Global Economic Crisis
Since 2008, the world has been facing the worst economic crisis since the Great Depression of 1930s. Although the magnitude of the current economic crisis has not reached the extent the Great Depression, they share a number of similarities in causes and effects. The current world economic crisis has led to liquidity shortfall in different countries and massive job losses. It has seen large financial institutions close down while the other sectors of the economy are struggling to stay afloat.
The crisis has also led to erosion of consumer wealth worth trillions of dollars. Like the Great Depression, the current economic crisis started in one sector and later affected the whole economy. A striking similarity between the two crises reveals that they all started with a bubble and later liquidity shortfall. The initial phase witnessed a bubble in financial and housing sector and financial problems in those sector later spread to other areas. It is worth to note that the current crisis has not been contributed by a single factor but rather multitudes of factors have conspired to aggravate the crisis. Market and regulation based factors can be held accountable for the current crises although other personal factors also contributed to the crisis in different ways. In order to save the economy which was eminently collapsing, the government was forced to take fast measures to mitigate the situation.
In United States, the government responded by committing 700 billion package and regulations to stabilize the market. However, this actions has been criticized in light of the fact that American tax payers were paying for mistakes of few individuals who were led by greed to amass wealth. Despite the conflicting stand taken by different analysts, this financial commitment was necessary since the government could not just sit and wait as major economic sectors collapsed one after the other. The necessity and validity of government financial commitment and regulations should be judged by the impact it has had on mitigating the situation. Therefore, government actions through financial commitment and market regulations were necessary to mitigate the situation as it was better than sitting and watching as the economy collapsed.
Economic and Financial causes
There is no single cause that can be said to have triggered the 2008-2010 financial crises. There were different factors that played different roles which in one way or another led to the financial crises (Thomas, 2009). In addition, the financial crisis did not take place at once but it can be assessed to have taken place in different phases that started with housing bubble, the subprime mortgage crisis which was followed by foreclosures, and later the problem spread to other sectors of the U.S economy and the world as a whole. However, the most interesting fact about the financial crisis is how a housing bubble in Florida could have caused financial crisis in a country like Iceland. The financial crisis revealed to the whole world how interconnected the world economy had become (Gillian and William, 2009). In consideration of the financial and regulation causes of the financial crisis, it is evident that there were two critical factors that created the financial crisis. First, there was profligate lending which had allowed people to take loans for overpriced housing properties where in real sense they could not afford to repay their mortgages (Cox, 2008). Second, there were excessive land use regulations and weak regulations of the financial market which both led to reckless lending.
However, profligate lending could not in any way have caused financial crisis by itself. It was an interplay of proliferate lending and lax regulations in connection with other factors that lead to the current crisis (Cox, 2008). It was revealed that in some markets, restrictions in land use like urban growth boundaries and others lead to higher mortgage exposures. In contrast, areas where land regulations was not severe like Texas, Georgia, and others, the market had traditional regulations in place and as result, they experienced modest increases in houses prices.
Therefore, it is evident that the financial crisis started with losses that were experienced in the housing sector. The U.S housing bubble is the proximate cause of the crisis as it triggered cycles of economic effects that spread to other sectors. In macro-economic assessment, profligate lending occurred in different markets especially in the housing sector (Gillian and William, 2009). The availability of mortgage funding made it easy for even individuals who were not credit worth to receive supbrime mortgages and this pushed demand for housing up. It became easy to get credit even when one was not credit worth. This led to overstretched subprime and prime borrowers who could not be able to settle their mortgages culminating to increased rate of foreclosures (Chen, 2008). Delinquency in repayment of mortgages and rate of foreclosures went to an extent that lenders could not absorb and eventual the collapse of firms like Bear Stearns and Lehman Brothers could not be evaded.
In micro-economic view, the other cause of financial crisis was lax regulations. Since the repeal of Glass-Steagall Act 1933 that provided model for financial regulations, which was replaced by Gramm-Leach-Billey Act 1999, there has been little concern on financial regulations (Toby, 2010). Deregulation failed to keep the regulatory framework in light of financial innovations like shadow banking system, derivatives, and others like off-balance sheet financing (Gillian and William, 2009). In advance, the Securities and Exchange Commission in 2004 relaxed net capital rule thereby enabling investment banks to increase their debt level which supported subprime lending. Most important, shadow banking system which had become important in credit markets was not well regulated and colluded to advance mortgage to people who could not repay. In addition, land regulations were not uniform in all states. As was noted by Nobel Laureate Paul Krugman, the housing bubble was experienced more in areas which had strict land regulations (Cox, 2008). Increase in housing prices was experienced in states with tight land use restriction.
In addition to the above factors, greed, in face of lax regulations also contributed to the economic crisis. The financial sector exhibited greed for short term profit maximization and exploited weak regulation to achieve this (Gillian and William, 2009). The financial sector designed different financial models including shadow banking for short term profits. The boom and collapse of shadow banking system triggered failure of financial sector. In this line, it is also important to note that government inability to monitor and regulate products in financial industry in light of changed regulation policies was a major factor that led to the crisis.
The increased demand in credit in the local market meant that there was a deficit that was experienced in U.S domestic market. Between 1996 and 2004, U.S current account deficit grew from 1.5 to 5.8 of the GDP (Gillian and William, 2009). In order to finance the deficit, U.S borrowed from abroad mainly from emerging economies like China which had surplus. As a result, a flow of funds was experienced in U.S financial market while foreign government purchased USA Treasury bonds which shielded them from direct impact of the crisis. Financial institutions increased their investment on mortgage-backed securities (Gillian and William, 2009). As a result, the whole world was interconnected to the bubbling U.S housing sector and the declining prices in housing sector and collapse of financial institutions spread the crises to other countries that had invested in U.S financial sector.
From the above analysis, it is evident that the current financial crisis was contributed by a host of financial and regulations factors. The cause of the crisis can however be traced to the 1990s repeal of act regulating the financial sector as it gave room for mushrooming financial packages and models like subprime mortgages and shadow banking system respectively, which had a greater role in causing the crises.
Government intervention
Although no one understood the extent to which the financial crisis would go, it was evident that it would come with devastating effects and the government could not just wait and see what unfolds. The first important step in understanding how the crisis could be dealt with was diagnosing the causes of the crises. It was observed that between August 9 and 10, 2007, money market interest rose sharply and interest rates also spread. In three months period, the interbank loans had grown to higher unimaginable levels (Taylor, 2009). Based on the events before and after the crisis, economists diagnosed the cause of the crisis, especially in the face of collapsing financial institutions, to be liquidity problem (Thomas, 2009). Therefore, the government has to respond in any way that could increase liquidity in the market. One of the main factors that contributed to the crisis was that banks were not open to each other on the extent of their investment in the housing market and it became apparent that interbank lending was constrained. The quality and transparency in banks balance sheet was questionable. The government had to respond either by making it easier for financial institutions to access the Federal Reserve discount window or open new windows for them (Taylor, 2009). The government had to deal with problem of liquidity head on.
In December 2007, the government created Term Auction Facility (TAF). This was aimed at reducing interest rate spreads and turnaround the trend to increase flow of credit. However this did not seem to work right and the government was forced to enact the Economic Stimulus Act 2008. This act committed about 100 billion of federal funds in order to stimulate growth by increasing individual spending but again this did not seem to work because short term provision of funds does not equal to increase spending in economic terms. The 700 billion package was a huge financial commitment the government was making to shield the economy from further effects of the financial crisis (Taylor, 2009). This package was introduced as Troubled Asset Relief Program (TARP) and was meant to rescue institutions which were facing eminent collapse like General Motors.
The third government response was reducing the target federal-funds from 5.25 in 2007 to 2 in 2008 (Taylor, 2009). This was considered to be a sharp reduction than dictated by momentary guidelines like Taylor Rule. However, this was criticized as it led to depreciation of the dollar and increased the oil prices.
Fourth, the government responded through enacting stricter regulations on the financial sector. The government has introduced a number of regulations which pertains to consumer protection, executive pay, cushioning bank financially, regulating shadow banking system and derivatives, and authority for Federal Reserve on winding-down important financial institutions (Taylor, 2009). The government has also introduced further regulatory measures that prevent banks from trading in proprietary trading.
Regardless the criticism on government intervention, it was evident that the financial crisis was taking toll on the economy and we could not wait and see what unfolds. This is the main reason why the government undertook the above measures in a bid to alleviate further effects the crises. Whether the measures were correct of not correct may be irrelevant for now so long as the market has been stabilized.
Arguments for and against government regulations
Government regulation on the financial sector can be traced back to 1933 with the enactment of Glass-Steagall act in response to the Great Depression (Toby, 2010). Like the current economic crises, the Great Depression had been contributed by lax in government regulation which did not provide appropriate procedures to monitor the financial banks from running parallel investment banks. It is evident that in the run up to the 2008-2010 financial crises, banks established parallel investment banks which were used to sell mortgage and their collapse had greater impacts on parent banks. The repeal of this act had direct impact on the 2008-2010 financial crisis as the government failed to regulate the finical sector adequately (Thomas, 2009). In 2009-2010, the government was again forced to introduce regulatory framework to have a control of the financial sectors.
Government regulations on the financial sector are important in a number of ways. They are meant to ensure that the events of the 2008-2010 economic crises are not repeated where individuals in the financial sector are led by greed for short term gains and as a result come up with their own financial models that are not sustainable. Financial regulations will ensure that the consumer is well protected from such short term greed of financial models. These regulations will also ensure that executive pay is brought under control. Joseph Stigliz proposes that this will restrict leverage that can be assumed by financial institutions and executive pay will be pegged on long-term performance (Taylor, 2009). There are many incidences where financial institutions continued to pay hefty packages to their executives even when they were faced by a financial crisis. These regulations will bring sanity in evaluation of customer credit worth before qualifying for loans to save them the problems of struggling to repay loans that are beyond their reach. In addition, the regulations gives the Federal Reserve more power to wind-down in a systematic manner any financial institution that is faced with economic meltdown before the effects spread to other institutions.
However, these regulations may have negative impact on the economy as well. The repeal of government regulations had led to vibrant growth of the economy as financial institutions were allowed to come up with their own models that advanced credit to large number of people. This means that these regulations will infringe on the powers of financial institutions to come up with such models again. These regulations also increase the power of the government, through Federal Reserve to wind up any institution they think is facing financial problems.
Conclusion
The 2008-2010 financial crises began with housing bubble and spread to other sectors of the economy. The crisis led to erosions of consumer wealth worth trillions of dollars, collapse of financial institutions, and widespread unemployment. There were many factors that contributed to the crises but failure in regulating the financial sector can be singled out as a major factor. The government responded in a variety of ways including financial package and increasing regulations. Government regulations will go a long way in streamlining the financial sector and prevent future incidence of financial greedy. These regulations increase government control of the economy which is not inline with free market ideals. However, government actions through financial commitment and market regulations were necessary to mitigate the situation as it was better that sitting and watching as the economy collapsed.