How the Financial Crisis Affected the Economy - Example

How the financial crisis affected the economy Name Institution Date Course How the 2007 financial crisis affected the economy Introduction The global 2007 financial crisis has been cause of debate for researchers and interested persons for years now, the debate focusing on the causes and the effects of the crisis. The financial architecture itself has been critically scrutinised, with several reforms proposed. The crisis resulted in great impacts on the global financial environment, with several countries experiencing difficulties in their real economies, though with certain variations. There was experienced a crash of the global financial system, unpredicted swings in the values attached to the housing industry and commodities. Of significant impact was the bankruptcy of banks and other financial institutions and the subsequent inability to provide credit to the real economy (Cortright, 2008). This paper critically discuses how the financial crisis affected the economy and investigates why bank interest rates have remained low over the years. The paper also focuses on why these rates may remain low for the coming years. Discussion The financial crisis was majorly contributed to by the poor governance in the financial institutions. The light regulation in the industry has been widely regarded as the cause for the crisis while other concerns have risen as to whether or not the finance has been able to grow in close proportions compared to the real economy (Sassen, 2009). The first two years of the financial crisis were seen to unfold in two phases. There was first experienced a liquidity crisis, then there was the more devastating insolvency crisis. As early as 2007, banks were already beginning to experience liquidity problems as they began to consider their lending. Banks were not willing to lend to one another because of the increasing default rates at the time and the rising uncertainty with regard to each other’s exposure to such bad debts. In 2007, the BNP bank had already announced that investors were not able to take money from some of its funds as a result of a ‘complete evaporation of liquidity’. In the UK, the pivotal moment was when the Northern Rock was bailed out by the Bank of England after the biggest run for more than a century on a UK bank. This bank was not anymore able to find the markets it required to fund its loan book. The following phase of the crisis was characterised by massive liquidity problems that became the increasingly severe insolvency problem as the prices of houses continued to fall while the subprime loans continued to record bigger losses. The extent of this damage was evident when Lehman Brothers applied for the Chapter 11 Bankruptcy protection in the 2008. This was after the bank recorded losses of about $3.9 billion in the second quarter of 2008. After the collapse of the Lehman, money markets increased its interest rates very rapidly to the extent that there was created a virtual freeze in bank-to-bank lending as a result of the fears that more banks would be allowed to fail. This meant that there was no more funding for business and individual loans leading to unprecedented intervention by governments to improve the liquidity and rescue vulnerable banks. The financial crisis led to a deep and prolonged global economic downtown which had significant effects on the interest rates. In the United States, the Federal Reserve had responded to the crisis by taking bold actions to stabilize the county’s economy and its financial system. Some of the actions taken included the reduction of the level of the short-term interest rates to almost zero. Efforts were also made to reduce the longer-term interest rates and further support the U.S. economy. This was achieved through the purchase of large quantities of longer-term Treasury securities as well as the longer securities that had been issued by agencies like Fannie Mae and Freddie Mac. The Low interest rates were intended to provide finances to households and businesses and support the prices of several other assets. As Haubrich (2013) said, one of the most significant contributors of to the interest rate charged is the credit risk. This represents the difference between the debt with risk and that without. That is, the difference between that debt that might not be paid back and that which is highly likely to be paid back. Financial institutions will often calculate a higher rate for the debt that with greatest credit risk, usually called a risk premium. The rates paid back by most consumers will usually be pegged upon this kind of risk. Since the credit risk is a major contributor to the interests charged, it is important to understand the factors that move that riskless rate around. The other contributor to the level of interest rate is inflation. Inflation describes the difference that exists between the real and nominal interest rates. With Treasury bonds in the United States, for example, people lend the government money but receive back amounts that are worth less due to the inflation. Therefore, for the sake of adjustments for inflation, the real interest rate received is usually less that the nominal rate of interest. Consequently, if investors look forward to getting a substantial return of 3% on their lending, and the rate of inflation is calculated to be 2%, then the final interest rate will be 5%. Inflation therefore directly affects the interest rate and may have been the reason for the low rates currently experienced in the financial markets. In the UK, inflation is currently at 1.3% and market experts and economists have pushed back expectations of a first move from 0.5% to the last months of 2015 as a result of the ‘lowflation’ worries (). The experts further suggest that only a rapid and sustainable burst of inflation in the developed nations can be able to shift that outlook. When interviewed by the Bristol Post’s Gavin Thompson, Andrew Haldane of the Bank of England stated that any positive changes on the current base rate in the coming year is still expected to be gradual. He said that the normal interest rate levels for a number of years to come could stick to figures around 3%. This is because the UK inflation rates only rose to 1.3% in November from the 1.2% experienced in October as was showed by the recent ONS figures. The chief UK analyst HIS Global Insight, Howard Archer was of the view that while the MPC minutes during the month of November were not highly likely to cause any significant effects on the increased expectations that the Bank of England will not raise its interest rates until the late 2015, these minutes show indications that a move could be made around August next year. The bank had forecasted an increase of about 0.50% to 0.75% by August next year, but the bank was not preparing to act until the fourth quarter of 2015, or maybe until the first quarter of 2016. Both the manufacturing and services sectors had pulled back, reigning in economic growth to 0.7% in the third quarter as had been indicated by official figures. Economic experts had forecasted that the recovery would ease off in the latter half of the year; the National Statistics office data release confirmed that growth had slowed down between July and September from the 0.9% in the second quarter (Lambert, 2014). Economists have now estimated that interest rates in the UK are likely to stick at 0.5% until next autumn and the rate of inflation could even fall to below 1% according to the latest inflation report released by the Bank of England. The governor of the bank, Mr. Mark Carney, further attributed the low interest rates on the prevailing low inflation rates as he delivered the inflation report. The weak wage growth and the sustained slack in the economy were also pointed out as the major contributors. The report also mentioned that the expected rise in the interest rates, in the coming years will still remain gradual and slow from the late 2015. In the coming three years, the rates are expected to rise only gradually to 1.7%. Kaletsky (2004) pointed out that the passing of another milestone by the European Central Bank to impose negative interest rates on a significant part on the global economy draws the attention to the ability of central banks to control interest rates. Central banks have the ability to set money-market interest rates very low or very high as they want by simply controlling the amount of money supplied to commercial banks and therefore influencing the level that the rates can be set at. In June this year, the European Central Bank set its deposit rates Thursday at negative 0.10%. This meant that it was charging other commercial institutions for storing their money at the central bank. Over the last five years, central banks all over the world have decided to keep the interest rates at their record low. There are indications that these central banks are keen to ensure that the rates remain low, or even negative, into the near future. Interested parties maybe wondering, however, why the interest rates are rock-bottom low both for short-term as dictated by the central banks as well as the long-term rates that are mainly dependant on the willingness of pension funds, investors and insurers to have their savings tied up for more than 10 years in government bonds? Investors have seemed confident, in recent years, about the persistent low interest rates mainly because of two reasons. This confidence may have resulted from the view that after the 2008 financial crisis, the global economy settled into a “new normal” of slow growth with insignificant inflation or even low prices. Those in support of the “new normal” are of the opinion that the central banks will be keen to keep the interest rates close to 0% for the larger part of the next decade so that the record low bond yields prevailing today will give investors considerably high profits that they will be able to make in the coming years. This view has, however, been contradicted by the recent trends in the global economic markets. Economists have found out that there is evidence of accelerated growth in the markets in America, Germany and Britain. Other parts of the world have also shown stabilization of the market slowdowns. China, Japan and large parts of Europe have shown positive trends. At the same time, in the financial markets, economists have discovered that equities are hitting all-time records while the industrial commodities are also rising. To a large extent, therefore, the equity and commodity markets have given indications that are contrary to the bonds market. We may therefore be urged to imagine that the bond markets could be unhinged from economic realities. This could be because of the very aggressive policies in the central banks in Japan and Europe; regions that have experienced still potentially harmful deflation and stagnation which have contributed to the depression of bond yields in the U.K. and the U.S. for investors from Japan or Germany, where governments only pay 1.4% and 0.6% respectively on 10 year bonds, doing business in other countries like the United States which yield 2.6% is preferable, particularly in circumstances where the currency risks can be kept significantly low. Conclusion This discussion shows trends in the manner in which interest rates have been affected by deliberate interventions put in place after the financial crisis by financial regulators and governments. The rates have been very low, with specific instances where negative interest rates have been observed. The global financial market has now gotten used to the ‘now normal’ low rates and investors have continued to have positive expectation. It can be seen that these rates will stay as they are for some time into the next few years, with only gradual growth, if any. In the UK, for instance, a growth to only 1.7% interest rate is expected in the next three years. List of references Cortright, J, 2008, Driven to the Brink: How the Gas Price Spike Popped the Housing Bubble and Devalued the Suburbs. White Paper. CEOS for Cities. Sassen, S, 2009, Too big to save: The end of financial capitalism, Open Democaracy, retrieved on 8th December 2014 from Kaletsky A, 2014, The Reasons for Those Low Interest Rates, retrieved on 8th Dec 2014 from Lambert S, 2014, When will interest rates rise? Economists tip no move until late 2015, as 'lowflation' concerns dominate, retrieved on 8th December 2014 from   Read More