The Breakdown of the Financial Markets of the World - Research Paper Example

Macroeconomics: The Breakdown of the Financial Markets of the World Abstract The objectives of this essay are threefold: (1) to briefly explain the factors that brought about the breakdown of the global financial markets (2) to determine the scale of the financial crisis; and (3) to present the effects of this breakdown on the countries all over the world. Areas for further studies are discussed as suggested recommendations in this global crisis. \ INTRODUCTION Our world today is beset with financial crisis of insurmountable coverage. A multitude of corporations on a global scale declare bankruptcy and render thousands of employees jobless. The inevitable nature of factors which interplay and caused this financial turmoil on a global scale deserves a closer examination. This paper would present pertinent issues resulting to the breakdown of the financial markets of the world by: (1) discussing the background of the crisis; (2) enumerating factors that lead to the breakdown, as analyzed by economists; (3) stipulating the scale of the financial crisis; and (4) detailing the effects this crisis imposed on economies of the world. BACKGROUND OF THE CRISIS Jarvis (2009) gives a concise and easy to understand presentation of the credit crisis in his video The Crisis of Credit Visualized. According to Jarvis, “the credit crisis is a world wide financial fiasco involving terms you probably heard such as: sub-prime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps where everyone is affected” (Jarvis, Jonathan, “The Crisis of Credit Visualized”. Vimeo. . 2009). This was brought about by financial investors searching for homeowners who are willing to mortgage their properties. Traditionally, these financial investors go to US Federal Reserve where they buy treasury bills which were believed to be the safest form of investment. However, due to the Bust.com which occurred in September 11, Federal Reserve Chairman, Allan Greenspan lowered interest rate to 1% to keep the economy strong. This lead to financial investors searching for alternative investments which would give them higher yields. There was an abundance of money, then, with Asian investors offering their surplus in the US financial markets. This makes borrowing easy and causes banks to utilize leverage. Jarvis defines leverage as borrowing money to amplify the outcome of a deal. When everything went fine with investing on prime mortgages, other investors sought more resorting to the utilization of sub-prime mortgages, which is the turning point of the financial crisis. “The sub prime crisis came about in large part because of financial instruments such as securitization where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others”. (Shah, Anup. “Global Financial Crisis”. Global Issues. < http://www.globalissues.org/article/768/global-financial-crisis#globalissues-org> 2009) What started out as a lucrative investment in Wall Street, cascaded into other areas due to the lure of financial profits. Due to the composition of risky mortgages, investors started to have problems in collecting payments which led to bad loans and foreclosure of properties. These properties eventually started to decline in prices due to the economies of supply and demand. Soon, banks and investors could not get back the money they invested and could not repay their loans. With large capital reserves ran out, these banks had to turn to the government for bail out. FACTORS THAT LEAD TO THE BREAKDOWN OF FINANCIAL MARKETS As simply put, the root of the breakdown of the financial market was the unattractive interest rate provided by the US Federal Reserve led investors looking for other alternative investments which would give those profits. Their utilization of sub prime mortgages was a risky investment that eroded the financial system. According to Raja (2008) “The downturn after four years of relatively fast growth is due to a number of factors: the global fallout from the financial crisis in the United States, the bursting of the housing bubbles in the US and in other large economies, soaring commodity prices, increasingly restrictive monetary policies in a number of countries, and stock market volatility.” (Raja, Kanaga. “Economic Outlook Gloomy, Risks to South, say UNCTAD”. Third World Network, September 4, 2008.) Shah (2009) stipulated that a contributory factor to the decline of the financial system, originating in the United States, is the issue of the derivatives. According to Dictionary of Financial Terms (2008), derivatives “are financial products, such as futures contracts, options, and mortgage-backed securities. Most of derivatives' value is based on the value of an underlying security, commodity, or other financial instrument.” (Dictionary of Financial Terms. “Definition of Derivatives”. Lightbulb Press, Inc. Retrieved from . 2008.) In Shah’s research, derivatives accelerated the downfall because “it gives you the right to buy something in the future at a price agreed now.” (ibid) The concept ingrained in the derivatives is the theory of speculation. When one speculates, there is the inherent risk associated therein because of the aspect of the future. Nobody really knows what will happen in the future. SCALE OF THE FINANCIAL CRISIS It is important to determine at this point the scale of this global financial crisis. According to Bloomberg (2009), “from a world credit loss of $2.8 trillion in October 2008, 14.5 trillion, or 33%, of the value of the world’s companies has been wiped out by this crisis. The UK and other European countries have also spent some $2 trillion on rescues and bailout packages.” (Pittman, M. and Ivry, B. (2009). “US Taxpayers risk $9.7 Trillion on Bailout Programs”. Bloomberg.com. Retrieved from ) A graph on the losses and bailouts of US and European countries in context are attached with this paper to show the extent and scale of this financial breakdown. The devastating part about this is since the United States is considered one of the most powerful countries in the world, this financial crisis cascades to the rest of the countries directly or indirectly doing business with it. A number of financial institutions and business enterprises fail and close in countries such as Europe, Iceland, and Asian countries like Japan, China, India, from among the rest. EFFECTS OF THE FINANCIAL CRISIS From among the most serious effects of this crisis, the repercussion on supply and demand for food is the most crucial. With manufacturing companies closing, prices of commodities are likely to increase. With people losing their jobs, there is less money to buy basic commodities. In addition, with credit problems in the West, poor countries would receive less financing for development. This would also mean loss in tax revenues which, according to Shah (2009) “revenue is significant for poor countries. It could reduce, or eliminate the need for foreign aid (which many in rich countries do not like giving, anyway), could help poor countries pay off (legitimate) debts, and also help themselves become more independent from the influence of wealthy creditor nations.” (ibid) SUGGESTED AREA OF FURTHER RESEARCH The enormity of the problem stifles scholars as which appropriate solutions are available to the situation. With various studies and researches already being conducted on this area, a consensus falls on the area of regulations as one of the main focuses of the solution. Stiglitz (2008) stressed that, “America’s financial system failed in its two crucial responsibilities: managing risk and allocating capital. The industry as a whole has not been doing what it should be doing … and it must now face change in its regulatory structures.” (Stiglitz, Joseph. “The fruit of hypocrisy; Dishonesty in the finance sector dragged us here, and Washington looks ill-equipped to guide us out”. The Guardian, September 16, 2008) In another study, Stiglitz (2008) suggested that “we have to design robust regulatory systems to protect us in the short run and encourage real innovation in the long. Much of our financial market’s creativity was directed to circumventing regulations and taxes. The agenda for regulatory reform is large. It will not be completed overnight. But we will not begin to restore confidence in our financial markets until and unless we begin serious reform.” (Stiglitz, Joseph. “A crisis of confidence”. The Guardian, October 22, 2008) ANALYSIS OF THE SITUATION The background of the essay identified the root of the breakdown of the financial markets of the world as stemming from the low interest rate imposed by the US Federal Reserve. The interplay of factors enumerated herein particularly investing in sub prime mortgages, relying on leverage and derivatives, and capital reserves running out, created a crisis so severe that the situation became unmanageable and complex. As Shah (2009) aptly analyzed the situation, “As people became successful quickly, they used derivatives not to reduce their risk, but to take on more risk to make more money. Greed started to kick in. Businesses started to go into areas that were not necessarily part of their underlying business. In effect, people were making more bets — speculating. Or gambling.” (ibid) The serious repercussions it created were its effects on the economies of all neighboring countries in scales so enormous that it continues to threaten the lives and survival of people, especially in poor countries of the world. The effects of global food crisis, bankruptcy, credit crunch, and decline in the confidence in the financial market are still eminent that until now, solutions seem to be far from reach. CONCLUSION From the point of view of an economist, Adam Smith in his book, The Wealth of Nations, presented the following discourse as an apt conclusion to this essay, to wit: “The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.” (Smith, Adam. The Wealth of Nations, Book I, (Everyman’s Library, Sixth Printing, 1991, pp. 87-88, 231-232). The breakdown of the financial markets of the world is, sad to say, attributable to a few, who have had such insurmountable opportunities to enrich themselves that they failed to realize that their actions could devastate the whole world. And it did. Works Cited Jarvis, J. “The Crisis of Credit Visualized.” Retrieved on March 14, 2009 from 2009. Stiglitz, Joseph. “September 16, 2008. The fruit of hypocricy; Dishonesty in the finance sector dragged us where, and Washington looks ill-equipped to guide us out.” Retrieved on March 14, 2009 from Stiglitz, Joseph. A crisis of confidence, The Guardian, October 22, 2008. Smith, Adam. The Wealth of Nations, Book I, (Everyman’s Library, Sixth Printing, 1991), pp. 87-88, 231-232 . Read More