A critical and thoughtful analysis of the origins of the recent financial crisis - Essay Example

?A critical and thoughtful analysis of the origins of the recent financial crisis Introduction The financial crisis of 2007 – proved that the ability of the international market to control severe failures is limited. In the past, signs were identified for such a case, i.e. concerns were developed regarding the level of security of the financial products provided by financial institutions. Particular emphasis was given on the potential risk of subprime mortgage products offered by most USA banks. However, no measures were introduced for limiting the relevant risk. In this context, the appearance of the crisis in 2007 can be characterized rather as expected; it was just the issue of ‘when’ the crisis was going to appear and not ‘if’ there were chances to occur. The origins of the recent financial crisis are critically discussed in this paper. The literature published on the particular subject is presented aiming to show the different approaches used for the explanation of the crisis as a series of events, which caused severe turbulences to economies worldwide. The potential differences in the arguments used for explaining the crisis reveal the following fact: even after its end, the above crisis has not been fully understood, in all its aspects. The fact that certain theorists set the end of the crisis in 2009 while other estimate the end of the crisis in 2010 is another proof the misunderstanding in regard to the actual forms and the effects of the specific crisis. 2. Origins of the recent financial crisis – critical analysis Theorists and researchers worldwide have used different approaches in order to evaluate the origins of the crisis. In accordance with Kolb (2010) the recent crisis has been the result of the use various methods for masking risk aiming to promote particular financial products (Kolb 2010, p.79). The turbulences in the prices of the assets on which these products were based have forced these methods to be revealed; however, then, it was too late for the crisis to be confronted. In other words, the development of the crisis has been related to the practices that financial institutions used in order to increase their customer base; even if employees in these institutions were aware of the risk involved, they had managed to mask this risk by giving emphasis on certain characteristics of these products, for example the potential of the customer to choose the number of instalments or the level of interest. In a report published by the World Bank in 2009 it is noted that the origins of the global financial crisis of 2007-2009 can be identified in ‘the economic growth of the years 2003-2007’ (World Bank, 2009, p.94); i.e. the crisis of 2007-2009 is considered to have its roots in the economic decisions of the pre-crisis period, a claim which leads to the assumption that the crisis was unavoidable. In accordance with the above view, the financial crisis of the period 2007-2009 was not related exclusively with the banking practices of 203-2007 but, mostly, with the management of the economics of the state, for example, the investment decisions promoted by the governments worldwide. In the case of Dubai, the continuous increase of investment on construction projects led to the high increase of the relevant debt – referring to the funds used for the completion of these construction projects. It is noted that during the above period, the economic growth reached a percentage of 5% - which was unique since the 1970s (World Bank 2009). However, no measures were taken for protecting economies from potential failures. In fact, the extended use of risky financial products, a result of the radical growth of the above period, has facilitated the increase of leverage. Legislators avoided reacting on time, mostly because the actual risks were not clear. The masking practices, as mentioned above, used by financial institutions helped to hide the risks of leverage and the risk related to the ‘structured financial products’ (World Bank 2009, p.94), extensively used by USA banks from 2003 up to 2007. Another reason for the late reaction of the markets towards the crisis is the following one: the economic growth of the period 2003-2007 was not directly related to specific financial products (that were proved faulty afterwards). Rather, it was considered as the result of the economic policies of the particular period, i.e. as a normal reaction of the markets, while this was not the case. As a result, any warning for potential risk was considered as not emergent or necessary; such reaction in a period of high economic growth could be probably seen as an effort to dynamite the economic development of the particular period. For this reason, no effort was made for protecting or even for warning the markets. Ringland et al. (2010) used a similar approach for explaining the crisis of 2007-2009; in accordance with the above theorist, the crisis of 2007 began actually in 2006 and was mostly related to the subprime mortgages extensively promoted by banks across USA. It is assumed that reference is made to the practice of banks to approve the requests for loans and credit cards without examining carefully the needs, which these funds had to cover, or the potentials of the customers/ applicants to repay the money borrowed. The specific problem is made clear in the Graph 2 – Appendix. Banks worldwide, including USA, had increased the level of loans provided to consumers, while the loans provided to the commercial sector have been kept at a standard level. Under these terms, the risk related with the lending practices of the banks in the period 2003-2007 was extremely high. At the next level, Ringland et al. (2010) highlight the importance of a series of additional factors to the appearance of the crisis, such as: a) the change in the distribution of job positions worldwide; it is noted that ‘the mobility of workforce’ (Ringland et al 2010, p.17) has led to the differentiation of the market structure in USA; the standardization of jobs was negatively affected, a fact that caused the limitation of compensation and the increase of unemployment across USA, b) on the other hand, the rate of growth of other economies worldwide has been significantly increased; the uniqueness of the USA market in terms of technology and skills has been eliminated; the decrease of the market performance led to the reduction of the asset prices and the following failure of the subprime products backed by these assets. From another point of view, LeClair (2009) noted that the global financial crisis has been the result of the limitation of the performance of investment banks in the international market (LeClair 2009, p.16); reference is also made to the potential role of ‘loss of consumer confidence and rapid price deflation’ (LeClair 2009, p.16) internationally. In the context of the above view, the failures in investment projects of banks worldwide have gradually led to the crisis, as these failures were followed by the decrease of the trust of consumers on the investment products of these banks. This view is verified by the figures included in Graph 1 (Appendix). In other words, the financial crisis of 2007-2009 is considered as rather a reflection of the turbulences in the international market, and not so much a problem of the USA market. However, the above view cannot explain the fact why the specific crisis was first developed in USA and not in other countries worldwide (Steil 2009); moreover, it is not made clear whether the crisis in the investment-banking sector was similar for all countries worldwide or whether there were states where the above problem was more acute. In any case, this view explains the rapid expansion of the crisis worldwide. If other countries in the international market were powerful enough to face the crisis, then this crisis would have been remained an internal problem of USA (Davies 2010). On the contrary, it seems that all countries around the world faced similar risks with USA regarding the potential appearance of the crisis. Moreover, in the study of Jansen et al. (2009) emphasis is given on the following fact: the rules of banking in countries worldwide are not effectively enforced; reference is made to the ethical code of practice, as applied on the banking industry. This problem involves not just the USA, where the crisis appeared, but also in other countries worldwide, which also faced the effects of the crisis. The above view is quite important revealing one of the key reasons for the development of the crisis; indeed, in markets which are based on a different banking system, which is highly based on the promotion of ethics in banking activities -referring to the Islamic banking finance, the crisis was more effectively controlled. Moreover, in USA, the provision of faulty financial products by most banks was continued for 4 years, from 2003-2007, because there was no intervention or control from the state (Choi et al. 2009). The fact that it took four years for the above practice to be revealed indicates the level of inability of the financial authorities worldwide to control the operations of financial institutions (Roncaglia 2010). In accordance with the above, if a decline in the prices of assets did not appear, then the continuation of this practice, promotion of faulty financial products, would have been continued up today (Saleh 2010). The implication of such case cannot be estimated; it is assumed that the effects on economies worldwide could not be reversed. Another issue highlighted through the financial crisis of 2007-2009 is the following one: the cooperation of states regarding the control of financial institutions that operating globally needs to be increased (Cline 2010). Only in this way, the potential risks from these institutions activities would be effectively controlled. In this way, the chances for a potential appearance of such crisis in the future are significantly reduced. 3. Conclusion The examination of the literature published in regard to the financial crisis of 2007-2010 has revealed that the specific crisis was quite difficult to be avoided. It was not just the structure of the USA market or the rules of banking across the specific country that have led to the crisis. It seems that the crisis was supported by additional factors, such as, the limitation of the USA job market and the reduction of performance of the USA economy under the pressure of other economies worldwide. In other words, the limitation of competitiveness of the USA economy because of the high development of other economies, for instance, the Chinese economy or the Indian economy, has led to the reduction of job positions across USA, a fact that caused the inability of many borrowers to respond to their economic obligations (Friedman et al. 2010). In other words, in its appearance the crisis, was rather a regional issue, an event revealing the inability of USA economy – and the USA financial institutions – to compete effectively in the international market. However, after its appearance, the crisis became a global problem, affecting also countries that had not face financial pressures before, for instance, the case of Dubai (Helleiner et al. 2010). The above fact proves the interaction and mutual dependency of economies in the context of the global market. From this point of view, in order for such crises to be avoided in the future, emphasis should be given on the improvement of economic coordination among countries of the international community. This means, that equality and fairness in the development of economies globally would be the most effective measure for eliminating the chance of similar recessions in the future. References Brandon, D., Welch, O. (2009) The History of Financial Planning: The Transformation of Financial Services. Hoboken: John Wiley and Sons Brown, W. (2010) Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and Across System: Congressional Testimony. DIANE Publishing Choi, J. (2009) Credit, Currency Or Deratives: Instruments of Global Financial Stability of Crisis? Bingley: Emerald Group Publishing Cline, W. (2010) Financial globalization, economic growth, and the crisis of 2007-09. Washington: Peterson Institute, 2010 Davies, H. (2010) The Financial Crisis. Cambridge: Polity Friedman, J., Posner, R. (2010) What Caused the Financial Crisis. Philadelphia: University of Pennsylvania Press Helleiner, E., Pagliari, S., Zimmermann, H. (2010) Global finance in crisis: the politics of international regulatory change. Oxon: Taylor & Francis Jansen, L., Beulig, N., Linsmann, K. (2009) US Subprime and Financial Crisis - To what Extent Can You Safeguard Financial System Risks? Norderstedt: GRIN Verlag Kolb, R. (2010) Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. Hoboken: John Wiley and Sons LeClair, C. (2009) The end of the (peaceful development) road: Is the financial crisis endangering the China-Southeast Asia relationship? Ann Arbor: ProQuest Ringland, G., Sparrow, O., Lustig, P. (2010) Beyond Crisis: Achieving Renewal in a Turbulent World. Hoboken: John Wiley and Sons Roncaglia, A. (2010) Why the Economists Got It Wrong: The Crisis and Its Cultural Roots. London: Anthem Press Saleh, N. (2010) An Anatomy of the Financial Crisis: Blowing Tumbleweed. London: Anthem Press Steil, B. (2009) Lessons of the financial crisis. New York: Council on Foreign Relations World Bank (2009) Global Development Finance: Charting a Global Recovery, I: Review, Analysis, and Outlook. Washington: World Bank Publications Appendix Graph 1 – Failed bank assets for the years 1988-1008 (Source: Federal Deposit Insurance Corporation) as in http://open.salon.com/blog/anthony_m_freed/2008/11/26/fdic_graphs_show_the_extent_of_financial_crisis) Graph 2 – Growth in commercial and consumer loans for the period 2000-2008 (Source: Federal Deposit Insurance Corporation) as in http://open.salon.com/blog/anthony_m_freed/2008/11/26/fdic_graphs_show_the_extent_of_financial_crisis) Read More