The Causes of the Financial Crisis That Started in 2007 - Case Study Example

Explore the causes of the current financial crisis that started in 2007. Which theoretical view(s) seem to be more relevant in explaining its causes?Introduction The financial crisis which started in 2007 impacted significantly on many countries, most especially the United States, the United Kingdom, Greece, Japan, and other developed nations. Although other countries were not directly affected by the crisis, they were still significantly affected by the crisis as their economies also crashed, the prices of oil and other commodities skyrocketed, and the banking crisis overwhelmed their economy. There are various causes for this crisis and this paper shall explore these causes as well as the theoretical views which seem to be relevant in explaining its causes. Body The global financial crisis which started in 2007 is considered one of the most disastrous economic issues the world has ever experienced. In so many ways, it is being likened to the Great Depression seen in 1929, as well as the Russian crisis in 1992 (Banking Law Committee, 2009). Most countries also seem to agree that the main cause of the crisis was the credit boom and the increase in housing prices. As the 2007 was starting to loom over the global market, the US ratio of debt to national income went up by 100% or from 3.75-4.75 to one (Banking Law Committee, 2009). At about the same time, the house prices also increased at a rate of 11% per year. Since 2007, the global market has been hit with various developments which were rooted on the earlier issues on the unfavourable performance of sub-prime mortgages in the US (Banking Law Committee, 2009). The housing boom was followed by a bust which then caused defaults and collapse of mortgages thereby causing financial turmoil. Financial institutions have been met with losses which amounted to billions of dollars and are still continuing to do so (Banking Law Committee, 2009). During the crisis, liquidity all but disappeared from the market, also causing the stock market to collapse. The central banks have carried out remedies in order to resolve the issue and to intervene in the support of the markets and to reduce the breakdown of the individual institutions. As a result of this crisis, governments have stepped in to provide bailouts for these banks and other financial institutions (Banking Law Committee, 2009). The gravity and the volume of negative financial outcomes at that time, coupled with the impotency of the remedies being carried out also forced the authorities to consider the origins of the crisis and the market tools by which the crisis could be contained and managed. The causes of the financial crisis which started in 2007 shall be considered below. Mortgage lending was considered as one of the main causes of the 2007 financial crisis. Before the crisis, abundant credit, low interest rates, and increased housing prices, the lending conditions were so relaxed that people started to buy houses they could not afford (Murphy, 2008). As prices started to fall and loans were being called in, the shock spread throughout the entire system. The housing bubble also made the crisis worse and the Federal Reserve allowed housing prices to increase at sustainable and impractical rates. As the bubble burst, the crisis was triggered (Labonte, 2007). There was also a lack of transparency and accountability in mortgage finance. There were numerous bad mortgages throughout the system as well as selling of bad securities. Lenders could sell mortgages to home owners and not feel any accountability for it; this pattern was also seen among brokers, realtors, and individuals in rating agencies as well as other market participants (Jickling, 2010). The crashing housing prices impacted on household wealth, including the spending and defaults on loans by lending institutions. Housing prices from 2000 to 2006 doubled and later subsequently collapsed. The housing bubble was caused by a long period of low interest rates offered by the Federal Reserve and these monetary policies were too permissive for too long and this gave rise to the asset price bubble as well as the rise of commodities (McKibbin and Stoeckel, 2009). The US bond yields produced low profits because of low global rates. These low interest rates in the US affected Japan and Europe which were also recovering from the 2001 economic downturn. It also put pressure on the US to keep these interest rates low. Fears of deflation in Japan also prompted the US to keep these interest rates low for a longest term (McKibbin and Stoeckel. 2009). These low interest rates from 2003-2004 also encouraged bank lending; and rising asset prices in China and developing nations also led to a commodity price boom. Concerns on inflation causing reversals in the monetary policy were seen in 2003 and became largely apparent from 2006 to 2007. The subsequent tightening of the US policy also led to the implementation of strict monetary policies in the other economies dependent on the US dollar (McKibbin and Stoeckel, 2009). This sharp reversal and the fall of the US housing prices as well as failure in regulations caused the financial issues seen in 2008. Global imbalances also made the issue worse. The global financial conditions were characterised as unsustainable with countries like China and Japan having huge surpluses and countries like the US and the UK having deficits. The deficits of the US have been reflected in their internal deficits within the governing and household sectors (Smaghi, 2008). The US borrowing could not persist indefinitely and this caused financial disruptions. Another one of the causes being considered by economists is the implementation of the deregulatory legislation laws, including the Gramm-Leach-Bliley Act (GLBA) as well as the Commodity Futures Modernization Act (CFMA). These laws allowed the financial institutions to be involved in large-scale, uncontrolled, and high-risk transactions. Moreover, these laws were mostly based on the unreasonable and excessive faith attributed to the sturdiness and stability of the market discipline and self-regulation (Lipton and Labaton, 2008). The shadow banking system was also blamed for the financial crash which started in 2007 (Roubini, 2008). Various high-risk financial activities which were usually limited to regulated banks impacted on the government safety nets including deposit insurance and safety regulations. Mortgage lending covered not just financial institutions but covered banks as well. The unsupervised high-risk activities were no more than shaky structures which were highly fragile and easily collapsible with the first sign of a crisis (Roubini, 2008). Non-bank runs also contributed to the financial crisis of 2007. With financial institutions beyond the banking system carrying out financial positions founded on borrowing short and lending long, their liquidity became highly suspect (Guha, 2007). In effect, they could fail if the markets did not feel confident with them and if these markets did not extend or bypass short-term credit (Guha, 2007). Moreover, although the liquidity risk was always seen, its manifestation at the extreme corners of the crisis was not apparent. The off-balance sheet finance was also blamed for the crisis. Various banks carried out off-the-books special entries in order to engage in risky investments (Blundell-Wignall, 2007). As a result, banks made loans during periods of expansion. However, they also established contingent liabilities that diminished the confidence in the reliability and creditworthiness of the banks. In the same vein, banks were also allowed to insure less capital for possible losses (Blundell-Wignall, 2007). Moreover, investors did not have much power to understand the exact financial positions of banks. The failure of risk management systems also contributed to the financial crisis. Some firms ventured into financial ventures without considering the risks to the market and to the credit system (The Economist, 2008). Financial innovations before the crisis broke out were also considered contributory factors to the financial crisis of 2007. New tools in the fully planned financial stations and systems were not ready when the innovations were stressed. Many economists believe that new markets must first be allowed to mature before they are allowed to gain a significant size (Mason, 2008). This would imply that accountants, regulators, and settlement systems must be given a chance to catch up. When these opportunities were not given, the economy became one big unregulated system which became vulnerable to various issues and failings. The shocks in the economic system were mostly seen in the US which was the epicentre of the crisis. However not all countries were equally impacted by the crisis. Japan’s manufacturing business would be hit significantly by the risk reassessment due to the collapse of their exports (McKibbin and Stoeckel, 2009). The impact on Japan was caused by the global crisis as well as the appreciation of the Yen which then led the collapse of commodity prices and trade improvements. However, the impact of the housing crisis in America would not be as much as a shock to their system. They had better safeguards in place in order to prevent economic disasters. The Credit Default Swaps (CDS) also contributed to the problem. A contradictory situation arose with credit derivatives instruments which were meant to assist in risk management grew and became more complicated due to financial engineering. As a medium of doubtful transactions, the credit derivatives increased the risk (Kim, 2008). Over-the-counter derivatives also added to the 2007 financial crisis. Since these derivatives were mostly unregulated, little data about risk exposures became accessible to regulators and the market (Lukken, 2008). The issue with these derivatives also explain the Bear Stearns and AIG interventions. With the substantial losses to counterparties, dealer defaults can lead to panic because of the instability on the extent of these losses (Lukken, 2008). These losses then prompted distrust among investors and the public in general which would have helped fill in the losses and the gaps. Fragmented regulation also made the 2007 financial crisis worse. The financial regulation in the US was carried out by various agencies, and these agencies have specific functions in regulating the US financial system. In effect, no agency was in the right position to evaluate emerging systemic issues (Jickling, 2010). The fact that there was no systemic risk regulator also made the 2007 financial crisis worse. There was no particular regulator covering all the systematically important financial activities in the US. The federal government had this role, however, only by default, but it did not have the authority to evaluate investment banks, hedge funds, and nonbank derivatives (Kaufman, 2008). The bursting of the housing bubble had the most impact on actual consumption which represented about 70% of the domestic economy and had the most impact on the GDP (McKibbin and Stoeckel, 2009). The actual loss in wealth led to consumption rates decreasing sharply as the housing issue became a permanent fixture. The financial shock had a negative effect on the stock market from its baseline rates in 2009 and also a significant impact with the “bursting of the housing bubble on investment” (McKibbin and Stoeckel, 2009, p. 9). In effect, the equity risk shock led to a change in equities into other domestic products including housing and government bonds and assets overseas. Shift to government bonds drove up their rates and pushed real interest rates down. It raised human wealth with favourable futures after taxes were priced at lower interest rates (McKibbin and Stoeckel, 2009). In the US, the equity shock was positive not negative for short-run consumption, on the other hand, investments fell sharply. This equity shock then caused a reduction of US investments by 20% below the desirable baseline levels. With higher equity risks, selloff of shares was also increased (McKibbin and Stoeckel, 2009). With higher equity risks, the capital stock could not generate the marginal produce needed from the financial arbitrage condition; in time, the capital stock would plunge and the output permanently set at a lower premium. The shocks on the economy had an unfavourable impact on the US and all in all lowered the real GDP by 7 percent below the 2009 baseline. Such shock was sufficient to cause a recession in the US in 2009 but also led to favourable growth in 2009 (McKibbin and Stoeckel, 2009). With household discount rates increasing and risk premiums also increasing, there was a sharp fall in the demand of durable goods relative to other commodities in the economy. Imports and domestic production of durable products decreased more than nondurable products and the gaps were significant. High risks in adjusted costs led to diminished flow of services from the durables with demands for goods falling significantly (McKibbin and Stoeckel, 2009). The Marxist theory can be used to explain the economic crisis. Marxists have developed an analysis of the economic crisis where an absolute barrier is seen in reproducing capitalism (Sweezy, 1970). Marxists agree that capitalism causes two kinds of crisis, one is the periodic business cycle recession (business cycle recession) which is soon resolved through normal mechanisms; and the second kind is the long-lasting crisis (structural crisis) which calls for significant restructuring if the crisis is to be fixed and capitalism restored (Kotz and Hall, 2009). The structural crisis was seen in the Great Depression and the 2007 crisis for the Marxists is also being considered a structural crisis. This structural crisis was seen as a real sector recession which started in the US with a decline in GDP seen by the end of 2008. The financial crisis started dramatically and gained momentum by the spring and summer of 2008 and finally collapsed in September of 2008 as various financial institutions in the US and other countries became insolvent (Kotz and Hall, 2009). The Marxist theory explains how the crisis is based on the economic structuring and how the economic processes unfolded and resolved issues which arose. The Marxists also declare that the cause of economic issues is founded on the internal structures of a capitalist system which also manifest its contradictory process. The Marxist theory assesses the internal mechanisms which give rise to the crisis. These causes care considered to be crisis tendencies which may include underconsumption, tendency of rate of profit to fall because of increase of value in means of production, profit squeeze caused by the decline reserve of labour, over-investments, and other internal mechanisms (Kotz and Hall, 2009). Marxist theories help explain how the 2007 financial crisis was prompted by a structural crisis which was brought on by issues in the internal mechanisms of capital and production. Conclusion The discussion above explains how the 2007 financial crisis was brought on by various contributory factors. The collapse of the Lehman Brothers in 2008 was the first sign of the major crisis hitting the global economy. Banks stopped lending to each other and the risk premium on interbank borrowing rose. With years of low interest rates in bonds, commodities, credit, lending, and housing, the capital and economic system could not keep up anymore. The housing market crashed, banks needed refinancing, and lending institutions collapsed. With these issues, prices of commodities rose to alarming rates and companies foreclosed after low customer spending. Financial activities dropped, companies went bankrupt and unemployment rates rose as employees were laid off. Governments responded through refinancing activities however, these efforts could not stem a major global crisis. To some extent, the impact of this crisis has tapered off and the economy is starting to recover. However, the structures and mechanics of the economy have yet to make the necessary push for the necessary recovery processes. Marxist theories explain how the crisis is credited to a structural problem which needs to be managed through adequate adjustments in the system. References Banking Law Committee (2009), Task force on the causes of the financial crisis, American Bar Association [online]. Available at: http://apps.americanbar.org/buslaw/committees/CL130055pub/materials/201001/causes-report.pdf [accessed 04 March 2012]. Blundell-Wignall, A. (2007), Structured Products: Implications for Financial Markets, Financial Market Trends [online]. Available at: http://www.oecd.org/dataoecd/53/17/39654605.pdf [accessed 04 March 2012]. Guha, K. 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