A Comprehensive overview
[Author Name]
Financial Crisis
Introduction
It’s of imperative importance to understand the link between financial system and the economy. According to various economists, it is gauged that there are two primary function of finance. As mentioned in The Economist, it essentially performs as an economic time machine, serving savers to haulage their present surplus income into the future, and on the other hand offering borrowers access to future earnings now. Finance also serves as a safety net, protecting against catastrophic unforeseen events. Hence, by performing these two acts, an efficiently running financial system ensures against the bumps in life, providing more certainty. Moreover, as sponsors are always in need of firms and individuals with the most lucrative business ideas, with financial services acting a mechanism of development. Despite of being this beneficiary, finance can turn into devil, a worst nightmare for the effected. ‘When bubbles burst and markets crash, strategies that were suppose to cover years into the future are easily devastated. As the effect of the financial crisis of 2008 diminishes, it left its bequest of unemployment and debt. It’s time to ponder what mistakes lead to the crisis and to evaluate the significance question that have correct measures been taken to rectify the damage done financial crisis and build a safety blanket against such an incident in future’ (The Economist). This is what we will delve into by carrying out a comprehensive analysis of the financial crisis of 2008.
Background
It’s of immense importance to scrutinize the causes that led to the devastating financial crisis. Initially, we will highlight the main factors that caused an upsurge in the financial market. ‘The primary reason was the dramatic change in the ability to create new lines of credit, which parched up the flow of money and decelerated new economic development and the buying and selling of assets’ (GUINA). This financial trauma had a huge adverse impact on the entities, firms, and financial institutions. It also resulted in numerous financial establishments left with mortgage funded assets, which had declined rashly in value and was not generating the required revenue necessary to pay for the loans. This wiped up their standby cash immensely and limited their credit and capacity to generate new loans.
When the housing prices started to decline in 2006 led to the initial suspicion, which suggested that the economy was in distress. Though, at that moment the realtors were feeling calm as it was assumed that the inflamed housing market eventually revert to a more decent level. The ignorance of the realtors was that they were not contemplating the fact that numerous homeowners held a dubious credit, with a loan amounting up to to 100% or even a higher amount of the home’s total price. To make the situation worse, ‘banks had resold these mortgages in packages as part of mortgage-backed securities’ (Amadeo). A mortgage is a property that act a security against the loan the debtor takes from the creditor. Primarily, the Federal Reserve assumed that the impairment from the subprime mortgage predicament would stay secluded to housing market. Though, the government failed to realize the fact that these were owned by various hedge funds and financial entities. A hedge fund serves as a limited partnership, which employs high-risk method from the borrowed money in order to achieve greater levels of profits. These investors were basically in company assets, mutual and pension funds. ‘As the basic mortgages had been sliced up and sold again in fragments, the genuine derivatives were unmanageable to price. This created a panic amongst the investors leading to a significant decrease in the value in the secondary’ (Amadeo). The pension funds made the blunder to invest in such a risky assests assuming that they will be insured by the their credit default swaps. A renowned company named AIG was the seller of these swaps. After the derivatives went broke, AIG bailed out, as it could not bear the burden of so many swaps. ‘In July 2007 after the credit crunch there was a thrashing of confidence by US investors in the value of sub-prime mortgages that instigated a liquidity crisis. This further led to the US Federal Bank instilling a huge amount of capital into financial markets’ (Davies). In September 2008, the situation became graver after the stock markets around the globe collapsed and became extremely volatile, dampening the consumers faith and trust to the lowest levels. This all led to chaos in the financial market igniting the crisis of 2008 and dooming the global financial system.
Aftermath
In order to analyze the financial crisis of 2008 we would evaluate its aftereffects in a comprehensive details. There were numerous dooming consequences, which the global economy suffered from. We will scrutinize a renowned article, published by the Federal Bank of Dallas, which highlights the major costs of financial crisis borne by the society as a whole.
Sacrifice of the Society
A way to measure the value of the output lost by the society is to examine the standard output that could have been there, if there were no financial crisis. This evaluation is of significant value, in getting an estimate of the scale of the incident and extends of its impact from which we are still recovering.
Source: Luttrell and Atkinson
As can be seen from the Table.1, the output per person as of mid-2013 stood 12% below the average of U.S. economic recoveries over the past half-century, validating numerous empirical researches, signifying that reclamations from financial crises are dimmer than recoveries from usual downturns. ‘The bottom-line in the diagram estimates the cost of the crisis, supposing output finally returns to its typical path, it reflects an output loss of $6 trillion to $14 trillion. This amounts to $50,000 to $120,000 for every U.S. household, or the equivalent of 40 to 90% of one year’s economic output’ (Luttrell and Atkinson). The wide rage of estimation echoes the fact that the time frame is unclear, for how long it will take the output to fall back to its typical path. Nonetheless, it’s a possibility that in reality output may never fallback to its typical trend. It means that the output in future might be perpetually lesser than before. However, if such a scenario occurs, cost of the crisis cost will surpass a shocking amount of $14 trillion in form of output loss. The crisis disbursed a massive amount of financial and housing wealth. ‘U.S. household net worth jumped $16 trillion, or 24%, from 3rd quarter 2007 to 1st 2009. Moreover, it smeared out an enormous volume of “human capital,” both current wage income and discounted future wage income (that is, a household’s expectancy of possible earning power)’ (Luttrell and Atkinson). Assuming the fact that consequences of financial crisis are everlasting, the route of consumption perceived since 2007 proposes that the loss from the crisis might be twofold, form $6 trillion to $14 trillion approximately.
We will also state the effects of the crisis, which are difficult to quantify. These are also presented in the Table.2. These consequences include the ‘extended unemployment, reduced opportunity and increased government presence in the economy’ output’ (Luttrell and Atkinson).
Source: Luttrell and Atkinson
Damage and Decreased Capacity
Despite the fact that recession was an economic occurrence, there were other dire consequences besides a substantial fall in the output or consumption. ‘The hostile mental effects were gigantic, even if they are not clearly measurable, we still can not ignore them. Nonfarm payrolls fell by more than 8.7 million, or 6.3%, and the number of unemployed mounted to 14.7 million over the way of the recession, climaxing at 10% of the nation’s labor force in October 2009’ (Luttrell and Atkinson). Moreover, numerous workers confronted protracted sessions of unemployment or fell out from the labor force entirely. The levels of the underemployed (workers who require a full-time job but unfortunately are only able to attain a part-time job) and discouraged job hunters (workers who feel disheartened and eventually stop searching for a job) increased to 12 million, a 94% increase. ‘Even after four years when the crisis hit the market, in July 2013, labor underutilization is still obstinately high: 11.5 million individuals are unemployed and a added 10.6 million are underemployed or unsatisfied’ (Luttrell and Atkinson).
Divisions of economics that investigates wider measures of life contentment separately from earnings have established the perception of the non-monetary costs of redundancy including the emotional consequences of strain and thoughts of weakened self-esteem. Moreover, increase in the unemployment levels have more adverse effects on the rest of the society inform of higher external costs. It results in lower job security for the workers who are employed as well as higher taxes imposed on them in order to support the unemployed and ensure a transfer of income to maintain equality in the society. This signifies the fact that despite bearing lesser mental pressure cause of the crisis, the employed workers suffer from other significant consequences due to high unemployment levels in the economy. ‘Though individual well-being can be difficult to calculate, a research assessed a cost of as much as $14 trillion from loss of security in the workforce owing to increasing joblessness in the economy’ (Luttrell and Atkinson). This number signifies the vanished income of the jobless, the worth of the loss of personal comfort for the jobless and the adverse impact on the laboring workers along with the adversative consequences of elevated redundancy on forthcoming income and work prospects.
When you are working, it gives you a feel of self-respect and achievement that is utmost importance to individual growth. Hopefulness concerning observed chances, the thought that the future holds a better promise and life then present, is an imperative source of crucial source of inspiration for work hunters as well as those who are currently employed. ‘The crisis collapsed this consciousness of safety and positivity for countless people, redirected in a descending modification to families’ perpetual income, some of the deterioration in the labor force participation rate and a dimmer stride of domestic development witnessed from 2007 through 2011’(Luttrell and Atkinson). Entities amended these actions when they reconsider their short-term as well as long-term scenarios and are not pleased with whatever they evaluate. An unambiguous bequest of the depression and the dreary labor market is concentrated prospect and weakening apprehended in individual actions of comfort. After the crisis more and more individuals started believing that there will be a downfall in their future income as oppose to them progressing in monetary terms. Such unenthusiastic income prospects were seen for the very first time since 1960’s.
Inadvertent Effects
The public loses its faith, whenever there is a threat to confidence. ‘Abiding the system from ample failure, specially with peculiar government support, containing bailouts to a minority of massive financial institutions, fortified a opinion that public support exists mainly for huge, interrelated, complex financial entities’ (Rosenblum). These particular financial institutions were missing discipline and accountability, due to their over confidence in believing that they were ‘too big to fail’. This over confidence doomed the financial system due to their extreme risk taking. Government’s distinctive handling on this matter for these financial giants negated the basic principle American capitalism: ‘All people and institutions have the freedom to succeed and also to fail based on the merits of their actions’ (Rosenblum). Hence the bailouts imposed an unjustifiable tax pressure on the common people.
Though exceptional fiscal and monetary accomplishment in the situation of financial distress during 2008–2009 might have averted a full-scale crisis. However, this involvement was with substantial costs. The economy must bear the weight of a extremely high federal debt, an prolonged Federal Reserve balance sheet and augmented rules and more government interference in the coming years. ‘Direct government sustenance for the U.S. financial sector equaled about $12.6 trillion, or more than 80% of 2007 GDP, a amount much higher than the one that was provided via precrisis Federal Deposit Insurance Corp. deposit insurance limits and the Federal Reserve’s traditional monetary policy operations and lender-of-last-resort functions’ (International Monetary Fund). This is unclear as how much to associate the adverse impacts of the policies with unintentional effects of the crisis. Its due to the crisis that the government had to take extreme measure of imposing countercyclical fiscal and monetary incitement, which resulted in all the above mentioned adverse impacts on the economy as well as the society as a whole. There were massive opportunity costs of government’s imperative spending in-order to rescue the economy from the crisis. These costs included the spending on infrastructure development, provision of public and merit goods by the government enhancing the economic capacity, which had been given up.
Corrective Measures
There are other better solutions available rather then government carrying out humongous bailout of the market. ‘A humble strategy would be to nationalize the depository establishments of the unsuccessful commercial holding businesses, and leave these business and financial establishment to go insolvent and default on their credit default swaps’ (Murphy). This would revert the system back to its conventional ways of individual making decision regarding the provision of loans. ‘Furthermore, state-owned banks could select to take supervisory equity positions in borrowing corporations in default on their loans and efficiently nationalize them too, so that it remains to function, generating production and occupation’ (Murphy)
Companies that have extra capacity in production and greater profit generation ability, ‘credit would optimally be permitted to that entity whose projected value of default losses were only about 3% less than the gross profit margin’ (Murphy). This would result in employment generation, also increasing effective demand by the consumers with higher output as will as ensuring higher profit levels for the firms.
‘Additional effective policy suggestion, which depicts those action by the government that would lead to higher profitability ratios for the business and assist in pulling up the economic, would be to have cases of defaults on protected consumer loans resulting in likely reconciliation of the loan terms as well as the collateral in a distinctive way’ (Murphy).
Conclusion
Works Cited
Amadeo, Kimberly. "What Caused the 2008 Financial Crisis and Could It Happen Again?" About News. N.p., n.d. Web. 06 Dec. 2014.
Davies, Justine. "Global Financial Crisis – What Caused It and How the World Responded." Canstar. N.p., 5 Dec. 2012. Web. 08 Dec. 2014.
"Financial Crises." The Economist. The Economist Newspaper, 10 Apr. 2014. Web. 05 Dec. 2014.
“Fiscal Implications of the Global Economic and Financial Crisis,” International Monetary Fund Staff Position Note, June 9, 2009.
GUINA, RYAN. "The 2008-2009 Financial Crisis." Cash Money Life Personal Finance Investing Career RSS. N.p., n.d. Web. 05 Dec. 2014.
Luttrell, David, and Tyler Atkinson. "Assessing the Costs and Consequences of the 2007–09 Financial Crisis and Its Aftermath." Federal Reserve Bank of Dallas. N.p., 7 Sept. 2013. Web. 07 Dec. 2014.
Murphy, Austin. "An Analysis of the Financial Crisis of 2008: Causes and Solutions." (n.d.): n. pag. Oakland University. Web. 9 Dec. 2014.
Rosenblum, Harvey. “Choosing the Road to Prosperity: Why We Must End Too Big to Fail—Now,” Federal Reserve Bank of Dallas 2011 Annual Report, March 2012.
