Current Global Financial Crisis and Resurgence of Keynesian Economic Model

¶ … Global Financial Crisis and Resurgence of Keynesian Economic Model The 2007-2008 global financial crises have been identified as the worst financial crisis apart from the 1930s Great Depression. The collapse of Lehman Brothers and two Bear Stearns in 2007 had been attributed to subprime mortgage crisis that led to the credit crunch, dry up of liquidity, bank failures, massive layoffs and private defaults. Moreover, the crisis threatens the collapse of many large financial institutions, which the national government prevented through the bailout operations.

In the contemporary economic environment, global economy is interdependence making the U.S. financial crisis to contribute to the European debt crisis. The crisis has been the primary cause of failure of key businesses, prolonged unemployment and foreclosure. Financial crisis is the disruption of financial markets where markets fail to channel fund efficiently, which consequently prevent productive investment opportunities. Several factors have been attributed to the global financial crisis. One of the major factors is the subprime lending characterized with corruption and greed on Wall Street.

Other factors include decline in equity markets, collapse of the U.S. housing markets and crisis in credit and financial markets. The outcomes of financial crisis lead to the resurgence of the Keynesian economic model. Objective of this paper is to investigate the root cause of financial crisis and how it has led to the resurgence of the Keynesian economic model. Moreover, the paper analyzes the main argument of Keynesian macroeconomics as well as policy measures that has been derived from the theory.

The study also recommends the policy measures to solve the global financial crisis in advanced nations. Root Causes of Global Financial Crisis The collapse of the U.S. mortgage financial institution is one of the root causes of financial crisis. Several states in the United States have rules and regulations guiding the lending policies. The lending law forbids banks or financial institutions to offer mortgage loans to individuals with bad credits.

By consequence, the sub-prime lending emerges because people with bad credits are unable to have access to standard bank loans. Subprime lending is the loans offered to people having bad credits histories. In other words, the sub-prime lending is the loans offered to risky borrowers. The sub-prime lending gained a national attention in 1990s because of the emergence of laws that allowed mortgage financial institutions to grant loans to individual with bad credit histories. (Chomsisengphet and Pennington-Cross 2006, Investopedia 2009).

In 2000s, there was a rapid growth of sub-prime lending and lenders aggressively offered mortgage equities to large number of borrowers especially people with lower income of between $15,000 and $25,000. (Temkin, Johnson, and Levy 2002). Between 2001 and 2006, millions of Americans became homeowners based on the borrowing opportunities offered by sub-prime lending. However, starting from 2006, there was a housing crash because the prices of housing units were devalued. The U.S. housing bubble reached a peak in 2006 and the value of mortgage securities fell and damaged the global financial institutions.

Homeowners in the United States were unable to sell their houses because housing prices are below the price paid for the housing units. By consequence, many homeowners were unable to honor their payments leading to acute shortage or scarcity of liquidity. Outcomes of the inquiry by the Financial Crisis Commission revealed that only 54% of the 900,000 mortgage loans issued between 2006 and 2007 met the originator underwriting standards. (Morgenson, 2010). Bianco, (2008) contributes to the argument by pointing out that subprime mortgage crisis is the major factor that triggers the financial crisis.

Typically, the mortgage meltdown led to rising in the number of foreclosures. Between 2007 and 2008, sub-prime mortgages, back up by market securities suffered a sudden dry up leading to increased information asymmetries and uncertainties. (Kirabaeva, 2000). The dry up of liquidity, and credit crunch led to the global financial crisis. In 2006, 50 banks were forced to close. For example, Country Financial Corp incurred $11.5 Billion debts. In 2007, the UBS lost $124 Million because the bank engaged in-housing hedge. The BNP Paribas also incurred a similar loss.

Many borrowers lost their housing because they were unable to honor their payments. A report by the U.S. Senate reveals that a combination of risky investments, excessive borrowing, and lack of transparency are the major factors that led to the financial crisis. A report by IMF (International Monetary Fund) in 2008 revealed that falling of U.S. housing units led to a loss of $565 billion. However, the loss reached $945 Billion when combining the loss to the loans originated from issued securities.

The aftermaths of the financial crisis make the policy makers to apply the Keynesian economic theoretical framework to stabilize the economy. Resurgence of Keynesian Economic Theory The 2008 financial crisis has led to the resurgence of Keynesian economic theory. The Keynesian economics is in response to Great Depression that deals with expansionary monetary policy and fiscal stimulus. Some commentators believed that total reliance of neoliberalism of Williamson led to financial crisis.

The neoliberalism theoretical frameworks argued that the financial system should be allowed to operate freely without government intervention and market forces should be allowed to determine the interest rates. The free operation of financial system provides a limited intervention of state regulations that guarantees the rights to carry out financial activities and capital movements. (Mavroudeas & Papadatos, 2005). After the global financial crisis, many people started questioning the application of the neoliberalism philosophy. Excessive greed and absence of meaningful regulation proved that free market economy was unable to correct itself.

The Keynesian philosophy emphasizes that the government should stabilize expansionary fiscal policy through monetary policy. The Keynesian theoretical framework argued that financial agents faced uncertainties in their daily business operations, and inability of agents to predict future accurately showed that free economy could not deliver optimal economic outcomes. The Keynesian economics argues that the government in advanced countries should intervene in a business cycle by increasing aggregate spending, reduce interest rates and taxes to boost aggregate demand when an economy is facing a recession.

In 2008, Obama Administration applied the Keynesian economics by applying stimulus package of $878 billion to bail out depressed financial institutions. The bailout process is very critical because total fall out of major financial institutions in the United States can lead to multiple financial turmoil. The application Keynesian model will.