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Overview of the US economy before the crisis

Question:

Discuss About The Factors That Caused The US Financial Crisis Of 2008-09?

Economies perform differently during various business cycles; there are two cycles; the boom (peak) period where there is an accelerated growth in the economy and the burst (recession) period where there is strained economic growth. Before 2008, the performance of the US was high. Pettinger (2017) pointed out that the US economy was stable from 2000 to 2007 with a strong growth, falling unemployment and low inflation. However, despite this economic stability Pettinger noted that there were rising concerns on the growing instability on the financial marketing and credit. There was a boom in the housing industry that resulted in an increment in the aggregate consumption component of GDP. Thus the GDP recorded before the crisis was high. This paper will analyze the changes in GDP before, during and after the crisis. During the crisis, many macroeconomic indicators performance was poor; these indicators include real GDP, Inflation, Unemployment, etc.

The paper will consider the actual causes of the crisis which resulted from the money supply growth. It will cover the origination of the money supply growth. This research will show that the financial crisis in the US was as a result of failure on the financial lenders and the government. Rosner (2013) pointed out that the government’s regulation on lending institutions was weak. It shall analyze how each of these parties failed and the impact of each of their failures. The impacts of the financial crisis were not only felt in the USA economy but was spread to other nations; there are just a few economies that wasn’t impacted by this crisis. Some of them that are financially stable were able to implement policies that led to a quick recovery while others are constrained up to date.

In the early 2000s the US economic growth was lower which stimulated the US Central Bank to lower its interest rates.  Malinen (2017) argued that prior to the crisis, the US monetary policy was loose. The impact of a lower interest rate is an increased money supply since people are attracted to loans advanced by financial institutions owing to the low cost of repayment. There was thus an increased borrowing of loans and a greater growth of the money supply in the circulation. Since investors are always uncertain about the future, they decided to utilize this available capital to invest in assets that would give them returns in the future. The major asset that demand went up was that of the housing industry. Households and investors decided to utilize this availability of cheap capital to buy homes.

Actual causes of the crisis

Fig: Growth of money supply

Source: Positivemoney.org (2017)

The graph shows that there was a huge money creation by the banks prior to the crisis. According to Positivemoney.org (2017), money is created every time a loan is made by the banks; the money and debt amount in the US economy had doubled in a period of seven year from the advancement of the loans.

An increased demand for homes raised the demand for mortgages. Initially, financial lenders could only advance loans to prime lenders who had good credit ratings and avoided loaning the subprime borrowers. This is what had kept the housing market in a stable state. The increased demand for mortgages resulted in the financial lenders weakening their lending standards. In the period before the crisis, banks were more aggressive and their willingness to lend to the risky borrowers had gone up (Nitta, 2013). They figured out a way to make the funds available to the low-income groups through pooling. This strategy was considered less risky but no analysis was done or had been done earlier to confirm its viability. The proposal was accepted and the financial lenders started lending to the low income groups without necessarily requesting them to provide some security. Many subprime borrowers went for the loans and there was a greater supply of money to many people in this economy. The loans were advanced as mortgage home loans meant for assisting the investors and households to acquire homes and repay as they used to houses. These subprime borrowers were risky since their income level was insufficient to service the loans; the banks failed to do a sufficient check on the ability of these borrowers to repay their loans; they recklessly gave them huge loans. The government had also set a regulation towards achieving the goal of non-discrimination on the acquisition of capital because of the brackets of income. After the credit crunch, these borrowers were left with huge unpayable loan amounts.

The Mortgage loans advanced to the subprime borrowers enabled them to buy homes and other houses used for businesses. The mortgage loans were given at a very low interest rate and thus attracted many borrowers. Pettinger (2017) noted that the high confidence for the borrowers and a growth in bank lending facilitated the housing boom. The access of these loans by the subprime borrowers caused the homes demand to shoot upward (Muddywatermacro.wustl.edu, n.d.). The law of demand accounts for a price rise whenever demand rises. The price rise generated great profits to the investors; more homes were constructed in order to raise more profit. Many people shifted their investment to the housing market so get a share of the rising profit

Impacts of the crisis on the US and other nations

Fig: Uses of money created by banks prior to the crisis

Source: Positivemoney.org (2017)

The greatest proportion of the huge amounts of money the banks created were used for mortgages and secured loans (Mee, 2012); this was equivalent to 31% of the total money created. The 31% went to residential property and there was a further 20% that went to commercial real estate.

Prior to the crisis, the personal debt in the US was very high. It even exceeded the income amount and thus at some point became difficult for the borrowers. The borrowers had to repay their loans with some stated interest rate. After the housing bubble burst, the financial lenders went into huge losses because borrowers were not able to service their loans further. The subprime borrowers couldn’t repay their loans; in addition, the prime borrowers could also not be able to repay their loans. There was a great challenge for the financial account lenders. What caused the global recession is that when people started defaulting on their loans, financial institutions such as banks tightened their lending behaviors; the money supply was reduced resulting in a lowered demand for homes and subsequently a fall in price. The demand law also account for a price decline on instances where demand is insufficient. The falling prices accounted for the bursting of the housing boom. The previous borrowers could keep toping up their loans to enable them to service the loans. The slowdown of lending made it difficult to access loans owing to the panic caused to the lending institutions. This forced these borrowers to decide selling their assets and repaying the loans. However, the assets value had declined compared to when the loans were advanced and thus insufficient money were raised from such sales and the full amount of the loans was unpayable given the income constraints. Further, the increased default rates caused the banks to continue tightening their lending such that investments were completely not possible. Investors’ confidence had also declined and thus economic activities fell significantly; the US fell into a recession.

Lehman was a giant investment bank and the 4th largest in the US. In 2003 and 2004 when the housing boom was showing up, this investment bank acquired 5 mortgage lenders. Lehman was accused of creating mortgage backed securities that were toxic and their sales put the financial market at risk (Williams, 2010). According to Alex (2017), this bank filed for bankruptcy in September 15th 2008; it was one of the largest victim of the subprime mortgages and thus argued to have been the major cause of the financial crisis (Cnbc.com, 2010). Its contribution to erosion of market capitalization was close to $ 10 trillion in October 2008. According to Mcdonald (2016), it is the collapse of this investment bank that triggered the global recession.

Increase in money supply and its impact

The US stock markets are strongly correlated with other universal related stocks; whenever it is declining, all other stocks declines. After the end of the 2000-02 stock market crush that resulted from the internet boom, the M&A was plunged by lenders one again (Nations, 2017). The 2000-02 was the 5th wave of stock market crush whereas the 2004-07 was the 6th wave. The percentage of cash deals rose with this wave and the role played by the LBOs was larger than with the initial waves (Hooke, 2015). The stock market crash caused the deal volume to fall by 60% during the 2007/2008 global financial crisis. According to Amadeo, (2017), a loss in investors’ confidence is responsible for causing a recession.

Mees (2012) argued that the American spending binge was prospered by China and not by the US. The US saving rate was around 15% from 2000 to 2006 whereas that for China rose from 38 to 54% during this period. The Chinese are risk-averse and thus their savings are ties to risk-free assets. The savings buildup in China and emerging economies had expanded and caused a depression of interest rate in the whole world from 2004; the US Treasury bonds price rose as there was too much money chasing. Subsequently there was a fall in the interest rate. China and Japan have been the greatest creditors for the US.

Fig: US treasuries foreign ownership

Source: Gantz (2017)

There was a decline in the US treasuries foreign ownership in 2008 which means that there was a reduction of the available credit; this contributed to the financial difficulties.

Conclusion

The US global recession was caused by the credit crunch; there was a shortage of liquidity for the banks and thus a reduced funding. The financial instability lowered business’s and consumers’ confidence. There was a negative wealth effect as the house prices fell after the boom. Since the economies are interrelated, the impacts of the US financial crisis were also spread to other economies and this deteriorated the trade system; there was a decline in exports as other economies also felt the financial constraints. There was a significant fall in GDP and the unemployment rate rose. There was a failure of the banks in that they recklessly advanced loans to the risky borrowers without a sufficient cross-check of their ability to repay. The government failure is argued in terms of low regulation on the lending behavior by the financial institutions. The central bank regulates the circulation of money and it could have ensured that the financial institutions did not cause such a big growth in the money supply. Otherwise it can be concluded that the government was more impressed with the growth of the economy that was accelerated by the rising house demand that it failed to look into the impacts that this would have on its future.

References

Alex (2017). The collapse of Lehman Brothers. [Online] Telegraph.co.uk. Available at: https://www.telegraph.co.uk/finance/financialcrisis/6173145/The-collapse-of-Lehman-Brothers.html [Accessed 13 Sep. 2017].

Amadeo, K. (2017). Causes of Economic Recession. [Online] The Balance. Available at: https://www.thebalance.com/causes-of-economic-recession-3306010 [Accessed 12 Sep. 2017].

Cnbc.com. (2010). Lehman Brothers Art Work under the Hammer. [Online] CNBC. Available at: https://www.cnbc.com/id/38622511 [Accessed 13 Sep. 2017].

Gantz, L. (2017). Market Euphoria, Chinas Dumping of Treasuries Ignite Recession Concerns. [Online] Streetwisereports.com. Available at: https://www.streetwisereports.com/pub/na/market-euphoria-chinas-dumping-of-treasuries-ignite-recession-concerns [Accessed 14 Sep. 2017].

Hooke, J. C. (2015). M&A: a practical guide to doing the deal. Hoboken, New Jersey: Wiley.

Malinen, T. (2017). Who Caused the Great Recession? [Online] Huffingtonpost.com. Available at: https://www.huffingtonpost.com/tuomas-malinen/who-caused-the-great-rece_b_9805056.html [Accessed 12 Sep. 2017].

Mcdonald, O. (2016). Lehman brothers: A crisis of value. management, Manchester University Press.

Mees, H. (2012). How China’s Boom Caused the Financial Crisis. [Online] Foreign Policy. Available at: https://foreignpolicy.com/2012/01/17/how-chinas-boom-caused-the-financial-crisis/ [Accessed 13 Sep. 2017].

Muddywatermacro.wustl.edu. (n.d.). Causes of the Great Recession. [Online] Available at: https://muddywatermacro.wustl.edu/node/92 [Accessed 13 Sep. 2017].

Nations, S. (2017). A history of the united states in five crashes: Stock Market Meltdowns That Defined a Nation. New York: HarperCollins.

Nitta, Y. (2013). What were the primary causes of the Great Recession that started in 2008? [Online] Blogs.yis.ac.jp. Available at: https://blogs.yis.ac.jp/14nittay/2013/02/13/what-were-the-primary-causes-of-the-great-recession-that-started-in-2008/ [Accessed 13 Sep. 2017].

Pettinger, T. (2017). The great recession 2008-13. [Online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/7501/economics/the-great-recession/ [Accessed 12 Sep. 2017].

Positivemoney.org. (2017). Financial Crisis & Recession? [Online] Positive Money. Available at: https://positivemoney.org/issues/recessions-crisis/ [Accessed 12 Sep. 2017].

Rosner, H. (2013). What Really Spurred the Great Recession? [Online] Kellogg Insight. Available at: https://insight.kellogg.northwestern.edu/article/what_really_spurred_the_great_recession [Accessed 12 Sep. 2017].

Williams, M. T. (2010). Uncontrolled risk: the lessons of Lehman Brothers and how systemic risk can still bring down the world financial system. New York, McGraw Hill

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