Economic Crisis 2008-2009
This report focuses on the events that took place in the Great crash of 2008-2009. It aims to highlight the events that took place and what the basic factors and events were that eventually led to the economy crashing. It is also a point of focus to determine what effects came about and how different parties were to be blamed for the deregulation that led to the catastrophic events of the crash. It is linked with the policies present at that time i.e. The Monetary Policies outlining the control of money supply and interest rates as well as the Fiscal Policy that focus on the government spending and taxation policies.
The to a situation whereby there is a contraction of money supply and the amount of wealth in the economy. This is also known as a “credit crunch” whereby participants of the economy lose their confidence in the money value and the repayment of loans by debtors. This ultimately leads to them cutting down on spending and limiting the amount of money that is lent out.
The foundation of the financial or banking sector lies in the credit creation through which money is deposited into the bank by people which is lent out to other debtors who then spend that money. Hence, a slight decrease in the lending in the economy can affect the money supply by massive amounts. This credit crunch is what gave rise to the Great Crash of 2008-2009.
Events of the 2008 Crash:
In the year 2008, the economy of United States experienced one of the ever seen. It is believed by many that some of the events that took place were associated to the Great Depression of 1929. It all began with the boom in the housing market in 2007-2008. This housing market bubble also had several reasons for its occurrence. One of the major reasons lies in the extremely low interest rates to fix the recession after the 9/11 attacks. To give people hope again and to encourage the consumption and spending, interest rates were kept at about 1% which were extremely low. These low interest rates did, to some extent, help the economy to recover but they also made it extremely easy for people to mortgage house loans.
With such low interest rates, people started investing in the housing market and loans were made to subprime borrowers as well. Subprime borrowers are the people who have a high default risk. One of the major developments in this sector was that of securitization. This was a process whereby the commercial banks made loans to the general public and these loans were then bundled together into a “mortgage backed security.” These securities are sometimes referred to as CDOs or Collateral Debt Obligations. These bundles of securities are sold on to other financial institutions that do not fully appreciate the risk they are taking. There are three parts of these CDOs. The first bracket is referred to as senior which is the safest investment and is usually bought by who want to secure some income for future. The second bracket is called the mezzany which has a moderate risk. The third bracket is called the equity and has the greatest risk attached to it. are organizations or individuals willing to invest in this risky business and they acquire the largest return on this CDO. These CDOs are further insured by companies which receive a monthly premium and account for the loss if the debtor defaults on these CDOs. These CDOs were insured by AIG at the time. Some economists suggest that one of the problem lay in improper regulation on part of the government although others argue that it was the wrong kind of regulation that led to this problem. Certain government policies actually encouraged the idea of borrowing so as to attain a house ownership. All these forces acted together to drive up the prices of the houses. Since the demand was rising and the supply was less, the prices rose as a result. Between the years 1995 to 2006, housing prices in the United States almost more than doubled (Mankiw, Gregory).
The high prices of the houses eventually proved to be highly unsustainable and between 2006 and 2008, the housing market saw a gradual fall in prices of about 20%. In a free market economy, such a movement is generally not considered to be a problem because as the invisible hand (Smith, Adam) suggests that there are self adjusting mechanisms in the economy that help to equilibrate the level of demand and supply in the economy. Gradually the housing prices returned to the level that was seen in 2004. This fall in price led to a number of problems for the economy and the people.
The first effect that came about due to this fall in prices were the numerous mortgage defaults and home closures. During the boom of the housing industry, many people bought the houses as an investment and when the prices began to fall, they saw that they owed more than they owned. They had no money left and found themselves bankrupt. Hence they started defaulting on their mortgages. The banks started seizing the houses of all those who defaulted. At that time, the main aim of the banks was to recoup as much as they could because they could for see the falling prices.
The second effect that became evident was the massive losses made by the financial institutions and the mortgage backed securities that they owned. What really happened was that these companies predicted the prices of houses to keep rising which is why they kept investing in the industry. Therefore when the market fell, these people lost out and saw themselves on the verge of bankruptcy. Large banks stopped trusting one another and they stopped lending out because an air of uncertainty surrounded them and no one knew who would fall next. This news started spreading among common people and people started pulling back their expenditures and consumptions. Even the trusted borrowers lost out as a result because the ability of the banks to lend out eventually went down and so all expenditures were basically impaired.
The third result that came about was the volatility of the stock market that rose each day. Many people were relying on the stock market as a way to attain their resources and raise finance for various reasons like expansion of businesses or even for their . The profitability of these institutions started to fall as a result and this led to the decline in consumer trust and a leftward shift in the expenditure investment function. Households started delaying all kinds of expenditures, companies postponed their investment plans. This led to the economy going into recession once again and the levels of uncertainty reaching beyond expectations.
The government of United States responded as they realized where the economy headed. The Federal Reserve cut its target for the funds from 25% to almost zero. The government also allocated $700m to help restore the financial sector of the economy because that was the root of the entire economy. The largest proportion of this amount was paid to restore AIG and bail it out because all the other banks and securities were dependant on it. Most of the banks ended up being bailed out except for the Lehman Brothers who were the first ones to go down.
Factors of Market Instability:
The market instability that occurred in 2008 was caused by various factors. The most dramatic change however, was due to the struggle to create a new line of credit and borrowing which gradually dried up the money flow and became a hindrance to the economic growth of the country. It also became a major problem in the buying and selling of assets. This crisis was a threat to everyone in the country. From individuals to businesses and financial institutions, everyone suffered. People had invested in stocks, the housing market and the financial securities. All this reserve cash started drying up as the general price level started to fall and their credit limit decreased.
There were several other factors that contributed to the crash of 2008, including the cheap interest rates which made it easy for everyone to borrow and make investments based on the speculation with that money. The cheap rates at which money was available, made people want to borrow and spend more. The problem arose when everyone was after the same kind of investment which was in the housing market. This pushed up the prices as the supply was limited and the demand exceed supply. Private firms and hedge fund managers made billions of dollars of wealth based on this speculation process but they did not exactly create anything of value. The increase in oil prices and high levels of unemployment further pushed the prices upwards (Ryan, 2008)
The foundation of the American economy is built on credit. Credit is a tool that can be quite beneficial for the economy if used smartly. It can become the basis of expansion or the start for a business. This will eventually lead to a generation of employment opportunities for people. It is also used to buy necessities and luxuries of life. To produce all this, people will be employed and this will again create employment opportunities. But in the last decade, the amount of credit in the U.S. economy was not checked and regulated properly which led to serious problems.
The middle men who were actually the brokers for the mortgages decided who got the loans and they had the responsibility of passing these loans to other people as mortgage backed assets after keeping a certain profit for themselves. These brokers started merging the bad and risky mortgages with the others and started selling them out to people as a source of investment when in reality people would lose out on these mortgages. A lot of people started borrowing way more than they could afford an pay back with the idea that they would earn on the purchase of the house and earn a profit. They considered their investment to be reliable. However, these investments eventually led them to lose out and go bankrupt.
Eventually it became extremely easy to buy a house. There weren’t much formalities attached to getting the loan. Everyone was out to make a profit and brokers rarely denied anyone the money. The brokers packaged the mortgages with the other mortgages and withdrew from claiming any responsibility from it. Soon all these mortgages failed and all the money went down the drain.
The Housing Market Decline:
A chain reaction was initiated by the slump in the housing industry. The individuals and investors went into a debt. They predicted to make a profit but instead ended up defaulting. Investors left the financial market, individuals pulled back spending. Mortgages were no longer affordable for people.
Banks and investment firms began to bleed money. People left the housing industry and fled from the houses they were already living in. This created a phase of depression all over as even the construction business and estate agents went out of business. This also caused the already existing houses to fall in value and become a worthless asset that people no longer wished to invest in. The value of the houses fell below the value of the mortgage that people owed. Hence, people considered it easier to walk away rather than pay off their mortgage payments.
Credit well dried up:
The ratio that banks lent out started to decrease and they increased their reserve ratios but this was too late as most of the damage had already been done. A number of banks were sold and merged with other institutions to recover the losses. The others received an economic bailout by the government but there was still a majority who got completely wiped out due to the crash.
Many of the institutions that played with the risky mortgages and securities could no longer afford to lend out money. Unfortunately, this is what banks do and without this power, they would obviously go out of business. If the current loans do not produce positive inflows, it is not longer before the institution crashes and has to close down.
The motive behind the bailout was to buy these mortgage backed securities and rescue the financial institutions from crashing down. This would also give the banks more lending power and this would restore the crashing economy.
The mess created by Credit:
It is quite ironic that credit is what made the economy of the United States unstable and to pull it back on its feet, it needed an inflow of cash because as already stated, the U.S. economy was built on credit. Had it not received the inflow of cash that it needed, the economy would again come crashing down and it would eventually start having ripple effects on the World Economy.
As mentioned earlier, credit itself is not a problem. It promotes growth and the generation of jobs. However, if it is not regulated, it creates problems like it did for the United States. In such a situation, the act of bailouts was important to restore the economy as long as it had regulations related to the amount lend out, policies to safeguard the tax payers and prevent brokers and individuals from greed where they destroy people in the attempt to make a profit for themselves (Davis, F. James, 2008).
Eventually the problem of this great crash was fixed by the bailout of AIG and several other banks which gave them the opportunity to rebuild their economy and start operating again. Alterations were made to the interest rates which were kept too low for too long. Along with that, proper regulation was enforced to look into the amount lend out. Loans were stopped being given out to subprime borrowers to decrease the risk attached. The money supply was closely monitored as well to keep it balanced. These policies did fix the economy gradually and the United States economy was brought back to stability.
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Stark, Jurgen (2009). Monetary Policy before, during and after the financial crisis.