A financial crisis is when the economy experiences a significant decline in economic activity. This will primarily focus on the late 2000s recession with references to previous recessions. It will also draw particular emphasis on economic bubbles and government policy and the need for structural adjustment.
Excess Capital
In the early 2000’s, an excess of capital globally had derived from Asian economies who had invested in Western treasuries to protect themselves following the late 1990’s recession. Demand was for low risk investments which would yield a good return. In the US economy, there were a scarce amount of investment opportunities and mortgage backed securities seemed like the safest ideal solution, as you had guaranteed return.
However, logically, if vast sums of money are in invested into a particular sector, resources will start to be misallocated. Once the good investments have gone, the money will be allocated to increasingly risky investments.
Toxic Combination
The securities proved to be a highly lucrative business for the banks and there was worldwide demand for these securities. Investors were encouraged to find more potential home buyers using sub-prime lending- mortgages for those with poor credit histories.
The excess liquidity meant the banks could afford to take these risks, and this led to a sense of overconfidence- the economy could not fail with surplus money available. Mortgage qualification guidelines were reduced to the extent that loans were given to customer’s who came under NINJA (No Income, No Job, No Assets.)
Interest rates were far too low, decreasing from 6.25% at the beginning on 2001 to 1.75% by the end of the year and 1% by 2003. (Fed Report, 2001, 2003) However, the Fed fund rate was negative, so the nominal rate was less than the actual rate of inflation, and the result is best summarised by Economist Steve Hank, (Greenspans's Bubbles, Steven Hank, Cato Institute, June 2008) "This set off the mother of all liquidity cycles and yet another massive demand bubble."
This bubble when into the housing market.
The toxic combination of low interest rates and excess liquidity led to easy credit conditions that allowed more and more people to take home loans, whatever their income. Perhaps, banks were purely motivated by the capitalist incentive of maximizing profits.(Tim Hinks, lectures 2009, Modern World Economy)
Banks were only able to make this blunder because there was extensive deregulation in the banking sector and because the money was available. Maybe excessive trust meant that banks trusted consumers that they would not default, whilst consumers trusted that banks would not lose their money.
Rating agencies further deteriorated the situation, as mortgage backed securities were given AAA ratings.
There was a miscalculation of risk because the crisis contradicted the academic orthodoxy, that is it was commonly believed that economic cycles are dominated by the producers and consumers as opposed to the banks and financial institutions. Secondly, there was inadequate information as the last housing crash was in the 1930’s, so rating agencies had no historical data to verify that the housing market could crash.
Bubble that Burst
The bubble had to burst eventually, as too much money was chasing two few assets. One condition banks failed to mention to customers was that these sub prime mortgages would face increased interest rates after two years. This, coupled with the overbuilding of houses caused a decline in housing prices, led to a plethora of home owners defaulting on their loans.
During 2007, nearly 1.3 million US housing properties were subject to foreclosures whilst 10.8% had zero equity in March 2008, leaving banks with huge losses.
Long Term
The financial crisis exposed fundamental issues in Western economies which need to be resolved. Why did the excess capital not go towards investing in new businesses, or in the stock market? Take the UK economy for example, once one of the largest manufacturing industries in the world, now imports the majority of its manufacturing goods from Tiger economies resulting in a trade deficit of -24.5 billion (CIA World Data 2008).
The increased economic integration of the world has meant many British businesses have outsourced their manufacturing jobs to emerging economies with lower wages. Supply of labour in the world has increased due to the recent improvements in education and communication of workers in emerging economies. As a result, many British workers were often left unemployed and an increase in unemployment led to a decrease in the productive capacity of the economy.
By focusing much of its economy in the services sector, there was a decrease in actual output, e.g. Decrease in manufacturing output, commodity extraction. Whilst services create output, they are also redistributions of wealth. After all economic growth can be defined as the increase in the production of goods and services over a given time period, but there seems to be a decrease in the production of goods.
The lack of investment opportunities decreased, and the fact that so much money went to the housing market implies that investors had little faith in the ability of British business to provide a decent return.
The excess capital went into fueling consumer borrowing instead. As there were no increases in consumer income, and no increase in the production of goods, there was nothing to back up the increased money supply. The Austrian School view can be applied here, as Western economies experienced an artificial boom, as consumer’s borrowed money fueled consumption, and the boom simply encouraged more lending, influencing more consumers to borrow more.
However there were not physically enough investments to sustain the economy- not enough wealth generating output, causing the bubble to burst.
Tamara Amarasinghe - -Previously written Economics articles for my school newspaper -Key areas of interest lie in Finance and Economics -Currently ...
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