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Causes And Prevention Of Global Financial Crisis Economics Essay

The Ex- President of the United States Ronald Reagan once said recession is when a neighbour loses his job; depression is when you lose yours. The biggest point of concern today is the global financial crisis or recession. The economic meltdown has caught us all wrong footed, the business organizations across the globe suffered huge amount of losses which resulted in pay cuts and slashing of jobs. Record numbers of people have lost their jobs in the past year and a half.

I have taken up the global financial crisis as my focus of discussion. The essay has been structured into three parts. The first part explains what recession is. The second part analyses the causes for this economic downturn and the third portion is where I have tried to provide some solutions that might help preventing the situation in the future.

Most economists and experts around the globe say that an economic recession can only be affirmed if GDP (Gross Domestic Product) growth is negative for two or more than two consecutive quarters. The base of a recession and its actual starting point in fact rest in the several quarters of positive but declining growth before the recession cycle actually starts. Although the "two quarter" definition is accepted all over, almost all economists find trouble backing it completely as it does not consider other very important economic constraints. For example, present national unemployment rates or consumer assurance and spending levels are all a part of the economic system and must be taken into accordance whenever defining a recession and its characteristics.

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Economic recession is mainly assigned due to the actions taken to control the cash supply in an economy. The Central Bank or the Federal Reserve is the agency responsible for exerting the fine balance between money supply, inflation and interest rates. When this equilibrium is disturbed, the economy is forced to rectify its state.

In an environment where price rises are evident, people cut down on things like spending lavishly. They tighten their budget more, spend less on things they would otherwise spend on, and start saving more money than they did. Hence, as people and businesses start finding ways to cutting down on costs and discard unnecessary expenditures, the GDP to declines drastically. The unemployment rates rise as organisations start relieving off workers to cut more costs, as consumers are not spending like they were usually and the profits go down. All these factors combine that manage to take the economy into recession. (Sources:

The paradigm shift in the US economy was a big contributing factor. The economy shifted to a service based economy from a predominant manufacturing sector. By the year 2009, manufacturing and agriculture constituted less than 10% of the whole economic base. Decline in manufacturing took place mainly due to off shoring or outsourcing but vastly increased productivity was the bigger factor. Lack of security became an issue as the employments trend changed from a long term employment relationship to a short term attachments. The result of the shift from manufacturing to service, in short, has been a disaggregation of employment in which the attachments of workers to particular firms is more tenuous, expected tenures are shorter, and workplaces themselves are often on a smaller scale. The new portable employment included portable pensions; that is a pension plan that moves with an employee when he or she changes the employer. Pension investment became a big business dominated by institutional investors. With a portable defined contribution systems pension is based on investment returns which created pressure for high returns and also removed employee incentives to stay with a single firm. This resulted in a vicious circle of profit pressure and employment instability. (G.F. Davies, 2009)

Following a sustained period of economic flourish, a speculative scheme that depends on unstable factors that the planner cannot control has now exploded. A breakdown of the US sub-prime mortgage market and the flip of the real estate flourish in other industrialized economies have had an adverse effect around the globe. Other weaknesses in the global financial system surfaced and some financial products and instruments became so complex, that as things started to unravel, trust in the whole system failed. (Forward Block, December, 2009) (Sources:

In a documentary by BBC's former economic editor and presenter, Evan Davies, called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14, 2008),some rating agencies were hired and paid to rate the products and inadvertently got high ratings, and people got encouraged to take them up.

It all started in Wall Street, others followed quickly. While profits soared higher by the day, everyone wanted in a share, even if they hardly had any expertise in them. Citing an example,

Banks borrowed more and more money to lend so they could create more securitization. Banks did not depend on savers as much, as long as they were able to borrow more money from other banks and sell them off as securities; bad loans would be the problem of whoever had bought the securities.

A few investment banks like Lehman Brothers got themselves into mortgages, buying them, so they could securitize them and then could sell them.

Some of the banks loaned even more and got the opportunity to securitize the loans.

Running short of whom to loan to, banks turned to the general mass- the poor; the subprime, the riskier loans. Soaring house prices led lenders to perceive it wasn't too dangerous; bad loans meant possessing high-valued property back. Subprime or "self-certified" loans (often called "liar's loans") became very popular amongst the mass, especially in the US.

Few banks started to get securities from others.

Collateralized Debt Obligations, or CDOs, (which is a further complex form of securitization) increased the risk and were very complicated and also often hid the bad loans. While things were booming, none wanted bad news.

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Venezuelan President Hugo Chavez faulted the ''laissez faire, laissez passer' model, saying it '' is what caused the crisis in the United States and is the reason why half of the world is under threat.'' German Chancellor Angelo Merkel took a more measured stance, defending financial markets but saying '' we do not need untamed financial markets, in which profit is the only thing that counts.''

Most experts agree one of the main questions will come down to how to prioritize a laundry list of potential policy actions. Sebastian Mallaby, the director of CFR's centre for Geo-economic studies, says that the first goal for policy makers should be to differentiate between immediate steps needed to restore credit markets and stop the economic bleeding- whether through stimulus, spending, bail outs, government lending programs or other means and long term goals that must be addressed to improve regulation and prevent future crises.

From the standpoint of preventing the next crisis, it is better to let an insolvent institution fail and use the government's funds to assist those individuals or institutions damaged by that failure than to use the government's funds to reward the behavior that caused the solvency in the first place. (Samwick, 2008)

The key energy feed which is oil, when goes to a decline, and as researchers say which is unavoidable; it would result in an economic contraction. So, ways to extract more oil and in a cheaper way has to be formulated.

According to experts such as Danny Gabay UK house hold sector that over borrowed and holds 170% of the annual GDP is the real burden. Govt. presently boosting most of the recovery but that in turn increases its debt. All intending to save, there is absolutely no one producing demand. The forecast of the growth for UK in 2010 is estimated to be a lowly 0.6-0.8 percent. A concentrated effort to increase demand has to be made.

Suggestions made very recently by the shadow Chancellor Mr. Osborne emphasized on the fact not to let Britain inflate its way out of trouble; talk of tweaking the inflation target to take account of housing costs; and a restatement of the case for putting the Bank of England in charge of more nuanced macro and micro prudential regulation of the financial sector. (BBC)

There is also a need to raise public sector productivity through a "radical program of public sector reform" feels Osborne.

Measures such as a global levy on banks should be agreed in the forthcoming G20 meetings, the Prime Minister Mr. Gordon Brown feels. Global leaders should follow the "radical" measures adopted in the UK, such as higher taxes on bankers' bonuses and on salaries above £150,000, Brown said. The new global guidelines should address issues such as capital requirements for banks, supervision and tax heavens -used by financial institutions to avoid higher taxes. (The Guardian, Feb 19, 2010)

''The government needs to spend more money in the short term to boost growth while simultaneously taking strong action to reduce the long-term budget deficit. According to Blanchard IMF estimates suggest that the fiscal cost of future increases in entitlements is 10 times the fiscal cost of the crisis. Thus, even a modest cut in the growth rate of entitlement programs can buy substantial fiscal space for continuing stimulus.

Lowering corporate and investment tax rates to a more internationally competitive level. If entitlement liabilities are downscaled, the UK economy can generate more than enough future economic growth and excess tax revenue tomorrow to "pay for" smart investments today. That would create jobs and strengthen UK's economic foundation -- and keep the bond vigilantes at bay. (James Pethokoukis, 2009)

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