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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 financial crisis refers 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 greatest financial crisis 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 Pension Fund Managers 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. Hedge Fund Managers 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 short-term cash inflows. 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…[continue]
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