Nature of the Recent Global Financial Crisis - Essay Example

Running head: Discussion of the nature of the Recent Global Financial Crisis (GFC) and Policies to address its effects on trading nations Student’s name Institution Course Professor Date Nature of the Recent Global Financial Crisis (GFC) The collapse of the United States housing market and the resulting upsurge in mortgage loans default were the major causes of the global financial crisis witnessed in the year 2007-2009. For example, the collapse of Lehman Brother in the year 2008 sent shocks all over world financial market. This resulted to larger and sharper decline in global economic activity (Carbaugh, 2011). The financial institutions that originated and invested in mortgages were heavily undermined due to loss of hundreds of billions of dollars in those mortgages. Because of that, creditors and bond investors run from all financial organizations that were deemed to fail. For instance, creditors and uninsured depositors pulled out their funds and cash out securities issued by risky institutions and later invested in U.S treasury securities that were considered to have no risk on default (Cooper, 2008). The bursting of the housing market that rippled through the entire financial sector was highly caused by; wreck less borrowing and spending by customers, provision of easy access to credit by many banks, artificial loose of interest rates by the Federal Reserve and poor regulation of the financial sector (Cooper, 2008). Global imbalances amalgamated with the flaws in financial markets, developed defined features of this crisis. The sharp rise in equity risk premiums made the costs of capital to rise while private investments fall and the demand for durable goods collapsed (Carbaugh, 2011). Against the backdrop of sufficient credit facilities, favourable interest rates and upsurge of houses prices, however, the lending standards were relaxed. Generally, the global financial crisis was a crisis of confidence. Since it started with bad real estate loans and highly leveraged bets accompanied those loans. Thus, credit markets got frozen and many households could not get short term loans required to finance their daily activities (Cooper, 2008). The reappraisal of risk by many households caused them to discount their future labour income and increase savings so as limit the consumption rate. Consequently, many banks feared making loans to one another. Notable financial institutions that failed were; Wachovia and Washington Mutual. Lack of fear in the booming housing market was the root cause of the crisis. In addition, the government made contributions to the global economic downturn by pressurizing banks to serve poor borrowers and poor regions of the country (Mishkin, 2009). Furthermore, the approach employed by the Community Reinvestment Act to traditional banks and Congress push to Fannie Mae and Freddie Mac, to increase the purchase of mortgages channelled to low income borrowers resulted in mortgages being made available to various households who were not able to repay the loans awarded. In addition, poorly designed capital requirements led to many banks have insufficient safety cushions in the event of economic downturn. Inadequate supervision and regulation of the financial system contributed heavily on global financial crisis. In that instance, control of moral hazard and discouraging of excessive risk taking by the financial institutions were not implemented effectively (Taylor, 2008). Global financial flows have exhibited unsustainable patterns; China and Germany run large surpluses while United States run deficits every year. Therefore, United States internal deficits have been associated with household and government sectors. Securitization promoted “the Originate to distribute model” which has reduced lenders’ initiatives to be prudent in cases of vast investor demand for subprime loans packages. Because of inadequate participant accountability, the originate-to-distribute model of mortgage finance generated a lot of risks. Lack of transparency and accountability in mortgage finance allowed the creation of bad mortgages and selling out of bad securities to the public ( Savona, Kirton and Oldani, 2011). Laws such as Gramm- Leach-Bliley Act (GLBA) and the Commodity Futures Modernization Act (CFMA) allowed financial institutions to engage in unregulated risky ventures on a larger scale. In addition, this crisis has been attributed to the persistence of large global imbalances due to long periods of huge loose monetary policy in the key advanced economies of that decade (Müller, 2011). Moreover, this crisis was accompanied by a rapid growth of China that shaped the level and pattern of world trade. There was too much faith put in credit rating agencies, whereby at times their own methodologies for valuing complex structured finances products were flawed. For example, the assemblage of unfavourable financial regulations, inefficient remuneration practices in the financial sector and excessive risk taking by distinct financial intermediaries added to global economic downturn. Effects of the Global financial crisis Detrimental effects of global financial crisis were; rise of unemployment, increase in domestic and international debt levels, and failure of key business such as automotive, banks and housing lenders to prosper and generally decline in consumer wealth. Consequently, the volumes of international trade and investment declined. The loose monetary policy has contributed to the reduction in the cost of wholesale funding for intermediaries, thus intermediaries build up leverage. Also, it increased the supply of and demand for mortgages thus asset prices skyrocketed (Carbaugh, 2011). The down turn in activity resulted to unemployment. Political response to secure domestic industries via assemblage of domestic subsidies and border protection were advocated. National security, economic wellbeing and value projection being vital national interests of the United States were adversely affected by global financial crisis. Inadequate supervision and regulatory measures of the financial system inhibited the control of moral hazard and encourage excessive risk taking on the side of financial institutions. Huge cross border financial flows and savings investment imbalances have caused detrimental consequences to financial intermediation procedures. The collapse of the securitized United States mortgage market and its associated derivative products heightened the weakness of the U.S housing sector (Müller, 2011). Reduced corporate taxes in private activities, declined royalties and import taxes have adversely affected the revenue of the central government. Possible Policies to address the effects of the Global Financial Crisis on trading nations The impacts of this crisis, for example; sudden loss of trillions of dollars in wealth, increase in unemployment level and historic decline in economic activity has posed a challenge to various policymakers. The policies to be employed should correspond to the crisis in question. Caution need to be considered to ensure that policies implementation is pro poor to shun elite capture (Nanto, 2009). The key focus of policy has become the prevention of a prolonged down turn on the order of great depression. Most of the policies championed are intended to maintain this global economic crisis and carrying out required procedures that will boast recovery and reforms process in the financial markets across the affected nations (Desai, 2011). This crisis could be rescued in confidence by bolstering the balance sheet of institutions that appear to be at risk and making it clear to all creditors that they can once again safely lend loans to those institutions in question. Thus will restore confidence and reduce the impact on the nation’s economy. The government of United States and China have declared plans to pump liquidity to troubled financial institutions and also increased deposit insurance to avoid run on banks (Nanto, 2009). Furthermore, central banks in the affected nations by the recent global financial crisis have engaged in a coordinated interest-rate reductions and purchased commercial paper and other money markets instruments directly from corporate issuers and money market funds. The government too has initiated large fiscal stimulus packages in the form of tax cuts and increased government spending. Entry barriers have limited competition in the markets for deposits which will reduce the need for bank to tap wholesale funding sources (Nanto, 2010). The European union have implemented comprehensive reforms in the financial system. For example, they have managed to cover all vital areas of financial re-regulation such as regulation of credit rating agencies, regulation of short selling, amendments to the capital requirements directive and creation of multiple regulatory authorities. These authorities will be responsible for identifying macro financial risks, coordinate banking regulation and supervision, securities market regulation and supervision and adoption of crisis (BOT, 2009). Various financial institutions such as banks should be rescued from securitization process because they are public utilities and are designed to serve the general public. For instance, if they are permitted to access government bailouts and guarantees, they should not be granted to securitize since it will undermine good underwriting procedures. Institute of International Finance, The U.S President’s Working Group on Financial Markets Actors and the recommendations of the Financial Stability Forum made the proposals in the following areas (OECD, 2009). Strengthening prudential oversight Increasing transparency and information sharing on risks independent of credit rating agencies (CRAs) Regulating the Credit Rating Agencies Improving risk mitigation procedures Adoption of new methods and practices to deal with system risks The American Home ownership and Economic Opportunity Act 2000 and the American Dream Down payment Act of 2003, promoted deregulation and tax lending practices in the mortgage market. Moreover, the conventional monetary policies have been utilized in a well co-ordinated effort to stimulate growth and stabilization of the global financial system with various central banks slicing their policy interest rates since September 2007 .Other proposals to regulate global financial markets include the establishment of World Financial organization (WFO). It will manage global trade by establishing minimum standards on capital and liquidity, increasing supervision and regulation of global financial markets and by ensuring sufficient risk aversions mechanisms. World leaders too have championed greater financial cooperation through the setting up of new comprehensive international institutions so as to remedy the inherent problems of a globalized financial system (United Nations, 2010). Consequently, there is need for the International Monetary Fund (IMF) to be involved in maintaining the stability of the international financial system. Every economy followed a Henderson-McKibbin-Taylor rule, as monetary policy was ease to near zero official rates of interest in major developed economies. Generally, the global economy requires a constant of capital liquidity so that it can remain robust in future. The focal point has been shifted from financial institutions and loosened monetary values to shoring up relevant manufacturers working in real economy and expansionary policy (Taylor & Weerapana, 2009). Reregulation of the financial regulations via appropriate incentives in operation will prohibit lenders fraud. Some affected nations opted to have task force to weigh up the state of financial crisis and later issue recommendations on means to respond to this economic turmoil in future. Furthermore, the macroeconomic policy proposed and structural measures in Africa continent will reduced the effects of global financial crisis and promote the basis for sustainable growth. Most of the nations to invest in early warning of poverty and vulnerability data systems so as issue both quantitative and qualitative parameters of the impacts of the global financial crisis with a focus on poor and unemployed people (Morgan, 2010). Domestic business enterprises that are vulnerable to this crisis require adequate support to muddle through inadequate credit services and declined demand in export markets. For effective techniques of global financial governance to be enhanced, it needs adequate participation and massive agreements from both developed and developing states governments (Taylor & Weerapana, 2009). International financial organizations such as International Monetary Fund (IMF), World Trade organizations (WTO) will provide support to varied nations that were faced by external payments problems and financial crises. They placed some mechanisms that will allow issuance of emergency liquidity assistance and enhancement of supervision of financial sector of the economy. Thus for many States, active fiscal policy is critical tool to reduce the consequences of global financial crisis. In developing countries, the following were advocated; advancement of technology transfer by foreign investors, development of infrastructures and promotion of manufacturing export competitiveness. In addition, reductions of interest rates, financial institutions recapitalization, means to increase liquidity to banks and organizations, fiscal stimulus, changes in the trade policy and regulatory reforms were also put into consideration (Savona, Kirton and Oldani, 2011). Revenue mobilization and efficient expenditure management has contributed to attainment of fiscal stability policies. In brief, these policies proposed worked towards the adoption of crisis regulation procedure, regulation of security markets and finally well-coordinated banking institutions regulation and supervision (Savona, Kirton and Oldani, 2011). To cushion the effects of global financial crisis, United States have worked tirelessly so as to promote transparency and accountability and flexible sharing of tangible information on risks independent on credit rating agencies, enhancement of procedures that mitigate risks and adoption of modern techniques and strategies to compact with systemic risks. Proper comprehensive review of the regulatory and supervisory regimes will ensure financial institutions to be investigated for proper oversight and regulation will limit the excessive risk taking (Mishkin, 2009). References Andreas Müller, (2011).Financial Crisis- Impacts and Reactions, GRIN Verlag. BOT, (2009). The impact of Global Financial Downturn and the Government stimulus package Carbaugh, R.J, (2011).The International Economy and Globalization, International Economics, 13th Edition, Cengage Learning. Dick K. Nanto, (2009).Global Financial Crisis: Foreign and Trade Policy Effects, DIANE Publishing. Dick K. Nanto, (2010).Global Financial Crisis: Analysis and Policy Implications, DIANE Publishing. George Cooper, (2008).The origin of financial crises: central banks, credit bubbles and the efficient market fallacy, Harriman House Limited John Taylor, Akila Weerapana, (2009).Principles of Macroeconomics: Global Financial Crisis, Cengage Learning Mishkin, F.S. (2009). Is monetary policy effective during financial crises? American Economic Review. OECD, (2009). Fiscal packages across OECD countries: Overview and County details, Paris Padma Desai, (2011).From Financial Crisis to Global Recovery, Columbia University Press. Paolo Savona, John J. Kirton, Chiara Oldani, (2011).Global Financial Crisis: Global Impact and Solutions, Ashgate Publishing, Ltd Richard Morgan, (2010).Lessons from the Global Financial Crisis: The Relevance of Adam Smith on Morality and Free Markets, Taylor Trade Publications. Taylor, J.B. (2008). The Financial Crisis and the policy responses: An Empirical Analysis of What Went Wrong. Tony, (2009). European reaction to crisis suffering from lack of co-operation. Financial times United Nations, (2010). World Economic Situation and Prospects 2010. New York: United Nations World Bank, (2009). The Global Financial Crisis Read More