The Causes of the Global Economic Crisis - Research Paper Example

The Global Economic Crisis Introduction The global recession that appeared to start in 2008 started well before that time with attempts around the world to fix the problems that were beginning to appear. While there are a variety of factors that contributed to the economic down turn, the factor that was most relevant was the proliferation of low interest loans that stretched the budgets of businesses and homes, breaking them once that interest rate returned to a high level. Home owners and businesses that were not highly in debt have survived, but those who believed that the bubble would never burst have been burned, their assets lost to debt that they could not manage. The evidence began to show in August of 2007. It is fear that is the core issue that has driven the state of the global economic state of health. Evidence of an Impending Global Crisis In 2005 there was a belief that the eventuality of foreclosure on a house was not really possible due to HPA (Home Price Appreciation). Should a mortgage no longer be feasible to pay, simply selling the house for a profit would be a solution to the problem. Four key interactive associations could be made between HPA and foreclosures. The first was the exit strategy that was provided by the HPA in that the house could easily be sold should the mortgage prove too difficult. The second aspect was that “analysts identified a close relationship between refinancing activity and prepayment speeds for untroubled borrowers, which also reduced losses” (Elemendorf, Mankiw and Summers 134). A third aspect was that a HPA meant that even if there was a default on a house, the losses would be small. The last aspect, however, for the relationship with HPA and foreclosure was that the exceptionally small losses that had been realized during the previous period was due to HPA and that a decline in HPA was going to lead directly to greater losses (Ememendorf, Mankiw and Summers 134). In 2005 there were projections made by analysts about what would happen should HPA decline, and the predictions were very accurate in terms of what happened in the global economy. The reason that this was yet to be taken seriously was that to that date, no AAA rated RMSB (residential mortgage service/bank) had ever defaulted. According to Ememendorf, Mankiw and Summers, there has still not been a major default by an RMSB, however, the many smaller organizations that feel were enough to effectively impact the global economy. Despite the proliferation of low collateral loans for housing that had the highest prices in history, there was no general feeling that the bubble would truly burst, thus with the unwise deregulation of loans and the lack of real credentials of many of the borrowers led to a fall that would lead to the devastation of thousands through job losses, home losses, and a virtual collapse of the whole system. The system was built like a house of cards, where one mistake would make the entire financial system fall. Many mistakes were made by trusting that the system was going to continue to work in exactly the same way that it had been working. The glut of money that was earned by those who were playing in the real estate market was such that a future fall could not be considered by the blinding stacks of bills that were being made. Greed was at the heart of the imprudent behavior, not truth. The focus on the immediate profits was so great that even though the signs were visible and some analysts were beginning to discuss the impending problems, no one was discontinuing their behaviors until the money wells were dry. In the fall of 2006 and the early months of 2007 the law of diminishing returns began to come into effect with the prices of homes falling and the sub-prime borrowers trying desperately to renegotiate their mortgages. The crisis began when mortgages fell in value and the borrowers were then beginning to default on their payments for homes that no longer held the value of the loans they had taken out on them. The crisis was then extending into other financial areas as panic began to spread and the CDO (Collateral Debt Obligation) market began to show no confidence. The entire system became stressed, thus creating the credit crunch and global economic disintegration. August of 2007 According to Soros, the economic crisis can be fixed as starting in August of 2007 when the central banks had to begin bailing out the banking systems (xii). A series of events heralded in the new economic status. Those events can be listed as follows: August 6: American Home Mortgage files for bankruptcy August 9: BNP Paribus, a large French bank suspends three of its investment funds worth 2 billion euros because of the problems with the U.S. sub-prime mortgage rate. The funds could not be valued because the market had disappeared. The European Central Bank, the U.S. Federal Reserve, and the Bank of Japan pumped money into their systems to ease the crunch created by the sub-prime rate. August 10: the European Central Bank as well as the U.S. Federal reserve provide more funds to funnel into the system to try and save the floundering economic system. August 13: Goldman Sachs pumps 3 billion dollars into a hedge fund to support its value. The European Central Bank puts another 47.5 billion euros into its money markets. August 16: Countrywide Federal , the largest U.S. mortgage originator, drew down its entire 11.5 billion dollar credit line. Australian mortgage lender Ram admits liquidity problems. August 17: The U.S. Federal Reserve cuts its discount rate for lending to banks by a half a percentage point in order to help banks with credit problems. This does not help the problem. September 13: Northern Rock, the largest British mortgage banker, discloses that it is bordering on bankruptcy which creates a run on the bank, the first run in one hundred years (Soros xiv). As it is shown, the crisis was worldwide with major banks in Europe, the United States and in Australia showing efforts to halt the problems that were beginning to affect those dealing with those banks. However, the economic ball was rolling, the boulder too large to stop by throwing a rock on its path. There was not enough money to stop the decline through injecting funds into the system. The ‘panic’ of August of 2007 was not caused solely by the housing market. In fact, it might be said that the problems that ensued were the cause of panic that changed behaviors within the market. The Dow Jones Industrial Average peaked on July 16th, but by July 26th there had been a 311 point drop which led George Bush to convene a meeting with leaders of the Working Group on Financial Markets which was headed by Treasury Secretary Henry Paulson. The drop had occurred due to disturbing news from the housing market, thus setting the stage for a psychologically driven set of changes that initially were not reflective of what was happening, but what was feared would happen. The housing market fears were being buoyed by fears that the oil prices were going to dramatically due to predictions by those who would see the U.S. come to harm. August ended with a meeting in Jackson Hole, Wyoming with economic leaders such as Harvard’s Martin Feldstein, analyst Robert Shiller, and the German central bank chief, Axel Weber, all predicting that economic failure was eminent (Phillips 26). The beginning of the end of a period was put into full effect. The Financial State of Affairs Before considering the future of the U.S. financial health, it is important to understand the real life situation in which the financial health of the U.S. was sitting by the middle of the first decade of this century. In 1950, 29% of the GDP was produced from manufacturing with only 10% being produced from financial services. In 2005, those figures had changed to 12% from manufacturing and 20.4% produced through financial services (Phillips 31). The result of this type of shift in financial foundation is indicative of a state that was dependent on the health of the economy over the health of their ability to produce and sell. The percentage of share that the financial services sector holds is comparable to that held by the seven-state farm belt in combination with the eight state Rocky Mountain belt in producing GDP. The predominant product of the United States is money. Therefore, when money sectors are no longer healthy, the production of product can have little effect, even in a global economy, on creating a resource for a healthy economy. In a book by Vidich and Bensman about the social and economic nature of the small town, Springdale, New York is used as an example of the ways in which a small community works. While it is well known that a manufacturer who moves its operation to a small town benefits from the lower wages and the lower cost of living, there are other benefits as well. A small town will more often provide a more permanent labor force where a large city is more transitory. This is because loyalty to home territory is higher, thus creating a sense of community that does its best to provide fairly to one another. The importance of this is in the balance that is created through commerce which helps to create a stabilized economy. In the instance of Springdale, the community is made up of about 70% farmers who contribute to the local economy. The rest are local business people with an insignificant number of people working outside of the community. Grain and feed are produced locally; therefore the price of milk has a significant influence on the overall health of the economy. However, the important instruction of a small town is that the economy is balanced in the way that each member of the business world supports the greatest possible number of needs of the rest of the community, thus creating a balance of goods and services that are exchanged so that each member can support and provide for his own family, as well as the rest of the community in order to create a well-balanced economy. The global community has not yet achieved this balance. Each country is not importing and exporting in a manner that supports the world in such a way as a small community is in balance. From the base, the fact that the economy is built with such a strong use of the financial sector as an industry throws the ability for countries to recover from problems into a serious void. The money that was plugged into the world banks was not to provide food and shelter or basic needs for people, but to support the financial problems in such a way that they could possibly recover, thus contributing more to the almost intangible basis on which the world economy is now run. It is credit and investing that runs the world economy rather than the production and sale of goods. While it is far more complicated, the basic problem in the world economy is that the shift from the exchange theory of economics has been moved towards the gambling of market interests. The Present. The world economy is still in a considerable amount of distress. However, according to the World Bank, the state of the global economy is moving towards a more stable and mature phase which will lead to global recovery. Some of the reasons that this may not be sustained is that conditions in Europe may lead to a derailment of the current trends toward growth. These conditions include market nervousness where there is a need for high income countries to invest and consume in order to help stimulate the economic growth. Developing countries, however, show promise for growth that will create stimulation in the world economy. Year to date capital flow to developing countries was up by 90% in the first six month from the previous same time period in 2009 (The World Bank). Global GDP is projected to increase by 3.3% in 2010 and in 2011 and to 3.5% in 2012. Private capital flows are thought to increase from 2.7% into developing countries in 2009 to 3.2% in 2012. As well, GDP in developing countries is expected to grow by 6.2% in 2010, with additional growth in both 2011 and 2012 to 6.0%. High income countries, in contrast, are expected to see 2.3% increases this year with only a 2.7% within the year 2012. What might cause problems in all of these projections is a tightening in the European high income countries where fear can induce a lack of investment and expenditure. This can have a high impact on the advances in overall economic growth as the projections are based on continued confidence in recovery (The World Bank). The contrast in the problems in high income countries in comparison to developing countries is that the deficits in developing countries are not being affected, while the loans and debt in high income countries are in jeopardy. According to the World Bank, a $1 trillion dollar aid package in the first half of the year 2010 has resulted in an initial “sharp uptick” of prices on credit default swaps, which did rebound after the initial reaction. As a result, markets have not been overly affected, thus there is some stabilization in those high income countries. However, should fear return, there will be more issues that will affect the overall global economic health. The Future The future is in question. While there is some evidence of rebounding in the world economy, the fear that has fueled the current crisis can always be refueled. Another indicator that cannot be adequately judged is whether or not the costs of housing will rebound. Due to the current environment, the costs of real estate are showing no incline, therefore there is no indication that real estate values will climb. The one prediction that might have credible value is that business rebounding may be shown as increased cash-flow provides for improved capital spending as it has in the past. There is also the possibility of an adjustment to balance sheets as the below historical averages in market shares is adjusted to meet current needs. In this case, a lower saving rate will be realized (OECD Economic Outlook 2010 44). Conclusion While the ten year outlook has some potential, there is no real analysis in predicting how the economy will respond to the many aspects and variables which will have a profound effect. The outlook for developing countries looks good, which poses the possibility of those territories seeing increases that promote those countries past countries with established high incomes in economic stability. The high income countries need to be shrewd, but act without fear in order to maintain their status. The current placement of the economy provides for a situation where there cannot be a further stand still in which people and institutions are afraid to act, despite the fear that is rooted in the financial community. The global crisis, while boiled down to the fear of the bubble bursting in the real estate market as put against the fear of the rise in the cost of oil, is a complex set of circumstances that have caused an issue that is not easily remedied. Each individual, company, and institution will have to find a way towards recovery, hoping that cooperation with impacting factors will provide for a more sound future. Fear has been the driving force in creating the poor economy with fear being the deciding factor in the future of the global economic state of health. Works Cited Elmendorf, Douglas W, N G. Mankiw, and Lawrence H. Summers. Brookings Papers on Economic Activity: Fall 2008. Washington, D.C: Brookings Institution, 2009. Print. OECD Economic Outlook 2010, Issue 2, Preliminary Version. Organization for Economic, 2010. Print. Phillips, Kevin. Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism. New York: Penguin Books, 2009. Print. Soros, George. The Crash of 2008 and What It Means: The New Paradigm for Financial Markets. Oxford: PublicAffairs, 2009. Print. The World Bank. “Global Economic Prospects”. The World Bank Group. 2010. Web. 23 December 2010. The World Bank. “So Far, the Fall-out from the High-Income European Debt Crisis has been Contained”. The World Bank Group. June 2010. Web. 23 December 2010. Vidich, Arthur J, and Joseph Bensman. Small Town in Mass Society: Class, Power, and Religion in a Rural Community. Urbana: University of Illinois Press, 2000. Print. Read More