Intermediate Macroeconomics: Causes of the 2008 Global Financial Crisis - Example

Intermediate Macroeconomics: Causes of the 2008 global financial crisis. Student Name: Student number: Tutor name: Institution: Causes of the 2008 global financial crisis The issue of global financial crises is a known phenomenon due to effects that it leaves behind. Looking at the world economy, there has been financial crisis from time to time taking into account an example of the great depression which occurred in the period of 1930 (Reddy, 2008). But what distinguishes the 2008 financial crisis from the rest was the extent into which it implicated most of world economy. Many factors contributed to this position which included flaws in the implementation of policies and problems in micro economics. The global financial crisis can be defined as a resultant of combined irregularities in the global housing and an increase in risk to premia firms, households and global investors (Taylor, 2009). The occurrence of global financial crisis in 2008 led to collapse of investments such as Lehman Brothers. The collapse of industries sent fear in the financial markets with authorities trying to put liquidity directly into financial markets. This did not help curb the crisis which had already affected the market in a great way. The crisis at last brought the worst performance into global market; most of the industries were deep in recession in the following year. In the year 2009, the global trade volumes were predicted to fall by 13 percent. As a result of these crises, employment levels fell as there was collapse of industries (Roubini and Nihm, 2010). The crisis hit hard the housing sector in United States of America which experienced high prices in 2006 and dropped by more than 30 percent in later years. According to the set laws, the responsibility of protecting and stabilizing finances is left to the governments and the Central Banks. This is intended to be achieved through good supervision and control of the financial markets as well as related institutions. This has led to analyzing what went wrong and could the crisis have been evaded (Roubini and Nihm, 2010). The causes of what 2008 global crisis need to be looked to know where the policies failed. One of main causes of 2008 financial crisis was failure of the regulatory structures that were in place to keep track of changes that were occurring in financial markets. This was experienced when the companies holding public finances expanded beyond the economy keeping their finances in great risk (Roubini and Nihm, 2010). The flaws that were in the financial system were the main cause of the problem. The shocks brought by crisis are as seen in table below using United States as having weight of 1 so as to provide a series. Weight for country and sector shocks USA JPN GBR DEU EUR CAN AUS OEC CHI IND OAS LAM LDC EEB OPC Equity risk by sector – Energy 1 1 1 1 1 1 1 1 0.8 0.8 0.8 0.8 0.8 0.8 0.8 – mining 1 1 1 1 1 1.2 1.2 1 0.8 0.8 0.8 0.8 0.8 0.8 0.8 – Agriculture 1 1 1 1 1 1 1 1 0.8 0.8 0.8 0.8 0.8 0.8 0.8 – Durable Manufacturing 1 1.2 1 1.2 1 1 1 1 0.8 0.8 0.8 0.8 0.8 0.8 0.8 – Non durable Manufacturing 1 1 1 1 1 1 1 1 0.8 0.8 0.8 0.8 0.8 0.8 0.8 – services 1 1 1.2 1 1 1 1 1 0.8 0.8 0.8 0.8 0.8 0.8 0.8 Household risk 1 0.1 0.5 1 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Household productivity 1 0.1 1 0.5 1 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Source: (Roubini and Nihm, 2010) Apart from the regulatory causes, another cause was based on macroeconomics factors such as low inflation and rates of interest (DeLong and Olney, 2006). The last few decades had experienced a good level of macroeconomic stability. The growth rate of economy was steady which came with an inflation rate which was stable. This was seen in most of the great economies of the world. In the previous decade prior to recession, the communist states became open to the world trade. This lead to occurrence of reduced cost of labor in the market. The world trade balance shifted due to increase in use of technology to manufacture goods and services which meant that the companies could locate their plant in any country overseas (Roubini and Nihm, 2010). The net effect was reduced cost of production in industries and increases profits. This scenario reduced power of bargaining in the local unions of trade significantly. The wage growth reduced in the developed economies which combined with high domestic inflation rates. Another cause was increase in taking risks in banks by the customers. There was a sharp increase in borrowing debts from the banks which did not level with bank deposits made (Reddy, 2008). This meant that banks had to look for another source of income to fund the debts. Banks sourced for funding markets such as wholesale funding to survive. Most of other institutions of finances offered short term funding despite the fact that most of their sources of income depended on long term investments. This led to high risks in terms of liquidity. During this period the treasury bonds yielded little than what was expected in returns by investors. This meant those investing in treasury bonds had seek for higher risks so as to receive good returns. The effect of taking high risks contributed to a great part in the financial crisis. At the end most of investors found themselves in situations in which they faced great stress as they could not finance themselves (Roubini and Nihm, 2010). Rising imbalances in microeconomics seen in many countries aggravated the situation. The situation was experienced by many countries having large deficits in their accounts (Taylor, 2009). During this period, the emerging economies were having large current account excesses which they invested in the developed economies. This increase in demand led to increase in prices and reduced returns in assets in all advanced countries. Another microeconomic cause of the crisis was the lack of address to the financial cycle. The rise in assets prices and credit was not responded in the right manner. Most of the banks did not respond and instead they dropped the interest rates, this led to economic fallout. This in many instances left the issue of rapid increase in credit and leverage unattended. The financial market was also a cause of imbalance (Taylor, 2009). Though there was a stable growth in the market, there were challenges such as imbalances in the macroeconomic, reduced rates of interest which was coupled with lack of liquidity. Though the financial market was expected to handle this problem, there was weakness which together with unattended high risk led to crisis. The financial markets consisted of global markets which brought cash flows across the borders. This led to high levels of complexity in the financial market due to increase in the levels of innovations. There was also reduction in management of risks in the financial market. The financial institutions relied mostly on the collected information from past years. This meant that market prediction was based on previous data collected. Investors were not expecting any financial crisis since the data used could not predict (Williamson, 2008). When the crisis hit them, most were unaware. The banks were not well prepared for large effects that lack of liquidity would pose. This is due to poor stress estimation which did not cater for unexpected large liquidity shortages. Looking at the way government regulated the financial market, there was lowering of credit control. The government especially in the United States of America made policies which allowed low income earners own houses. This was done through mortgages and provision of cash to pay for homes. There were loans which borrowers’ income was not documented and lacked security (Bems, Dedola and Smets, 2007). These loans increased at a very high rate and were known as non prime loans. This later came to play a great part in fueling the financial crisis. The provision of guarantees by the state to banks and other financial institutions also contributed in a way to financial crisis. The deposit insurance had become a procedure in many states in the globe. This leads to a situation in which the creditors are not capable of knowing which banks to trust. The guarantee has a negative effect on the stability of the financial market. The investors had faith that incase of failure, the government would come to their rescue with public funds (Taylor, 2009). The notion did not materialize as seen in cases like the falling of Lehman Brothers. Many factors contributed to this crisis as has been expressed here. The microeconomic imbalances played a great role in the crisis onset (Bems, Dedola and Smets, 2007). Looking at other factors such as globalization, and increased use of technology, they had a great impact. This was evident when pressure on inflation was decrease leading to reduced rate of interest. Other major causes were underestimation of risks as well as uncompetitive rating agencies which gave inaccurate estimation of risks. Several lessons can also be learned from the causes of the 2008 financial crisis. The countries ought to make sure that they are addressing the control of risks. Lacking a good mechanism to curb risks led to some countries being more affected than others. There is also need for government to ensure they are using relevant policies on microeconomics. This especially vital during the time financial market are experiencing boom. An imbalance in macroeconomic has led to a situation in which country risks having a great effect in case of financial crises onset. There is also need to have good fiscal policies where there is surety of economy recovery (Roubini and Nihm, 2010). One of the areas in which there was failure which led to crisis was bad supervision which in many countries need overhaul. This cause was mainly a government failure which can be rectified by making sure all structures of supervisory and regulations are working. The 2008 crises have also led to the public being more aware on need to have finances for cater the crisis. After the financial crisis, many countries made fiscal policy response. The table below shows the fiscal response of different countries which mainly took place in 2009 and 2010. The fiscal response was meant to ease fiscal burden. Country/ region 2009 2010 2012 2013 cumulative United States 2.07 1.55 1.04 0.52 5.18 Japan 1.46 1.10 0.73 0.37 3.65 United Kingdom 1.32 0.99 0.66 0.33 3.29 Germany 1.38 1.04 0.69 0.35 3.45 Euro area 1.30 0.98 0.65 0.33 3.25 Canada 1.68 1.26 0.84 0.42 4.20 Australia 2.48 1.86 1.24 0.62 6.21 Rest of OECD 1.00 0.75 0.50 0.25 2.50 China 4.80 3.60 2.40 1.20 12.00 India 0.50 0.38 0.25 0.13 1.25 Other Asia 2.00 1.50 1.00 0.50 5.00 Latin America 0.50 0.38 0.25 0.13 1.25 Other LDC 0.50 0.38 0.25 0.13 1.25 EEFSU 1.70 1.28 0.85 0.43 4.25 OPEC 3.00 2.25 1.50 0.75 7.50 The assumed fiscal policy response per cent of GDP Source: (Roubini and Nihm, 2010). Looking at these causes of the crisis, there is also need for the government to be fully accountable to what they provide to the public in terms of services. This would ensure that the government audit and give statement on how public funds are being spent to promote transparency (Roubini and Nihm, 2010). This would ensure that the government is also taken into action in case of crisis. Financial crisis should make the country more aware of the manner in which to respond and prevent future crisis. This is because the financial market in some cases becomes unpredictable as was seen in 2008. This is why there is need for knowing the causes of 2008 global financial crisis. References Bems, R., Dedola, L. and Smets. H. (2007). U.S Imbalances: The role of technology and policies, Journal of International money and Finance, 26(4), 523-45. DeLong, J. and Olney, M. (2006). Macroeconomics. New York: McGraw-Hill/ Irwin. Reddy, S. (2008). U.S news: amid pressing problems, threat of deflation looms, Wall Street Journal, 134-67. Roubini, N. and Nihm, S. (2010). Crisis Economies: A Crash Course in the Future of Finance. New York: The Penguin Press. Taylor, J.B. (2009). Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis. Stanford: Hoover Institution Press. Williamson, S. (2008). Macroeconomics. Boston: Pearson Education, Inc. Read More