Roots and Causes of the Current Economic Crisis, Monetary Policy - Research Paper Example

?Client’s 10 August The great economic depression in 1930, in the US, was triggered off by the collapse of the US stock market which is now known as Nasdaq. It was the worst period of the US history; people slept on Hoover blankets and had no money to spend. The economy of the US recovered from this setback only to suffer from a similar setback of a lesser magnitude in 2008, which is called recession. This paper will comprehensively shed 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 discussed herein. Bear Stearns, AIG, Lehmann Brothers, Northern Rock, and Goldman Sachs are some elite names that suffered most because of the economic crisis also known as recession. Lehmann Brothers filed for bankruptcy while AIG and a few other elites just hung in there with the skin of their teeth. This economic crisis is still having repercussions on countries such as Greece and Spain; the whole of Euro Zone is facing a financial turmoil. There are a few other countries that have been not so severely affected by the same. The crisis was triggered off because of unchecked debt; banks kept issuing loans to people who invested heavily in buying assets; several things were taken for granted but when proved otherwise, there was hardly a place in the world to hide. 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 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. The overvaluation is the biggest factor that caused the current economic crisis. Factors such as 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”). Role of Monetary Policy Some of the main plausible reasons that caused the recent financial crisis have been identified in the above sections. According to Brunnermeie, 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 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, 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 1). The rosy macro-economic picture that prevailed prior to 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. However, there is a general perception by many economists that the developments on this front were mainly benign for three main reasons. The financial innovations, as evident from the increase in securitization, had a positive impact in the form of low borrowing costs and reduced risk borne by the lenders. Due to the limited supply of houses in the short-run, an increase in housing demand raised the housing prices. According to Greenspan, though concerns about the boom in the housing market were present, there was a perception that the domestic economy could easily bear the slowdown in the household prices in some highly speculative markets without an impact on aggregate conditions. In addition, central banks stated that they were vigilant and could offset any decline in aggregate demand by adopting a suitable interest rate policy. During this period, the U.S. was facing a current account deficit, (which is measured as the surplus of imports over exports), signifying the weakness in domestic savings compared to national investments. The amount of this deficit increased from 0.5% to 1.9% of global output. A persistent deficit implied an increased reliance of the U.S. economy on outside sources for meeting financing needs. By 2005, a rise in global imbalances was perceived as a serious threat to the stability of the global economy. Gourinchas states that stable monetary environments do not always indicate a “stable macroeconomic outcome.” According to Obstfeld, though the pre-crisis period was characterized by stability in the rate of inflation, consumer prices and output, it was marked by an uncontrolled leverage (both on the part of households as well as financial intermediaries), which is believed to be one of the main reasons behind the crisis. The excessive leverage conditions had mainly developed due to low real and nominal interest rates, which ultimately fuelled rising asset prices. After the emergence of the credit crisis, it became ostensible that interest rate regulation policy is not enough to achieve stabilization in output and to nullify any demand contraction. The federal rates rapidly reached levels of less than zero, which called for supplementing traditional monetary tools with vigorous fiscal measures and some non-conventional monetary tools (Gourinchas 1). Effectiveness of the Monetary Policy The strictness of credit standards and the failure of a fall in the cost of credit directed towards businesses and households gave rise to the view that monetary policy was ineffective in the context of the crisis, despite an eased monetary policy throughout the greater part of the decade. These views have been seconded by Paul Krugman and have also been affirmed by the minutes of a meeting of the Federal Open Market Committee (FOMC). These views are also in line with the earlier Keynesian discussions regarding failure of monetary policy during the Great Depression. Based on these views, many arguments exist about the efficacy of monetary policy in coping with a credit crisis. The easing of monetary policies in times of crises can be counterproductive because it can considerably weaken the ability of regulatory authorities in taming inflation. However, the abovementioned views have been challenged by several economists such as Mishkin, who argues that in order to nullify the effects of the crisis, monetary authorities need to adopt a more aggressive easing of monetary policy. Friedman and Schwartz have argued that in the absence of sufficient liquidity allowed by the Fed (and an eased set of monetary norms), the impact of the recession would have been even more severe. Their opinions are followed by the logic that monetary policy has been effective during the recent financial crisis. In fact, it is said that monetary policy has been more potent during times of crises (compared to normal situations) because not only did it lower interest rates on default-free or government securities but it also lowered credit spreads. However, it cannot be said that monetary policy can nullify the contractionary impact arising from a financial disruption similar to the one that the economy most recently experienced. The recent financial crisis resulted in such levels of credit spreads widening and credit standards tightening that even an aggressive easing of monetary policy failed to put a brake to the crisis (Mishkin). Works Cited Blackburn, Robin. The Subprime Crisis. 2008. Web. . Board of Governors of the Federal Reserve System. Statistical and Historical Data. 2010. Web. . Cecchetti, Stephen G. Monetary Policy and the Financial Crisis of 2007-2008. 2008. Web. . Cheung, Lillian, Chi Sang Tam, and Jessica Szeto. “Contagion of Financial Crises: A Literature Review of Theoretical and Empirical Frameworks.” Hong Kong Monetary Authority. 2009. Web. . Domash, H. (2002). Fire your stock analyst!: analyzing stocks on your own. New Jersey, USA: Financial Times-Prentice Hall. Dow Jones & Company, Inc. “Did the Fed Cause the Housing Bubble?” The Wall Street Journal. 2011. Web. . Federal Housing Finance Agency. Quarterly Average and Median Prices for States and U.S.: 2000Q1-2010Q2.2011. Web. . Federal Reserve Bank of St. Louis. Bank Credit of All Commercial Banks. 2011. Web. . Federal Reserve Statistical Release. “Charge-offs and Delinquency Rates on Loans and Leases at Commercial Banks.” 2011. Web. . Gourinchas, Pierre Olivier. U.S. Monetary Policy, “Imbalances” and the Financial Crisis. 2010. Web. . Lee, Susan. “It Really Is All Greenspan's Fault.” The Forbes. 2009. Web. . Marques, B.L. “Interest Rates and Crisis Revisiting the ‘Taylor Rule.’” SAIS Review, 30.1(Winter-Spring 2010):157–160. Web. . Mishkin, Frederic S. The Financial Crisis and the Federal Reserve. 2009. Web. . Mohanty, Deepak. “Lessons for Monetary Policy from the Global Financial Crisis: An Emerging Market Perspective.” RBI. 2011. Web. . Palley, Thomas I. The Limits of Minsky’s Financial Instability Hypothesis as an Explanation of the Crisis. 2011. Web. . Reinhart, Carmen M., and Kenneth S. Rogoff. This Time is Different: Eight Centuries of Financial Folly. Princeton University Press, 2009. “Root Cause of the Financial Crisis.” Wise Bread, 2010. Web. . Read More