Macroeconomics 2301
18.04.2014
HCC
Spring 2014
8 week course
The world’s economy has faced several periods of crisis during the last twenty years. The financial crisis in 2008 is the one that is most recent. It emerged in the United States and then spread to Europe, later affecting the rest of the world. The most problematic sector in the US was the mortgage sector, and was one of the main causes leading to the financial crisis. The house prices have been rising from 1998 to 2006, prompting home builders to construct more new houses every year, but these injections helped rising the GDP for a decade, and then the housing prices stopped increasing.
Figure 1. AD shift .
A drop in the housing industry in 2007 shifted the AD curve to the left, as in Figure 1, leaving a large amount of construction people unemployed. This provoked a series of consumption-based AD shifts in a sequence called the multiplier process.
On the other hand, the mortgage sector affected the financial markets and then the real economy. What outset the events, which later converted into the crisis we know today, was the burst of the housing bubble consisting of low interest rates, easily accessible credit and toxic mortgages. The stock markets were catastrophic, which lead to an economics recession for the world’s economy. Lehman Brothers, Bear Stearns, Goldman Sachs, Merrill Lynch, and Morgan Stanely – five of the biggest investment banks, were running their market performance with remarkably little capital. The leverage levels of these big investment banks were extremely high, and they were performing mostly with short-term debt, which was risky and also time-consuming as it had to be renewed every day. The problem was not only the increased level of debt, but also that banks supported each other and did not realize the beginning of the “too big to fail” moment.
The consequences of the crisis started in the United States and transferred to Europe. Many banks, financial institutions and businesses were affected. Some economists claim that the last time they saw something so severe as the current financial crisis was in 1929 when the Great Depression happened. There were a considerable amount of unobvious risks in the mortgage markets such as the liquidity risk, credit risk, and interest rate risk which made the banking sector vulnerable.
When looking at commercial banks, it seems that they have been failing the aftermath of the financial crisis. Since 2008, a large number of US small banks are reported to have failed, whereas UK banks, for example, have been failing at a pace of approximately one per month. German banks were also a leading player in the financial crisis, and they have remained fragile after that period. Numerous small banks in Spain have folded because of the burst of the property and construction bubble.
More than six years have passed since the financial crisis happened, when five of the biggest US investing banks collapsed, and the mortgage bubble burst. Lehman Brothers was one of the key participators, and the bank had the extreme debt ratio of 30:1, which can be interpreted that for every one dollar of cash, the bank had thirty dollars of debt. Today, the debt level has dropped down significantly
.
Figure 2. Risk on bank assets as % of GDP, selected countries .
The whole system was seen to have been built on fragile grounds: Figure 2 reveals that banks had allowed their balance sheets to enlarge, but at the same time, they have put aside not enough capital to absorb losses. In reality, they had bet on themselves with money they had borrowed, which is a gamble that had been successful in good times but proved cataclysmic in bad. Overall, the effect of the financial crisis is fading away but people still feel it both in the US and Europe. Many businesses are still recovering, but the world’s economy is now stronger than before.
References
Allen, Franklin and Elena Carletti. Global Fianncial Crisis: Causes and Concequences. 30 June 2009.
Bloomberg. 20 September 2013. Article. 20 April 2014.
Coppola, Frances. Forbes. 10 December 2013.
Gross, Daniel. The Daily Beast. 17 September 2013.
Impact of the Financial Crisis on Banking Sector. 2012.
Jordà, Òscar, Moritz HP Schularick and Alan M. Taylor. "When credit bites back: leverage, business cycles, and crises." National Bureau of Economic Research (2011).
Schiller, Bradley R. The Economy Today 13th edition. New York: McGraw-Hill Irwin, 2013.
