Financial Crisis of the US in 2008 - Coursework Example

Financial Crisis, 2008-A detailed analysis The current financial crisis had its origin in United s of America mainly because of the inefficient financial policies and banking system as a whole. It has affected trade of goods and services not only in United States, but also in most of the other countries. There is wide spread loss of jobs and unemployment. The global financial market is heading towards a collapse if necessary measures to resolve financial crisis is not taken by the authorities, not only in US but also in other countries facing the same situation. The present paper is intended to analyze the evolvement of the current financial crisis, its effects on the economy of United States as well as its financial market, some of the problems the United States may face in the future and also to discuss some of the short term and long term solutions. Factors that lead to evolvement of current financial crisis According to Taylor (2008) financial crisis is the result of monetary or any other form of excesses, which leads to a boom and results in a bust. It can also occur when financial institutions or assets lose its value (Kindleberger and Aliber (2005). It is also characterised by the reduction in flow of credit to the businesses and households (Jickling, 2008). During the period from 2000 to 2007 the monetary policy by the Federal Reserve was highly flexible and easy to follow. Loans and mortgages were easily available even when there was no evident means to repay it. The Federal Reserve lowered the interest rate compared to those prevalent at the time before crisis. They even explained that the lowering of the interest period would be only for a short period of time and that after that time the interest rate would be restored to normal by slowly increasing it at a fixed rate. Thus it is quite evident that the lowering of the interest rate, which resulted in monetary excess, was actually a wrong decision by the Federal Reserve. The reason they gave for such an action was to avoid the occurrence of a deflation that occurred in Japan in 1990’s (Taylor, 2008). Sub prime mortgages were designed actually to make each and every citizen of US, a homeowner. These mortgages were given to those people who were having a very high-risk profile and were on variable interest rates. Most of the banks did this based on the assumption that housing price would continue to rise. This nature of these mortgages resulted in foreclosure of loans when the house prices began to fall. The fall of price of houses resulted in loss of asset value of most of the banks. The housing boom and bust that followed not only affected the housing sector, it affected the overall prices of each and every commodity (Taylor, 2008). Agencies such as Fannie Mae and Freddie Mac sponsored by the government became pioneers in buying sub prime mortgages involving great risk. These agencies did not asses the risk accurately mainly because they did not have a competitor in the field and because they were sponsored by the government and still another reason was that the procedure was too long and so the risk assessment was overlooked. (Taylor, 2008) Another explanation for the financial crisis is a global saving glut, which affected the economy of United States and other countries. As a result of the increase in global savings, the interest rate reduced. Some argue that the lowering of the interest rate was not actually a decision of the monetary authority, on the other hand it so happened because of the changes in global economy. But this argument does not stand because the global saving rate was very less during this period. The central banks of most of the other countries followed the same pattern of interest rates as in United. Greater they deviated from the normal interest rate, greater was the housing boom, as in Spain. Lesser the deviation lesser was the housing boom, as in Austria (Taylor, 2008) Still another view of the present financial crisis is that it is actually quite premature to call it as a financial crisis. This because although there is some tightness in the financial market, the credit flow is not affected and the economy is continuing to grow. This tightness is normal in the cycle of financial market, as after every financial expansion due to low interest rates, high availability of credit, easy risk assessment, etc, there should be a time of correction when the situation turns back to normal. Although some losses occur during this period, it would force the financial institutions to gather large reserves and would be cautious in their risk assessment and eventually the normal situation would be restored. So this is a correction period in the financial cycle and need not be called as financial crisis and therefore need not be feared of (Crutsinger, 2008). Consequences The effect of the present financial crisis on the US economy is tremendous. All the US major banks as well as financial market suffered severe losses by October 2008. The equity prices reduced to a great extent and the stock indices reveal a reduction of more than half of the value of the shares of the major companies. The short-term credit has become a really costly affair and liquidity has almost reduced to nil. After the recession in 1930’s this is for the first time that the US economy has faced such a worse situation. According to the Bureau of Economic Analysis, in United States the growth of GDP was not affected until the first quarter of 2008. But the Federal Reserve has predicted that there would be a reduction in the GDP growth rate in 2009 (Khatiwada and McGirr, 2009). Job loss is rising after 2006 and more than one million people have lost jobs. Of these more than 10% was in the month of September 2008 and the trend is continuing. The construction and real estate sectors have experienced most of these job losses. The income security has also been affected badly by the financial crisis and this is having serious impacts in the life of low-income groups (Khatiwada and McGirr, 2009) Although the effect of the current financial crisis was very high and millions have already lost their jobs, studies reveal that this effect is less compared to recession periods of 1990-91. This is mainly because of the rise in price of the oil which was unaffected by the financial crisis. (Khatiwada and McGirr, 2009). As per prediction of International Monetary Fund unemployment would be increasing in the year 2009 and it was increasing in the year 2008. Although this also has not reached the values of 1990-91, the downward trend is continuing. Both state and local governments are facing financial challenges as it is finding it difficult to make financial arrangements for its own operations. Some of such instances have already occurred in California and Massachusetts. Resolving financial crisis In order to prevent the collapse of the financial market of USA, the government has spent almost a trillion dollars. An emergency economic stabilization act was approved which gave authority to the US treasury to buy those mortgages, which cause great financial losses to the banks. Re-capitalization of banks, FDIC insurance on non-interest bearing accounts and federal guarantee for debt for three year were other measures taken to encourage deposits in banks (Khatiwada and McGirr, 2009). The Federal Reserve is using open market operation to inject liquidity into the market. It has reduced the Fed fund rate at least six times by March, 2008 (Jickling, 2008). Another intervention by the Government is through the use of discount window. The Fed is lending to the banks through the discount window. The banks, which fulfill the criteria to receive this, could directly get cash from the central bank. This is actually a short-term compensatory measure and is targeted to help those banks in trouble and is not designed to improve the system as a whole. The Term Auction Facility is another tool used to provide funds to banks. There are a number of drawbacks in the decisions of the US government to counteract financial crisis. If the government buys the troubled assets with a high price, in order to save the financial institutions, taxpayers would be losers and such an action requires a lot of time to be effective in practice and will not be able to allow inflow of cash into the market (Khatiwada and McGirr, 2009) are of the opinion that instead of this step, if the government had allowed the use of equity by the troubled firms, the firms would have got enough capital to pull on their business and at the same time the government would be able to bring those firms under their direct control. The compensation structures devised by the government to resolve the crisis would be advantageous under a short-term basis only. In long-term view, it is having much risks involved (Rajan, 2008). The financial markets are still in the danger of collapse. The Federal Reserve is anticipating a reduction in flow of credit to businesses as well as other household consumers. Such a situation would be drastically affecting the economy of the country. It would result in the reduction of spending and investment by the people thus straining the financial market. These is mainly because the participants in the market are mostly not willing or are not confident to lend. There are many reasons for this behavior. One is that in the current situation it is very difficult to assess the financial situation of the borrowers. Another reason is that the asset value is continuously fluctuating. Presently, even though there is tightness in the market, the flow of credit is not affected. According to Caplen (2008), this is “the longest anticipated crisis”. In order to avoid future financial crises it is necessary to consider consumer price index inflations and deflations also along with asset price inflations and deflations while designing financial as well as regulatory policies. Rude (2008) is of the opinion that the central banks are keen to keep the consumer price index low and they would never check the asset inflation values. This is the main reason for financial instability and the slow growth of economy. The inefficiency of the current financial system has already been proved, as it is not even in a position to rescue the market from collapse (Krugman, 2008). So there is a need for the complete restructuring of the financial system increasing transparency, resiliency and better assessment of the risks. Such regulations should be implemented by the government as well as by international authorities. The government should see that financial institutions are taking profit out of the globalization without endangering the entire financial system. The regulations designed should cover all the activities of the banks such as instruments, hedge funds, on and off balance sheet items, taxation systems etc. The securities, which involve great risks such as over-the-counter securities as well as exchange-traded securities, have to be strictly regulated and monitored (Rude, 2008). In this way the present crisis could be solved and future crises may be avoided. Another important aspects that needs consideration here is that the banking system is now not restricted by borders and therefore there is a necessity for a multilateral harmonization and regulation of the banking system so as to prevent the failure of banks in one country transmitting to other courtiers as well. A world financial authority has to be formed to harmonize the activities of International Monetary Fund. It would be ideal to create a central bank above all the central banks. Sphere of activity of the regulator and the market should be the same (Rude, 2008). This would help in better monitoring of the global financial market as a whole and prevent malfunctions of financial institutions in all the countries. Conclusions Thus it could be seen that the current financial crisis started due to some untimely and inefficient decisions and overlooking of the risk factors by the financial institutions in US. It is affecting the economy of US by its negative impact on GDP, employment and trade. Although the government has taken a lot of steps to solve the situation it is very difficult to put those decision into practice. So there is a need for finding short term as well as long-term solutions that would make the entire global financial situation into control and also to prevent further collapse of the financial markets and also to avoid such crisis again in the economy of all the countries round the world. Works Cited “Bureau of Economic Analysis”, Canada Economic Accounts Quarterly and Eurostat. 2008 Caplen Brian, “Credit Suisse CEO: Clear View Curtails Crisis Fallout,” The Banker, January 1, 2008. Crutsinger Martin, “Paulson: No Simple Solution to Housing Crisis,” York Dispatch, January 7, 2008. Jickling Mark. “Averting Financial Crisis”, CRS report for Congress. March, 21, 2008. Khatiwada, Sameer and McGirr, Emily. “Current Financial Crisis: a review of some of the consequences, policy actions and recent trends”. International Institute for Labour Studies 2009. [online] Available at: http://www.scribd.com/doc/7882284/Current-Financial-Crisis-a-Review-of-Some-of-(Accessed on 29 June 2009) Kindleberger, Charles. P. and Aliber, Robert “Manias, Panics, and Crashes: A History of Financial Crises”, 5th ed. Wiley, 2005. Krugman, Paul. “The Return of Depression Economics and the Crisis of 2008”. W.W. Norton, 2008. p. 224 Rajan, Raghuram “Bankers’ Pay is Deeply Flawed,” Financial Times, January 9, 2008, p. 11. Rude, Christopher. “Global Financial Crisis: What Needs To Be Done?” FES Briefing Paper 12 , November 2008. Taylor, John. B. (2008). The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong [online] Available at: http://www.stanford.edu/~johntayl/FCPR.pdf (Accessed on 29 June 2009) Read More