Causes of the Great Recession of 2008-10 - Case Study Example

Great Recession 2008-10 College: Name: Students ID: Date: Course Name: Unit Code: Time: Instructor: Introduction The financial crisis that began in 2007 in the United States (US) spread and gathered intensity in 2008. Authorities tried to quell the situation in vain and by the start of 2009, the US economy and the global financial system were somehow locked in an economic downturn. The world experienced the biggest and sharpest slump in international economic activity of the modern age. This ended up being the second worst economic crisis in history following the great depression of the 1930’s. However, different parts of the world have experienced financial crises at different times that did not blow up out to the world. Part 1 of this paper reviews the causes of the GFC (Bean, 2009). The roots of the GFC are traced to the US. The country was badly bruised by the GFC and has faced major problems in the past two decades including the Dotcom bubble. Within this period, China’s economy has been growing rapidly. The Asian economic giant has established firm strategic partnerships with many countries in the world. Its power is growing. Amid this developments is a general feeling that the world is about to experience great regional and international systemic changes. Within this context, part 2 of this paper provides insight as to whether there is a shift in global economic power from the US to China (Antkiewicz & Whalley, 2006). There is also an ensuing debate as to whether the US dollar may in the near future lose its global position as a medium of international currency transactions and global assets. Other currencies such as the sterling pound, the ducat, the guilder and the bezant have faced a similar fate in the past. Part 3 of this paper delves into this discussion (Cockerell & Shoory, 2012). Part 1: Causes of the Great Recession 2008-10 Quite a lot of factors combined to make the 2008-10 GFC the second harshest economic crisis ever since the Great Depression of the 1930’s. Over this period the world experienced dramatic fallout in international trade, both in terms of volume and the pattern of trade. The GFC led to a fall down of huge financial institutions, bailout of banks, along with a depression in stock markets all over world. The key factors that contributed substantially to the GFC are; (1) Bursting of the housing bubble; (2) Lower interest rates and Inflation; and (3) High risk assumption (Bean, 2009). Bursting of the housing bubble The Federal Reserve had instituted recovery policies after the threat and collapse of the Dotcom bubble in 2000-01 by cutting interest rates to about one percent. At this time housing prices were still growing quite strongly at a rate above one percent. Hence people were motivated to borrow. There were other additional mortgage incentives such as tax advantages among others that supported low income earners to own a home (sub-prime mortgage lending). Household debt had increased significantly. The ensuing rising demand of houses led to an increase in housing prices. House prices peaked in 2006 and then dropped more than 30 per cent. This was the largest decline since the 1930s on a national level in the US. There were property problems in other parts of the world, such as Spain and Ireland, which supported the global spread of the crisis from the US (Kanda, 2010). Lower interest rates and Inflation In the period prior to 2008, the US and many other developed economies enjoyed incredibly healthy macroeconomic steadiness. During this time interest rates and inflation were near zero. In fact the period was named a period of Great Moderation (Bean, 2009). Low inflation came into being as a result of several factors. More importantly was the opening up of communist states such as China. Therefore, the world economy enjoyed massive cheaper labour force. There was also a rapid technological development hence production costs were low (Bean, 2009). Also a lot of central banks in the developed countries had adopted inflation targeting that saw a reduction of inflation expectations. Hence a combination of low inflation along with lower than expected inflation consequently meant that interest rates would be kept low. Between 2001 and 2004 the Federal Reserve had cut interest rates by 550 basis points. However, this had numerous several implications. Individuals found it cheaper to borrow money so as to buy homes that had turned out to be more reasonably priced and house prices rose considerably in a lot of countries. With such a booming housing market, prices more than doubled in just a decade. The result of that was a rapid increase in household debt levels but incomes were not growing. Therefore debts could not be paid fast enough which saw people default to pay and thus affecting the market negatively (Bean, 2009). Figure 1: Global Interest Rates Source: International Monetary Fund (2014). High risks assumption The rising demand for debt could not match increase in bank deposits. As a consequence, banks had to look for other sources of finance. They relied heavily on wholesale funding markets. On the other side, there were other financial actors, such as hedge funds, also relying deeply on short-term financing on the same market but their investments were more long-term. Generally, financial institutions ended up building up extensive liquidity risks. Moreover, risk adverse investors took advantage of the low interest rates to find margins for their investments. Even though people thought that macroeconomic conditions were stable, this was not real. Hence, the risks were underestimated. Liquidity dried-up once investors doubted the worth of assets invested in asset-backed securities and other markets. Numerous companies along with financial institutions became stressed financially since they were not able to refinance themselves through their usual sources and banks were unwilling to intervene (Bean, 2009). Part 2: Change of Economic Power from the US to China Before the GFC, it was perceived that there would be high economic growth rates and stepped up growth rates of exports from the highly populated economies of China and India together with high growth in ASEAN, Brazil Russia as well as South Africa. In face of the GFC, it still remains highly speculative that in the near future global economic power will gradually shift from the Organisation for Economic Co-operation and Development (OECD) (in particular the US and the EU) to the non-OECD (in particular Brazil, India, Russia, China, ASEAN, South Africa, Egypt, Turkey and Nigeria). In the midst of this impending shift in power, the global economy is expected to experience a major shift in command. At the centre stage of these developments are two big economies, China and the US (Kanda, 2010). The recent and continuing rise of China raises a lot of questions for the US given that it is the single true base of global power. The rise of China has universal implications for the US but is for the most part and evidently felt economically. The GFC hurt the US. Its growth slowed considerably and unemployment levels have been high. Moreover, the general practices of financial institutions in the US that led to the GFC have raised questions regarding the economic intelligence of the previous decade that was behind such noticeable prosperity. On the other hand, China has posted admirable growth as of the late 1970’s and its growth remains strong. Its financial institutions pulled through the GFC basically without a scratch. The country holds large amounts of foreign exchange reserves, mainly in US Treasury Bonds. In fact the foreign reserves have grown to over US$2 trillion at present from just about US$70 billion in 1995. China can nowadays fund key foreign acquisitions and its domestic investment is growing as global manufacturers set shop there (Antkiewicz & Whalley, 2006). The trade deficit between the two countries is widening in favour of China. Given that China is growing at a faster rate than the US, the economic gap stuck between the two economies is becoming narrower each year. Regardless of these statistics, a number of commentators hold the opinion that the US decline will not last long. Their argument is based on the buoyancy and strength of the US financial system, not just its recent struggle. The truth is that the US is confronted by the intensity of China in bilaterally, regionally and internationally. Also, it is usual for writers to muse over living all the way through a period of big change. The past offers some good lessons for them. In the 1990s, the US President George Bush senior talked publicly of a New World Order that we have not seen. Again today the US is talking of a period of great change. Earlier events did reshape the world. For example, the effects of oil shocks did, the US withdrawal from the gold standard did, and the US withdrawal from Vietnam along with the fall down of the Soviet Union did. A shift of economic power from the US to China is about to happen too. The economic rise of China is changing the world (Antkiewicz & Whalley, 2006). The US has not recently had to deal with any other nation reminiscent of China in size that is growing so rapidly neither has it had to deal with a country that is expected to develop into a bigger economy. Part 3: Future Fate of the US Dollar Following the demise of the gold standard, as the World War II was coming to an end in 1944; the US dollar was proclaimed to be the international reserve currency a position it holds to date. However, the US dollar has been quite unstable with its value fluctuating every now and then. As a result in the recent past, the US dollar has come under sharp criticism. Indeed, the US dollar has had a difficult past amid various financial and economic crises in the US and globally. In the 2008-10 GFC the dollar suffered substantially despite the efforts to save it; it has been declining since then. Today there is news all over regarding the discussions of the US dollar’s imminent loss of international pre-eminence. There are calls all over for the US dollar to end its status as the international reserve currency and swap it with another medium (Chinn 2012). Table 1: Share of national currencies in total identified official holdings of foreign exchange, end of year (%) Currency 1977 1982 1987 1992 1997 2002 2007 2008 2009 2010 2011 2012 2013 US Dollar 79.2 57.9 53.9 48.9 59.1 67.1 64.1 64.1 62.0 61.8 62.3 61.9 61.2 Sterling 1.6 1.8 1.9 2.6 3.3 2.8 4.7 4.0 4.2 3.9 3.8 4.0 4.0 Euro 0.0 23.8 26.3 26.4 27.7 26.0 24.7 23.9 24.4 J. Yen 2.2 4.1 6.8 7.4 5.1 4.4 2.9 3.1 2.9 3.7 3.6 3.9 3.9 Swiss Franc 1.9 2.3 1.7 0.8 0.5 0.4 0.2 0.1 0.1 0.1 0.1 0.1 0.2 others 15.2 33.9 35.9 40.3 30.0 1.6 1.8 2.2 3.1 4.4 5.4 6.9 4.6 Source: International Monetary Fund (2014). Figure 3: Currency Composition of Foreign Currency Reserves (COFER) 2001 - 2013 Source: International Monetary Fund (2014). However, (as indicated in table 1 and figure 3 above) the US dollar is still the leading currency in the world by far. Still lots of international transactions are settled in US dollars. Moreover, it is still the principal reserve currency for central banks and governments in the world. The figures also indicated that other currencies, in particular the Euro, pose great threat to the future of the US dollar. Also there is the component of the rising China, whose currency the Yuan is a great threat to the Euro and the IMF is considering Special Drawing Rights (SDRs) (Chinn 2012). Below I discuss each of these alternatives against the US dollar. Euro Today the data indicates that the euro is a conceivable rival to the US dollar. Despite the recent economic challenges in the region, the Euro has survived crucial tests. The currency has had a relatively smooth transition. In fact today 12 countries in the European Union (EU) use the Euro. In addition, currency is progressively more used internationally (Chinn 2012). Yuan In March 2013, China made a first major push for the US dollar to be replaced as the international reserve currency. The country’s economy has been growing strongly in the recent past and is positioning itself as a major global player (Cockerell & Shoory, 2012). Special Drawing Rights (SDRs) A number of countries such as Russia, France and Brazil suggest that the US dollar ought to be supported by other key currencies as a pooled reserve currency. This could be in form of Special Drawing Rights (SDRs). These are a mock currency created by the International Monetary Fund (IMF) in 1969 as it intended to even out the international foreign exchange system. The SDRs are a mishmash of four currencies. These are: (1) US dollar; (2) the Yen; (3) the Euro; and (4) the British Pound. However, the US dollar by itself constitutes nearly a half of the value of a single SDR. The IMF Executive Board determines the amounts of each currency making up an SDR depending on the virtual substance of the currency in the scene each five years (Chinn 2012). Conclusion The great recession of 2008-10 had devastating effects on the global economy. The GFC was caused by a combination of various factors including bursting of the housing bubble, low interest rates and low inflation and high risk assumption. Seeing as the crisis broke out in the US and given other troubles the country has faced, there is an impending threat especially from China to replace the US an a global economic power. Also, since the crisis started along with other problems from the past, the US dollar currency that has been the international reserve currency and medium for holding global assets has been threatened by the rising Euro, the Yuan and support for the Special Drawing Rights (SDRs). References Antkiewicz, A. Whalley, J. (2006). Recent Chinese Buyouts Activity and the Implications for Global Architecture. NBER Working paper series #12072. Bean, C. (2009). The Great Moderation, the Great Panic and the Great Contraction. BIS Review 101/2009. Chinn (2012). A note on reserve currencies with special reference to the G-20 countries. Mimeo, University of Wisconsin. Cockerell, L. and Shoory, M. (2012). Internationalising the Renminbi. Bulletin, Reserve Bank of Australia, June Quarter 2012. International Monetary Fund (IMF). (2014). Currency Composition of Official Foreign Exchange Reserves (COFER). Viewed 11 April 2014, Kanda, D. (2010). Asset Booms and Structural Fiscal Positions: The Case of Ireland. IMF Working Paper 10/57. Read More