The Financial Crisis in 2008 - Research Paper Example

The Financial Crisis in 2008 Although it had been looming for a while, the global financial crisis began to show its effects during the mid 2007 and into 2008. World stock markets fell, great financial organizations either collapsed or were bought out and even the wealthiest nations’ governments had to bail out their monetary systems by coming up with rescue packages. This paper discusses the 2008 financial crisis, its impacts on the world’s economies and their response. It also cites several views on this subject and gives an evaluation of these views. The study is relevant because it explains how since 2008, financial crisis has taken hold of the world significantly undermining its trade and economy. As a result, there has been a severe depreciation of financial currency, down turn of economic indicators and increase in unemployment among others. This has made the world’s economic outlook unpredictable and has severely threatened global economic order. Additionally, the future international community’s sustainable development faces a serious challenge. Introduction Financial crisis is a situation in which the demand for money outpaces money supply – available money is withdrawn from banks rapidly evaporating liquidity and forcing banks to either collapse or to vend other investments in attempt to compensate the deficit. We can also define financial crisis as a sharp decline of a set of financial indicators, for example asset prices and short‐term interest rates, which goes hand in hand with financial institutions’ failures. When there is a financial crisis, financial markets are disrupted and they cannot efficiently direct finances to those with investment opportunities that are most productive. Consequently, a financial crisis shifts the economy to equilibrium with a sharp decline of output from one with high output wherein there is a great performance of financial markets (businessdictionary.com, para1). The 2008 financial crises started in the United States due to the United States’ housing bubble-burst negatively affecting the country’s economic development. It led to a severe financial crisis that spread around the world rapidly. Due to globalization, trade, stock and financial markets, housing, goods and services are closely inter-connected worldwide. This has resulted in greater global interdependence. Being the largest economy in the world, any slowdown in the United States’ economy will inexorably spread to other countries. The nature of this crisis has made many people measure it up to the great depression of 1929. Others have argued that it may be worse because almost the whole world felt its strong impact (Shah, p2). Chari argues that the financial crisis in the United States and other countries is evident in that a number of key financial institutions have failed and that there has been a dramatic fall of a variety of stock markets. Additionally, there has been dramatic widening of spreads on a variety of diverse kinds of loans over comparable treasury securities in the United States and other countries. He also adds that policymakers and the financial press hold several views about the nature of the crisis. For instance, they argue that there has been a sharp decline in the issuance of commercial paper by nonfinancial corporations and that there has been an increase in rates to unequaled levels with a sharp decline in lending to individuals and nonfinancial corporations by banks. They also argue that basically, interbank lending does not exist. On the face of it, some pundits censured the propagation of poor loaning practices that resulted in sub-prime loans as well as related risks’ wholesale worldwide dispersal via complicated toxic waste-derived monetary tools for igniting the existing worldwide fiscal crisis. Others held their blame on the lack of political intervention or regulatory controls for encouraging low-interest rates that triggered otherwise faltering economic milieu that a series of corrections of minor market-cycle would have better served (Kritayanavaj, p8). Nevertheless, Spiegel and Rose argue that the current global financial crisis is deeply rooted in the historically largest housing and credit bubble. It concerned several parties and players including mortgage lenders and brokers, borrowers, investors, investment banks, financial innovators, credit rating and securities agencies, dealers and issuers, regulators and financial insurers among others. Continually, housing has been a key contributor to the growth of the economy of the United States and other nations. In the past, the growth of housing has always contributed positively to overall consumption, well-being of the society and employment. A complex and lengthy succession of causes and outcomes led to the financial crisis. For more than a decade, there was successive increase in the prices of housing beguiling housing speculators that extended a flourishing market. Majority of mortgage lenders started pursuing reckless lending practices such as giving sub-prime loans, which they traded for securitization in the secondary mortgage market. Anticipating higher yield, they also sold many mortgage-backed securities and other sophisticated and innovative sub-prime loans-backed debt products to investors. By means of high credit ratings, agencies for rating strengthened confidence in these usually intricate mortgage securities and those who issued them. Owing to the high demand for these complex investments, lending standards slackened thereby encouraging more loans. This increased house prices fueling a bigger housing market bubble. It is therefore evident that the 2008 United States’ housing market bubble-burst resulted from more than ten years of housing boom that has shot up into a complete global financial and economic meltdown. During the boom, many banks increased their leverage by dispensing and eventually holding more of the complex mortgage securities. Motivated by quick profits, they embarked on high-risk and unsound risk-management practices. Towards the end of this boom, giving dubious sub-prime loans to unqualified purchasers at first extended the bubble and ultimately set off the recent global fiscal crisis (Kritayanavaj, p8). Kritayanavaj concludes that the current financial crisis may be an indisputably result of the unavoidable financial bubble and housing-burst that arise when markets happen to be excessively optimistic. He adds that basically, the major contributors of boom and bust market cycles are the mental roots of human behavior. These include over optimistic and over confident perception of the markets, short term speculation, excessive greed, easy profit making, lending and borrowing recklessly during the upturn, misconceptions on price appreciation in addition to unwarranted panic, distress, fears and depression in the event of any downturn, which lead to great crises. The months of August to October in the year 2008 marked the peak period of the financial crisis. There was a drastic fall in the prices of shares, the cost of bank and corporate borrowing rose considerably and the volatility of financial market was at levels that had never been experienced. The decline in new loans to large corporations hastened during the financial crisis’ peak period. During this period, compared to the previous three months, new loans were 36 percent less. The fall was predominantly great in October. Lending for productive investment, for leveraged buyouts as well as acquisitions and mergers fell. Compared to investment grade lending which fell by 19 percent, non-investment grade lending also dropped by 50 percent. Similarly, revolving credit facilities dropped by 39 percent, which was more compared to term loans which dropped by 26 percent. In September of the same year, the health of the banking sector raised much concern resulting in banking panic and in the first half of October; world governments had to intervene (Ivashina, p1). In response to this financial crisis, countries have come up with policy actions and initiatives such as bailout plans and liquidity injections for financial institutions that have become insolvent and collapsed. For instance, globally, central banks announced distressed assets-purchase programs, synchronized policy cuts on interest rates and personal bank deposits’ guarantees backed by states. Many countries also asked for rescue packages and liquidity support from the International Monetary Fund. On October 1, 2008, Congress passed the Economic Stabilization Act in an attempt to help prevent financial crisis and a credit freeze. Other countries such as Ireland introduced the Credit Institutions/Protection Act 2008 in response to this crisis (Shah, p8). To date, many countries’ economic and financial situations present grave dangers especially the risks of systemic financial downturn. Many developed economies for example the United Kingdom, United States of America, Japan, France, Germany and Italy are now in economic slump and possible broken cycles. International Monetary Fund’s report indicated that in 2009, these developed economies’ Gross Domestic Product growth would fall and would contract from negative 0.3 percent to negative 1.3 percent, which since the Second World War, would be the first fall. The International Monetary Fund also forecasted the world Gross Domestic Product to increase merely by 2.2 percent compared to 5.0 percent in 2006 and 3.7 percent in 2007. Further, the World Bank projected that this year’s global economic growth would just be 1 percent (Kritayanavaj, p7). This global financial crisis is the worst since the Great Depression of the 1930s – it weakened the entire financial and banking markets worldwide and the overall economy of not only the United States but also the upcoming markets. The most severely affected countries were those with intricate capital and financial markets because the world has developed into a single economy connected by a chain of financial markets, stock markets and international investment and trade. Although the world has previously endured several crises, the crises did not entail complex and innovative sub-prime securities backed by mortgages that global investment banks, huge mortgage creditors, big hedge funds and other huge global financial institutions eventually dispersed globally. In other words, what makes the current crisis more severe than previous crises is the fact that it involves more persons, countries and financial institutions. Consequently, any resolution would require the synchronized international efforts for a basic reformation of the financial environment worldwide. This may call for a strong world organization such as a global central bank to tackle global or regional economic crises that may manifest themselves continually (Kritayanavaj, p3). Conclusion The current systemic financial crisis is really a global problem that the global community must resolve. No single country has enough resources and power to tackle it efficiently. It calls for coordinated and intensive efforts of central banks and wealthy governments mainly from economic super-powers of the world. They must draw important lessons from the crisis that would help them to either prevent its recurrence or competently deal with it the next time it occurs. The financial crisis offers an opportunity to the world to reform and restructure the international system of financial regulation with appropriate structures for the present financial, economic and political environment. Moreover, recognized international organizations including the United Nations, World Bank and International Monetary Funds among others need to review and reform their current roles to provide long-term financial stability and deal with any global financial crisis in future. Creation of other new and more powerful organizations such as a new global central bank would also cope with the current financial crisis and others that may arise in the future effectively. Such organizations would oversee the stability of the world’s financial system, supervise and regulate financial institutions across borders, to formulate stimulus or rescue plans in the event of global crises and coordinate with respective countries’ central banks. Work cited Businessdictionary.com, Financial Crisis: Definition, 2009. Retrieved on 14th November, 2009 from: http://www.businessdictionary.com/definition/financial-crisis.html Chari, V.V., Christiano, L. & Kehoe, P.J. Facts and Myths about the Financial Crisis of 2008, 2008. Retrieved on 15th November, 2009 from: http://www.minneapolisfed.org/research/WP/WP666.pdf. Ivashina, V. & Scharfstein, D. Bank Lending During the Financial Crisis of 2008, 2008. Retrieved on 14th November, 2009 from: http://www.people.hbs.edu/dscharfstein/Lending_During_the_Crisis.pdf. Kritayanavaj, B. Global Financial Crisis 2008: A View from Thailand, 2008. Retrieved on 15th November, 2009 from: http://www.ghb.co.th/en/Journal/Vol4/36.pdf. Shah, A. Global Financial Crisis, 2008. Retrieved on 14th November, 2009 from: http://www.globalissues.org/article/768/global-financial-crisis. Spiegel, M.M. & Rose, A.K. Searching for international contagion in the 2008 financial crisis, 2009. 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