The Causes of the Recent Financial Crisis in Britain - Research Paper Example

The Financial Crisis Introduction A financial crisis is a situation which may occur when assets and financial institutions suddenly lose a lot of their value. In the 1800s and early 1900s, most of the financial crises were related to banking panics with numerous recessions taking place during these panics. Other situations that may be regarded as financial crises include currency crisis, sovereign defaults and crashes in the stock market (Kindleberger and Aliber, 2005). This paper explores the possible causes of the recent financial crisis and gives alternatives that the British government should apply to avoid accumulating huge debts. According to leading economists in the world, the recent financial crisis, which started in 2007 and gathered intensity in 2008, has been the worst since the Great Depression in the 1930s. The financial crisis led to failure of main businesses, reduction in consumer wealth approximated to be worth trillions of US dollars and decline in economic activity. There are several causes that have been proposed to have caused the financial crisis with experts assigning each cause with a weight. The proximate cause of the financial crisis points to the mortgage sector in the United States of America. Fundamentally however, the crisis could be attributed to the persistence of huge global imbalances which were due to the long periods of global inequality which had resulted from lengthy sessions of extremely loose monetary policy occurring in the major advanced world economies in the beginning of the 2000-2009 decade (Mohan, 2007; Taylor, 2008). Global imbalances have been evident through the extensive rise in deficit of the current account of the U.S. reflected by the significant surplus in Asia, in particular China and countries exporting oil like Russia and the Middle East (Lane, 2009). These discrepancies in the current account can be viewed as the resultant from the relative inflexibility of China. The global macroeconomic discrepancies were, therefore, what caused the financial crisis (Portes, 2009). The massive financial market flaws that were taking place across the globe interacted with the global imbalances to generate the precise features of the crisis (Portes, 2009). The housing bubble that collapsed had peaked in the U.S. in 2006 and caused the value of securities, which are attached to the pricing of real estate, to fall leading to damages in the global financial institutions. The global stock markets were further impacted by the damaged investor confidence, reduction in credit availability and the questionable bank solvency. The securities suffered losses towards the end of 2008 and beginning of 2009. During the same period, worldwide economies slowed down with the tightening of credit and decline in international trade. Some critics argue that investors and credit rating agencies failed to accurately value the financial products related to mortgage and the risk involved. Governments have been blamed for not adjusting their regulatory practices to enable them tackle challenges faced by financial markets of the 21st century. Central banks and governments responded to this with institutional bailouts, monetary policy expansion and fiscal stimulus. Background of the crisis Before the crisis, borrowers in the U.S.A. had assumed difficult mortgages encouraged by the increase in loan incentives like the easy initial terms and the tendency of housing prices to rise. The borrowers believed that the terms would change to be more favourable enabling them to quickly refinance. Between 2000 and 2003, federal funds rate target was lowered from six and a half percent to one percent by the U.S Federal Reserve. The rates remained at one percent up to June 2004. This was done as a precaution against risk of deflation following the infamous September 11 attacks in 2001 and the dot-com bubble collapse. The burst of the dot-com bubble in the U.S resulted in the monetary policy of the world’s advanced economies to ease fast. The period that followed saw the gradual monetary accommodation withdrawal. An evaluation of the monetary policy of the U.S., within 2004-2006, indicated a policy much looser than that required by Taylor Rule. The period that came after the dot com bubble collapse experienced an excessively loose monetary policy which in turn enhanced investment and consumption within the U.S.A. The enhanced investment and consumption activities caused the aggregate demand to steadily exceed the domestic output within the U.S. The other world economies, especially the Asian economies like the Chinese economy fed the American demand providing low cost goods and services. The surpluses in these countries were spurred to growth by this ready American market. Dysfunctional global imbalances then emerged and were accelerated from 2004 onwards. The surpluses of the oil exporting and East Asian countries rose. The sharp rise in commodity prices in 2008 is attributed to the quick rate cuts in the last months of 2007 after the emergence of the sub-prime cuts. The low cost goods and services from China spread across the world further causing economic imbalances with some countries experiencing surpluses while others were in demand. The pressure to further lower the interest rates came from the already high and rising trade deficit in current account which, in 2006, peaked together with the housing bubble. The U.S then started borrowing money from abroad following the trade deficit, which lead to a built up in bond prices and a reduction in interest rates. In the period 1996-2004, the current account trade deficit in the U.S. rose by 650 billion U.S dollars, which was almost six percent of the Gross Domestic Product. America borrowed large sums of money from abroad with the bulk of the cash coming from countries that were experiencing trade surpluses. The identity of balance of payments requires a country with a deficit on a current account to in addition have a capital account surplus of a similar amount. For this reason, huge and growing quantities of foreign funds began flowing into the U.S. The result was a demand for differing kinds of financial assets with the rise in price for those assets and the reduction of interest rates. Foreign governments contributed to the flow of funds in the U.S by purchasing Treasury bonds and hence experienced minimal effects of the financial crisis. The households utilized the foreigner’s cash inflow to finance consumption. The borrowed cash from the foreigners was, in addition, used by financial institutions to invest in mortgage barked securities. The raising of the federal funds rate by the Federal Reserve in the period 2004-2006 led to a rise in one year and five year Adjustable Rate Mortgage (ARM) rates resulting in ARM rate resets that were more costly for home owners. This is considered as one of the contributing factors to the deflating house bubble. This is because house prices are inversely proportional to interest rates. High interest rates make speculation on housing more risky and therefore pushing the housing cost downwards. In the period 1997-2006, the value of a typical American house went up by 124%. Between 1981 and 2001, the median home price nationwide ranged around three times the median household income. This ratio increased to about four in 2004 rising to four point six in 2006. This housing bubble led to only a small number of homeowners refinancing their mortgages at lower interest rates. In addition, few homeowners secured second mortgages on the account of house price appreciation therefore reducing consumers spending significantly. Moreover, in 2006-2007, interest rates started rising with housing prices dropping moderately in many places within the U.S. making refinancing difficult By September 2008, the mean price of houses in the U.S. had reduced by more than a fifth from the peak in mid-2006. The decline in price made it difficult for borrowers with mortgages whose rates were adjustable to refinance their loans and avoid higher repayments that came with the high interest rates and began defaulting increasing dramatically as easy initial terms came to an end, numerous home prices failed to rise as expected and ARM interest rates reset at higher rates. In 2007, lenders increased foreclosure proceedings by 79% to 1.3 million properties compared to 2006 values. In 2008, the number rose to 2.3 million, an 81% rise from 2007. August 2008 saw the foreclosure of more than nine percent of all mortgages outstanding in the U.S. with the figure having risen to 14.4% by September 2009 (MBA, 2009). Other probable causes of the crisis Jickling (2009) has made several arguments on what may have worsened the financial crisis. One such argument is the presence of imprudent mortgage lending. With the low interest rates, abundant credit and the rising cost of houses, Jickling argues that lending standards were relaxed enabling many people to take mortgages for houses they could not afford. This resulted in the financial system experiencing a shock when the housing prises started rising. Another argument is that the current financial disruptions have been due to U.S. external deficits being reflection of the internal deficits in the government and household sectors. The recent global financial flows have been unsustainable, with some countries in deficits while others experiencing surpluses. America cannot continue indefinitely with borrowing, hence stresses emerge causing financial disruptions. The financial innovations may have also contributed to the financial crisis. New instruments within the finance structure developed too rapidly for the market infrastructures to be prepared on the emergence of stress on those instruments (Taylor, 2009). This situation would have been avoided if markets in new instruments were allowed time to mature before they are allowed to gain a systematically significant size. This can also be viewed as allowing settlement systems, rating agencies, regulators and accountants time to catch up .Some of the financial instruments were so complex that they resulted in regulators being baffled, obscurity of the risks of market sanctions and investors being unable to make informed and independent judgements on the advantages of their investments (Taylor, 2009). The financial crisis rapidly extended from the U.S. to other world nations due to several factors like the foreign banks that acquired collateralized U.S. debts. Most of the sub-prime mortgages were repackaged into Collateralized Debt Obligations and sold to financial institutions around the globe. Many European banks including British Banks had been exposed to these mortgage loans and when defaults started taking place, the banks lost lots of money (Porter, 2009). The banking system is linked internationally in such a way that when some banks started losing money, banks were reluctant to lend one another money. This extended to consumers and firms who found it more difficult to access loans from the banks. According to Porter (2009), the reduction in lending from banks contributed to aggregate demand falling hence the global credit crunch which affected even the countries that had not been exposed to sub-prime lending. The consumer confidence dropped with the emergence of problems in the banking and financial sectors. The financial problems of the banks in the United Kingdom and America hit stock markets worldwide with 2007 and 2008 seeing a big fall in prices of shares reducing confidence and wealth and hence slower growth (Porter, 2009). There may not be a direct link between consumer spending and stock markets. Be that as it may be, a significant fall in the stock markets affects business investments and therefore consumer spending. What the British government should do to stabilize and regulate financial markets and reduce government debt The recent financial crisis triggers a great recession due to financial excesses especially in real estate lending. Policy makers are seeking ways of reforming the financial system to prevent future financial crises. They however are fixated on capital standards which happen to be already in place. The better way of regulating the financial markets would be through imposing requirements of asset based reserve which widen margin requirements to an expansive array of assets of the financial intuitions. Asset based reserve requirements (ABRRs) are reserve requirements that can be easily implemented. In addition, they are compatible with the existing regulations and would satisfy questions regarding adequacy of instruments of financial policies (Palley, 1999). ABRRs have both microeconomic and macroeconomic merits. A macroeconomic merit includes furnishing policy makers with extra policy instruments. This is especially useful given the recent concerns on asset price inflation and the prospective need to check asset prices. Additionally, they are useful in restoring traction of monetary policy. A microeconomic advantage includes being used to raise significant seignorage. When applied to all intermediaries of finance, the ABRRs system becomes fully effective. The financial markets have undergone several innovations that have lead to a number of problems. One of the notable problems of banking disintermediation is the behaviour of monetary policies that have turned out to be more cumbersome due to the reduction in demand for liabilities from central banks (Friedman, 1999; Palley 2001/2) Another significant problem centres on the interaction between asset price inflation, increased home equity credit access and increased equity holdings. This inflation can largely affect aggregate demand owing to wealth effects. The wealth may also contribute to financial fragility building up to a level that may allow agents to take loans against risen asset prices. Apart from raising the overall interest rate levels, central banks do not have much power to control inflation due to asset price. This causes a dilemma since cooling of an overheated market requires cooling the whole economy which is counterproductive. Earlier markets obeyed the Keynesian rule of market automatic stabilization but the current financial systems destabilize automatically (Palley, 1999). When asset values increase, or on generation of new assets by the financial sector, ABRRs automatically generate monetary restraints by making the financial sector come up with extra reserves. On the other hand, should the financial assets get extinguished or the asset values fall, ABRRs produce automatic monetary easing by relieving reserves formerly held against assets. In all these situations, ABRRs stay consistent with the current system of monetary control (Palley, 1999). The reserve requirements would be adjustable at the will of central banks though their definition will be broadened to contain government bonds. In addition, the ABRRs system will not only apply to banks but to all financial intermediaries as well. The current regulation system is based on regulation of liabilities, which is centred on banks and demands holding of reserves against deposit liabilities by banks and satisfaction of the capital requirements of the shareholder ((Palley, 1999). Proper financial regulation will reduce government expenditure on institutions in terms of financial packages and bailouts when financial markets are in turmoil. It will also reduce inflation which would otherwise have increased government spending to control. References Friedman, B (1999) “The future of monetary policy: The central bank as an army with only a signal corps?”, International finance, 2,pp 321-338. Jickling, M. (2009) Causes of the Financial Crisis, viewed on 15th January, 2010 http://moore.house.gov/uploads/R40173.pdf Kindleberger, C. P. and Aliber, R (2005) Manias, Panics, and Crashes: A History of Financial Crises, (5th ed.)Wiley Publishing. Lane, P. (2009) “Global Imbalances and Global Governance”, Paper presented at the `Global Economic Governance: Systemic Challenges, Institutional Responses and the Role of the New Actors’, Brussels, February. MBA (2009) Delinquencies Continue to Climb in Latest MBA National Delinquency Survey, viewed on 15th January, 2010 http://www.mbaa.org/NewsandMedia/PressCenter/71112.htm Mohan, R. (2007) “India's Financial Sector Reforms: Fostering Growth While Containing Risk”, Reserve Bank of India Bulletin, December. Mortgage Bankers Association (2009) Delinquencies Continue to Climb in Latest MBA National Delinquency Survey, viewed on 15th January, 2010 http://www.mbaa.org/NewsandMedia/PressCenter/71112.htm Taylor, J (2009) “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”. Working Paper 14631, January, National Bureau of Economic Research Palley T. (1999) End of expansion: soft landing, hard landing, or crash? 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