Causes of 2007-2009 Financial Crisis - Essay Example

Financial Crisis Financial Crisis is a term used to refer to a variety of situations where financial s, such as banks, or assets unexpectedly lose a huge fraction of their value with many detrimental effect to the economy. Many economists have theorized on how crisis develop and how they could be prevented. However there is little in way of consensus and financial crisis are still a regular happening globally. It is of utmost importance to deal with the issues surrounding the just the 2007-2009 financial crisis, the reasons that led to it and the implication. Indeed These decades of banking stability were the times of prosperity and growth. The financial crisis put to waste years of growth and resulted to unfathomable harm the fundamental productivity of the economy. One of a direct result of financial crisis is the loss of paper wealth (that can be measured monetarily). Loss of paper wealth has an indirect effect on the real economy in that it effects are felt incase depression or recession follows. Causes and Implication of U.S 2007-2009 Financial Crisis The 2007-2009 financial crisis originated from within the United State market. it coincided with what many saw as a shift from the geopolitical dominance of the United States to a multi-polar international framework. It was not accident but rather a mistake driven by deregulatory mentality that took half a decade of post-New Deal financial stability for granted. The crisis was a failure of free market capitalism and over regulation which helped sow the seed of the crisis. The world experienced the most severe financial crisis in most recent times since Second World War. It was precipitated by sub-prime mortgages crisis which became apparent to the wider public in the year 2007. In 2008, it became a global financial crisis, and consequently into a global economic down turn that forced many countries to into recession. Stock market fell, large financial institutions collapsed and government had to come up with rescue packages to bail out the financial systems (Manuel, 2009). For a clear understanding of the crisis there is need to look at the economic happenings of Post -world war II. This period shows a significant decline in the rate of profit in the economy of the United States. From 1950 to mid 1970s, profit rates declined almost by 50%. As in past depression times, this decline triggered reduction in business investment, and consequently slower growth and higher unemployment rate. As a result many governments adopted expansionary monetary and fiscal policies. However the policies resulted to higher inflation rates as capitalist firms, responding to the government stimulated demand, increased prices so as to reinstate the profit rates as opposed to increasing inflation and employment. Revolting against the higher inflation rates in 1980s, the capitalist firms were forced by the prevailing circumstances to adopt stricter monetary policies that included high interest rates. The result was reduced inflation but increased rates of unemployment. These facts show that government policies have affected the particular combination of unemployment and inflation at particular times, but nevertheless the fundamental cause of both of these “twin evils” has been the decline in the rate of profit (Mosely, 2009). The capitalist have attempted to restore the rate of profit in various ways as a response to the decline. One of them is the strategy of inflation where workers have been left with no choice than to either accept lower wages or live their jobs. Another way has been to worker speed up their operation as a way of gaining more value. There is also the strategy of declaring bankruptcy by companies as a method of cutting benefit and wages drastically. By declaration of chapter eleven bankruptcy, companies are allowed to operate, renegotiate debts, and of most significance state their contract null and void. The steel industry came up with the strategy in early 1990s and as expected other industries followed suit. In 2009, half of United States airline industries were declaring chapter eleven bankruptcies (Mosley 2009). Having said that, financial crisis was the worst since the great depression. It genesis was in the home mortgage market and soon spread to the prime mortgages, corporate junk bond Commercial real estate and other types of debts. The loss incurred was humongous and could total a third of all the banks capital put together. This led to a reduction in bank lending and consequently the recession in the U.S Economy (Mosely, 2009). The housing bubble started to burst in 2006, and the decline accelerated in 2007 and 2008. Housing prices stopped increasing in 2006, started to decrease in 2007, and had fallen about 25 percent by 2008. The decline in prices meant that homeowners could no longer refinance when their mortgage rates were reset, which caused delinquencies and defaults of mortgages to increase sharply, especially among sub prime borrowers. From the first quarter of 2006 to the third quarter of 2008, the percentage of mortgages in foreclosure tripled, from 1 percent to 3 percent, and the percentage of mortgages in foreclosure or at least thirty days delinquent more than doubled, from 4.5 percent to 10 percent. These foreclosure and delinquency rates are the highest since the Great Depression; the previous peak for the delinquency rate was 6.8 percent in 1984 and 2002. And the worst is yet to come. The American dream of owning your own home is turning into an American nightmare for millions of families. The above plotting of American: home prices, bond yield, building cost and population from the 2nd edition of Robert Sheller’s Irrational Experience. From 1890-2004 the prices of homes increased by 0.4% per annum and 0.7% from 1940-2004. The underlying reasons for the bubble crisis are complex. Laxity in lending standards, low interest rates which are historical, and speculative fever are some of the factors. Rapid rise in Valuations of real property to levels that could not be sustained in relation to: people incomes, Price and rent ratios and other economic indicators. When this is followed by a decrease in the prices of homes, many find themselves with negative equity; where the mortgage debt is above the property value which is a sure disconnect. Prior to the 2007-2009 financial crisis, Alan Greenspan admitted that there was a bubble in the housing industry. It was caused by the inability of mortgage owners from financing their debts as the low introductory rates reverted to usual interest rates. The chief executive officer of Freddie Mac admitted that they had a bubble. He concurred with Robert Sheller’s that mortgage pricing appeared overhauled and their correction could take very long with trillion of dollars worth of home getting lost. There was also the case of Bank Run. This result in a situation where there is an unexpected rush by depositors to make withdrawals. Since banks use deposits on loans, it may prove difficult to pay back causing lots of depositors to lose saving unless they are cushioned by way of insurance cover. Northern Rock in 2007 And Bear Stern (2008) experience this. The federal government was left with no option that to step up and bail out the largest insurance company, AIG .This move was unprecedented and extraordinary but necessary. AIG had for a log time, dominated the credit Default swaps market, a type of insurance against bond’s default that includes, high-risk mortgage based securities and form of speculation that bonds and other securities will fall. Driven by the fear that AIG could be unable to pay off all the sold insurance policies, which would have meant huge losses for the banks and other parties who had purchased the insurance, the federal government intervened. This was to prevent the adding of more losses to the bank hence worsening the crisis. As previously in other crisis, the U.S government broke of the principal free market economy and had to bail out AIG in an effort to salvage the financial system. The crisis was a failure of free market capitalism. Lack of regulation of the capitalist firms helped sow the seed of the crisis. However increasing intervention will be detrimental in the long run. In all this experience, was the realization of the fact that there was need for independent and competent regulation of U.S financial systems to guard against the multiple risks which they have to deal with. New deal policies (including federal deposit insurance and bank supervision) worked to stabilize the financial systems Work cited Fred Moseley, (2009),The U.S. economic crisis: Causes and Solution. ISR Issue 64, March–April 2009 Haner, T. Financial crisis: causes and solutions Manuel Kaar, (2009), A critical analysis of 2007-2009 Global financial economic Crisis. Mark Trumbull / Staff writer / March 12, 2010-publisher. The Christian science monitor Morgan, Trace "When Credit Problems Become a Personal Financial Crisis." When Credit Problems Become a Personal Financial Crisis EzineArticles.com. http://ezinearticles.com/?When-­Credit-­Problems-­Become-­a-­Personal-­Financial-­Crisis&id=1153087 Spill, G. How to Overcome a Personal Financial Crisis. Read More