January 10th, 2018
Causes of the 2008 Global Economic Crisis – antecedents
The origin of the 2008 economic crisis was attributed to the failure of the mortgage market but there were other contributory factors such as prolonged application of an expansionary monetary policy and trade imbalances of the US with respect to countries such as China. This section considers these factors.
Mortgage Bubble (Prices of Goods and Services)
An antecedent of the economic crisis that is cited severally is the inflated prices of houses in the US (Financial Crisis Inquiry Commission 2011, p. 4; European Communities 2009, p. 10). Once the demand of the houses was created via various factors (e.g. risky lending practices and government policies that favoured lending for home ownership as discussed below), the house prices in the market continued to increase to capitalize on the enhanced demand (Larson 2007; Financial Crisis Inquiry Commission 2011; Rötheli 2010; European Communities 2009). Motivated by the seemingly cheap costs of financing home purchases, borrowers acquired mortgages beyond their ability to pay (Financial Crisis Inquiry Commission 2011, p. 7).
Such inability to pay meant that borrowers refinanced their mortgage through other loans, which lenders crafted to make them attractive to such borrowers, but in effect doubling or tripling the cost of financing for the borrower (Financial Crisis Inquiry Commission 2011, p. 7). Eventually such loans wiped out the borrowers equity thus making them reliant on more loans to finance interest payments to postpone the repayment of the principal amount advanced (Financial Crisis Inquiry Commission 2011, p. 7). Eventually, with inability to service the loans, a large proportion of the borrowers defaulted on their payment, thus resulting into loss of incomes for entities that had financed such loans or inability of the underwriting institutions to cover the losses resulting from the defaults (Financial Crisis Inquiry Commission 2011). However, the attribution of the antecedent of 2008 to the bursting of the housing bubble in the US, fails to consider the factors that had contributed into a highly leveraged status. Such factors form the basis of discussions in the subsequent paragraphs.
Over-application of an Expansionary Monetary Policy
Spurring the risky lending practices by the financial institutions was a government policy that had sustained interest rates at very low levels over a long period. With an intention of protecting the economy against the potential effect of the collapse of the Internet bubble, and the adverse effects that would have affected the US economy following the September 11 terror attacks, the Federal Reserve had lowered the Federal funds rate by as much as 5 percentage points (Larson 2007, p. 18; Rotheli 2010). Although initially such a policy had helped the economy remain strong even with the terror attacks, its continued application after the economy had recovered from these events had a largely negative effect on the economy.
Firstly, the low interest rates brought inflation levels to an all time low thus eliminating the value of otherwise prudent saving instruments such as government stocks and deposit certificates (Larson 2007). Secondly, possibly through the interest rate transmission mechanism (Mishkin 1995), the low federal rate encouraged lending institutions to pass on these benefits to individuals or organizations that were borrowing for long-term projects (Larson 2007). Such long-term projects in the case of individual borrowers were the mortgage intended to purchases private homes, which in turn resulted into increased demand and subsequently to higher prices (Financial Crisis Inquiry Commission 2011). Thirdly, the prolonged application of the low federal fund interest rates altered the usual balance between risk taking behaviour and saving, with lenders speculation of enhanced gains on loans advanced favouring risk taking to saving (Larson 2007). Due to low cost of credit both lenders were motivated to engage in risk lending without usual appraisals of the ability of the borrower to repay such amounts, while the borrowers perceived such reduced costs of finance as a way through which they could acquire homes in estates that were initially beyond their reach (Financial Crisis Inquiry Commission 2011). Eventually, with declining prices, lenders began readjusting their rates to avoid losses thus many borrowers were unable to pay such rates resulting into refinancing and eventual default (Kirkpatrick, 2009). The overall effect of this cascade was the collapse of the lending institutions that could not recover their amounts or the insurance companies that were overwhelmed to compensate such lenders for defaults suffered (Kirkpatrick, 2009).
Imbalances in international trade especially with respect to China, Japan and the oil producing countries also contributed to the onset of the 2008 financial crisis (European Communities 2009, p. 12). Due to net surpluses in these countries as compared to the US, the latter’s bond yields remained low thus shifting capital flows towards its enhanced and highly liquid capital market (Kenc & Dibooglu 2010; European Communities 2009). Such imbalances in trade also had a second effect of postponing inflation. For instance, despite the resultant increases in prices of commodities following increased demand, favourable supply conditions brought about by the focus of export commodities in such emerging markets as China, largely averted the rapid development of inflation (Kenc & Dibooglu 2010; European Communities 2009). Such aspects allowed the expansionary monetary policy to remain in place even though the economy was in a boom trajectory (European Communities 2009).
Other aspects that are attributed to have provided an impetus to the 2008 global crisis included the inability of the regulatory institutions to identify imprudent practices and establish relevant preventative measures at the earlier stages of the crises (Drawbaugh 2010; Weiss & Larson 2008; Larson 2007). Such was for instance attributed to the massive profits that financial institutions reported in their financial reports (Drawbaugh 2010). In summary, the antecedents of the 2008 economic crises may be identified to both macroeconomic and microeconomic factors. On the macroeconomic end, factors contributing to the economic crisis included low interest rate that resulted into curtailed consideration of the risk behind lending to borrowers without appropriate appraisal of their ability to repay and persistent trade imbalances resulting into low bond yields thus shifting of capital to the attractive and highly liquid capital markets. On the microeconomic end, the ability to repackage and resell loans, which was also contributed by technological aspects that ensured development of such complex and attractive financial products (European Communities 2009), facilitated the progression of the economic crisis into severe depths. Go to part 3 here.