC including interest rate levels, misperception of risk, mismanagement and financial system regulation. The dominant factor that triggered the crisis involved risk perceptions. During good periods, risk perceptions among individuals reduce but when there is a cycle change, there is also increased risk of aversion. In the years that led to the crisis, risk perceptions among the investors changed. Yields from emerging market bond narrowed down compared to what the US government bonds and other securities could be deemed safe. This implies there was a cycle of global events leading to the GEC (Sherlund et al, 2009).

The start of GFC is demonstrated by 3 major shocks. Among shocks leading to the crisis was the burst of the housing bubble (Stoeckel &McKibbin, 2009). Falling prices of houses had the tendency to greatly influence household spending, loan defaults and wealth. Various events occurred in the United States characterizing this global/international phenomenon. Between 2000 and 2006, prices of houses in some regions doubled and collapsed eventually. Therefore, overall, the US house price index dropped by 6.2 from 2008 to 2009 (Sherlund et al, 2009). While housing prices were increasing strongly, credit was offered freely in order to satisfy the demand as the risk perceptions dropped. As such, the increasing wealth boosted confidence and spending among people. The housing bubble comprised a global phenomenon that was primarily based on Anglo-Saxon world. The bubble arose from lengthy period of low IRs advanced by Federal Reserve of the United States, which minimized rates of interest by 550 basis points in the duration 2001-22004 (Stoeckel & McKibbin, 2009).

The monetary policy aided the commodity price spike and the asset price bubble since it remained loose for long periods. Contrarily, if the Federal Reserve complied with Taylor rule, the interest rates would have risen sooner while the bubbles wouldn’t develop to such a degree. Low interest rates (IRs) arose as a result of deflation fears leading to housing boom in the United States (Mohan, 2009). The yields of the country from bonds were also low as a result of low global rates. Further, an international aspect contributed to low IRs in the United States since Japan and Europe were recovering at slow rates after the economic crisis of 2000 and 2001. Therefore, this placed great pressure on the US to maintain IRs at the lowest level. What is more, there were fears regarding the resurfacing of deflation in Japan. Matter of fact, this was the core reason IRs were kept at low levels in the US for a longer duration than usual till the mid of 2004 when the Federal government begun to tighten the cycle strongly.

Davies (2009) noted low IRs through 2003 to 2004 served the purpose of fuelling the boom of commodity price apart from increasing the asset prices, increasing demand in China and other countries that are less developed (LDCs) and fuelled the boom of bank lending. The up-trend within the United State houses was clear from the year 2000. In 2001, small investors left the stock market settling for the housing market, a state that sustained and increased the prices. Further, the surge of commodity prices in 2005 to 2008 was greatly associated with the developments in China plus delayed supply response. The bubble housing burst was designed in a manner that permitted easy services flow from housing investment bigger in Europe, UK and the US while retaining its importance throughout the globe.

According to Ellis (2009), the rising equity risk was a shock that facilitated GEC in 2008. The upswing unexpected prices from 2003 and especially in 2006 and 2007 resulted in concerns related to inflation which led to sharp reversal of monetary policy within the United States. The tightening of the US policy also meant tightening of monetary policy in countries that were pegged to the US dollar. The reversal’s sharpness, drop in house prices in the US and financial regulation failures contributed to the financial crisis or problems seen between 2008 and 2009. Lehman Brothers failure was largely because of the huge losses the bank sustained on subprime mortgage market of the United States (Davies, 2009). The bank held positions that were big within subprime plus other mortgage markets of low rates. However, delinquencies of mortgages increased following the burst of the United States housing bubble in 2006 through to 2007. Also, GFC was triggered by increase in household risk. The risk re-appraisal by companies as a result of the crisis was also applicable to households. Households took into consideration the future as far riskier as such, discounting their earnings in future and affecting spending and savings as well (Rogoff & Reinhart, 2009).

The GFC, in 2008 led to synchronized and severe drop in international growth and trade. What is more, it served as a harsh reminder of the importance of international connection in global economy. Nonetheless, despite the global ramifications triggered by the crisis, most countries experienced varying levels of growth. According to Matheson (2013), the advanced economies with strong trade and financial connections suffered the most from the economic crisis. GEC saw the biggest and sharpest from in global economic activities in the contemporary world. In 2009, the largest percentage of developed economies faced deepest recession. What is more, global trade fallout in relation to terms of patterns and volumes has been dramatic. According to Crotty (2009), the response of the governments was to ease the monetary and fiscal policy which consequently, have their impact on trade flows and activities. As such, the activity downturn has caused high unemployment levels while political responses have aimed at safeguarding domestic industries through a combination of different domestic subsidies and border protection.

In absence of a response from fiscal policy, the bubble housing burst had the largest kind of effect on real consumption which comprised 70 percent of domestic economy. This implies that it caused the greatest negative effect on real GDP (gross domestic product). Permanent loss of wealth also led to sharp drop in consumption, especially since it assumed the housing shock would be permanent. The financial shock had the tendency to have a great negative effect on stock market values based on the baseline of 2009, an equal impact as housing bubble burst on investment (Stoeckel & McKibbin, 2009). The shock of equity risk led to shift from equities to other domestic assets such as governments bonds, asset purchase abroad and housing. A shift in government bond increased prices upwards while pushing down the real IRs. Surprisingly, this has increased human wealth taking into consideration the expected taxed income in future is discounted at lower real IR.

Allen and Carletti (2009) on the other hand made the observation that investment dropped sharply since equity shock helped minimize US investment by 20% below the baseline. Increase in equity risk also meant sharp shares sell-off as a result of the huge increase in required capital return rate. A high premium of the equity risk also meant the existing stock of capital was extremely high in production of the required marginal product from financial and economic arbitrage condition. Also, over time, investment dropped since the adjustment costs made capital stock reduce while the possible yields were minimized permanently. The United States exports also suffered to a great extent as a result of huge capital outflow as the US savers made some investments offshore into household risk shock. As such, the country’s trade balance improved by four percent GDP, especially due to the sharp depreciation of the dollar (Stoeckel & McKibbin, 2009)

Conclusion

The discussion above indicates that global financial crisis started in 2007 following the credit crunch. Investors lost confidence on mortgages, which resulted to crisis in liquidity. The condition became worse after shock markets crashed throughout the globe and became extremely volatile. Similarly, consumers lost confidence and they had great uncertainty regarding the future. According to the analysis, the housing market is among sectors that suffered the most since most people who had prime loans were not able to pay their mortgages back. Many governments struggled and they still do to salvage giant financial institutions as a result of the deteriorating situation. The discussion presents research that is comprehensive in relation to the effects and cause that followed the 2007 to 2013 happenings. From the discussion, it is clear the credit crunch had a wide spread impact, which shook the US economy and the international markets since 2007.

 

References

Allen, E., Babus, A., & Carletti, E. (2009). Financial Crises: Theory and Evidence. European University Journal, 1(1):1-43.

Carletti, E., & Allen, F. (2009). The Global Financial Crisis: Causes and Consequences. Economic Journal, 1(1):1-43.

Crotty, J. (2009). Structural Causes of the Global Financial Crisis: A Critical Assessment of the New Financial Architecture. Cambridge Journal of Economics, 33(4):563-580.

Davies, J. (2009). Global Financial Crisis-What Caused it and how the World Responded. Retrieved from http://www.canstar.com.au/home-loans/global-financial-crisis/

Detragiache, E., Dell, E., & Rajan, R. (2008). The Real Effects of Banking Crises. Journal of Financial Intermediation, 17(1):89-112.

Ellis, L. (2009). The Global Financial Crisis: Causes, Consequences and Countermeasures. Centre for Strategic Economic Studies Journal, 1(1): 24-34.

Gale, D., & Allen, F. (2007). Understanding Financial Crises. Oxford, UK: Oxford University Press.

Matheson, T. (2013). The Global Financial Crisis: An Anatomy of Global Growth. IMF Working Paper, 1(1):1-40.

Mohan, R. (2009). Global Financial Crisis; Cause, Impact, Policy Responses and Lessons. BIS Review, 54(1):1-24. http://www.bis.org/review/r090506d.pdf

Rogoff, K., & Reinhart, C. (2009). The Aftermath of Financial Crises. American Economic Review, 1(1):1-21.

Sherlund, S., Pence, K., & Mayer, K. (2009). The Rise in Mortgage Defaults. Journal of Economic Perspectives, 1(1):1-17.

Stoeckel, A., & McKibbin, W. (2009). The Global Financial Crisis: Causes and Consequences. Working Papers in International Economics, 2(9):1-44.

Whalen, C. (2008). The Credit Crunch: A Minsky Moment. Studi e Note di Economia, 13(1):3-21.

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