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Roots and Causes of the Economic Crisis - Literature review Example

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This paper will comprehensively throw light upon the roots and causes of the current economic crisis. All the major causes will be expansively presented in this paper. The valuable lessons learned from the crisis will also be thrown light upon in this paper…
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Roots and Causes of the Economic Crisis
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Download file to see previous pages Overvaluation in real estate is perhaps the biggest cause of the current economic crisis, it is better known as the subprime crisis in the US. The likes of Lehmann Brothers and other financial services went bust because they kept issuing a credit to the people who thought the property price would increase and they would be easily able to pay off the debt that they are borrowing. It did not turn out that way and there was a short of equity, this is exactly why the financial institutions went bankrupt. Overvaluation is the biggest factor that caused the current economic crisis. Factors like bad income tax practices have added insult to injury, bad mortgage lending also contributed heavily to this current economic crisis. “The way to address the root cause is to let house prices drop to where an average house is within the means of an average household. (Or, alternatively, boost the income of the average household to the point that they can afford an average house. But that's very hard. Letting houses prices go on falling, although painful for everyone who owns a house or who has lent money to someone who owns a house, is very easy.)” (Root Cause of the Financial Crisis) Some of the main plausible reasons that caused the recent financial crisis have been identified in the above sections. According to Brunnermeie (2009), cheap mortgage financing to sub-standard borrowers fuelled the boom in the U.S. housing market. Three factors were primarily responsible for the fall of the housing market in the U.S. (which in essence, constituted a very small segment of the financial market in the country) transforming into a global contagion. First, the “originate and distribute” banking model, together with the high rate of securitization, led to declining lending standards and made it impossible to re-price the complex structured products. This significantly eroded the confidence level of banks, thereby disrupting the inter-bank markets and credit flow. Second, banks relied heavily on short-term funding sources, hence raising the risk of funding. Finally, the ever-growing integration of global financial systems and the increasing interest towards structured financial instruments quickly transmitted the crisis to all the major regions of the world.
Gourinchas (2010) focused on the role of monetary policy in the recent financial contagion as well as the role played by exogenous influences, particularly the rising external deficits referred to as ‘Global Imbalances’. According to Gourinchas, both explanations are not satisfactory as the sole reason behind the crisis. This opinion has also been corroborated by Caballero (2009), who suggested that the primary reason for the crisis lied in the “imbalance” between worldwide demand for secured liquid instruments of debt in the U.S. and abroad, and the limited asset supply. Per Gourinchas, the imbalance in safe assets impacted the monetary policy effects and the external deficit patterns of the U.S. (Gourinchas, 2010, p.1). The rosy macro-economic picture that prevailed prior to the year 2005 was blemished by the overheated housing markets and the rising external deficits in the U.S. During the period between January 1997 and January 2006, the S&P Case Shiller Composite-10 Home Price Index rose by 128% in real terms. The household leverage, i.e. the household debt as a proportion of disposable household income, increased substantially with the rise in the prices of real estate. ...Download file to see next pagesRead More
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