Why did the global financial system meltdown in 2008 - Essay Example

? Why did the global financial system meltdown in 2008? Introduction The global financial system meltdown happened as an effect of the spread of the financial crisis that occurred in the US due to losses in the subprime housing markets. The losses in the subprime markets occurred as a result of aggressive investment in housing properties with lending activities undertaken without due diligence on the credit policies. The increase in the number of bad loans led to devaluation of company assets and the benchmark indices plunged as a result of the erosion of investor confidence. This effect spread across other economies of the world. The national production levels, imports and exports lowered which gave rise to reduction of consumption demand. The fall of consumption in the economy again pulled down the productivity levels thereby forming a vicious circle which prompted appropriate actions from policymakers for economic recovery. Overview and key rational concepts: global financial system meltdown and relevant issues of world economy The global financial meltdown that occurred in 2008 had its root in the economic crisis in US. The economic crisis in US started with the crisis in the housing markets of US. The prices of the housing market were steadily increasing during the middle period of the 1980s to 1990s. The investments in the housing market were lucrative as the investors in real estate and housing properties could realize multiple values of their initial investments within a short period of time. The investment funds were borrowed from the banks and financial institutions. The banks and the financial institutions also observed that their loans could earn them interest repayments in short time and the underlying mortgage properties were also of high value in the market. In the plight of higher growth in short span of time, the financial institutions lacked due diligence while assessing the credit parameters of the borrowers. The policies of the US government also influenced such activities in the market as every citizen of US had a fundamental right of holding housing property. This phenomenon led to the formation of a housing bubble. Due to lack of tighter credit policies, the income level of the borrowers and their past credit history were not fully checked. This caused the housing bubble to burst when the borrowers at one point of time were not able to repay the loans. The crisis situation occurred when the weight of bad loans increased beyond proportions (Kates, 2011). The financial institutions and the corporate houses which held the housing properties as underlying mortgages incurred heavy losses as a result of the bad investments. The share prices of the companies including big names like the Lehmann Brothers fell and the shareholders’ wealth was eroded in quick time. This led to a huge crisis in the economy of US that created the financial recession in 2008. The economic crisis in US is also referred to as the subprime crisis. The losses that occurred in the housing market is referred to as subprime because this market had a relatively lesser adherence to credit parameters for lending and included borrowers who could not avail loans from the prime house lending market. The economic crisis slowly and gradually spread to other economies as well and the global financial system was hit by the economic crisis (Allen, 1999). This was the age of economic reforms by developing countries like China, India which led to its integration with the world trade. The international economy was heavily dependent on the exports and imports of the countries all over the world like US, UK, Canada, countries of the European Union, Middle East, China, India, etc. The economic crisis in US led to the fall of consumption demand and productivity in the economy. As a result of this, the exports and imports of the country hampered which in turn affected the imports and exports of other countries all over the globe. Thus the effect of economic crisis melted down to the economies as well as the productivity levels of those countries was bad hit due to fall of demand. This created the global financial meltdown. Apart from the reduction in economic growth rates due to the evil effects of the crisis, the debt crisis of Euro-zone also took place. The countries of European Union faced the debt crisis as they were not able to repay the debts incurred. The impact of the economic crisis was such that it led to the global financial meltdown all over the world. This stimulated the policymakers of different economies to adopt policies for safeguarding their economies and implement such policies for economic recovery. Apart from the policies of the central governments, the international financial bodies like the World Bank, International Monetary Fund, European Central Bank took necessary measures to recover from the position of global financial meltdown and granted funds for bailout of the economies. Analysis of facts: Global financial system meltdown The analysis of the global financial system meltdown depicts the reason of the financial meltdown across the globe and the impacts of the crisis on the economies all over the world. The rippling effect of the financial crisis that started from the subprime losses in US spread to other developed and developing economies as well. This happened as the world in 2008 was integrated through international trade and the subprime losses in US spread to other economies as well. The fall in the productivity of the companies led to devaluation of shares and company valuation fell as the investors’ confidence was eroded (Kolb, 2010). The decline in productivity transmitted across other economies as well as the exports and imports were hit. The graphical representation given below shows a clear demarcation of the fall of housing market activities post economic recession as compared to the period before economic recession. As a result of the fall in productivity of the economy, the gross domestic products of the world economies were severely hit. This was evident from the declining growth rates of GDP of countries like US, UK, etc. The fall of the GDP growth rates of US is evident from the graphical representation given below. It is clear that due to the effects of global financial meltdown, the GDP growth rates of US dipped from 2008 to 2010. A look at the GDP level of UK also depicts the effect of global financial system meltdown. Due to the spread of the financial crisis, the benchmark indices in UK dipped as a result of the fall of investors’ confidence and devaluation of the companies. From 2008 onwards to 2010, the GDP level ok UK also lowered after which it staged a recovery. This was the case with almost every economy across the world which was impacted by the rippling effect of the economic crisis. As a result of the plunge in economic productivities across the globe, the workforce required for production of goods and services were reduced. This led to reduction of employment level and the purchasing power of people reduced. A reduction in the purchasing power led to the fall of consumption demand. This created a vicious circle in the economy with fall of demand and productivity supporting each other thereby creating a grave situation for the global financial system. The fall of the employment level of the US economy is apparent from the graphical representation given below. Due to the impact of financial meltdown, the employment level in US dipped from 2008 to 2010. This has been shown by the red dotted lines in the graph shown below. As an evidence of the meltdown of the global financial system, the reduction in employment level of UK has been cited as an example. The reduction in employment level has been a common feature for the economies all over the globe during the period of global financial meltdown. An analysis of the graphical representation given below indicates that the employment level in UK has gradually decreased from 2008 to 2010 as an effect of the rippling effect of the global financial meltdown. On one hand when the impacts of the financial crisis melted the financial system across the globe, the effects of the financial crisis like the fall of employment level, fall of consumption demand in turn supported further meltdown of the global financial system. Due to the fall of productivity of the economies, the government rose in proportion to GDP which meant depletion of treasury. This was the risk faced by the economies as an impact of the financial crisis which prompted policy maker to take necessary actions for economic recovery. As an example, the rising government debt to GDP for US as an effect of the financial crisis is given below. The global financial system meltdown is evident by taking the government debt to GDP ratio for UK as an example (Trading Economics, 2013). The graphical representation given below shows that the government debt to GDP of UK increased from 2008 to 2011 as an effect of the global financial system meltdown. The global financial meltdown attained greater significance as a result of the occurrence of the sovereign debt crisis in the Euro-zone. The debt crisis in the Euro-zone occurred due to loss of funds by the European nations that were invested in the global financial markets that offered higher returns than the US treasury bonds. The spread of the financial crisis in the global financial markets led to heavy losses for which the debt incurred by the European nations could not be repaid. The bloodstream of the Euro-zone is the interbank credit facility between the member countries. Thus non-repayment of debt by one member affected the debt repayments of the other member and this led to the spread of debt crisis in the Euro-zone (Berend and Berend, 2012). Due to the global financial system meltdown, the central governments of the countries and international fund agencies adopted policies for bailout in order recover from the global financial crisis. The fiscal and monetary policies were revised in order to inject liquidity in the financial system and government grants were provided to increase the productivity and spending with a close eye over control of inflation in the economy. Argument: Competing views on the global financial system meltdown There were contrasting views on the cause and impacts of the global financial system meltdown. The financial system and the investors in their plight of quick economic growth invested in the housing markets and global financial markets which offered returns even higher than the treasury bonds. The aggressive investment policies in the subprime markets demanded a higher due diligence as the borrowers were not eligible in the prime lending markets. The competing views hold the financial system accountable for their downfall as they did not keep a tighter credit policy for lending. The repayment visibility of the borrowers should have been assessed before lending of the financial institutions. Even the volatility of returns of the global financial markets should have been assessed before investments. Thus the risk taking aspect for economic growth led to the downfall of the financial system. This is supported by the financial theory of risk-return trade off. While the productivity of the manufacturing sector was badly hit during the period of financial system meltdown, the performance of oil and gas sectors was booming during that period. This is evident from the graphical representation given below. This could be attributed to the fact that the investors who lost confidence on the performance of the companies and subsequent devaluation of the market indices, preferred to invest in gold assets which were considered to be safe as compared to the stocks. This supports the behavioural response of risk-averse investors to the crisis situation. This led to the rise in the prices of gold and subsequently the prices of oil and gas rose. The rise in oil and gas prices worked in favour of the oil rich countries of the Middle East. Even after the fall of demand, the oil rich countries like Saudi Arabia, Iran, UAE, etc earned high share of foreign exchange revenues through exports. This led to the accession of countries in the Middle East and developing economies like China and India in world trade (Batten and Szilagyi, 2011). On the one hand, when the US and Europe were badly hit by the economic recession, the countries of Middle East and South Asia adopted suitable policies to gain comparative advantage and closed their gap with the developed economies. Conclusion The causes of the global financial meltdown were the adoption of aggressive investment policies mainly in the subprime markets of US and other financial markets that offered lucrative returns for quick and high growth. This led to the formation of a bubble which burst when the investments turned bad as a result of the lack of due diligence, non-adherence to credit parameters at the time of investments and lending. The financial crisis in US had a rippling effect across the globe as the international economy was highly integrated through exports and imports and as an effect of economic reforms of developing countries. The economic recovery was possible though the revision of policies by the policymakers in different countries. References List Allen, R. E. (1999). Financial Crises and Recession in the Global Economy. Edward Elgar Publishing; Great Britain. Batten, J. A. & Szilagyi, P. G. (2011). The impact of the global financial crisis on emerging financial markets. Emerald Group Publishing; UK. Berend, I. T. & Berend, T. I. (2012). Europe in Crisis: Bolt from the Blue? Routledge; UK. Kates, S. (2011). The Global Financial Crisis: What Have We Learnt? UK: Edward Elgar Publishing. Kolb, R. (2010). Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. New Jersey: John Wiley & Sons. Trading Economics. (2013). United Kingdom Government Debt to GDP. Retrieved from: http://www.tradingeconomics.com/united-kingdom/government-debt-to-gdp. Read More