Financial recess is never a novel term. Depressions have always hit the financial system of the world, and the latest recess America is most likely not the final one. Nonetheless, many issues worked together to make the recent U.S crisis the worst financial recession since the global downturn. These factors include failures of market, weaknesses in the execution of policy, as well as macroeconomic problems. The primary concept, which had controlled economic thinking for many years, was that markets functioned. The appropriate prices often get a buyer as well as a seller. Besides, millions of sellers, as well as buyers, are appropriate in comparison to a few authorities of government at establishing the correct price. Because of mortgage securities and failures of markets, the economy stopped working in 2007. Sellers, as well as buyers, could not settle on prices, which caused an impasse that spread to affect many debt markets. For that reason, banks started to lose trust in the solvency of one another. Trust was lost until the government came to promise that some of the major banks or financial institutions would not collapse. This paper is biassed to discuss how the latest U.S monetary crisis demonstrated that markets are imperfect.
The latest financial recession can be traced from the renowned housing market. The activity of construction decreased significantly in 2006 as the prices of house begun to fall. The economy slugged as households reacted to the decrease in the prices of houses by increasing savings. Additionally, credit organizations began to make strict their lending standards by the end of 2006. This trend continued in the subsequent year. Nonetheless, the decrease or drop in domestic demand, to some extent, was offset by steady growth of exports (Dejuán 49). The reduced speed was directly linked to ordinary recession until the depression erupted. This made many financial organizations failed. Besides, equity prices or costs toppled. The financial industry could not support normal activities, a situation that adversely affected the economy in many aspects. Housing starts registered low levels; trade financial challenges led to a reduction in exports, as well as made the private industry lower debt.
The response or reaction to policy was extraordinary. The Federal Reserve (FR) reduced the rate of policy to approximately zero, purchased bonds, as well as introduced liquidity measures. Additionally, the government introduced fiscal stimulus programs of about one trillion dollars. Such measures by government or Federal Reserve restored confidence, which made the financial market work. The equity market began to recover or work and by 2009, the other part of the economy started functioning. Ideally, the occurrence of financial crisis demonstrated that markets are imperfect (Dejuán 53).
Another issue causing financial crisis was that banks created excess money as well as using that cash to escalate prices of houses. Additionally, the banks speculated on monetary markets, which contributed to the recession. The excess money, which banks or financial institutions created from 2000 to 2007 were used in other businesses other than the financial sector. For example, approximately thirty-one percent were consumed by residential property that increased the prices of houses faster in comparison to wages. Household debt significantly increased and in the last stage of this boom (sub-prime lending), that is, lending to income borrowers with low income, increased quickly demonstrating that markets are imperfect (Hunt 236).
Rapid Debt Increase
Source: Claessens 220
In the mid of 2007, the losses emanating from mortgages of sub-prime exposed the weaknesses within the markets. For instance, BNP Paribas froze recoveries for 3 funds, which were invested within structured products. The move was appropriate because their market had stopped working, which made it difficult to value such products. As a result, the counterparty risk of banks increased sharply (Claessens 222). The rates of interbank, the rate of interest that banks lend one another, soared. It caused the average approximately twenty basis points on treasury bills within the Euro region as well as about forty within America; the TED-spread increased to a hundred basis points within the Euro region and about two hundred within America in the early phase of the depression. These are demonstrations that markets are imperfect.
TED-Spreads Soured
Source: Claessens 217
The liquidity challenges within the market compelled central banks or institutions to offer liquidity in many forms. However, losses, as well as challenges, persisted in increasing in the downturn of 2007. At the end of 2007, central banks or financial institutions from five main currency regions pronounced coordinated measures created to control pressures within short-run funding markets (Claessens 221). At the beginning of 2008 challenges in the temporary funding market resulted in the Northern Rock nationalization within the United Kingdom. In America, the worst shortage of liquidity at Bear Stearns within March forced Morgan to accept buying Bear Stearns (a transaction completed by facilitation of American authorities). This led to financial recession and demonstrated that markets are imperfect.
The concept that economy would never be influenced was still welcomed. Besides, such a concept was strong in the mid of 2008. The European Union as well as emerging markets ought not to be affected. This was because of strong domestic development or progress. The prices of goods soared; besides, inflation within Europe kept the trend of increasing, which compelled central banks to keep increasing rates of interest (Hunt 238). These demonstrate that markets are imperfect.
Lending huge amounts of money or cash to the property sector led to increase in house prices, which was characterized with personal debt. The interests must be paid or processed with loans that the banks make, and coupled with the fact that debt rose faster than incomes, some individuals were unable to process repayments. They stopped processing loans, which made banks be in danger of bankruptcy. Such a process created the financial recession that showed that markets are imperfect (Hunt 237). Following the financial crisis, banks or financial institutions limited their novel lending to households as well as businesses. The measure not to lend by banks caused prices within these markets to fall, and this implied that individuals who have borrowed in excess were compelled to sell assets to repay or process their loans. The prices of house fell and bubble disintegrated. Consequently, banks panicked as well as reduced lending (Claessens 217). A downward trend thus started and the financial system tips into depression, which was a demonstration that markets are imperfect.
Following the financial crisis, banks declined to lend, which made the economy to shrink. This is a demonstration that markets are imperfect. Banks always lend only when they are sure that loans will be processed. Therefore, whenever the economy is progressing badly, they opt to limit lending. Nonetheless, as much as banks lower the sum of novel loans they process, the lenders must continue repaying their debts. The challenge is that money utilized in repaying loans is destroyed as well as disappears (Claessens 210). Whenever individuals repay loans at a faster rate in comparison to the rate banks make novel loans, economy is destroyed as it slows down, which causes decrease of prices (Claessens 205). Consequently, the risks of economy slipping or termed debt-deflation spiral, in which prices as well as wages decrease but individuals’ debts never adjust in value, resulting in debts being relatively expensive in reality. This affects even the individuals who never participated in the establishment of the bubble, leading to a recession.
The financial crisis showed that markets are imperfect because the recession took place in a circumstance having stable as well as high development although with increasing macroeconomic imbalances, ample liquidity, and low rates of interest. Nonetheless, a properly governed as well as resilient monetary sector can work in such a condition, without establishing the excess that were experienced during the financial hard times. Ideally, the financial crisis in America in many aspects was due to persistent weaknesses within the markets that permitted a huge though underestimated upsurge of risk (Claessens 211).
The financial crisis in America demonstrated that markets are imperfect because monetary improvements increased complexity. The monetary markets as well as its organizations advanced significantly in the past. In the United States, deregulation of markets from the 1970 in combination with globalization resulted in the creation of very complex as well as a large cross-border fiscal institutions or organizations. World markets are integrated with huge capital flows and exchange across countries as well as emerging markets gaining a rising share of global trade (Balleisen and David 428). Financial innovations or improvements advanced the networks scale as well as complexity of inter-relationships among financial bodies. These advancements were feasible by improvements in technical infrastructure and financial theory of markets.
An example can be quick increase in financial improvements, for instance, OTC derivatives, as well as securitization. These were considered to attain high returns (nominal) without a remarkable increase of threat. Later, it became clear that banks, supervisors, or regulators never fathomed risks intrinsic within these novel products (Balleisen and David 429). The development of securitization was introduced by many financial sector commentators as a way of reducing or lowering risks of banking system. The justification of securitization was selling as well as repackaging assets to those investors that could properly manage such assets (Claessens 215). The agreements prior to the financial recession was that distribute as well as originate model or method of banking led to risk being distributed or diversified broadly across the world financial system.
Nonetheless, when the financial recession occurred it was clear that risk diversification had not been attained. Ideally, some securitized credit’s holdings were missing in the books or documents of investors anticipating to hold their assets to maturity though on the documents of leveraged financial institutions. The rising application of the distribute as well as originate method of lending implied that lenders technically had inadequate incentive to use strict credit measures as the loans were anticipated to just remain on balance sheets of lenders temporarily (Dejuán 60).
Financial recession occurred because of a broken global monetary system. Non-functional global financial system was a demonstration that markets are imperfect. Trade imbalance between first world as well as third world countries represented an underappreciated factor for financial crisis (Dejuán 55). Through maintaining their currencies or exchanges artificially depressed against America dollar (that is executed through purchasing dollars with just printed local currencies) export-oriented countries, for example, China amassed huge reserves of U.S dollars. Similar to the 1980s as well as 1990s petrodollars, these cash were recycled into America’s financial system or economy (Claessens 216). To use such cash, financial institutions had little option but to reduce underwriting standards, hence, advanced the pool of prospective borrowers.
In conclusion, the literature has demonstrated that the recession was due to many factors, for example, macroeconomic challenges, failures within financial markets, as well as problems in the execution of policy. The financial industry has advanced, become complex, and the actors become too big to manage. These organizations as well as their services have become challenging to supervise or regulate. Additionally, internal control or measures of the financial bodies failed in many cases. For that reason, system-wide threats became larger causing risks to build up. The central banks as well as government had a duty of maintaining financial stability by prudent regulation or supervision of markets and financial institutions. Nonetheless, the supervisory frameworks in many areas were disintegrated that resulted in inadequate accountability for system-based risks. The structures of regulation and supervision failed to maintain pace with the changes of markets. Additionally, when financial institutions became large in comparison to the entire economy, the finances of public were exposed to greater risks. Ideally, the factors and challenges causing financial recession demonstrate that markets are imperfect.
Works Cited
Balleisen, Edward J, and David A. Moss. Government and Markets: Toward a New Theory of Regulation. Cambridge [U.K.: Cambridge University Press, 2010. Print.
Claessens, Stijn. Financial Crises: Causes, Consequences, and Policy Responses, 2014. Print.
Dejuán, Óscar. The First Great Recession of the 21st Century: Competing Explanations. Cheltenham: Edward Elgar, 2011. Print.
Hunt, Emery Kay. History of economic thought: a critical perspective. ME Sharpe, 2015. Print.