Origin and Consequences of the Financial Crisis - Essay Example

Financial Crisis Name: College: Course: Tutor: Date: Table of Contents Introduction………………………………………………………………………………. 3 Origin of the Financial Crisis……………………………………………………………...4 Consequences of Financial Crisis…………………………………………………………7 Response to Financial Crisis………………………………………………………………9 Short-Term Responses…………………………………………………………….9 Long-Term Responses…………………………………………………………...10 Conclusion……………………………………………………………………………….11 Works Cited……………………………………………………………………………...13 Financial Crisis Introduction Generally, the global economy has bee affected negatively by the prevailing financial crisis. Critical understanding of the origin as well as the causes of financial crisis is of significance to government leaders, business and non-business managers in establishing mechanisms to prevent severe negative impact. Financial crisis has been defined as an economic situation when supply of monetary resources is outpaced by the demand of monetary resources. As a result, liquidity within the economy declines substantially since available monetary resources are withdrawn from banks forcing banks to collapse or to sell out other investments to address the shortfall. Financial crisis has also been defined as a rapid deterioration of various financial indicators such as asset prices and short-term interest rates. Normally, the financial crisis is accompanied by failure of financial institutions (Kindleberger 5). Both developed, developing and other third world countries are experiencing the effects of financial crisis. The consequences of financial crisis have been so severe to certain economies and business organizations thus destructing their operations. However, there are various responses which can be used to address the financial crisis. Short-term responses can be used to mitigate the effects of financial crisis in the short-run while long-term responses can mitigate the effects of financial crisis in the long-run. Financial crisis is a bad economic situation on which government leaders and business and non-business managers should come up with effective short-term and long-term measures to minimize or even prevent its occurrence in future (Kindleberger 57). Origin of Financial Crisis The global economy is currently experiencing a financial crisis. The financial crisis of 2007 to 2009 has been referred as the most severe financial crisis since the great depression. The fundamental origin of financial crisis of 2007-2009 has been attributed to housing bubbles in United States which peaked in 2005/2006 financial years. Increased loan incentives and long term trend of rising housing prices encouraged borrowers to assume more difficult mortgages since they believed that they will be able to refinance the mortgages quickly and at better terms. However, as interests rates began to rise and house prices declined, refinancing the mortgages became more difficult. As a result, defaults and foreclosure increased leading many financial institutions into financial difficulties. Massive employees’ layoffs and closure of subsidiaries was experienced. Due to financial contagion, the financial crisis has affected almost all the countries across the world. As a result, government authorities, corporate managers and economists are coming up with strategies to mitigate the effects of the financial crisis (Anna 19). The financial crisis of the year 2007 to 2009 has been described as a speculative bubbles and crashes type of financial crisis. Speculative bubbles occur when the price of a financial asset outpaces the present value of future income to be received by holding the assets up to maturity. A bubble is usually present when investors purchase assets with hopes of selling it at a higher price instead of purchasing it for income that it will generate in future. Presence of a bubble in the market poses a risk of asset price crash. Investors and other market participants will only go buying certain assets because they expect others to purchase the financial assets. As a result, when many market participants decide to sell their assets at a certain time, the price will definitely fall causing speculative bubbles and crashes financial crisis. Anticipation of future substantial increase of prices of a certain financial market will enable many market participants to purchase the asset. As a result, the prices of such assets are likely to go down in future since the supply of the asset will be higher than the demand causing a speculative bubbles and crashes financial crisis (Mishkin 79). The United States housing bubble has affected many states in United States including Florida, California, Arizona, Colorado, Nevada, Michigan and Oregon. The housing prices were at peak in 2005 but started to decline at a high rate in 2006. Due to high price of houses in 2005, investors constructed many houses for sale. However, a financial crisis is currently being witnessed because most of the investors are not in a position to service their mortgage loans. The prices of house have gone down causing credit crunch and financial crisis in general (Mishkin 71). There are various causes which have contributed to emergency of financial crises in economies. Leverage is one of the factors which have been pinpointed by economists, managers and regulators as a contributor to financial crisis. Leverage is a financial term which implies borrowing for investment financing. When organizations use their own finances to invest, they can only lose their own money incase of losses. However, when an organization utilizes borrowed money to finance its investments, it can lose finances including those of external stakeholders. Though leverage magnifies expected investment returns, it also exposes organizations into bankruptcy. A bankrupt organization is unable to honor its entire obligation indebted to other firms thus it can easily spread financial problem to other interdependent firms. A financial contagion is experienced when one organization is declared bankrupt thus causing a financial crisis in an economy (Christopher 219). Leverage as a cause of financial crisis is currently being experienced in the global economy. The prevailing financial crisis which emanated from United States was mainly caused by leverage status in the housing industries. Most of the companies dealing with construction and sell of houses in United States depended more on borrowed funds to finance their operation. As a result, when the prices of houses went down and the interest rates skyrocketed, the housing market was rendered into financial difficulties. Due to low returns of their investments and increased interest rates, the housing investors were not in a position to service their loans. Due to financial contagion, the financial crisis was transmitted from the housing markets to financial markets and later to other business organizations. As a result, a global financial crisis has hit the world since 2007 up to 2009 (Anna 20). Regulation failure on financial institutions and other business organizations has been pinpointed by researchers as one of the causes of financial crisis. Government authorities are required to regulate institutions in order to enhance transparency and ensure that they have sufficient assets to settle their obligations. However, when the regulations of the government hinder effective transparency and allow institutions to operate with insufficient assets to meet their debt obligations, a financial crisis is inevitable. Compromise of standard of financial reporting procedures hinders transparency thus paving way for fraudulent actions (Anna 19). Regulatory failure has been blamed for the global financial crisis of 2008. The regulatory institutions failed to protect the economy against immense risk taking in the financial market. As a result, many organizations used borrowed money which were more than their asset values to finance their investments. As a result, many organizations especially in United States could not service their loans. This led to closure of some of the business organizations especially financial institutions. Moreover, many financial institutions sought financial assistance from governments and international organizations in order to survive the financial crisis (Anna 20). Consequences of Financial Crisis Financial crisis has various negative effects on national economies and the economy as a whole. To start with, the global financial crisis has led to a decline of global growth rate. Due to the global financial crisis of 2007-2009, the global economic growth rate has decline by 2% from 2007 to 2009 according to the IMF report of 2009. The global growth rate is lower by 0.9% than forecasted growth rate in 2008. This is a major indication that a financial crisis has a negative impact on global economic growth (Khatiwada, Sameer and McGirr). Financial crisis has also led to government financial challenges. States, countries as well as well local governments feel the pinch of financial crisis especially in this case where the crisis linger on for long period of time. As the governments try to come up with new regulations and financial arrangements to protect their economies from the effects of financial crisis, the governments also fall into financial challenges. For instance, in order to protect severe economic downturn, the government undertakes bailout plans which are more costly. The bailout plans by the governments is likely to cause budget deficits thus the governments will not be in a position to carry out their activities effectively (Tonn 53). Financial crisis has also increased the unemployment rates of the economies affected. Due to decreased product and service demand, some business organizations have shut down their operation while others have lain off massive number of employees. Besides, collapse of various business entities during financial crisis has left many individuals unemployed. The unemployment rate in G7 countries has currently reached 6.5% from an average of 5.7% in 2006. With an exception of German, all other G7 countries have experienced a substantial increase in unemployment rate due to global financial crisis of 2007-2009 (Khatiwada, Sameer and McGirr). Economic contraction has also resulted due to financial crisis. Studies have shown that the economies of countries stroke by financial crisis have contracted during the crisis. For instance, France and Italy have experienced substantial decline in GDP. Moreover, G7 countries also experienced a decline in GDP during the prevailing 2007-2009 financial crisis. A decline in GDP is an indication of economic contraction which is accompanied by other negative economic aspects. These negative economic aspects include increased interest rates, inflation, low rate of investment, low tax returns among others (Khatiwada, Sameer and McGirr). Decline in volume of world trade is also a consequence of financial crisis. Due to the prevailing financial crisis, the world trade volume has decline by 1.9% to reach 4.1% in the year 2009 according to the report produced by IMF. The decline of the world trade volume has got a direct impact on labor markets in developed, developing and emerging economies. A decline in exports and capital inflow triggers a falloff in investments. Besides, deterioration of financial conditions and deceleration of growth triggers further business failures and probably more emergencies in the banking industry. As a result, many countries are likely to slip towards a payment balance crisis (Mike 4). Responses to Financial Crisis Economies need to establish effective policies and strategies to respond to the effects of financial crisis. Short-term and long-term responses are very vital in addressing the effects of financial crisis in an economy. The short-term responses insulate an economy or organizations from immediate effects of financial crisis while long-term responses aim at protecting business organizations and economies from future effects of financial crisis (Allan 25). Short-term Responses One of the short-term responses which should be taken by economies to avoid the risk of deflationary spiral is expansion of monetary supply. Expansion of monetary supply protects the economy from the deflationary spiral risk in which higher unemployment rate and lower wage rates results to self-reinforcing decline in global consumption. Moreover, enactment of fiscal stimulus packages is another short-term response to address financial crisis. The government can borrow and spent in order to offset the decline of demand in private sector caused by the financial crisis. The governments can raise the capital of their major banks by purchasing stocks. This will prevent substantial decline of stock values and skyrocketing of interest rates thus insulating an economy from financial crisis effects (Nancy 7). Introducing bail-out plans is also a short-term response to financial crisis. Financial institutions as well as other business organizations which have been immensely affected by the financial crisis should be bailed out by governments. Collapse of financial institutions as well as other business organization exacerbates financial crisis effects within an economy thus should be prevented through bail-out plans. Business organizations facing financial difficulties due to financial crisis are likely to carry out massive layoffs of employees thus increasing the unemployment rate in an economy. As a result, bail-out plans will restore the financial stability of business organization thus prevent them from carrying out massive layoffs of employees (Dorn 31). Long-term Responses In order to address the issue of global crisis in the long-run, introduction of more effective regulatory frameworks will be of great significance. More effective regulatory frameworks to address consumer protection, capital requirements of business organizations, bank financial cushions, derivatives, shadow banking system and executive pay will protect economies from financial crisis in the long- run. Besides, enhancing the authorities of central banks to wind up institutions systematically is another long-term response for the financial crisis (Nancy 9). Establishing more effective resolution procedures for winding up of troubled financial institution is an important measure to address the effects of financial crisis in the long-term. Besides, remuneration of executive officers should be based on long-term performance of an organization rather than short-term performance. Such a move will enable executive officers of business organizations to develop effective strategies to enhance profitability in the long-run. Besides, strict regulations on all institutions in the financial market should be embraced. Financial institutions should have stronger capital cushion with effective regulatory capital requirements. Capital ratios should be increased as the size of financial institution increases. Such a move will discourage financial institution from becoming too big and offset their competitive advantage (Koo 15). Strict regulations should be made to ensure that each financial institution has adequate capital to support its financial obligations. Besides, counterparty risks should be minimized through effective regulation of credit derivatives and insuring that they are traded on effective capitalized exchanges. In addition, introduction of debt to equity swap regulation will help immensely in protecting business organization from collapsing in future. In a debt to equity swap, the prevailing shareholders of organization having a financial difficulty are wiped out and the bondholders become the new stockholders. Such a move reduces the debt burden in a business organization thus preventing it from collapsing (Jason 511). Conclusion Though the prevailing financial crisis is believed to have emanated from United States where investors where enable to pay out their mortgages, the effects of financial crisis has been felt in various countries and business organizations in various sectors. As a speculative bubble and crashes, the 2007-2009 financial crises has had negative impact on economies of many countries both developed and developing economies. Consequences of financial crisis are very severe since they include decline of global growth rate, government financial challenges, and increase in unemployment rates, economic contraction, and decline in volume of world trade, increased income insecurity and disproportionate effect on low-income earners. Introduction of short-term and long-term responses will help immensely in safeguarding an economy from immediate and long term effects of financial crises. In this regard, government leaders, business leaders as well as non-business leaders should implement the aforementioned short-term and long-term strategies to curb the effects of financial crisis and minimize the chances of its occurrence in future. Works Cited Allan, Meltzer. “Reflections on the Financial Crisis.” Cato Journal 29.1 (2009): 25-30. Anna, Schwartz. “Origins of the Financial Market Crisis of 2008.” Cato Journal 29.1 Christopher, Whalen. “The Sub-prime Crisis-Cause, Effect and Consequences.” Journal of Affordable Housing & Community Development Law 17.3 (2008): 219-235. Dorn, Anthony. “Lessons from the Financial Crisis.” Cato Journal 29.1 (2009): 30-35. Jason, Furman. “Preventing and Mitigating Economic Crises.” International Social Science Journal 51.162 (1999): 501-510. Khatiwada, Sameer and McGirr, Emily. Current Financial Crisis; A Review of Some of the Consequences, Policy Actions and Recent Trends. International Institute of Labor Studies, 2009. Kindleberger, Charles. Financial Crises: Theory, History, and Policy. Cambridge: Cambridge University Press, 2008. Koo, Jahyeong. & Sherry, Kiser. “Recovery from a Financial Crisis: The Case of South Korea.” Economic & Financial Review 20.4 (2001): 13-24. Mike, Taylor. “Maintaining Perspectives during the Credit Crisis.” Money Management 22.21 (2008): 4-4. Mishkin, Frederic. The Economics of Money, Banking and Financial Markets. New York: Addison Wesley, 2001. Nancy, Killefer. “The New Business of Government.” McKinsey 1.3 (2009):7-10. Tonn, Victor. “Impacts of Financial Crisis and Its Theoretical Implications.” ­Northeast Region Decision Science Institute Journal 24.1 (2008): 92-95. Read More