Causes and Effects of the Global Financial Crisis of 2007-09

Describe about the Causes and Effects of the Global Financial Crisis of 2007-09.

The global financial crisis of 2007-2009 is considered by many to be the worst economic recession since the time of the great depression of the 1930’s. The global financial crisis of 2007-2009 was characterised by the economic collapse of the large financial institutions of the world and the toppling of the global stock markets amid a selling frenzy by the investors. The financial institutions were still provided an economic lifeline through financial stimulus which came from the respective governments and this played a vital role in helping to bail out the financial institutions from economic bankruptcy (Beber & Pagano, 2013). Many countries such as the US also suffered a collapse in their housing markets and this resulted in people being evicted from their homes due as they were unable to pay their mortgages. There was rampant and wide scale unemployment as companies were forced to reduce their total workforce as a part of their cost cutting measures due to the volatility and uncertainty in the markets (Quizpe & Rossini, 2010).

The global economic crisis played a key role in the failure and closure of business establishments all around the globe and the total economic loss from the global economic meltdown was estimated to be around a few trillion dollars. There were a lot of factors which played a role in triggering the financial crisis of 2007-2009 and these included a complex relationship of policies which was aimed at encouraging home ownership, such as providing easy access to home loans for the subprime borrowers, increasing the valuation of the collective subprime mortgages by assuming that housing prices would continue to increase in the market, dubious trading practices from both the buyers as well as the sellers, compensation policies which aimed at prioritizing the short-term value creation rather than the long-term value creation, banks and insurance companies not having the adequate capital holdings to honour the financial commitments which they had made (Attinasi et al 2009).

The global economic crisis was largely attributed to the collapse the American housing market. In the year 2006, the housing prices peaked in the US and then it all of a sudden it dropped more than 30%. This decline was the largest decline which was not witnessed since the 1930’s in the US.  This resulted in a significant increase in the amount of household debt as compared to the previous decades as the lending to low income borrowers rose quickly (Acharya & Schnabl, 2010). In the first quarter of 2007, the losses generated from the sub-prime mortgages exposed a lot of potential weaknesses in the housing markets. Banking major BNP Paribas was forced to freeze redemptions for three funds that had heavily invested in structured products. The market for these products ceased to exist and thus made it impossible for the fund managers to arrive at an appropriate valuation of the funds (Claessens et al 2014). There was an increase in the counterparty risks between banks and as a result there was a sharp increase in the rates at which banks lend money to each other. Having recorded an average fluctuation of around 20 basis points over treasury bills (TED-spread) in the Euro Zone and around 40 in the US, the TED-spread increased around 100 basis points in the Euro Zone and almost 200 in the US during the initial stage of the economic crisis (Hasan & Dridi, 2010).

Furthermore, the bankruptcy of the Lehman Brothers during September 2008 sent shockwaves around the global financial markets which forced the banking establishments to stop lending to each other. There was a surprise up­swing which was witnessed in the commodity prices from 2003 but it become more prominent during the years 2006 and 2007. This caused a lot of concerns regarding the inflation in the markets which led to a sharp reversal in the monetary policies of the US (Lo, 2012). The US tightened their monetary policies and as a result it had a detrimental impact on the economies of those nations which were pegged to the US dollar. It was due to this reversal in the monetary policies combined with the sharp fall in property prices in the US house price and the failures of the US government to incorporate an effective financial regulation which caused the global financial crisis during 2008­-2009 (Bekaert et al 2011). The failure of the Lehman Brothers’ was largely attributed to the huge losses which the organisation incurred on the US subprime mortgage market. Lehman Brothers' had invested heavily within the subprime and other lower­ rated mortgage markets. The mortgage delinquencies arose after the US housing price bubble burst in the year 2006-2007 and as a result Lehman reported a loss of $2.8 billion (Haas & Lelyveld, 2014). This threatened the business operations of Lehman and as a result the organisation was forced the company to sell off around $6 billion in assets in order to ensure adequate liquidity within their business. The risk premium on corporate bonds witnessed a sharp increase of more than 6%. Business establishments were forced to shelve many of their large CAPEX projects due to lack of funds. The corporate sector stopped borrowing as trade credit was hard to obtain (Goodman & Mance, 2011).

The reappraisal of business risk by corporate establishments in the aftermath of the economic crisis was also applicable to the normal households. The general population was really anxious about the economic condition in the markets and they started viewing the future as being more risky and uncertain (Bernanke, 2012). This led the general population to discount their future earnings and this brought a predominant change in their consumption and spending patterns. They started to cut down on their consumption and focused more on saving their hard earned money (Lastra, & Wood, 2010).

The global recession of 2007-2009 had a detrimental impact on the economy of both the developed as well the developing countries. In the US, there was large scale unemployment as the business establishments stopped recruiting individuals to address their manpower needs. May people lost their jobs as a result of this economic recession as companies went on a cost cutting measure and terminated a large percentage of their existing employees.  There was total chaos and anarchy in the financial and stock markets due to the economic uncertainty and this dented the investor confidence in the market which gave rise to wide spread selling of stocks (Atkinson et al 2013). There was a fall in the consumer demand for products and services in the market as people cut down on their economic spending and tried to save their hard money to encounter the tough times ahead. Many companies suffered economic setbacks and as a result of which they were forced to close down their business operations (Quizpe & Rossini, 2010). The US government had to provide economic stimulus to the financial establishments in order to keep them operational and ensure their survival under such economic uncertainty in the markets. Prices of essential commodities arose significantly due to the rising inflation levels combined with the decrease in the production levels (Herndon et al 2014).

On the other hand, the impacts of the global economic crisis of 2007-2009 were not so far reaching on the Australian economy. Australia survived the global recession and came out of it without any serious economic consequences. Australia has been quite successful in weathering the storm of economic uncertainty which took place as a result of the global recession as opposed to the US and European markets (Levchenko et al 2010). Experts have attributed the success of Australia in coming out unharmed from the global economic crisis to two main factors. Unlike the US and UK, Australia never had a high amount of government debt and high fiscal deficits and this made them immune to the  adverse shocks which were felt by the other countries around the globe. This low government debt and low fiscal deficit became pillars of strength for the Australian economy which enabled the country to weather the financial shocks in an effective manner. Had the other countries followed the same example that have been set by Australia they would also have been able to successfully come out of the economic recession without serious consequences (Acharya & Schnabl, 2010).

Australia encountered the financial recession in absolute financial health. The country had almost zero levels of government debt and the economy was growing strongly on the back of surplus budgets and healthy financial markets (Nier & Merrouche, 2010). It is on the back of these strong and robust economic foundations combined with a very favorable terms of trade that provided the much needed immunity to the Australian economy during the economic uncertainty and helped in ensuring  that Australia would survive and come out of the global economic crisis almost unscathed (Beber & Pagano, 2013).

Before the onset of the economic crisis, the reserve bank governor Glenn Stevens tried to draw attention to the excellent financial position that have been created on the back of a decade long economic reforms which has been carried out by Australian treasurer Peter Costello. The economic reforms played a vital role in making Australia self reliant to tackle any kind of economic uncertainty without requiring any help from the other nations (Obstfeld & Rogoff, 2009). The pre-existing strength of the Australian government’s finances proved to be a major factor which helped in fortifying the Australian economy against the future economic storm which was to be encountered by the global economy. This helped in reassuring the investors, businessmen, consumers and financial markets regarding the financial stability of the Australian economy. On the back of the stable economic foundation, almost every political party in Australia were in a sound and healthy economic position and this enabled them to provide economic stimulus packages to those business establishments who were impacted by the global recession of 2007-2009 (Herndon et al 2014). There will be a lot of debate among the financial experts regarding the advantages of the respective stimulus packages which have been provided to the business establishments to help them to weather the economic storm. However, there is no question of denying the fact that Australia with its strong terms of trade has been able to outperform other countries once the economic recession began showing its true effects and they deserve to receive all the accolades from the International Monetary Fund for their achievement (Haas & Lelyveld, 2014).

In October 2008, the then prime minister of Australia Mr. Kevin Rudd delivered their first budget after the onset of the global economic crisis and the main objective of this budget was to keep the inflation in check. The Australian government had announced that they would provide guaranteed bank deposits and in doing so they came up with an economic stimulus package worth $10.4 billion (Claessens et al 2014). This stimulus package was to cover the payments made to seniors, carers and families in order to help them to cope up with the tough economic conditions in the market. The economic stimulus was delivered just before Christmas which enabled the normal population to take care of their personal finances before the festive season. This helped in ensuring strong market demand and consumption of goods which was evident from the increased sales margins of the Australian retailers. The automobile industry was also provided an economic package by the Australian government which enabled the automobile companies to sustain their business on the back of the withdrawal of the major lenders from the market (Beber & Pagano, 2013).

During February 2009, the Kevin Rudd led government introduced a second economic stimulus which was even larger than the previous one. A total of $47 billion had been allocated in order to boost the Australian economy (Claessens et al 2014). This stimulus included $14.7 billion for schools, $6.6 billion for 20,000 new homes, 890 million for road repairs and infrastructure, $3.9 billion to insulate 2.7 million homes, $2.7 billion in small business tax breaks, $950 for every Australian taxpayer who earned less than $80,000. This economic package was to be paid out between March and April 2009 (Haas & Lelyveld, 2014).

The other countries need to learn from Australia regarding how to keep their economy in check and ensure that there is not a huge fiscal deficit and government debt which could compromise the economic stability of the nation.

Hence depending on the illustrations of the cause and effects of global financial crisis it could be said that the massive crisis did not occur for a shorter time global economic issues but the ignorance of policy makers and financial institutions towards sustainably increasing economic issues is the major responsible cause for the Global Economic Crisis 2007-09 (Bekaert et al 2011). Depending on the above illustrated cause and effects of the Global Economic Crisis 2007-09 the most effective recommendations which could be suggested to policy makers and financial institutions in different nations across the world for stronger recovery from the impacts of this financial crisis are provided below,

Monetary policies should be developed by the policy makers with better ease through lowering federal fund targets for business industry growth and faster developments. The Federal Reserve could also be a significant financial resource for countries to gain effective support for normalizing the liquidity in markets both in domestic and international aspects (Herndon et al 2014). Collateralized lending programs could be performed depending on Federal Reserve so that effective liquidity support could be provided to potential industrial fields for faster development of the economic balance and market economy as well. FDIC should also be provided by financial institutions with expanded guarantees so that proper financial assistance could be provided to the impacted industrial fields (Atkinson et al 2013). The governments of every different nation could enhance the economic balance and cash flow within their domestic markets and industries through injecting capitals. There is no doubt of getting the best financial support from the concerned governments of every different nation across the world for faster recovery from the impacts of Global Financial Crisis 2007-09 on their domestic economic balance (Lastra, & Wood, 2010). It is the duty of the policy makers in every different nation of the world to be accurate about conducting stress tests for the largest and widely trusts banks operating within their nations so that similar type of crisis could not occur again due to unnecessary financial risks taken by the baking organisations going beyond their capacities (Haas & Lelyveld, 2014). For supporting the mortgage market home foreclosures and agency mortgage asset purchases by Federal Reserve should also be avoided as well. Hence it could be expected from the provided recommendations that nothing is permanent and wiser approaches would be effectively helpful for the world to entirely uproot the adverse impacts of Global Financial Crisis 2007-09 (Bekaert et al 2011).

References

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Beber, A., & Pagano, M. (2013). Short?selling bans around the world: Evidence from the 2007–09 crisis. The Journal of Finance, 68(1), 343-381.

 

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