What Caused the Current Economic Crisis - Term Paper Example

?What caused the current economic crisis? The whole world was taken aback as the slow and destructive financial turmoil unfolded in various parts of the world in late 2007. The credit crunch initiated a long chain of inter-connected events that threatened the existence of financial markets all around the globe. This meant the very foundations on which our principles and understanding of the whole economic system was based on were shaken and jolted to an extent that people lost confidence in its integrity. It raised questions that directly pointed fingers on the functioning of the global financial markets. The whole crisis began when the US investors lost confidence in the value of sub-prime mortgages resulting in an adverse liquidity crisis. In fear of the effects of the looming liquidity crisis, the US Federal Bank injected huge sums of capital, liquid money, into financial markets in an attempt to prevent several hundred thousand businesses and individuals from declaring bankruptcy. By the end of September of the following year, the economic crisis had worsened as its negative effects started to crash stock markets on all the continents. This made investment highly volatile and investors lost millions of dollars overnight as this continued to spread further. A pinnacle was reached where consumer confidence was at its lowest in fear of the inevitable outcomes. Analyses reveal that at a more fundamental level the economic crisis could be attributed to the diligence of massive global imbalances. These imbalances were the outcomes of long periods of excessively loose monetary policy in the major advance economies during the early part of this decade. A major factor in this was the significant increase in the budget deficit of the United States, while at the same time the accumulation of huge amounts of surpluses in Asia, particularly in China and the oil exporting countries of Middle East. The current account balance of US in 2008 as a percent of its GDP was -4.7%, and for China, Saudi Arabia, Russia and UAE was 10%, 28.9%, 6.1% and 15.8% respectively. This showed that even after billions of revenue for the Western Giant United States, the global net flow of money was directed towards the Eastern part. This imbalance was ever growing as the Economic power was slowly and gradually shifting from the West to the East. Experts stated that these imbalances were seen as the consequence of the relative inflexibility of the currency regimes in China and other such countries. According to Portes (2009), prevailing global macroeconomic imbalances were the major underlying cause of the crisis. The gap between the saving-investment function was extensive and this gap was only widening with time since developing countries started relying more heavily on developed economies to provide for their development expenditures. The immediate impacts of these huge cross-border financial flows were seen on the financial intermediation process. (Mohan, 2009) As stated earlier the monetary policy of US was also a contributing factor to the financial crisis of 2008. To understand this we have to visualize the dot com bubble burst in the early 2000’s. This resulted in a reduction of the interest rates and consistent ease in the monetary policy of US and other advanced economies. These rates maintained as low as 1 per cent in US during the period 2003-2004. This gave ample opportunity for new businesses to thrive in the country and huge investments were made during the first half of the decade. Figure 1 clearly demonstrates that during 2008 the effective federal fund rate in the US was around 1 per cent margin. This relatively loose monetary policy meant that transactions were being done on a credit basis more than ever in the history of the country. The effects of this were visible in the credit crunch of 2007 that eventually combined with other factors to bring about the economic crisis. The growing demand from the US consumers and its increasing reliance on cheap consumer goods being imported from Asian countries, mainly China, triggered an effect that the whole world witnessed. (Cox, 2008) The lax lending standards and the increasing sub-prime mortgages prior to 2007 led to an increased credit mortgage. As 2007 approached and inflation levels rose, creditors found themselves in a weak and fragile position to pay back their amounting dues. The sudden fall in the house prices that had reached a record high a year back started to hit the mortgage market in the US. House owners found themselves stranded in a situation where the overall value of their investment was negative and still they had to pay back installments of their loans. When increasing prices took a toll on them many of them defaulted and were left without houses. This spread like wild fire from cities to states and within no time the whole country was struck by a mortgage crisis, with banks trying to recover what was left of their loans. The lax policies and the heavy dependence on credit piled up until it finally hit back on everyone’s face. Many experts and politicians in the US believe that although the housing collapse is referred to as the trigger for the global financial crisis, they still believe that a better financial system was needed that would have regulated and prevented the excessive unscrupulous spending in the economy. (Shah, 2011) The global economic crisis entered into a new phase that only widened the extent of its damage. On 14th September the Lehman Brothers collapsed as it faced unavoidable liquidity crisis. Many giant financial institutions became prey of the same as governments all across the globe failed to provide support and the whole spiral crippled the US economy. Across the globe the Australian government announced its first stimulus package in an attempt to jump-start the slow and dying economy. The main objective of this stimulus package was to effectively fight and control inflation in Australia as it was becoming a major issue at that time. The first stimulus package comprised of a substantial $10.4 billion and was aimed at helping provide payments to seniors, to sustain the slowing house industry and save the automotive industry from collapsing. This was soon followed by a second massive stimulus package amounting to $47 billion. This encompassed everyone from a simple taxpayer to small businesses and emphasized greatly on the successful continuation of the education system in the country. In comparison to this the US proposed $700 billion rescue package was inherently not passed by some of the Congress members as they argued that this is too humungous an amount to save the Wall Street investment bankers especially when they could have been the very cause of this devastative financial crisis. They continued that the tax payers should not be spent on such a scale that might further leave the government in a liquidity crisis. Investors, on the other hand, shifted their focus to gold, bonds and the US dollar as a safer mode of investment since the recovery of the stock and housing market still seemed questionable. The banking sector was hit badly in three ways. Firstly, the solvency of the bank was at question since bad debts were rising and were at an all time high. Secondly, the noticeable change in the Federal Reserve Policy created a panic in the inter-bank lending market. The whole system started to seize up as banks stopped to lend anyone at all in the market in fear of which bank will survive and which will dissolve. Thirdly, the panic amongst the stock market investors sent the prices of the bank shares into a freefall. The plummeting prices resulted in huge selling of shares thereby creating a chain of uncertainty and loss of confidence in the stock market. This spread across all major markets and the banks found their capital value decrease many folds, thereby restricting them from lending money for any kind of investment. This effect was felt across the Atlantic as well since many European countries had invested heavily in the US stock markets. This dragged them into the mess and created a cycle that slowly but eventually engulfed the whole world in its grip. (Global Financial Crisis - What caused it and how the world responded, 2009) The global financial crisis can be attributed to a variety of reasons but it is evident that creeping inflation in the United States along with the poor regulation of monetary policy led to the worst turmoil on this planet. The US Bureau of Labor Statistics announced that consumer price index had reached an all time high of 121.0, which resulted in decreasing purchasing power of the consumers who were already lacking behind in their mortgage repayments. This along with the housing bubble burst in the US crippled the economy to a stage where investor confidence was near to non-existent. The whole world was deeply pegged to the financial institutions in the US, and when they fell the whole world was dragged along with it. It can be argued that developing countries that were not directly involved in US financial system were the least affected relative to the developed economies that saw the most of this financial turmoil. The bail-out packages from various governments attempt to restore the financial institutions but the main focus should be on strengthening the monetary system and adopting policies that will ensure excess unwanted demand is kept in check. The future is still bleak but only careful planning and a global effort will bring back the whole economy back to its feet. Figure 1: Bibliography Cox, W. (2008, October 28). ROOT CAUSES OF THE FINANCIAL CRISIS: A PRIMER. Retrieved from Newgeography: http://www.newgeography.com/content/00369-root-causes-financial-crisis-a-primer Global Financial Crisis - What caused it and how the world responded. (2009, March). Retrieved from Canstar: http://www.canstar.com.au/global-financial-crisis/ Mohan, R. (2009, April 23). Rakesh Mohan: Global financial crisis - causes, impact, policy responses and lessons. Retrieved from Bank for International Settlements: http://www.bis.org/review/r090506d.pdf Shah, A. (2011, December 11). Global Financial Crisis. Retrieved from Global Issues: http://www.globalissues.org/article/768/global-financial-crisis Read More