Causes of the 2008 Global Financial Crisis - Example

Econ202: Causes of the 2008 Global Financial Crisis Name Course Tutor’s Name Date Causes of the 2008 Global Financial Crisis A classic explanation as to why financial crises occur indicates that excesses in an economy lead to a boom, which eventually busts. The 2008 financial crisis was no different; only this time, the root cause was not the housing boom and bust. The housing boom and bust are arguably a consequence of monetary excesses in the US market, and as such, this paper will argue that they (monetary excesses) were the root cause of the 2008 financial crisis. Notably, the 2008 global financial crisis was complex, and has a combination of causes. As early as August 2007, the Federal Reserve (the Fed) had indicated that it was no longer concerned about inflation as it was about financial stability (Jickling, 2010). While it is agreeable in academic circles that multiple reasons played a role in the financial crisis, Wallison (2008, cited by Gwartney, 2008) provides a very succinct explanation of the root cause of the crisis. According to Wallison, U.S. housing policies were the main cause of the crisis. Other players, who included, imprudent investors, insatiable investment bankers, reckless bankers, reckless housing speculators, inept rating agencies, short-sighted homeowners, and rapacious mortgage borrowers, lenders and brokers all played a part in the crisis, but according to Wallison (2008), they were only utilising the incentives provided by the government. Beachy (2012) sums up the foregoing factors as a “broken system”, which was evident in the moral hazard adopted by bankers, the overconfidence and opacity taken up by investors, and the misguided theories used by the regulators (p. 24). The term ‘broken system’ is ostensibly used in reference to the Fed and other institutional regulators who deviated from standard monetary policies. The Fed specifically had in response to a mild recession witnessed in the US in 2001, lowered the federal funds rate with a 4.25% margin (i.e. from 6% to 1.75%), in an apparent effort to stimulate employment. The Fed pushed the rates further down to 1% in 2003 until a year later when the rates were pushed to 5% (Beachy, 2012). By failing to increase the rates soon enough, the Fed has been criticised as having gone against the Taylor rule (see figure 1 below), which is a formula that was generally followed in the 1980s and 1990s. The Taylor rule is generally a monetary-policy rule which suggests that the central bank (or the Fed in the US context), should change a nominal interest rate depending on the inflation and other economic conditions (Taylor, 1993). Proponents of the Taylor rule argue that it is an important way of controlling inflation and stabilising the economy. They therefore argue that the deviation of the Fed, and other central banks across developed countries (especially in Europe), led to the housing bubble, which led to the financial crisis when it burst. Figure 1: The Taylor Rule when seen against the low interest rates between 2001 and 2004 Source: Taylor (2010). Taylor (2010) dubs the moments preceding the 2008 financial crisis as the ‘great deviation’, arguing that the period between 2001 and 2004 created a prolonged monetary accommodation, which created the right environment for a financial crisis. The manipulation of interest rates by the Fed specifically increased the demand for housing, subsequently pushing the prices higher. Additionally, the low interest rates meant that more consumers were attracted to the low down payments. Finally, when the Federal Reserve pushed short-term rates upwards, the entire housing market was affected because the payment on mortgages went up, house prices fell, adjustable rates were reset, and defaults on mortgage repayments shot up (Gwartney, 2008). Another factor also played a critical role in fuelling the 2008 financial crisis. The Securities and Exchange Commission (SEC) had adopted a rule change, which according to Gwartney (2008), “led to highly leverage lending practices by investment banks and their quick demise when default rates increased” (p. 16). The rule encouraged more lending for people willing to purchase residential housing. The leverage ratio went up considerably, and when bundled together, leveraged residential housing could be financed with securities. Although it was thought that residential mortgage loans were safe, the low interest loans between 2001 and 2004 had eroded lending standards thus meaning that most loans had no down payment (Gwartney, 2008). Ultimately, the highly leveraged backs collapsed when the default risks hit an all-time high level in the 2006/2007 period. Another factor that is closely tied to the Fed’s decision to lower interest rates is the increased debt/income ratio. According to Gwartney (2008), the debt/income ratio in most US households had risen to 135 percent by 2007, which was a departure from 60-80% rates that were the norm in the 1980s as seen in diagram 2 below. With the high debt/income ratios, there was higher interest on household debts. This happened at a time when consumers would tie their debts with their housing loans, because the former was tax deductible. When interest rates began to increase therefore, households caught up in heavy debts did not have enough leeway to deal with rising mortgage repayments and unexpected expenses. Figure 2: The ascent debt/income ratio Source: Gwartney (2008). Behind the intricate details of the financial crisis, Beachy (2012) notes that there were economic tell-tales which indicated the initial stages of a looming financial crisis. For example, banks had an incentive that enabled them to capitalise on gains obtained from risky lending, while transferring default risks to Mortgage-Based Securities (MBS). In economic terms, this can be defined as a moral hazard since banks were presumably acting in their private interest and to the detriment of the public. On their part, investors (especially those buying into MBS) were overconfident, while some had no clear understanding of what they were getting into. The herd mentality (i.e. the tendency of people to act similarly to the actions of the majority) must also have played a part in the crisis, because investors bought houses and MBSs among other financial products without first considering the underlying value of the purchases. Instead, and as indicated by Beachy (2012), investors primarily considered the popularity (in terms of demand) of specific products and invested in the same. Lending to subprime borrowers by banks – i.e. borrowers who have lower incomes, higher debts, and/or a bad credit history – also exposed the financial sector, especially mortgage lenders, to increased risks of losses. Demyanyk and Van Hemert (2011) note that ordinarily, lenders do not lend money to subprime borrowers; if and when they do, they charge high interest rates as a compensatory measure against the high risk exposure. In the years leading to 2008, lending restrictions to subprime borrowers had been relaxed. Again, the propensity of banks to lend to subprime borrowers may have been occasioned by the moral hazard discussed elsewhere in this report. Poorly designed and implemented liberalisation, the absence of effective regulation and supervision, and poor regulatory and supervisory interventions also played a role in the making of the 2008 financial crisis. The US regulators for example were unable to intermediate the capital flows realised in the wake of the 2001-2004 lowering of interest rates. Deficiencies in supervision especially in the mortgage sector also fuelled the housing bubble, and concentrated the credit risks (Classens et al. 2012). Sufficient prudential oversight was also absent, and as a result, failed to restrict extreme risk taking. The systemic risk created by the shadow banking system, which included the derivative markets and financial institutions, posed a greater risk to economies because there was not much oversight, and the markets were to a great extent unregulated and poorly supervised (Claessens et al. 2012). Taylor (2010) argues that in the warning signs of a looming financial crisis were present as far back as 2004. Taylor (2010) observes that high and sustained credit growth should always be viewed with suspicion especially when macroeconomic interventions have caused it. According to Taylor (2010), when not stimulated by external imbalances, home-grown credit booms herald financial crises. In conclusion, it is important to indicate that the 2008 financial crisis, just like others in the past, revealed the severe weakness present at the time in the financial infrastructure of most developed countries. As indicated in the introductory part of this report, monetary excesses largely caused the 2008 financial crisis. The financial crisis was also the culmination of the extended deviation from the Taylor rule, which indicates that the Fed and central banks throughout the world need to apply higher interest rates in order to control inflation and extra liquidity in the market. While interest rates were stabilised to approximately 5% in 2004, their prolonged low rates since 2001 had created an environment that exacerbated the housing bubble, which eventually burst in 2004. The systemic nature of the financial infrastructure meant that the boom witnessed in the housing sector in the US was a reflection of the goings-on in the economy, just like the bust was. Admittedly, and as indicated elsewhere in this report, the causes of the financial crisis were diverse; however, this report has covered what the writer believes were the main causes of the crisis. References Beachy, B. (2012). A financial crisis manual: Causes, consequences, and lessons of the financial crisis. Global Development and Environment Institute Working Paper 12-06, 1-91. Claessens, S., Kose, M., Laeven, L., & Valencia, F. (2012). Understanding financial crises: Causes, consequences, and policy responses. International Monetary Fund Seminar Reports. Retrieved 20 August 2013, from http://www.imf.org/external/np/seminars/eng/2012/fincrises/pdf/ck.pdf Demyanyk, Y & Van Hemert, O. (2011). Understanding the subprime mortgage crisis. The Review of Financial Studies 24(6), 1850. Gwartney, J. (2008). The economic crisis of 2008: Cause and aftermath. Retrieved 20 August 2013, from http://www.commonsenseeconomics.com/Activities/Crisis/Economic%20Crisis%202008.pdf Jickling, M. (2010). Causes of the financial crisis. Congress Research Service 7-5700, 1-10. Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195-214. Taylor, J.B. (2010). Getting back on track: Macroeconomic policy lessons from the financial crisis. Federal Reserve Bank of St. Louis Review May/June, 165-176. Read More