Causes to Global Financial Crisis

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Introduction

The current global financial crisis is thought to be the worst financial crisis after the great depression. This financial crisis started in 2006 and has affected many areas of the economy. Every country in the world, from developed countries to developing countries felt the effect of the crisis in one way or the other (Global Economic Crisis Resource Centre, 2009, p.14). There have been many debates on the causes of this crisis and why the crisis had to happen. Some argue that it resulted due to a conspiracy, while others blame it on negligence from financial regulators. In the past there have been various financial crises in the world, but in many of these crises, there was evidence of the causes that had triggered them. This is important since clear identifications of the causes of these crises is the first step towards preventing future financial crises, as well as identifying strategies for solving the current financial crisis.

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Causes of Financial Global crisis

The current global financial crisis started in United States of America in late 2006 or early 2007, and then spread to other parts of the world. Global economic interdependence allowed the financial crisis to spread to other parts of the world within a time. From United States, the financial crisis was felt in Europe and then other parts of the world. This crisis led to falling of major world companies in America and affected nation leading to many people losing jobs. In a strategy to solve the financial problems, many companies opted to reduce their workforce while others opted to cut down some of their operations. The crisis forced many people to cut down their expenses for fear of exhausting all their savings. Thus, the buying capacity of most people was reduced leading to poor business performances. The crisis also caused the price of essential commodities such as foodstuffs shot up and trigger a food crisis.

The current global financial crisis is highly associated with the collapse of global housing bubble. As many financial institutions were associated with housing bubble, the collapse had severe effect on the institutions (Shiller, 2008, p.69). The high risk assumed by financial institutions in offering mortgaged led to huge financial losses as a result of sudden fall of housing bubble. This is because the collapse of housing bubble led to securities that were associated with real estate drop. This sudden drop in the value of real estate securities and especially in United States had a severe effect on financial institutions that offered mortgages or that had invested in real estate securities.

Although the causes of the global financial crisis are many, the most obvious cause was the drop in business in housing industry. The United States had a constant growth in demand for houses. This growth reached its peak between 2005 and 2006. Due to high demand for houses many investors were motivated to invest in the sector so as to take advantage of the increasing houses prices (Shiller, 2008, p.67). With increases in number of investors applying for mortgages, financial institutions lowered requirement for mortgage applications so as to motivate more people to apply. Incentives offered by financial institutions, increase in loans offered, easy terms encouraged investors to go for mortgages from financial institutions (Mohan, 2009, p. 5). In addition, the steady increase of house prices assured investors of quick returns on investment. Confident of making good returns in a short period of time, many investors went for mortgages hoping that they could refinance the mortgage in fair terms (Fox & Madura, 2009, p. 152). The anticipated situation, however did not last for long. This is because interest rates to mortgages rose up while housing prices dropped. The anticipated situation made it difficult for many of the mortgage investors, who had large mortgages to service them. Due to difficulties of refinancing the mortgages, there was increase in mortgage defaults. The initial easy terms in which the mortgages had been offered started to expire while housing prices failed to improve. In addition, interest rates of Adjustable Rate Mortgages (ARM) became higher.

In addition, an increase in debt among many people contributed highly to the global financial crisis. Low interest rates offered by financial institutions together with growth in funds from foreign investors led to an easy credit situation. Easy credit motivated many people to go for loans in various forms from financial institutions (Willem, 2008, par 5). As a result of easy credit, there was a burst in housing business while debt-financed consumption also increased. Loans in various forms such as credit cards, housing mortgage and auto increased. As many financial institutions were encouraging many investors to go for credit, many went for credit creating an unprecedented level of credit load (Emerson, Youngs, Setser & Xiang, 2009, p.72). This resulted in a mortgage boom. Financial institutions developed new ways for trading with mortgage loans. There was an increase in Mortgage-Backed Securities (MBS) as well as Mortgage Backed Obligation (CDO) (Kamin & Gruber, 2007, p. 178). The values of these securities depended on mortgages payment as well as the prices of houses in the market. These securities opened doors to foreign investors to invest in a booming housing market (Kamin & Gruber, 2007, p. 176). Therefore as housing prices started to drop in United States, global financial institutions that had invested in America’s housing sector through mortgage lost heavily (Global Research, 2008, par 7). Defaults in other forms of credits also increased leading already to a bad financial situation in financial institutions. Thus, as the financial crisis continued to worsen, credit defaults emerged in other areas of the economy other than the housing sector.

Fall of a booming housing sector in United States is blamed as the immediate cause of global financial crisis (Rudd, 2009, par 3). However, the root causes of the crisis can be found in failure in financial regulations, global economic imbalance and immoderation of economic agents. The financial crisis can also be blamed as a result of a series of global financial crises.

It should be noted that for seven years prior to the current financial crisis, financial institutions had been offering low-interest rates to credit. The low-interest-rate had motivated high global economic growth (Emerson, Youngs, Setser & Xiang, 2009, p. 70). Financial regulators, especially United States’ monetary policy, relaxed regulations on financial institutions to maintain economic boom. Low-interest rates allowed by central banks in various countries led investors to take unprecedented risks while investing (Karam, 2008, par 5). Low interest rates allowed investors to try to look for yield even below credit quality curve. Poor regulation of financial institutions led to high-risk financial instruments. The new financial instruments which seemed to offer adjusted risks turned up to be riskier when economy started to come down (Rogoff & Reinhart, 2009, p.39). With high optimism for high returns, investors and financial institutions compromised market discipline by engaging in high-risk investments for short-term gains.

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Imbalance in participation in global economy played a big role in the global financial crisis. While United States, United Kingdom and other countries had been holding huge external current accounts, developing economies such as China, Asian Four Tigers, and oil-exporting countries had surplus (Kaar, 2009, p. 86). With this imbalance, there was huge inflow of investment to America’s economy. High inflow of capital pushed interest rates in the United States and other deficit countries down, creating an environment for the crisis.

Failure in regulation to financial institutions in United States, United Kingdom and other countries motivated the financial crisis (Wray, 2008, p.87). For example, in United States tight regulation was only applied to insured deposit-taking financial institutions (Karam, 2008, par 11). Other financial institutions such as mortgage, and investment banks were lightly regulated. Due to poor regulation, some banks avoided capital prerequisites by pushing risks to associated institutions that were less regulated. The result was a risky financial system that collapsed with the financial crisis.

Avoiding a Financial crisis in the Future

Global financial crisis was more of a failure in regulations than booming global economy or American’s housing bubble. Failure of financial regulation, especially governments’ central banks allowed risky investment and borrowing that later led to the crisis (Karam, 2008, par 7). Inability to foretell the crisis made it impossible to control the situation before it became a crisis. Imbalance in the global economy and uncontrolled inflow of foreign investment compromised market laws. To avoid the danger of another global financial crisis, United Kingdom government should work on ways to raising the standards and integrity of its financial institutions.

Global financial crisis happened due to level of liquidation. This is because the low interest rates that were being charged by financial institutions, as a way of attracting credit were the root of the crisis. Therefore regulation of the lending process in financial institutions should be enhanced to ensure responsible lending (Weerapana, 2009, p. 44). In addition, the level of dept in the United Kingdom should be regulated. Before the financial crisis, many people were taking credit in form of mortgages to a level where they could not service. UK governments should regulate the level of credit in the country to ensure a healthy level of credit. The Central bank should provide guidelines on the level of credit that individuals or organizations should be allowed.

Financial institutions have played a big role in motivating UK’s economic growth. With this in mind, the solution to the financial crisis does involve making lending impossible but instead instilling discipline in how financial institutions practice ensuring responsible lending. High-risk lending through securitization and other practices should be controlled (Korhonen & Fidrmuc, 2009, p.114). UK government also should provide guidelines for foreign investment in the country.

Conclusion

The current global financial crisis is among the worst financial crises the world has ever experienced. Therefore, necessary measures should be taken to avoid an occurrence of a similar crisis in the future. Economic stimulation and bailout programs are important as short-term solutions. For long-term solutions, there is a need for effective regulation of financial institutions. Although there is often a periodic occurrence of global financial crises, such future crises can be avoided through global financial planning.

Reference

Emerson, M., Youngs, R., Setser, B. & Xiang, L. 2009. “The Strategic Consequences of the Global Financial and Economic Crisis”. CEPS, New York.

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Fox, R. & Madura, J. 2009. “International financial management”. Cengage Learning EMEA, New York.

Global Economic Crisis Resource Centre. 2009. “Global Economic Crisis: Impact on Business”. Cengage Learning, New York.

Global Research. 2008.” Causes and solutions to the Global Financial Crises: President of UN General Assembly invites Expert Panel”. Web.

Kaar, M. “A Critical Analysis of the 2007 – 2009 Global Financial and Economic Crisis and Its Implications for the Travel Industry and Associated Businesses”. GRIN Verlag, Oxford.

Kamin, S. & Gruber, J. 2007. “Explaining the global pattern of current account imbalances”. Journal of International Money and Finance.

Karam, G. 2008. “Root causes of the current global financial crisis”. Web.

Korhonen, I. & Fidrmuc, J. 2009. “The impact of the Global Financial Crisis on Business cycle in Asia Emerging economy”. Journal of Asian Economics.

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Mohan, R. 2009. “Global financial crisis-causes, impact, policy responses and lessons”. Annual India Business Forum Conference.

Rogoff, K. & Reinhart, C. 2009. The aftermath of financial crises. American Economic Review.

Rudd, K. 2009. “The Global financial crisis”. Web.

Shiller, R. 2008. “The subprime solution: how today’s global financial crisis happened, and what to do about it”. Princeton University Press, New York.

Weerapana, T. 2008. “Principles of Economics: Global Financial Crisis Edition”. South-Western Pub, London.

Willem, D. 2008. “The global financial crisis and developing countries”. Web.

Wray, R. 2008. “Financial Market Meltdown: what can we learn from Mynski?” Public policy Brief No. 94.

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