Topic: Critically analyse how the Global Financial Crisis erupted and assess the damages caused (not only to the individual economy but the contagion effect in the contemporary global economy) and examine the role the International Monetary Fund played during this financial crisis.
Introduction:
The financial crisis of 2007-2008 is also known as the Global Financial Crisis, and it is considered the worst financial crisis after the great depression of the 1930s. It is known that, in the present economic scenario, there has been increased competition among various industries, and such competition has been more intense after globalisation.
It is known that after globalisation, there has been more integration socially, economically and financially among various economies and nations. That means there is more interconnectedness among the nations, and thus, unfavourable conditions in one economy can spread to other economies as well.
After globalisation, the incidence of foreign direct investment (FDI) has increased, as has the expansion of various multinational corporations.
This crisis in one country can lead to an economic slump in other countries as well. The global financial crisis of 2008-09 is one of the worst crises in recent years and it affected each and every economy throughout the globe.
It also threatened the collapse of large financial institutions, but that was prevented by various measures taken by the government through national banks (Davies, 2010).
The main aim of this essay is to analyse how the global financial crisis erupted, and the damages of the crisis are also assessed here. The role played by the International Monetary Fund during the financial crisis is also mentioned in the economy.
Impact of Global Financial Crisis:
The global financial crisis of 2008-09 was the worst crisis since the global recession of the 1930s. It threatened a total collapse of global financial institutions, and the government prevented the breakdown with the help of national banks, but the stock markets dropped significantly worldwide.
The housing market suffered as a result of the crisis, and the recession also caused the sovereign-debt crisis and the liquidity crisis. The bursting of the housing bubble in the United States is considered the main reason for the start of the global financial crisis, which expanded throughout the globe.
Due to the global financial crisis, the aggregate demand of various economies fell. That also affected the growth rate of the economy and other economic indicators like unemployment rate, inflation rate, exchange rate, etc. The impact was evident in developed and developing nations.
The bursting of the housing bubble in the United States caused the value of securities tied to the U.S. and house prices to plummet.
This affected and damaged financial institutions worldwide (Feenstra and Taylor, 2012). Housing prices continuously escalated, and this trend expanded to other economies. Banks and financial institutions could not back up their financial commitments, creating major issues in the market.
It led to damaged investor confidence, decline in the credit availability, and the bank solvency in the global stock market (Alam, 2012). During 2008-09, there were large losses in the securities.
During the period various economies slowed down all over the world as there was a decrease in the world trade and the credit also tightened.
The central banks and the government responded with institutional bailouts, monetary policy expansion, and fiscal stimulus (The Consequences of the Global Financial Crisis: The Rhetoric of Reform and Regulation, 2013).
The causes of the global financial crisis and its impact on the contemporary global economy can be discussed now in detail.
Causes of Global Financial Crisis:
Various experts and policymakers have suggested that the main cause of the global financial crisis is complex and high-risk financial products, failure of regulators and credit rating agencies, conflicts of interests, etc. (Brusov, 2012). According to the Levin-Coburn report of the US Senate, there are various causes of the global financial crisis.
Many major financial institutions failed in corporate governance and risk management, and the combined impact of excessive borrowing, risk investment, and lack of transparency has led to this situation.
A systematic breakdown was seen in the accountability and ethical values of business units. Deregulation was seen in the Credit market. The risks could not be assessed by the agencies and the investors and there was inconsistent behavior of the government as well.
The inception of the financial crisis actually started in 2006, but the crisis took an extensive form, and it was widespread in 2008. Now, some of the reasons for the crisis can be discussed here(CARMASSI, GROS and MICOSSI, 2009).
US Housing Market:
The global financial crisis mainly originated in the housing market. It was believed from the macroeconomic perspective that after the housing market in the US collapsed, it led to the global financial crisis. As the house prices started to decline, the construction activity also declined in 2006.
The households responded to the fall in house prices, and thus, the real economy slowed down. There was a tightening in the lending standards in the market by the credit institutions throughout the year 2006(CARMASSI, GROS and MICOSSI, 2009).
It was believed that the housing market was one of the safest and profitable industries. But from the late 1990s, the cost of houses increased fourfold, and the prices only increased at an annual compound growth rate of 8%. There was a slump in the equity market as well.
The problem in the credit market was faced due to an increase in the demand more than the supply. The GDP of the country was affected by the increased debt level.
Source: (UNCTAD, 2010)
Source: (UNCTAD, 2010)
Some other causes of the global financial crisis can be discussed here. It is evident that the initiation of the crisis occurred from the housing market of the United States and it spread in other nations as well.
The countries with a weaker economic position faced the worst conditions as they were hit by the crisis the most (Gupta, 2012). Some of the causes of the crisis can be macroeconomic policies, inadequate regulation, financial system failure, and some economic policies (Kayrak, 2008). These can be described here.
Macroeconomic Causes:
Various macroeconomic factors can be considered as one of the causes of the financial crisis. These are,
- Low Interest Rate and Low Inflation: It is evident that throughout the decade a low inflation rate was evident and due to the progress in the information technology that led to a shift in the balance of trade. The monetary policy framework of various countries changed and the policy makers tend to lower the expected inflation rate and consequently there was a fall in the historic standards of the interest rate.
Source: (INTOSAI, 2010)
There were severe implications of the lower interest rate (Kirshner, 2014). The house prices rose as the individuals could easily borrow in the market to purchase houses in various countries.
Within a decade the house prices rose significantly and thus the indebtedness in various countries also increased.
- Higher Risk-Taking: the risk-taking behaviour increased in the market as the dependence on the wholesale funding market increased, as well as in the hedge fund market. The liquidity dried up in uncertain situations, and it led to financial stress when the investors could not get the required support from the banks (Kirshner, 2014).
Source: (INTOSAI, 2010)
- Growing Imbalances: it I evident that many countries operate on huge current account deficits. In 2000s, the situation worsened when there was an increase in investment demand for the developed countries and that led to high prices and reduced bond yield of the government (Matheson, 2013). Across all developed economies, there was a low return on fixed income of financial assets.
Source: (INTOSAI, 2010)
Financial Market Causes:
It is known that the crisis occurred due to ample liquidity, low interest rate, and the growing macroeconomic imbalances.
But the role of financial sector needs to be emphasized here for causing the global financial crisis. The weakness of the financial system is one of the major causes of the crisis and thus the financial market cause can be discussed here.
- Increased Complexity Through Financial Innovation: it is known that financial institutions and markets have grown significantly, especially after globalization, and that led to the formation of big and very complex cross-border financial institutions. There has been increased integration and through capital flows, and the network of interrelationships has become more complex (Ozkan and Unsal, 2012). However, such a structure could not diversify the risk, and each and every economy was affected by the crisis.
- Underestimated Risks System-wide: in recent years it is evident that the financial system was more vulnerable to market shocks and thus the financial institutions depended more on the wholesale funding market and continuous liquidity market. The risks were underestimated in the market which led to grave consequences in terms of the financial crisis (Summary of General Discussion on “The Global Financial Crisis: Causes and Consequences”, 2010).
- Inadequate Risk Management: the risks could not be managed properly by the financial institutions and that led to failure of the financial institutions in addressing and preventing the issue (Ozkan and Unsal, 2012). The risk models that were developed by financial institutions and banks were a poor representation of the actual market structure. The stress testing was also inadequate in the market.
- Failure of Credit Rating Agencies: the credit rating agencies also failed to assess or evaluate the actual risks of various policies and market condition and that alleviated the crisis situation in the market (Pinnuck, 2012).
Policy Implementation and Regulatory Failures:
It can be said that the central banks and the government are also responsible for local financial system stability. The failure in the financial market supervision and regulation can be asserted as one of the causes of the global financial crisis.
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- Credit Control Lowered by Government Policies: in various economies the government intended to increase the mortgage lending for increasing the home ownership and that was the main cause of the crisis Pugel, 2012). The government provided assistance to minority and low-income families for obtaining mortgage and the borrowers were provided opportunities in terms of affordable loans. Thus there was extensive demand in the market and that increased the price of houses significantly leading to the crisis (Weiss, 2014).
- Lack of International Coordination and Harmonization: there was lack of international coordination and harmonization within the world economies. Thus the crisis was extensive and it also affected many economies especially the developing nations as they could not react in a timely manner. Thus the IMF implemented policies to maintain the integrity in the financial system so that similar problem is not faced later.
- Winding up Procedures of Banks and the Failure: it is evident that when one bank fails it creates a domino effect in other banks as well due to the potential externality in terms of the insolvency. Thus due to the externality the global crisis expanded due to the failure of the banks (Sui, 2014).
- The Financial System Guarantee by the Government: The state provided implicit and explicit guarantee to non-financial institutions. The failure in the recurrent bailouts of these institutions by the banks helped in the financial crisis.