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Causes of the 2008 Global Economic Crisis

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Essay Topic: Outline the major arguments put forward to explain the emergence of the 2008 crisis. Discuss in detail the two that seem most relevant together with the supporting evidence about their validity

The world economy witnessed its most dangerous crisis in 2008 since the Great depression in the 1930’s. The contagion, which began in the United States when the housing prices finally turned assertively downward and spread quickly to the entire financial sector in the U.S and then to other financial markets abroad through financial and trade linkage . The financial crisis prompted in the early 2006 when the subprime mortgage began to show an increasing rate of mortgage defaults which later increased higher than normal rate in the late 2007, and on September 15,2008, one of the biggest investment banks in the world, failed, Lehman Brothers (2008financialcrisis, 2015). This essay would look at the major factors that explains the emergence of the 2008 crisis and also critically discuss in details the two most relevant arguments with supporting information and data that proofs its validity.

Various arguments were proposed to explain the emergence of the crisis, which are; capitalist instability, financial deregulation and innovation, debt and crisis and rising inequality. The financial crisis shows inherent instability of capitalism; John Maynard Keynes believed that it was necessary to use monetary and fiscal policy to tame instability because he sensed that the market economy was unstable, this system became the pillar after the Great Depression and was a success this success later was carried to extreme and became overgrown and highly wasteful. Financial capitalist revolted against higher rates of inflation in the 1980s by forcing government to adopt restrictive policies, especially tight monetary policy (this is higher interest rates) and the result was less inflation and a return to higher unemployment, this shows that government policies have affected the combination of unemployment and inflation at specific times. Milton Friedman later came up with the neoclassical theory that states that the market economy should be kept free from government intervention and regulation to enable more efficiency and stability. This thinking has been carried too far by the Bush Administration of 2001to2008, which has sought to do away with regulations and allows securitization of debts and everything else imaginable, these workings of market was spread globally. It is however fair to say that what led to the financial crisis can be a grand experiment of global scale aimed at the creation of the laissez-faire ideal comprehended by the neoclassical school (Katsuhito, 2008).

The financial liberalization is also considered as one of the main causes of an increased frequency and intensity of financial crisis, these deregulations has a potential negative effect on the financial stability. Although the evidence towards these effects is inconclusive for several reasons, it increases bank risk-taking in both developing and developed countries through different channels in both groups of countries. In the developed countries, increased bank competition is the main channel of bank risk but in the developing country increases in bank risk associated with increased bank competition is not found. However, research also indicate a different effectiveness of capital regulation, official supervision, and financial transparency for limiting bank risk-taking across countries, this essay would later focus on the financial deregulation and innovation to explain the emergence of the crisis with theoretical background and hypotheses to discuss the potential effects of financial liberalization on bank risk-taking.

Household indebtedness has a cause and a long-run macroeconomic implications, this has grown in most considerably developed countries over the past 25years, sustaining consumption growth and contributing to the fall in the household saving rate. The rapid household indebtedness manifested in the USA, housing bubble started to burst in 2006 and fell about 25 percent from the peak so far after prices stopped to increase in 2006 and decreased in 2007. This decline was obvious that homeowners could no longer refinance when their mortgage rates were reset, this caused delinquencies and avoidances of mortgages to increase rapidly, especially among subprime borrowers. The percentage of mortgages in foreclosure tripled in the first quarter of 2006 to the third quarter of 2008 from 1 percent to 3 percent or at least thirty days delinquent more than doubled , from 4.5 percent to 10 percent. The delinquency and foreclosure rates are higher than that of the Great Depression which was 6.85 in 1984 and 2002, the American dream of owning your own home turned into an American nightmare for millions of families. By 2009, a total of about 6 million mortgages are either in foreclosure or has already been foreclosed which is about 12 percent of all the mortgages in the United States, this means losses for lenders and it was estimated to be $1trillion or more. In addition to losses on mortgages, due to the weakness of the economy, there were also losses on other types of loans which was ranged up to another $1trillion, so total losses for the financial sector as a could be as high as $2trillion.

It was also argued that rising inequality in the past three decades has led to political pressure for redistribution that eventually came in the form of subsidised housing finance and has been found in general to impede growth. Political pressure was applied so that low-income households who overall would not have qualified gotten enhanced access to mortgage finance. The subsequent lending boom made an enormous run-up in housing prices and empowered consumption to keep above stagnating incomes. The boom switched in 2007, prompting to the emergence of the 2008 crisis. Along the lines, this essay would further review evidence that suggest that unequal access to political impact produces unequal access to finance and eventually unequal opportunities, which can underpin any initial economic inequality.

Inequality has blended much contention amongst economists due to its role in the economy, a critical number of economist have exhibited the implications created by rising economic inequality and its role in the current global financial crisis while different other economist reject this thought and also minimalizing the importance of inequality as a contributor by stating other factors that contributes to the crisis. Most developed countries have experienced a great increase in inequality in the last few decades, especially in the US where there has been a wide aggregation of wealth and capital amongst the top-earning bracket of society whilst the average workers have encountered a relatively small increment in real wages in connection to inflation and rising productivity. This has in turn increased household debts for low income earners in the economy due to the need of maintaining a comfortable living. Krugman (2013) believed and argued that these two phenomena are possibly related “Inequality is linked to both the economic crisis and the weakness of the recovery the followed”.

Figure 1 shows the common trends in the share of total income amongst the high income earners in the US. The share of total income grew gradually from 1943 to 2008, although there has been a slight decline in shares over the period but the overall trend has been a significant increase. Going before the current financial crisis, the to 5 percent accomplished far more prominent increments than the next 5 percent, which income stagnated. Also, there is a sharp increment in the share of total income of the top 1 percent before the Great Depression and the current global financial crisis. In both cases, the share of total income reached roughly 24 percent within a year of the crisis that is 1928 and 2007 correspondingly. Following the financial crisis, both periods had a sharp decline in share. Wisman (2013) discovers that the rate of income increases for the first bottom 20 percentile was just 6.3 percent and 15.8 percent for the second bottom 20 percentile, Which is significantly lower than the top 1 percentile that witnessed a staggering increase of 228.3% and the to 20 percentile increased by 79.9%, wage stagnation is a clear evidence. Based on household debt, as a rate of GDP, there has also been a non-stop increase from third quarter of 2006 to third quarter of 2009 as seen in Figure 2. As the overall debt increases, whilst top 10 percent earners experience increasing earnings, this would inevitably result in an “ever-growing gap between the rich and the rest” (Krugman, 2013)

However economist differs in their assessment of the inequality contribution towards the crisis, it was also argued how inequality affects access to finance. Another empirical study focuses on firms; firms reliably need to bribe officials to dodge regulatory harassment in developing countries (Berger and Udell, 1998). Access to financing can help overcome most barriers, as money is fungible. Recent evidence demonstrates the significance of access to finance for less established producers, Perotti and Volpin (2007) proofed that in a large study of entry rates across countries; better investor protection is indeed allied with larger average entry rates, and in addition with more firm density in sectors which depend all the more on external finance. This then shows that poor financial access is a major source of entry barriers. Their outcome indicates that poor investor protection is more probable in nations with poor political institutions and in countries with more economic inequality. Interestingly, they find that it is no longer significant once they present effective investor protection while the size of domestic capital markets subsidises to explain entry. Consequently individual access to finance is more dangerous for new entry than the general state of financial markets. Also, Firm data demonstrate that, in specifically affecting their growth, access to finance is top three barriers for growth, so it therefore affects smaller firms more compared to the larger counterparts. Estimations of the effects of absence of financing constraints propose that small, medium and large firms have grown slower by 10.7, 8.7 and 6.0 percent correspondingly in the period 1996–1999 (Beck et al., 2005a). This low growth suggests that absence of access to financing raises indirectly inequality.

Financial deregulation and Innovation, the 2008 crisis has highlighted the limitations and hazards of financial innovation while dimming the light on its core benefits for an economy. The sole purpose is that complex financial instruments related with innovation were broadly used as vehicles in the credit expansion that prompted to the crisis (Sánchez, 2010). Mortgage securitizations during the housing bubble years did not diminish the information problem that neither are typical of credit transactions, nor edit it induce appropriate risk assessment. Moreover, innovation has had a critical and positive role in financial innovation, leading to the development of economic wellbeing. Hence provided that we reinforce sensible regulation to discourage excessive risk taking in the future, innovation can continue to benefit our societies (Sánchez, 2010).

The most important conditions are those needed to abate possible causes of excessive leverage and risk taking. Notably, monetary policy should pursue its objectives and avoid any expansionary undue credit or assert price booms. Similarly, fiscal policy should make sustainability of financial institutions a priority without resorting to subsidies loan that may lead to risk taking. Regulation should focus on making financial system resilient to crises; there aim should be to align incentives toward responsible risk taking and moral hazard risks. It should be borne in mind that regulation is not a guarantee for protection. Rather, regulation should make customers and risk managers more demanding, as it does not eradicate the risk inherent in financial products. Regulatory and supervisory efforts should never crowd out the responsibility and due diligence of market participation.

An analysis on monetary and fiscal policies in the US prior to the recent global crisis by Taylor (2009) focuses on Taylor Rule which examines the rate of growth and the level of interest rates. This rule explains that an increase in economic growth must be equalled by a subsequent increase in interest rates (Taylor, 1993). He stated that interest rate reduced in the 2001 recession, as it was expected to expected to rice back but then it became very low, which fuelled the housing boom and eventually resulted in a housing foreclosures. Interest rates stayed far too low as the US economy experienced economic growth (2009:166). The demand for houses would decline once the short-term interest rates increased back to its normal levels significantly, followed by a decrease in construction. Housing prices inflation declined. Delinquency and increases in foreclosures followed, which lead in “the meltdown in the subprime market and on all securities that were derivative from the subprimes” (Taylor, 2007:3). Essentially, government policies, rather than increases in inequality, were the source of the housing crisis and eventually the financial crisis. Cheap credit influx of capital from China into the United States was one reason, China’s capital surplus was the mirror image of the U.S. trade deficit, lots of dollars were sent to China in exchange for cheap good sold to the U.S consumers by the U.S corporations.

The shift in which institutions hold mortgages, is a key reason that mortgages were made available so widely and with such little review of recipients. Financial Deregulation and Unchecked Financial “Innovation”. Initially, banks created mortgages and held them. In the current global crisis, banks and non-bank mortgage lenders created loans, but these loans was then sold to others. Investment banks sealed lots of mortgage loans into “Collateralized Debt Obligation” (CDOs) and then was sold to Wall Street, with an insurance of a steady stream of revenue from interest payments. These system was pretty much unregulated, no one took account of how sub-standard the loans were or more fundamentally, the certainty that huge numbers would go bad if and when the housing bubble popped, despite the fictional erudition of the investors involved (Weissman, 2011).

In conclusion, the arguments presented in this essay explaining the emergence of the 2008 crisis which are capital instability, financial deregulation and innovation, debt and crisis and rising inequality, an also focused more on two arguments which are Financial Deregulation and Inequality in financial market. The financial crisis was avoidable, because this crisis was more or less due to human action and inaction, not by natural factors or computer models miscalculation. It obviously ignored warnings and failed to question the knowledge and manage developing risks within a system crucial to the well-being of the Citizens of the United States.


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Phillips, M. (2013). Americans Are Now Taking On More Debt Than At Any Time Since 2008. [online] The Atlantic. Available at: http://www.theatlantic.com/business/archive/2013/11/americans-are-now-taking-on-more-debt-than-at-any-time-since-2008/281537/ [Accessed 24 Mar. 2015].

Wisman, J. D. 2013. Wage stagnation, rising inequality and the financial crisis of 2008. Cambridge Journal of Economics, 37 (4), pp. 921--945.

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Sánchez, M. (2010). Financial Innovation and the Global Crisis. IJBM, 5(11).




Figure 1 – Shares of Total Income Accuring to Each Group in The US - (Kenworthy and Smeeding, 2013: 36)

Figure 2 – Total US Household debt balance - (Phillips, 2013)

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