Essay Sample on Causes of the Financial Crisis

Introduction

According to Blankenburg & Palma (2009), the global financial and economic crisis in the United States occurred due to different reasons and had devastating effects on the financial and economic dimensions of the United States. The subprime mortgage bubble is one of the critical causes of the crisis during that period. It involved a high default rate in the subprime mortgage sector. The value of the loaned houses was increasing despite the inability of the homeowners to repay their debts within the stipulated periods. That left most homeowners with negative equities. That meant that the assets that the banks had repossessed were of lower value compared to the initial houses guaranteed. Defaulting largely contributed to the paralysis of a section of the economic sector hence affecting operations in such sectors. However, the causes of the bubbles were not well-known. The low-interest rates are some of the factors that may have contributed to such bubbles. Additionally, securitization is also considered as a factor that may have contributed to the emergence of the bubbles owing to the nature of mortgage bundles that existed. Most mortgages were merged into mortgage-backed securities. The mortgage bundles were then offered into the market as low-risk securities since they were backed by the credit default swaps (Edey, 2009).

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Moreover, the credit crunch also contributed to the global financial and economic crisis in the United States. Most investors had lost their confidence in sub-prime mortgages, which then led to a liquidity crisis in the United States. Consequently, the Federal Reserve of the United States injected a considerable amount of capital into the financial markets. Investors' confidence further deteriorated by 2008 when the stock markets across the globe started crashing and becoming volatile. Allen & Carlett (2010) posits that irresponsible lending practices may have led to the crisis. Banks and other lending institutions had no stiff regulations and measures that could ensure that the loaned assets were fully recovered.

Effects on the Global Economy

The 2007 financial and economic crisis had a devastating impact on the global economy. Developing countries experienced economic slowdowns, which primarily affected their economic growth rates. For example, Cambodia depicted a fall in economic growth forecast from 10% to close to zero by the end of the 2009 financial year. Kenya, on one hand only showed a marginal increase in growth rate from 7 % to 3-4%. These reductions in economic growth rates of different countries occurred due to a fall in trade activities, a fall in commodity prices, a fall in investments and remittances from migrant workers. Such has since led to an increase in poverty levels; hence many people living below the poverty line (Reddy, Nangia & Agrawal, 2014).

Additionally, the financial and economic crisis negatively affected the gross domestic product of the United States. The crisis led to a lower output of goods and services in the labor and property markets. Unemployment rates increased to close to 10%, which was the highest unemployment rate ever experienced since 1983. Additionally, the average hours per work decreased to 33 hours per worker (Reddy, Nangia & Agrawal, 2014). Such factors affected the gross domestic product recorded by the country. The fall in the gross domestic product also led to a decline in innovation since most people could not risk the available fewer resources for creative destruction in the markets.

Measures

The US Federal Reserve and the central banks of different countries took several measures that could address the challenges posed by the crisis. First, they increased the money supplies, which could help in reducing risks of a deflationary spiral. Additionally, governments in various countries enacted fiscal stimulus packages. The packages were vital in offsetting the reductions in demand in the private sector. Such packages were implemented through borrowing and spending. Furthermore, the European Central Bank, The Bank of England, The Federal Reserve and other central banks took initiatives to purchase the government's debts, and other troubled asserts recovered from the banks. They further guaranteed the debts issued by the banks and raised the capital in the respective national banking systems (Carmassi, Gros & Micossi, 2009).

Other governments, such as the United States also introduced regulatory proposals that could help mitigate some of the effects of the crisis. The proposals aimed at addressing consumer protection, expanded regulation of the shadow banking systems, executive pay, and authority of the Federal Reserve. Additionally, the government of the United States enhanced additional regulations that could limit the ability of banks to engage in proprietary trading. The European regulators, on the other hand, introduced the Basel III regulations for banks. That increased capital ratios and enhance limits on the advantage. Furthermore, the introduction of the Basel III narrowed the definition of the term capital. The definition excluded subordinated debt as part of the definition.

Other countries such as Iceland adopted the devaluation of currency as a solution to the financial crisis. Iceland devaluated its currency by 35% to help it maintain a balance between the demand for exports and ensuring economic growth. The devaluation of Krona, therefore, helped Iceland since it made the exports cheaper (Carmassi, Gros & Micossi, 2009. That led to an increase in demand for exports hence an avenue for increased economic growth. However, devaluation as a method of control of the crisis had some negative consequences. For example, it increased the prices for imports hence depicted a low standard of living for consumers that largely depend on imports.

Current Challenges

Despite the various measures that were put in place to address the financial and economic crisis, different countries are still grappling with issues due to the crisis. The world's economy remains weak. That leaves many countries underperforming in their efforts to recover from the pre-crisis development. The banking sectors in some nations are still struggling to recover from the global crisis. That has led to the closure of banks and other financial institutions hence leading to mass lay-off of workers. In addition, the global crisis resulted in disparity in the distribution of wealth. The effects of such circumstances are still in existence. In the current economies, they lower the demand for consumers. That means that the production levels of industrial goods are declining hence an increment in the lay-off of workers in different nations (Toarna, & Cojanu, 2015).

The effects of the crisis are currently spreading into other different sectors of the economy. For example, the global crisis enhanced the spread of the financial crisis into some sectors such as the motor industry. Their effects in such industries are still felt and may be felt for some longer period. Some countries have not recovered fully from the crisis. The paralysis of the financial institutions in some countries is causing a deep recession in some countries. Most banks are not able to support their operations owing to their debt ratio. That has caused the closure of some banks due to bankruptcy (''Shawn" Lee, & Goldblatt, 2012).

References

"Shawn" Lee, S., & Goldblatt, J. (2012). The current and future impacts of the 2007-2009 economic recession on the festival and event industry. International Journal of Event and Festival Management, 3(2), 137-148.

Allen, F., & Carletti, E. (2010). An overview of the crisis: Causes, consequences, and solutions. International Review of Finance, 10(1), 1-26.

Blankenburg, S., & Palma, J. G. (2009). Introduction: the global financial crisis. Cambridge Journal of Economics, 33(4), 531-538.

Carmassi, J., Gros, D., & Micossi, S. (2009). The global financial crisis: Causes and cures. JCMS: Journal of Common Market Studies, 47(5), 977-996.

Edey, M. (2009). The global financial crisis and its effects. Economic Papers: A journal of applied economics and policy, 28(3), 186-195.

Reddy, K. S., Nangia, V. K., & Agrawal, R. (2014). The 2007-2008 global financial crisis, and cross-border mergers and acquisitions: A 26-nation exploratory study. Global Journal of Emerging Market Economies, 6(3), 257-281.

Toarna, A., & Cojanu, V. (2015). The 2008 Crisis: Causes and Future Direction for the Academic Research. Procedia Economics and Finance, 27, 385-393.