Critical Evaluation of the Reasons for Global Financial Crisis - Essay Example

Global financial crisis The Ex- President of the United s Ronald Reagan once said recession is when a neighbor loses his job; depression is whenyou lose yours. The biggest point of concern today is the global financial crisis or recession. The economic meltdown has caught us all wrong footed, the business organizations across the globe suffered huge amount of losses which resulted in pay cuts and slashing of jobs. Record numbers of people have lost their jobs in the past year and a half. I have taken up the global financial crisis as my focus of discussion. The essay has been structured into three parts. The first part explains what recession is. The second part analyses the causes for this economic downturn and the third portion is where I have tried to provide some solutions that might help preventing the situation in the future. Many professionals and experts around the world believe that a true economic recession can only be confirmed if GDP (Gross Domestic Product) growth is negative for a period of two or more consecutive quarters.  The roots of a recession and its true starting point actually rest in the several quarters of positive but slowing growth before the recession cycle really begins. While the "two quarter" definition is accepted globally, many economists have trouble supporting it completely as it does not consider other important economic change variables. For instance, current national unemployment rates or consumer confidence and spending levels are all a part of the economic system and must be taken into account when defining a recession and its attributes. An economic recession is primarily attributed to the actions taken to control the money supply in an economy. The Central Bank is the agency responsible for maintaining the delicate balance between money supply, interest rates, and inflation. When this delicate balance is tipped, the economy is forced to correct itself. In an environment where inflation is prevalent, people tend to cut out things like leisure spending. They also budget more, spend less on things they usually indulge in, and start saving more money than they did. As people and businesses start finding ways to cut costs and derail unneeded expenditures, the GDP begins to decline. Then, unemployment rates will rise because companies start laying off workers to cut more costs, because consumers are not spending like they were. It is these combined factors that managed to drive the economy into a state of recession.(Sources: Recessiom.org) The paradigm shift in the US economy was a big contributing factor. The economy shifted to a service based economy from a predominant manufacturing sector. By the year 2009, manufacturing and agriculture constituted less than 10% of the whole economic base. Decline in manufacturing took place mainly due to off shoring or outsourcing but vastly increased productivity was the bigger factor. Lack of security became an issue as the employments trend changed from a long term employment relationship to a short term attachments. The result of the shift from manufacturing to service, in short, has been a disaggregation of employment in which the attachments of workers to particular firms is more tenuous, expected tenures are shorter, and workplaces themselves are often on a smaller scale. The new portable employment included portable pensions; that is a pension plan that moves with an employee when he or she changes the employer. Pension investment became a big business dominated by institutional investors. With a portable defined contribution systems pension is based on investment returns which created pressure for high returns and also removed employee incentives to stay with a single firm. This resulted in a vicious circle of profit pressure and employment instability. (G.F. Davies, 2009) Following a period of economic boom, a financial bubble—global in scope—has now burst. A collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail. (Forward Block, December, 2009) The subprime 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. (For banks, millions can be made in money-earning loans, but they are tied up for decades. So they were turned into securities. The security buyer gets regular payments from all those mortgages; the banker off loads the risk. Securitization was seen as perhaps the greatest financial innovation in the 20th century.)(Sources: Globalissues.org) As BBC’s former economic editor and presenter, Evan Davies noted in a documentary called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14, 2008), rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up. Starting in Wall Street, others followed quickly. With soaring profits, all wanted in, even if it went beyond their area of expertise. For example, Banks borrowed even more money to lend out so they could create more securitization. Some banks didn’t need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities. Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on. Some banks loaned even more to have an excuse to securitize those loans. Running out of who to loan to, banks turned to the poor; the subprime, the riskier loans. Rising house prices led lenders to think it wasn’t too risky; bad loans meant repossessing high-valued property. Subprime and “self-certified” loans (sometimes dubbed “liar’s loans”) became popular, especially in the US. Some banks evens started to buy securities from others. Collateralized Debt Obligations, or CDOs, (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. While things were good, no-one wanted bad news.(Bird and Fortune, 14 Feb,2008) Venezuelan President Hugo Chavez faulted the ‘’laissez faire, laissez passer’ model, saying it ‘’ is what caused the crisis in the United States and is the reason why half of the world is under threat.’’ German Chancellor Angelo Merkel took a more measured stance, defending financial markets but saying ‘’ we do not need untamed financial markets, in which profit is the only thing that counts.’’ Most experts agree one of the main questions will come down to how to prioritize a laundry list of potential policy actions. Sebastian Mallaby, the director of CFR’s centre for Geo-economic studies, says that the first goal for policy makers should be to differentiate between immediate steps needed to restore credit markets and stop the economic bleeding- whether through stimulus, spending, bail outs, government lending programs or other means and long term goals that must be addressed to improve regulation and prevent future crises. From the standpoint of preventing the next crisis, it is better to let an insolvent institution fail and use the governments funds to assist those individuals or institutions damaged by that failure than to use the governments funds to reward the behavior that caused the solvency in the first place. (Samwick, 2008) The key energy feed which is oil, when goes to a decline, and as researchers say which is unavoidable; it would result in an economic contraction. So, ways to extract more oil and in a cheaper way has to be formulated. According to experts such as Danny Gabay UK house hold sector that over borrowed and holds 170% of the annual GDP is the real burden. Govt. presently boosting most of the recovery but that in turn increases its debt. All intending to save, there is absolutely no one producing demand. The forecast of the growth for UK in 2010 is estimated to be a lowly 0.6-0.8 percent. A concentrated effort to increase demand has to be made. Suggestions made very recently by the shadow Chancellor Mr. Osborne emphasized on the fact not to let Britain inflate its way out of trouble; talk of tweaking the inflation target to take account of housing costs; and a restatement of the case for putting the Bank of England in charge of more nuanced macro and micro prudential regulation of the financial sector. (BBC) There is also a need to raise public sector productivity through a "radical program of public sector reform" feels Osborne. Measures such as a global levy on banks should be agreed in the forthcoming G20 meetings, the Prime Minister Mr. Gordon Brown feels. Global leaders should follow the "radical" measures adopted in the UK, such as higher taxes on bankers bonuses and on salaries above £150,000, Brown said. The new global guidelines should address issues such as capital requirements for banks, supervision and tax heavens –used by financial institutions to avoid higher taxes. (The Guardian, Feb 19, 2010) The government needs to spend more money in the short term to boost growth while simultaneously taking strong action to reduce the long-term budget deficit. According to Blanchard IMF estimates suggest that the fiscal cost of future increases in entitlements is 10 times the fiscal cost of the crisis. Thus, even a modest cut in the growth rate of entitlement programs can buy substantial fiscal space for continuing stimulus. Lowering corporate and investment tax rates to a more internationally competitive level. If entitlement liabilities are downscaled, the UK economy can generate more than enough future economic growth and excess tax revenue tomorrow to “pay for” smart investments today. That would create jobs and strengthen UK’s economic foundation -– and keep the bond vigilantes at bay. (James Pethokoukis, 2009) BIBLIOGRAPHY Davis, G. F. (2009). Managed by the markets: How finance re-shaped America. Oxford, U.K.: Oxford University Press. Serkan Cankaya, Ph.D. Candidate, Kadir Has University, Istanbul, Turkey. 2009. Behavioral Approach to Subprime Mortgage Crisis: A European Perspective. The Business Review, Cambridge * Vol. 12 * Num. 1 pp187-194. Andrew A. Samwick. 2009.Moral Hazard in the policy response to the 2008 Financial Market meltdown. Cato Journal, Vol. 29, No. 1 pp 131-139. Davis,G.F.( 2009). The Rise and Fall of Finance and the End of the Society of Organizations. BBC News. 2008. Financial crisis hits . [online] available at http://news.bbc.co.uk/1/hi/world/europe/country_profiles/1038820.stm Smith,M.H. and Smith,G (.2009). Bubble, Bubble, Where’s the Housing Bubble? Davis,E (14Jan,2008). The City Uncovered with Evan Davis: Banks and How to Break Them  Robbins,L & Weidenbaum,M (15 Mar,2009)The Great Depression Flanders,S (23:29 UK time, Wednesday, 24 February 2010). Mr. Osborne’s Prescription Niinimaki, J.-P. (2009) Does collateral fuel moral hazard in banking? Journal of Banking and Finance, Volume 33 Issue 3, March 2009 Pethokoukis,J(24 Aug,2009). How Obama Could Prevent A Second Recession. Harvard Business Review on sub prime mortagages Interviews of Danny Gabay & Steven Bell on BBC Interview of Chris Sander, Political Economist, Sanders’ Association of Research. Documentary on peak oil: Speakers: Michael Meacher MP, Former Environmental Minister MP, Colin Campbell, Founder – Association of Study of Peak Oil and Gas. Council on Foreign Relation’s award winning report on Recession. *Bird,J and Fortune,J(14 Feb,2008) Subprime mortgages. GLOBAL FINANCIAL CRISIS,2008 Web Help: Investopedia, Recession.org, Economics Help Read More