Early Causes of the Economic Crises - Coursework Example

PRINCIPLE CAUSES OF THE 2007 ECONOMIC CRISIS Prepared by (Student’s Name) Professor’s Name Institution Course Date Introduction The recent 2007 global financial crisis resulted to direct effects of the immediate economic positions of different countries; developing, underdeveloped and emerging economies all in one accord, in what is now known as the Great Recession. The recession started off as an isolated instability within the United States of America sub-prime housing sector but later extended into a recession that affected the entire globe (Adrian & Shin, 2007). The US instability resulted to major economic shocks in other major economies especially Europe and Asia in 2008 before affecting the entire world economies in 2009. It is important to understand that in the course of 2008, the immediate effects of these isolated global instability remained underestimated and consequently, compelling leading economic institutions like the IMF and World Bank engage in making substantial number of alterations for their respective growth forecasts in the period between 2008 and 2009 (Acharya, Philippon, Richardson,& Roubini, 2009). To eliminate the possibility of making great mistakes made by policymakers in the prior crises, governments for developed and developing economies reacted in a much timely fashion by injecting enormous amounts of credit into the financial markets while at the same time nationalizing their banking institutions, reducing interest rates and, also improving on discretionary spending through a fiscal stimulus package. The aggressive response resulted to a significant reduction in the level of possible damage in many of these countries however; the effectiveness and efficiency of the policies employed varies greatly in relation to the response and uncertainties of domestic economies (Acharya et al 2009). The focus of this paper is on identifying the principle causes of the 2007 global economic crisis. Early Causes of the Economic Crises In the period between 2002 and 2007; most of the world economies enjoyed a distinctive boom. However, it is also being ascertained that during this period, these economies overlooked the imminent level of stresses and strains that later affected the overall global labour markets (Crotty, 2009). It is during this period that most economies experienced substantial level of expansions in employment especially in the developing countries but despite this growth; that were faced with severe real wage growth, overreliance of the informal sector, intensive casualisation of the work force and increased inequality. In essence, despite the boom; Acharya and Richardson (2009, p.198) notes that there was a failure to translate the improvements in the economic growth to increased household incomes. For instance, research indicates that in major developing economies like Indonesia and South Africa; real wages in this period did not show any level of possible sustained improvements. Even in consumption-driven markets like the United States of America also experienced redundant growth in real wages. Unlike the developing economies where the situation resulted to intensive levels of poverty, in the US; households in fact, engaged in increased consumption activities by way of tapping into their respective wealth especially increases in the household equities that also accompanied ever rising commodity prices. It is noted that the imminent increase in the consumption resulted to a complete overhaul of the US current account deficit worsening it from 3.9% in 2001 to 6% in 2006 (Foster & Magdoff, 2009). In addition to this, in the course of late 2007 and early 2008, it is determined that many of the developing economies experienced both food and energy price shocks that resulted to immediate impairment of the fiscal and current balances of all affected economies, which, later resulted to food protests in many countries while at the same time pushing greater percentage of the population to poverty (Foster & Magdoff, 2009). The process is noted to be the fundamental reason for the global boom and reduced demand for goods in such already developed markets like China. Even in oil-rich exporting countries, the poor were suffered expansive inflation levels while exports returns remained minimised for the entire period (Foster & Magdoff, 2009). It is estimated that the food and energy price shocks resulted to an increase of at least 100 million new poor people while the World Bank ascertains the figure could remain way above 64 million in number in 2010. Contributory Causes of the Crisis In the period between 2007 and 2009, the world underwent the most renowned and severe economic crisis that was intertwined by inefficiency in the financial sector. The exposure of lenders and investors remained a complicated affair especially with the unprecedented degree of securitisation of mortgages provided through collateral debt commitments; that resulted to enormous levels of uncertainties in financial markets (Poole, 2010). Poole (2010, p.421) notes that, in turn, this led to a sudden need for risk reversal of risk perception from risk-taking to risk-aversion by most of the financial institutions. It is identified that the prior US administrations played a significant role in bringing about the recession. In 2001, the US enjoyed a dot.com bubble prompting the US monetary agencies to significantly reduce the level of policy interest rates to unprecedented levels; a course of action that resulted to a propelled debt-financed consumption boom as interest rates stood steady at 1% until 2003 (Stuckler, et al, 2011). The phenomenon causes an insignificant recession that was short-lived but contributed immensely to the 2007-2009 global recession. In retrospective, Stuckler, et al, (2011, p.124) argues that the period between 2001 and 2006, the US Federal Reserve policy was inefficient and loose thereby resulting to interest rates that were far too low in comparison to the suggestions made by the Taylor Rule; real funds rate remained negative for more than 30 months. Taking a closer look at the end of the market, the different levels of yields on US government bonds or rather treasury bills were deemed unusually lowly-positioned prior to the crisis period. In fact, the low interest rates in the United States persisted for a long period due to the fact that oil exporters within the Middle East economic powerhouses like China embarked on fulfilling their intrinsic appetite for accumulating substantial amounts of foreign exchange in US dollar-specific assets especially the low-yield US government bonds that eventually resulted to global imbalances (Rose and Spiegel, 2012). These global imbalances were the main reason for excessive level of savings by surplus economies like China and excessive consumption by deficit economies like the United States of America. Prior to the 2007 crisis; many of the economists perceived the US current account deficit as a probable cause for alarm given that it was unsustainable. The 5% in the level of deficit indicted that there was a high potential for the crisis (Gan, 2007). It s further argued that the relationship between the global financial crisis as well as the imbalances that resulted to the 2007 recession arose out of the excessive flows of capital from China as well as other exporting markets being injected into the US housing bubble and a consequent credit boom that also fostered depressing effect on bond yields. As a result of this, the US mortgage rates remained relatively lower even with efforts made by the Federal Reserve to improve on tightening the monetary policies in 2004 (Gan, 2007). Notably, there was intensive foreign borrowings that funded investment in the US firms and the mortgage debt items that facilitated an eventual sub-prime disaster. Subsequently, the recession was a result of a search for higher yield levels, misperception of risk as well as inexplicable lax on financial regulations (Gan, 2007). It is important to note that the lowly-placed interest rates and significant amount of yield on government bonds encouraged investors to look for higher-yielding assets especially in dollar-dominated US economy. With the surge on yields on corporate bonds within the emerging economies, fostered a narrow down search for T-bills resulting to leading potential investors to seek high returns; mortgage-backed securities. Having exhausted credit-worthy borrowing options, existing American-based lenders opted to take advantage of the low interest rates to further expand their operations and thus, opted for riskier market segments like issuance of non-standardised loans and engaged in sub-prime related activities (Blundell-Wignall, Atkinson, and Lee, 2008). The pressure to ensure positive outcomes especially in relation to financial innovations was a complete benefactor of lax financial regulations that had been initiated in the early 1990s and later on fostered by the Gramm-Leach-Bilely Act of 1999. The resultant political interference sought to promote home ownership rates especially amongst the poor as well as low-income households thereby developing into the sub-prime housing market in the US. The sub-prime borrowers that, would under normal circumstances, perceived as being not credit worthy were now profitable and worthy as business targets; prompting aggressive lending with a decrease in lending standards in the period (Blundell-Wignall, Atkinson, and Lee, 2008). Numerous analysts indicate that the US housing bubble was in fact that major cause of sub-prime crisis that fostered a wider economic imbalance; since it overflowed to international lenders that specialised in securitisation of mortgage-backed bonds. In this regard, mortgages were sold by the initial owners to third-parties before being repackaged as mortgage-backed securities and later sold to investors. This process resulted to lenders engaging in the scrapping-off of the loans from their books. For instance, special investment vehicle (SIVs) were compressed into service and scrapped of statements of financial position; a phenomenon that resulted to financial institutions increasing on their leverage positions as well as returns on their immediate investments (Blundell-Wignall, Atkinson, and Lee, 2008). Following this line of argument, it can be seen that mortgages, which was a previous reserve of financial institutions, was now being traded in the open markets in the US and other international markets without a clear guideline and regulations from regulatory agencies given that the trade was done over-the-counter (Acharya et al 2009). In essence, the formulation of sophisticated products outside the confinements of existing guidelines prompted to be a major undoing of the crisis. Retrospectively, a combination of an enormous shortfall in such important financial item like revenues and a relatively higher expenditure has in conjunction with small buffer levels resulted to a reduction in the most government’s capability to offset the immense fall in economic activities with the development of expansionary fiscal policy plan (Acharya et al 2009). In conventional times, monetary policies were held responsible for the entire stabilisation of policy frameworks but while the interest rates approached a zero mark, the notion relating to improved expansionary monetary policies was indeed restricted. As the recession became even more severe in nature, there was a perceived call for expansionary fiscal policy but given the lack of proper fiscal sustainability mechanisms in the course of the dot.com boom postulated that many countries; and especially the relatively smaller economies were unfairly positioned to convince international investors to execute immediate purchases of government-held debt. Research indicates that the crisis hit hard the UE region in the late 2008 and resulted to restricted access to capital flows while the future certainty of many banking institutions remained a risky affair while the equity markets fumbled altogether (Adrian & Shin, 2007). The real EU region economy was significantly affected given that trade financing platforms dried up while exports plunged by 15% or more over the preceding operational period. Consumer confidence levels within the larger region also fell to record lows while households embarked on limiting possible discretionary forms of spending; this could be seen in a significant reduction in purchases of capital goods as car sales dropped immensely. Markedly, economists further argue that the lack of proper international harmonisation and coordination framework resulted to further crisis. In fact, it is ascertained that the regulatory frameworks in most of the individual countries failed to sustain a pace perceived useful of internationalisation oof credit markets as well as the developments witnessed in cross-border banking mechanisms (Adrian & Shin, 2007). In the period when the crisis was slowly emerging it was established that regulators had not yet opted for a sufficient level of cooperation; a process that would have triggered real time responses. A perfect example of a lack of proper and timely coordination mechanisms needed in due time relates to the differences witnessed in deposit guarantee systems that affected global operations at once. In subsequent, the lack of international harmonisation was indeed perceived to be an issue whenever dealing with banking institutions in distress. It should be known that even in the EU where cooperative mechanisms were already set in place between supervisors and central banks; still there was inefficiency in the delegation of duties and responsibility and it was a result of the EU lacking an efficient framework for eliciting cooperating between central banks and supervisors on matters related to the financial stability challenges. The inefficient and unregulated winding up procedures for banking institutions also posed as a major threat to the widening of the crisis even further. It is important to note that in the banking sector there exists a great degree of externalities attributed to matters related to insolvency (Adrian & Shin, 2007). It is a known fact that a single bank’s failure to continue with operations might result to a domino effect that go way ahead to threaten the entire banking sector as a whole. Thus, these externalities call for a special winding procedure for all banking institutions to prevent unnecessary bailing out of banks by governments. It is crucial to note that the United States of America was the sole epicentre of the entire imbalance and thus, the crisis prompting its economy to be hit directly especially within the sub-prime mortgage market and credit crunch altogether. Due to this, the US overall economy plunged into economic recession towards the end of 2007; statistically, it fell by 2.7% as at the end of the crisis in 2009 (Rose and Spiegel, 2012). The severity of the economic crises was commonly felt in the middle-income markets especially in Central and Eastern Europe. The effects are a direct result of a combination of so many factors especially credit crunch as well as domestic imbalances like the enormous current account deficits and housing bubbles especially in the United States of America. Considering that there were many financial factors that resulted to the wider economic crisis, there was still an enormous diversity in the impact of the entire meltdown on the labour markets. There has been significant increase in the level of unemployment rates from 5.7% to a high of 8.6%., which represents more than 230 million jobless people at the end of the crisis in 2009 (Rose and Spiegel, 2012). Conclusion In sum, it can be noted from the discussion above that the economic crisis was a result of macroeconomic environments of prior decades that triggered a growing imbalance especially in China and US. For instance, the high savings ratio in China assisted to propel a current account deficit in the United States of America while not improving the local economy’s interest rate. Low interest rates in conjunction with favourable liquidity position resulted to a credit boom within the overall financial markets that prompted insufficient loan coverage ratios. Significantly, the paper has successfully argued that certain policies and especially in the United States of America like encouraging of home ownership even by disadvantages and not credit worthy individuals increased sub-prime lending that resulted to decreased credit controls hence extension of the crisis to the global markets as a whole. References List Adrian, T. and Shin, HS 2007 Liquidity, Monetary Policy and Financial Cycles, Current Issues in Economics and Finance, Federal Reserve Bank of New York, 14(1) Acharya, V., Philippon, T., Richardson, M. and Roubini, N., 2009. The financial crisis of 2007‐2009: Causes and remedies. Financial markets, institutions & instruments, 18(2), pp.89-137. Acharya, V.V. and Richardson, M., 2009. Causes of the financial crisis. Critical Review, 21(2-3), pp.195-210. Blundell-Wignall, A., Atkinson, P.E. and Lee, S.H., 2008. The current financial crisis: Causes and policy issues. OECD Crotty, J., 2009. Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’. Cambridge Journal of Economics, 33(4), pp.563-580. Foster, J.B. and Magdoff, F., 2009. The great financial crisis: Causes and consequences. NYU Press. Gan, J., 2007. The real effects of asset market bubbles: Loan-and firm-level evidence of a lending channel. Review of Financial Studies, 20(6), pp.1941-1973. Poole, W., 2010. Causes and Consequences of the Financial Crisis of 2007-2009. Harv. JL & Pub. Pol'y, 33, p.421. Rose, A.K. and Spiegel, M.M., 2012. Cross-country causes and consequences of the 2008 crisis: early warning. Japan and the World Economy, 24(1), pp.1-16. Stuckler, D., Basu, S., Suhrcke, M., Coutts, A. and McKee, M., 2011. Effects of the 2008 recession on health: a first look at European data. The Lancet, 378(9786), pp.124-125. Read More