Why the Financial Crisis Took Place, Need for New Regulations, the Role of the Federal Reserve, and International Considerations of the Crisis
The financial crisis and its causes
The financial crisis is believed to have started in December 2007 in the US and its effects may still be felt even at this point not only in the US but even in many parts of the world. Theoretically, there could be possibly numerous causes of a crisis. One could be as a result of depression or recession, which the economy must have to undergo in the course of time. This is on premise that the economy could not always be up it has to be down at some point. Another possible cause is a bubble that is created due to artificial increase in prices of some important goods like housing in the market and then followed by sudden defaults in payments because the economy could not sustain the same due to misplaced behavior of some players in the economy wittingly or not unwittingly. Investors could be motivated by greed as necessary part of capitalism but such could lead to bubbles simple because there are more speculative acts than actual outputs in the economy as against the law of supply and demand. Still another cause could be a very-high-inflation economy that could wipe out the purchasing power of consumers.
Since the purpose of this paper is to outline and summarize, possible causes of financial crisis could be categorized also into structural and cyclical factors.
Under the structural factors, there is basis to attribute the same crisis to the possible confusion between free markets and deregulation of market. In other words, there could be over reliance on the self-regulating qualities or claims of markets as the domineering pattern of the past three decades of US economy may point out (Alliance of Liberals and Democrats for Europe, 2008). Each school has its own justification, some way or the other and to declare which is correct can be assessed on the basis of results. At one point, discounting the possibility of wrong diagnosis of the problem or wrong application of the paradigm of whether market should be allowed freely or whether more government intervention should be done, would be an oversimplification. A keen observer may find that the policy of allowing more the market force to work may have been the cause of the dramatic rise in the role of the capital markets, which may refer to non-bank or non-traditional financial institutions in the financial intermediation process (Alliance of Liberals and Democrats for Europe, 2008). This could be traced to the rise of companies to source their financing from the stock market and other forces and the increasing use of new global financial instruments as more companies wanted to spread out risk. With the resulting more speculation coming from the presence of many forms of derivatives in the market, the resulting crisis may indeed find strong connection. Thus some quarters pointed the presence of more derivatives than actual output in the real economy in terms of goods resulted to producing bubbles that would eventually break out to produce the financial crisis (Alliance of Liberals and Democrats for Europe, 2008).
The structural factors encompass also the conflict of interest among market participants in terms of the absence of the expected checks and balance that should have been part of an effective regulation. Thus, the banks were believed to be performing more investment functions over their commercial banking functions which could triggered more speculations with actually producing real values in the economy (Lal,2010).
The cyclical factors which may refer to economic realities because of the need to economy to respond to changing condition may include the excessive use of extremely low-risk free interest rates up to their maturities were observed in major economies of not only in US but also in Japan and Europe (Alliance of Liberals and Democrats for Europe, 2008). In the case of the US, there is basis for the reports of excessive lending related to housing mortgages even to those who are not qualified to pay. Thus, the crisis could be particularly related to subprime mortgage crisis because of increase in delinquencies produced from the unreasonably low credit risk. This situation had been taken advantage basedon many instruments used for speculation over the last years Alliance of Liberals and Democrats for Europe, 2008).
The Need for New Regulations
The need for new regulations presupposes the government has an indispensable role of addressing the relevant causes of the crisis. This would therefore include actions that should be taken by the US Federal Reserve (or Fed) and Federal governments to address the crisis. Regulation mean intervening in the market forces simply because the latter alone is not enough to allow effective attainment of economic, political and social goals. Economic goals are not just the consideration why the new regulations are needed. The US is also a political economy where it has to keep its people employed by maintaining stability in the economy. As early as after the case of Enron and World a few years before this 20072008 financial crisis in the US, the federal government has enacted the Sarbanes Oxley Act of 2002 to strengthen corporate governance was a way of prevent economic dislocations that could amount to a financial crisis by the collapse of some companies and the eventual loss of confidence of investors in the economy.
In respond to the recent crisis, the US government even went beyond regulations. IT extended bail-outs to some companies to prevent what could have been a greater damage to the economy. Such therefore include massive government spending which further aggravated traditional budget deficit spending for a number of years. Keynesian economists would have the government must come to the rescue as the market forces alone could be allowed to solve the crisis (Sameulson and Nordhaus, 1992). The strategy was used in solving the 1929 Great Depression when life was very difficult and when market forces alone could not save the economy (Slavin, 1996). Increase regulation would essentially increase cost of doing business while the government would need to protect the investing public but such actions net effect is still additional government spending which would preserve the US economy to be net spender. Thus, it is even predicted that a future time will come when the owners of many business in the US will no longer be Americans but foreigners (Slavin, 1996).
The Role of the Federal Reserve
The remedies taken by US Federal Reserved and the Federal government to address financial crises vary. If crisis is one with high inflation, the Fed can tighten money supply by selling securities on increasing the reserve requirements of banks. If there opposite happens as when there depression and low economic activity due to low demand for goods and services, it could just do the opposite by lowering the lending interest rates of central banks or lowering reserve requirements of banks as what happened in the latest global financial crisis. The Federal governments also reacts to high inflation by reducing budget deficit and does the other way spending higher when there is depression or low economic activity (Slavin, 1996).
By focusing on 20072008 financial crisis, it can be argued that the Fed and other central banks on many parts of the world and their governments just generally did what was discussed earlier. In the case of the US Federal Reserve which functions as central bank of the United States, it has implemented very low interest rates to increase economic activity in order to restore the confidence in the business community which were much affected because of the losses they suffered as a result of fall of big financial institutions and companies like Lehman Brothers and AIG (BBC News, 2008). The crisis also affected the automotive industry where two of biggest auto companies, the General Motors and Chrysler Motors have undergone bankruptcy. The Obama government implemented bailout plans to help these some of the companies at some point like in the case but allowed some to go into bankruptcy since the government thought that market forces must still be allowed to work at some point after the governments and central banks have done their share to the problem. To sustain or keep more employed people the US has continued to spend bigger amounts despite higher budget deficits as a way of to increase employment due to many people not having jobs due to the crisis (BBC News, 2009).
International Consideration
What happened in the US has actually a big effect to the world since the US is still the biggest economy around the world. As such it buys a big part of the world economic output. As a market of some of worlds big producers, any slowdown in the US economy will cause a slowdown in the economy of these countries. Hence, the US financial crisis has become a global crisis since many of the other economies in the world suffered a financial crisis in some form or the other (Chan, 2010). Affected countries include those of Europe like the United Kingdom, France, Germany those of Asia like China, Japan and many other parts of the world. Although, problems could be preventable by theory, if all people will only act justly and in accordance with expectations, but the real world may speak otherwise because of greed as borne by massive speculations. In another aspect, not everything is full-proof or anticipated since conditions change as what continuously happen in technology and the environment. The future continue to unfold with surprises and many challenges for business.
Conclusion
To conclude, this paper has outlined and summarized explanations of why the financial crisis took place. That the causes of the financial crisis could vary which and could be combination of a number of factors where the remedy needed could also vary. Surely regulations are needed given the government even went beyond by having to rescue the economy from bad to worse by providing bail-outs where necessary. The new regulations have come even before the 20072008 financial crisis including the Sarbanes Oxley Act of 2002. Unfortunately, this was not enough as the crisis has occurred and its effects have extended beyond US causing a global financial crisis. The events had caused the US government and other governments of the world including their respective central banks also to act together in responding to the crisis. The Fed had been consistently keeping low interest rate as a way to revive the economy in additional to massive government spending that included the bail-out that had resulted to creating positive economic growth starting in the latter quarter of 2009. However, the targeted effects of such government efforts appear to be felt still given the still high unemployment which has affected the lives of many US citizens and other residents. The international economy could not separated from what may happen to the US economy, the being the still the biggest in the world given that central banks of these non-US countries and their government need to work together with the US to help the world economy to go back to normal path of growth. Many have recovered but there are still few which are reeling from the effects of this crisis.