Free «The Principal Causes of the Economic Crisis of 2007/2008» Essay Paper

The global economic crisis took place around 2007-2008, which is considered one of the worse economic downturn ever experienced in history. The 2007-2008 credit crunch led to collapse of large financial institutions, deterioration of stock performance and bailing out of banks by the federal government. Consequently, it led to rise in unemployment levels, deterioration of business returns and reduction in investment levels. As a result, restlessness in the economy became a normal condition with many investors expressing lack of confidence in the performance of the economy (Belke and Polleit 2010, p.456-459).

Poor monetary and fiscal policies instituted in the US economy, at that time, are to blame for occurrence of credit crunch. The genus of the problem dates back to 2001, when the federal government was in its move of saving the economy from recession. In an attempt to keep recession away, the government lowered the interest rates from 6.5% to 1.75%. Lowering of the interest rates spurred economic expansion through rapid investment. Creation of excess liquidity in the economy made low-income earners access the credit easily and cheaply. As a result, high-risk borrowers could easily access the credit to make investment ventures in assets (Cadieux, Conklin & Richard Ivey School of Business 2008, p.5-6).

 

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In 2004, the federal government lowered the interest rates to 1%, which was the lowest interest rate ever experienced in the history. In addition, the financial asserts underwent vigorous transformation in the financial assets. This included the introduction of various financial instruments that led to the creation of excess liquidity in the economy. The emergency of sub-prime mortgages increased demand pressure for ownership of homes by individuals. High demand was stimulated by the availability of credit to individual due to excess liquidity in the economy. Increased demand for houses leads to the increased investment in real estate development, which increased demand for finances from a monetary institution in the form of loans. Despite various measures by the government to stabilize economic development, the global credit crunch hit the entire economy in 2007. The federal government, in an attempt to salvage the deterioration of the economy, revised the interest rates upwards. This led to depreciation of the house prices and increased burden of the borrowers to finance their loans. The financial market experienced a tremendous shock as many borrowers failed to honour their loans repayment agreement. This is because they were also hard hit by recession, and could manage to service their debt. In addition, the leading financial institutions were not left behind from the roller coaster effect of the economy; this lead to shut down of some of the biggest financial institutions such as banks (Financial Crisis Inquiry Commission 2010, p.345-349).

The emergency of the financial crisis in the economy is something that economists agreed on as controllable. However, due to lack of proper control of the financial market by the authorities the problem got out of control. The following are the main reasons for the emergence of the recent global financial (Jackson 2010, p.23-34).

First, financial crisis originated from the availability of excessive liquidity in the economy. The low interest rates that prevailed at the material time created pressure for more borrowing. Banks diverted from prudential practice of leading. This is because loans packages were customized to the needs of borrowers. As a result, the banks diverted from the tradition of offering the loans by depending on the customers’ credit worthiness. Thus, banks reduced excessive collateral conditions for the borrowers to facilitate easy access of credit facilities. Moreover, the banks offered various financial products to high-risk individuals, which increased the individuals’ capabilities of acquiring more financial assistance using the packages that suited their needs. This resulted into increased domestic spending financed by excessive borrowing. However, some loans products were given at adjustable interest rates, which created loan-financing pressures to the borrowers after the federal government revised the interest rates upwards (Kolb 2010, p.567-587).

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 In addition, the federal government instituted measures that saw a reduction of bank capital reserves ratio, which increased the lending capacities of financial banks in the economy. Thus, banks were in a position to increase their lending by a remarkably large proportion. However, for the banks to increase their lending level, they relaxed underwriting standards. Relaxation of under-writing standards created a danger of driving the financial market out of existence due to entire failure in the future (Belke & Polleit 2010, p.234).

 The increased demand for loans due to the low interest rates was a predominant phenomenon in the economy. The main aim of increasing liquidity in the economy was to spur economic growth in the economy after the recession period. However, due to reckless fiscal and monetary policy coupled by inefficient policies that aimed at achieving the short-term gain posed eminent danger in economic performance. Thus, the liquidity measure later on translated to indebted problems among individual and firms due to poor borrowing and lending framework. The situation was even more volatile as the interest rates rose, which lead to depreciation of market value of assets and increased rate of loans defaulting (Kolb 2010, p.67).

Therefore, the effectiveness of creation of liquidity in the economy was never realized in the end. This is because the financial market was left in the worst condition with the threat of total closure of operation of some of financial institutions. The result a ripple effect that was translated into the entire world’s economy (Kolb 2010, p,90).

Second, the complexity of financial market due to the increased adjustment in the financial production is another cause of credit crunch in the period. Increased competition among financial institution led to pressure of tailoring financial products to meet the needs of their clients. Accordingly, the financial market introduced numerous financial products to the borrowers to facilitate their competition power by acquiring large market shares. The innovation in a financial product refers to increased changes in the conditions necessary in acquisition of the financial assistance. Some of the changes instituted in the financial products include availability of adjustable-rate mortgage, collateralized debt obligations and credit default swaps. The financial institution engineered financial products with distinctive interest of increasing their market share by tapping low-income earners segment. Moreover, the new financial market was designed to offer loans product in high-risk areas; thus, the credit access to individual with doubtful income sources became real. The formulation of various financial products led to complication of financial market. This led to lack of proper policy frameworks of regulation of banks and other financial institutions. Some banks expressed lack of proper knowledge of how some financial products worked. Therefore, financial product innovation increased confusion among the financial institutions and associated parties. This led to the complexity of the proper way of assessing the risk and the way risk spread among different parties (Belke & Polleit 2010, p.45).

Third, failures of financial market are attributed by lack of proper mechanism of determination the risk level. This is because of existence of complex financial products that made it difficult to ascertain the magnitude of risk. As a result, the value that was set as the level of risk was not optimal, leading to unequal distribution of resources. The financial market favoured one side, as risk was not evenly distributed among the parties. This rendered the financial market inefficient due to inaccurate models of pricing. The existence of inaccurate model of determining the level of risk explains the bloated size of financial products that was allowed at the material time, which the economy could not sustain. Therefore, the inaccurate information lead to complete disturbances in the financial market after the level of interest started to rise. The market forces could not react to resolve the financial market as the situation had already developed to the critical level (Jackson 2010, p.24).

Fourth, increases in debt burden worsened financial crisis making it exceedingly hard to improve the performance of the economy. Prior to the recession period, the federal government had instituted various measures to augment domestic spending through increased liquidity. The government reviewed the interest rates downwards to coax the public to increase their borrowing to finance its spending level. Attractive mortgage finance plan was one of the critical financial products that captured the interest of many citizens. As a result, majority of citizens borrowed to finance the cost of owning houses. However, an upward revision of the interest rates by the federal government led to the beginning of their economic demise. They soon failed to service their loans agreements, thus, increasing loan’s defaulting rate. As a result, the households and customers languished into financial instability coupled by high level of debt burden. Debt burden also did not leave behind large financial institutions as most of them were forced into bankruptcy. Consequently, the level of domestic spending fell drastically and reduced the public investments (Kolb 2010, p.58).

Fifth, the push for deregulation of the economy also contributed to the financial crisis that hit the U.S in 2007-2008 fiscal years. The proposition is that free market mechanism, with minimal or no government interference, is capable of bringing optimal results. The argument behind the advocacy for letting market forces determine the operation of the financial market is that the intervening boards cannot keep the pace of financial innovations. Hence, various financial products came into being due to limitation of government’s control over the financial markets. The financial institutions such as banks set various financial products to attract bigger market share. High competition among the financial institutions led to rapid growth in the financial market innovations. Consequently, the complexity of the financial products led to confusion among the players in the market. The formulation of sound policy to oversee its operation became inherently difficult, and this lead to unconventional business practices among different players in the market. Therefore, the push for liberalization of financial market from government interference is a factor that fuelled the occurrence of global financial crisis that led to completely failure of the financial markets in the economy (Belke & Polleit 2010, p.28).

Sixth, information asymmetry in the financial markets played a significant role in instigating the global credit crunch. The players in the financial markets had contradicting objectives. Some of the objectives were unethical; thus, meant to protect their own gains at the expense of the clients. For example, in the mortgage financing, some of financial institutions played predatory tactics to sweet-talk customers into purchasing their financial products. Predatory techniques are applied to consumers to encourage them in purchasing a product by furnishing them with imperfect information in order to meet some pre-determined ill objective(s). Lenders used false advertisement of lower interest rates mortgages, which was not practicable. They introduced to the customers the adjustable-rate mortgages after the contract is sealed. As a result, the customers were charged high interest rates beyond the previously agreed rate (Kolb 2010, p.298). 

Dealing in markets dominated by imperfect information is what economist describes as ‘the lemon market.’ This is market were one party has more information about a given economic phenomenon. In such a case, the party with information takes advantage in exploiting the one information deficiency. This was the scenario of the financial markets before the beginning of the recession. Most of transactions effected by the government had a negative implication on the well-being of their customers. The loan products offered by the banks were well engineered to lock-in customers in paying interest rates for a long duration to facilitate their profitability. Therefore, lack of transparency in the banking system and other financial institutions accounts for failure to the financial market that led to economic recession experienced in 2007-2008 (Belke & Polleit 2010, p.456).

Seventh, lack of investors’ confidence had serious repercussions on economic development. This is because once investors express the lack of trust towards a given market, they divert their resources in other markets or prefer holding their wealth in risk-free assets. Deterioration of economic performance in 2007-2008 due to disturbances in financial market is the source of investors’ lack of trust in increasing their level of investment. As a result, many people preferred holding their wealth in risk-free assets leading to increase in financial markets pressure. In addition, the level of economic investment dropped significantly creating more pressure due to a rapid decline in economic progress (Kolb 2010, p.678).

Economic performance depends on the confidence level of potential investors. Where the confidence level is predominantly high, likelihood of elevated level of investment is guaranteed. On the other hand, lack of confidence in the economy leads to minimal or no investment in the country. For this reason, failure of financial market in the U.S explains why the economic recession became the immediate outcome of the event. Despite government intervention to address the challenge, the problem persisted. Rekindling the confidence of the investors takes time and resources; this is because they will speculate of possible occurrence of the same events. Thus, investors exercise a high degree of care to avoid the high-risk associated with failing of the system. Therefore, the failing of financial market in the U.S was further worsened by the lack of investors’ confidence in the safety of their investment in the U.S economy. As a result, the effect was transferred to other markets; since, the U.S serves as the biggest economy that has a significant impact on the economic system of other countries in the world (Kolb 2010, p.10). 

Finally, the economic recession stemmed from poor and in-adequate practices of underwriting. This is the reason for collapse of mortgage financing in the U.S. Banks had relaxed their underwriting standards. As a result, the poor underwriting policies led to volatile housing financing through mortgage financing. Consequently, the rise in interest rates led to high mortgage defaulting. The implication of this was increased repossession of houses by financial bodies, which were acquired on mortgage financing. Thus, the house ownership dropped significantly due to breach of contracts resulting from the defaulting payment of loans agreement (Kolb 2010, p.19).  

In conclusion, the financial crises of the U.S economy in 2007-2008 had a significant effect throughout the entire world’s economy. The inter-dependence of different economies in the world, and the globalization of economic activities accounts for the spread of United States’ economic woes to the rest of the world. This is because the U.S is one of the superpower countries; thus, it has various inter-linkages with different countries. For example, the U.S offers various forms of the financial support to many developing countries. For this reason, negative effect on the U.S economy shifted to its development partners. In addition, the credit crunch that hit the country affected the dollar value; the main currency that many countries use in international trade. Hence, the recession period in the U.S translated to the economic crises of the world at large due to international trade imbalances. However, the economic downturn was corrected through the implementation of regulatory policies, increased financial market transparency and federal government bailing out some of the bankrupt institutions.