Causes of 2008 Financial Crisis - Essay Example

Causes of 2008 Financial Crisis The financial crisis experienced in 2007-2009 was a global economic crunch, and economists d it as the worst of its kind to happen after the Great Depression in 1930. According to Wallison (2009), key issues that led to the crisis included increment and sudden reduction in house prices as well as increases in default rates in 2006. Furthermore, the collapse of stock prices in 2008 speeded by Bear and Lehman’s failures fuelled the crisis (Wallison, 2009, p. 3). Additionally, Thomas, Hennessey and Holtz-Eaki (2011) suggest that the main causes of the recession comprised the state involvement in the housing market and adverse influences of financial institutions. Moreover, economists identified another cause of the recession to be deviations in labour input and productivity. In the 2007-2009 recession, reduction of Gross Domestic Product was more severe than earlier ones. Real per capita income, investments and consumption levels fell to worst cases during the recession. Ohanian (2010) explains the cause to be due to the fall in the value of asset-based securities and a let-down by financial institutions. There were reduced intermediary services in finance that had a connection to the rise in interest rates (Ohanian, 2010, p. 55). First, banks produced too much currency in the economy. Normally, if banks give out loans, there is the creation of new money in the economy. As Eakins and Mishkin (2012) confer, banks made too many loans, creating huge sums of money. By 2008, the amount of money in the economy had doubled compared to the amount seven years prior. As a result of this, huge sums of money were remitted to the public, especially the mortgage sector. Despatch of large amounts of loans happened, without consideration of the credit histories of the lenders. After creating a huge amount of currency in the economy, house prices went up since large quantities of money ended up in the property market. Arnold (2012) connotes that financial institutions largely used the currency created between 2001 and 2007 to finance the residential property. Thirty-one percent of it was loaned to the mortgage sector, 20% to profit-making real estates, while 32% went to monetary divisions. While 8% went to businesses external to financial segments, another 8% was given as personal loans (Arnold, 2012, p. 23). The above statistic shows that much of the money in the banks went to the mortgage and housing investors compared to other institutions. Altman (2009) denotes that major Government Sponsored Enterprises like Fannie Mae and Freddie Mac enhanced easy acquisition of loans by housing lenders. The facilitation became possible by two mortgage corporations through advocating for easy credit conditions, leading to predatory lending. In the long run, most people could not pay the debts. Murphy (2008) elaborates that since there was much money availed to the housing investors, a price increment in houses, as well as debts people owed the banks became inevitable. Individuals had to pay the loans with interests. However, there was a high increase in debts than incomes of the individuals (Murphy, 2008, p. 13). Eventually, several people were unable to pay their debts, and banks ended up facing the challenge of bankruptcy. At this state, banks could not lend any more to businesses and persons (PositiveMoney, 2015, p. 1). The stoppage in the lending to mortgage investors led to a fall in the house prices. According to The Economist (2013), investors who borrowed so much while speculating further increase in prices faced the challenge to sell the mortgages in a bid to repay the banks. Even though there was a stop in lending, borrowers were still obliged to pay. Regarding Murphy’s (2008) argument, the withdrawal from the lending exercise, while on one hand receiving from the public caused the economy to shrink, since there was payment to banks, which never released the money. It caused a debt-deflation cycle, a scenario where wages and commodity prices fell while debts remained constant. At last, even individuals and enterprises that never involved themselves in housing investments felt the adverse impact, resulting in the recession. Ritter, Silber, and Udell’s (2003) suggestions for the prevention of future recessions include improving regulations. A regulation in the monetary sector should be able to cover all financial institutions including banks, hedge funds and insurance companies. Regulations should consider not only the dependability of institutions but also steadiness of the whole system. A chosen council should be monitoring any potential risks while other individual organizations should adjust their operations to adhere to the set regulations. The proposal of Gulati, Nohria, and Wohlgezogen (2010) in preventing the recurrence is to prevent bailouts of institutions. As with the case of the 2008 incidence, when a big financial institution faced a crisis, policy makers either left them out to experience bankruptcy or bailed them out. Since this caused inadequacy of financial institutions, it should be a lesson to observe, to prevent recurrence (Gulati, Nohria, and Wohlgezogen, 2010, p. 67). Another proposal from Grauwe (2008) suggests the formation of a consumer protection agency suitable for preventing another incidence of a recession. There is a need to develop an institution that checks on the issues concerning the consumers of financial services. Before the occurrence of the 2008 recession, there were cases of misleading, deceitful and complex financial products offered to consumers. What is important is to be transparent in the terms of lending consumers and providing mortgage services. According to Federalreserve.gov (2009), in the United States, The Dodd-Frank Bill led to the formation of Consumer Financial Protection Bureau, which implements regulations on institutions that provide mortgage services and other providers of financial commodities. Additionally, the bill introduced the Financial Stability Oversight Council, which looks on the product price bubbles. Meanwhile Bolton, Freixas and Shapiro (2012) observe that in the United Kingdom, the Financial Service and Market Act 2000 led to the formation of Financial Service Authority. It is in charge of regulations in banking and financial institutions. The Bank of England is mandated to act as lender of last resort, inventing policies, which ensure the economy is stable (Bolton, Freixas, and Shapiro, 2012, p. 89). The Treasury ensures it overlooks on factors that affect finances in the country. Therefore, if the above bodies observe the outlined suggestions, the possibilities of recurrence of a recession will be very minimal. Bibliography Altman, R. C., 2009, ‘The great crash, 2008: a geopolitical setback for the West’, Foreign Affairs, 2-14. Arnold, G., 2012, The Financial Times Guide to Investing: The definitive companion to investment and the financial markets, London: Pearson UK. Bolton, P., Freixas, X., & Shapiro, J., 2012, ‘The credit ratings game’, The Journal of Finance, 67(1), 85-111. 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. De Grauwe, P., 2008, ‘There is more to central banking than inflation targeting’, The First Global Financial Crisis of the 21st Century, 159. Eakins, G., & Mishkin, S., 2012, Financial markets and institutions, Boston: Prentice Hall. Federalreserve.gov, 2009, FRB: Testimony--Bernanke, Federal Reserve programs to strengthen credit markets and the economy--February 10, 2009. [online] Available at: http://www.federalreserve.gov/newsevents/testimony/bernanke20090210a.htm [Accessed 5 Dec. 2015]. Gulati, R., Nohria, N., & Wohlgezogen, F., 2010, ‘Roaring out of recession’, Harvard Business Review, 88(3), 62-69. Murphy, A., 2008, ‘An analysis of the financial crisis of 2008: Causes and solutions’, SSRN 1295344. Ohanian, L. E., 2010, ‘The economic crisis from a neoclassical perspective’, The Journal of Economic Perspectives, 24(4), 45-66. Positive Money, 2015, What Caused the Financial Crisis & Recession? | Positive Money, [online] Available at: http://positivemoney.org/issues/recessions-crisis/ [Accessed 5 Dec. 2015]. Ritter, L. S., Silber, W. L., & Udell, G. F., 2003, Principles of money, banking, and financial markets, Boston, MA: Addison-Wesley. The Economist, 2013, The origins of the financial crisis: Crash course, [online] Available at http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article [Accessed 5 Dec. 2015]. Thomas, B., Hennessey, K., & Holtz-Eaki, D., 2011, ‘What Caused the Financial Crisis?’ The Wall Street Journal, 1. Wallison, P. J., 2009, ‘Cause and effect: government policies and the financial crisis’, Critical Review, 21(2-3), 365-376. Read More