The Global Financial Crisis - Example

The Global Financial Crisis Institution Name The Global Financial Crisis Introduction The global financial crisis that started in the United States in 2007 developed to become a full-blown economic recession -- dubbed the Great Recession -- in 2008 and 2009. The Great Recession affected world economies in ways that were directly unrelated to the causes of the crisis (Verick & Islam, 2010). The world suffered the worst economic slump since the Great Depression of 1930s. Since the Great Recession, most developed countries have experienced slow growth. Among the significant effects included collapse of investment banks, drawing up of rescue packages and substantial reduction in interests rates across the globe in what appeared like a coordinated response. This paper describes the causes of recession, the effects that it had on the world economy, and US and UK government interventions to counter the crisis. Causes of the Great Recession A proximate cause of the financial crisis included the housing bubble that characterised the United States economy in 2005 and 2006. The low interest rates in the United States meant more borrowing. Between 2000 and 2003, the Federal Reserve Bank reduced federal funds rate from 6.5 percent to 1.0 percent to counter perceived deflation risk. However, the credit encouraged investing in housing rather than business (Verick & Islam, 2010). This contributed significantly to the crisis as it led to the housing bubble. This further led to the rise in default rates of on adjustable-rate mortgages and sub-prime. When banks started to issue more loans to prospective homeowners, the price of houses significantly escalated. Easy credit conditions were another cause. In the United States, this was fuelled by the huge inflow of foreign funds following the Asian financial crisis and Russian debt crisis that happened between 1997 and 1998, leading to a boom in housing construction. This triggered debt-financed consumer-spending (Kenc & Dibouglu, 2009). Numerous loans, including credit card, mortgage and auto were easily obtained resulting to cumulative debts by the consumers. However, when the household debt increased radically, the households became dependent on refinancing the mortgage. When the global credit markets stalled from funding mortgage-related investment in 2007, homeowners could no longer refinance their mortgage leading to record high defaulted payments. This led to collapse of securities backed by the mortgages. The U.S. current account deficit was another primary cause. The rising U.S. current account deficit exerted pressure on interest rates to reduce, which reached its peak in 2006. The current account deficit rose by $650 billion, to 5.8 percent from 1.5 percent of the GDP (Verick & Islam, 2010). To finance the deficits, the U.S. government borrowed huge sums of money from abroad, specifically oil exporting countries, and the emerging economies. Consequently, there was a large inflow of foreign funds into the country causing trade imbalances (Kenc & Dibouglu, 2009). The immediate impact of the housing bubble was the collapse of major financial institutions across the globe, such as that of Bear Stearns and Lehman Brother in 2008 in the United States. The collapse of these institutions also contributed to the crisis. More critically, these financial institutions had made investments in risky securities, which lost great value when the European and American housing sector shrunk in 2007. In particular, the global economy declined drastically following the fall of Lehman Brothers in 2008. The company was a major global financial-services organisation in fixed-income sales, equity, private equity, investment management and investment banking. The company had global operations. On September 15, 2008, the company filed for bankruptcy protection. This marked the biggest ever bankruptcy case in world history, heralding the recession. On the other hand, Stearns was among the largest global security trading and investment bank. It was affected by the subprime mortgage crisis of 2007. Despite an emergency loan that Federal Reserve Bank provided to save the company in 2008, it appeared as the collapse was unavoidable as it was sold to JP Morgan eventually (Blinder & Zandi, 2010). The fall of these two major financial institutions had far-reaching effects as many investors stopped purchasing stocks. This marked the start of the 2007 financial crisis. The financial crisis extended to UK, Germany, Japan and eventually to the emerging nations. In Germany, the situation was brought to attention after Sachsen Landesbank that had invested in securitised instruments related to subprime loan slumped in business in 2008. Effects on the world economy The Global Recession stagnated economic growth of developed nations such as the United States, Japan, and Britain. In The U.S. for instance, high employment rates resulted. In December 2007, the country’s national unemployment rate increased to 5.0 percent and further climbed to 9.5 percent in June 2009 (BLS, 2012). The Japanese economy also stagnated leading to a fall in its car industry due to over-dependence on foreign markets. International sale of automobile fell drastically after 2007. Correspondingly, the car manufacturing companies experienced loss in revenues leading them to terminate workers. Brazil, Russia, India and China (BRIC countries) also went through volatile situation during the economic depression. In particular, many U.S. investors withdrew vast amount of money from stocks in these countries. Hence, there was transfer of funds to developed nations and a fall in direct investment in the BRIC countries (Paul & Ichinoise, 2010). Developing nations such as Tanzania, Kenya and Democratic Republic of Congo also had similar effects. In addition to decline in direct investment in Tanzania, there was a decline in transfer of funds to the country through remittances and tourism. For instance, the Tanzania Association of Tour Operators announced a fall in tourism by more than 50 percent (Zulu, 2011). Government Interventions The financial crisis and the interventionist efforts by some state governments to steady their economies served to alleviate the adverse effects of the crisis. Apprehensive of the escalation of the crisis, leaders from the western industrialised countries took drastic measures to rescue the trouble financial institutions (Aikins, 2009). The response of the US government to the Great Recession of 2008 and 2009 included some aggressive monetary and fiscal policies in the same way it was to the Great Depression in the 1930s (Richardson & Troost, 2009). Indeed, the United States was again at the forefront by initiating a comprehensive government intervention followed by Great Britain. Statistics by the Institute for Policy Studies (IPS) show that the United States bailout was $1.3 trillion, while that of the European nations together amounted to $4.3 trillion (Aikins, 2009). The United States government approved $700 billion to rescue the troubled relief programs. Additionally, $243 billion was allocated to commercial paper funding facility. Another $200 billion was given to Freddie Mac and Fannie Mae to keep them afloat. AIG was given $112.5 billion to guarantee losses accrued from investing in Bear Stearns. $13.2 bullion was given for FDIC takeovers. In addition to this, the U.S. Congress approved $787 billion to stimulate the economy and to resolve the declining housing market (Aikins, 2009). On the other hand, The UK rescue plan offered funds to an aggregate sum of $734 billion in guarantees and loans -- to promote interbank lending and for short-term loans. £200 billion was allocated for short-term loans to Bank of England’s programme called Special Liquidity Scheme. In addition, the government gave support to UK banks in a scheme to increase market capitalisation using the newly created Bank Recapitalisation Fund worth of £25 billion. The government also temporarily underwrote eligible lending among UK banks, issuing a long guarantee totalling £250 billion (Aikins, 2009). Overall, the rescue plan was intended to reinstate confidence in the UK banking system. Such funding was to give the banks stronger footing. In addition to the UK and US rescue plans, coordinated and strategic global efforts were made by several central banks from OECD countries in October 2008 to counter the financial crisis. The strategy was to cut interests rates by 0.5 percent. They included US Federal Reserve Bank, the European Central Bank, the Bank of England along with Sweden, Canada, Switzerland, and China. In response to the moves, the global stock exchange started to recover from the losses. Conclusion Among the significant effects of the Great Recession included collapse of investment banks, drawing up of rescue packages and substantial reduction in interests rates across the globe in what appeared like a coordinated response. Two primary factors that triggered the crisis included the US housing bubble of 2007. This resulted to huge U.S. trade deficit and the low interests rates. To finance the deficits, the U.S. government had to borrow huge sums of money from abroad. Consequently, there was a large inflow of foreign funds into the country causing trade imbalances. The collapse of Bear Stearns and Lehman Brother had far-reaching effects as many investors stopped purchasing stocks. This marked the start of the 2007 financial crisis, which stalled economic growth of developed nations such as the United States, Japan, and Britain leading to fall of manufacturing industries and massive layoffs. Emerging economies and less developed nations also went through volatile situation during the economic depression as U.S. investors withdrew vast amount of money from stocks in these countries. In response, the US and UK came up with comprehensive rescue plans. The United States bailout totalled $1.3 trillion, while that of the UK totalled $734 billion in guarantees and loans. References Aikins, S. (2009). Global Financial Crisis and Government Intervention: A Case for Effective Regulatory Governance. International Public Management Network 10(2), 23-32 Blinder, A. & Zandi, M. (2010). How the Great Recession Was Brought to an End. Retrieved: BLS. (2012). The Recession of 2007–2009. BLS spotlight on statistics. Retrieved: Kenc, T. & Dibouglu, S. (2009). The 2007-2009 Financial Crisis, Global Imbalances and Capital Flows: Implications for Reform. Retrieved: Paul, J. & Ichinoise, R. (2010). Impact of Global Recession On Developed and BRIC Countries. International Conference on Applied Economics 1(1), 597-602 Richardson, G. & Troost, W. (2009). Monetary Intervention Mitigated Banking Panics during the Great Depression: Quasi-Experimental Evidence from a Federal Reserve District Border, 1929-1933," Journal of Political Economy 117(6), 1031-1073 Verick, S.& Islam, I. (2010). The Great Recession of 2008-2009: Causes, Consequences and Policy Responses. Forschungsinstitut zur Zukunft der Arbeit Institute for the Study of Labor Discussion paper IZA DP No. 4934 Zulu, P. (2011). The Impact of The Global Recession on Developing Countries. Pontifical Academy of Social Sciences, Acta 16, 2011 Read More