The Global Financial Crisis

Financial crises have become commonplace over the years especially in the contemporary world. The frequency at which these crises take place has been noted to be twice that of the period 1945 to 1971 and 1880 to 1993 referred to as the Bretton Woods Period and the Gold Standard Era respectively. The crises experienced today can only draw similarities from the Great Depression period. However, the financial crisis that began in 2007s summer surprised many people. The crisis started off as challenges in the subprime mortgage market of the United States but spiraled out of control later, spilling over into financial markets followed by the real economy (Helleiner, 2011). Suffice to say that the worlds financial landscape was changed by the 2008 global financial crisis and evaluation of its full costs remains a daunting task.

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The aim of this paper is to elaborate the causes as well as the consequences of the 2008 global financial crisis and recommend reforms that should be undertaken concerning the financial system in order to prevent recurrence of the crisis and to alleviate its adverse effects. In spite of its severity and broad effects, the 2008 financial crisis resembles other past crises from many perspectives. Various researchers document banking crises and their effects via wide data set of middle-to-low and high income nations. They reveal that systemic banking crises are normally preceded by asset price bubbles and credit booms. They also show that several financial crises are caused by bubbles in real estate markets.

Intensive analysis of the events that preceded and characterized the 2008 global financial crisis points originate from the low interest rates policies that were upheld by the Federal Reserve as well as other central banks after the cataclysm of the technology stock bubble. Moreover, the central banks of Asia wanted debt securities and this led to lax credit. Such factors catapulted a drastic increase in prices of house in the United States not to mention European countries such as Ireland, Spain and the United Kingdom. By 2006, this bubble had attained its peak in the United States and the prices of houses in the U.S. together with other countries had started to decline. The drop in house prices resulted in the decline in the subprime mortgages prices thus affecting financial markets all over the world. The interbank markets experienced significant pressures and central banks had little choice but to inject huge liquidity in August 2007. Collateralized market conditions also changed considerably. It became more difficult to borrow against low quality collateral. The Federal Reserve along with other central banks came up with many measures in an attempt to improve the money markets functioning. Several financial institutions came under compelling strain as the decline in the prices of subprime mortgages continued to fall during the fall of 2007. The Federal Reserve, via a merger with J.P. Morgan, bailed out Bear Sterns.

Despite enormous pressure upon the financial system especially banks during the time, the real economy remained largely unaffected. However, the real economy was affected when the collapse of Lehman forced re-assessment of risks by markets in September 2008. In addition to inducing hefty losses to various counterparties, Lehmans bankruptcy also sent a negative signal to the international markets. As investors had previously overlooked risk reassessment, they withdrew from the markets leading to drying up of liquidity.

The following months, as well as 2009s first quarter, saw a sound decline in economic activity within the United States including several other countries. As a result, unemployment rose drastically. The 2008 global financial crisis is widely regarded as the worst of its kind since the Great Depression.

Causes

There was moderately widespread consensus that the cause of the crisis was poor incentives in the United States mortgage industry. As per this explanation, what had taken place was the manner in which the mortgage industry functioned had undergone cogent changes over the years. In the traditional sense, banks would increase funds, evaluate borrowers, and eventually lend money to those who have been approved (Ivashina & Scharfstein, 2010). In the event that the borrowers defaulted or failed to pay their loans, the banks would be responsible for bearing the losses. As such, this particular system offered appropriate incentives for banks to carry out careful and comprehensive assessment of borrowers creditworthiness.

As time went by, however, the process of lending out many changed along with the incentives. Banks originating mortgages and selling them for securitization substituted the practice where banks would originate mortgages and dearly hold on to them. The brokers, originators and banks received payment based on the number of mortgages that they approved hence selling as many mortgages as possible provided the incentives. They were not at any fault in the event that borrowers defaulted in paying the loans since they were selling them off. Another perspective with respect to the issue of incentives involves the rating agencies. Several people argue that rating agencies were not doing a good job because they had started receiving a huge percentage of their income from performing ratings of the products that were securitized. The main point lies behind the idea that they had lost focus on their objectives and started issuing unjustified ratings.

Besides, the entire methodology of checking borrowers creditworthiness as well as the mortgages underlying the securitizations had disintegrated. This perspective of the world claims that it is relatively easy to find a solution to the crisis and prevent its reoccurrence. The government should ensure proper regulation of the mortgage industry in order to ascertain that every party has the correct and appropriate incentives, thereby curtailing the problem.

Considering statements from the Treasury and Federal Reserve during the time, it seems that this was the view they adopted. Nevertheless, this view that pointed out subprime mortgages as the reason for the problem became less and less credible as the financial crisis continued to rear its ugly head following Lehmans bankruptcy and the global real economys dramatic collapse.

The economies of numerous countries around the world, particularly in Europe and Asia were immensely affected despite the fact that their bank had limited exposure to United States securitizations and remained robust. In Japan, for instance, GDP decreased by 4% in the first quarter of 2009. More or less of what was happening in Japan was the case around the world and the economy of the world began to steadily seize up. It became extremely difficult to believe that the cause of the situation was merely an incentive problem in the mortgage industry of the United States.

The basic challenge that caused the 2008 global financial crisis was that there was a real estate bubble in the United States and in other countries such as Spain, the U.K., and Ireland. The bubble was caused the bubble in the U.S. has a lot to do with the policies adopted by the Federal Reserve in 2003. To avoid a recession after the 2000 tech bubble and the 2001 9/11 terrorist attacks, the Federal Reserve reduced interest rates to a very low one percent, creating and incentive to buy houses. Apart from the low interests, another incentive that encouraged house purchasing was the tax advantages of having the ability to roll back interest on mortgages unlike on rent payments.

All these factors contributed to creating a huge demand for house buying. This increased demand led to an increase in the prices of houses. When house prices began rising by 5 or 10 percent per year, it became a worthwhile venture to borrow despite the Federal Reserve raising interest rates. Therefore, the initial factor that really triggered an escalation of house prices was the Federal Reserves interest rate policy. However, European countries such as Ireland and Spain experienced huge property bubbles suggesting that the Feds low interest rate policy was not the only factor.

Another factor that caused the crisis is the global imbalances which had begun with the 1997 Asian Crisis. A great number of Asian countries such as South Korea found themselves in serious problems. South Korea banks and firms had borrowed more than necessary in terms of foreign currency and soon sought help from the International Monetary Fund (IMF). The conditions for financial assistance were that the Asian country was required to raise interest rates and to reduce government expenditure (Fidrmuc & Korhonen, 2010).The harsh conditions inspired many Asian countries to accumulate assets worth trillions of dollars. In contrast, Central and Eastern European, as well as Latin American nations, failed to increase their reserves at the time. The Chinese purchased various debt securities such as Freddie and Fannie mortgage-backed securities, especially for mortgage borrowers. This big debt supply aided in bringing down the standards of lending. As such, the second principal factor that contributed to the bubble was the huge amount of debt due to global imbalances

The effects on the real economy

Following the collapse of the bubble, the entire world economy declined. This can be attributed to the wrong decisions people made for nearly a decade with the notion that asset prices would keep appreciating. The aggregate rate of saving fell to nil in the United States. There was basically no point of saving since houses or stocks that people owned kept going up in price and value respectively. People halted saving and started borrowing in order to finance their consumption. Leverage ratios of firms, households and institutions all escalated. When asset values experienced a huge fall, people realized that they were overleveraged and their savings were minimal. There was also price uncertainty regarding products. The stock markets rose and fell by ridiculous percentages within a shortage period of time.

The figure below shows how the response of the economy to the AS/AD framework to contemporary events. The events involved two connected shocks:

(1) A fall in housing and equity prices that led to the decline of household wealth.

(2) Increase in the risk premium at which households and firms borrow. The two shocks together cause the AD curve to shift to the left and down. This causes a deep recession that drives the rate of inflation to fall below its optimum. The AS curve gradually shifts downwards over time since firms cut their price increases because of recession.

In the AS/AD analysis, the recession causes inflation to decline further, therefore raising the likelihood for inflation to turn negative. This situation is referred to as deflation.

Effects on the financial system

The crisis began in the summer of 2007 accompanying the subprime mortgages meltdown. This resulted in a problem since these mortgages were held by debt-based financial institutions that deal harshly with falls in the price of assets. A majority of them were structured investment vehicles (SIVs) or investment banks. The challenges started in securitized subprime mortgages before they spread to other sections of the financial system which gave the connection to the real economy (Brunnermeier, 2008).

Three important reforms that should be undertaken to prevent reoccurrence of the 2008 global financial crisis are as follows. The first reform entails basing banking regulation in a logical and comprehensive intellectual system of correcting failures in the market. The second reform is that transparency should be ensured as far as the Federal Reserve, as well as other central banks, are concerned. The third reform is that the International Monetary Fun...