Global Financial Crisis and Its Roots

Introduction

Over the past few decades, the world has been trying to recover from the 2008 economic recession, which affected many economies around the globe. The recovery process has been slow to the extent that many countries around the globe are still struggling with high unemployment rates coupled with low industrial outputs. All the listed negativities are attributed to the 2008 global economic crisis, which greatly influenced the world financial sectors (Taylor 56). The recession commenced in the United States before spreading to other parts of the globe. The recession was characterized by the then liquidation of reputable financial institutions in the US and other parts of the globe. Financial institutions play a pivotal role in promoting the growth of an economy. Hence, their liquidation was a major blow to global economies. The debate concerning the causes of the recession has been heating up, with scholars in the field of economics presenting different theories to explain its causes. This paper explores the different theories that attempt to explain the causes of the recession.

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Causes of the Recession

World Trade Imbalance

In the period between 2001 and 2007, the global trade was characterized by heavy imbalances where some countries were exporting goods that exceeded what they imported. Trade imbalances may either harm or boost the economy of a country in the end. Any country, which exports more than it imports, will have its industries flourish, hence leading to positive economic growth. On the other hand, a country that imports more than it exports stands to lose its economic power since it may lead to trade deficits. The described situation caused the economic recession of 2008. While China benefited from international trade, other countries around the globe experienced economic slowdowns. China used its strong industries and advanced technology to minimize the production cost for its industrial products. Consequently, its exports became cheap and highly attractive in the international market (Taylor 65).

It is important to note that the cheaper a product is, the higher its demand. In light of the stated view, China’s products automatically dominated the international market while the products from other countries became less attractive. The country recorded higher exports than exports in the period that immediately preceded the time of the recession. The result was that China recorded rapid economic growth at the expense of the other global players. American goods specifically became less attractive in the international market, a situation that caused the failure of its local industries. The collapse of the local industries caused the country to import more goods from China. Consequently, the US economy underwent a recession, which equally affected other countries across the globe.

As China’s economy flourished, the US and other countries deteriorated due to their over-reliance on imports. The US was the most affected by Chinese imports. As of 2007, the year of recession, the US trade balance had more than tripled from $69 Billion in 1999 to more than $256 billion (Taylor 37). The rapid growth of the US trade balance was attributable to the increase in its borrowing. As the US consumers increased their overall consumption of the Chinese products, America had to borrow funds to facilitate its importation of goods. Much of the borrowings came from China, a situation that greatly strengthened the Chinese Yuan. Given that China exported more than it imported, it had financial surpluses that it would invest in the US’s treasury bonds. This situation worsened US financial deficits. The high trade balance coupled with increased borrowing significantly weakened the US economy, thus leading to the recession. As of 2007, America had a public budget deficit of about $1.5 trillion, which was significantly high compared to the previous years (Taylor 45).

Excessive Deregulation of Financial Markets

The other possible reason why the recession occurred is the existence of gaps in the legislation regarding the regulation of the financial markets. The US relaxed its regulations for the financial markets in the 1980s in a bid to promote the accessibility of funds to the poor (Taylor 56). Consequently, laws governing the operations of banks and other financial institutions were either scraped off or made less stringent. Trade liberalization played a major role in shaping the laws governing the financial sector in the US. In the 1980s, most countries around the globe embraced trade liberalization, which allowed countries to trade freely with each other. Bilateral and multinational agreements were made to liberalize trade. To boost trade further, the US eased up its financial sector and removed some of the legislation that regulated the banking sector. Consequently, banks became independent of government regulations. They could make decisions on themselves. The deregulation caused the advancement of credit to even the un-creditworthy persons. This provision increased defaults and bad debt, which harmed the country’s financial sector. The result was the failure of large financial institutions since they were forced to go into liquidation for not meeting their short-term and long-term obligations. The poor performance of the country’s financial sector caused the erosion of the public and investors’ confidence in the banks. Since banks rely on funds obtained from customers and other investors, the lack of public confidence was a major blow to their operations.

The problem was compounded by Clinton’s directive that banks could facilitate the acquisition of homes by the poor people in society. Clinton’s administration threatened to bring legal suits against banks that did not comply with the directive. Consequently, banks were compelled to give loans to citizens without considering their credit ratings. Many people who acquired such loans defaulted in payment, a situation that caused the downfall of major banks in the country. Historically, the overall default rate was averaged at 0.5 to 2% (Taylor 37). However, as of 2007, the default rate was more than 6%, which is illustrative of the negative effects that Clinton’s directive had on the performance of the banking sector.

The Dominance of the Dollar

After World War II, the US dollar rapidly strengthened against other currencies. The dollar strengthened even further following the Bretton Woods agreement in 1944, which allowed the country to peg its currency with gold (Taylor 67). Consequently, the demand for the dollar increased rapidly, as other countries in the world bought it anticipating profits from gold. Years later, the US entered into agreements with the international community. This move liberalized trade. Under such agreements, goods from other countries around the globe would trade freely in the US. The increased demand for the dollar coupled with the increased export of goods into the US caused the country to adopt the Floating Exchange Rate in 1971 (Taylor 45). Consequently, the country printed more dollars to meet the high demand. The unregulated printing of the dollar caused the free flow of goods into the US. As of 2007, the country consumed more than it could afford. The result was that it experienced huge deficits in its trade balances, which gradually harmed its economy. After several years of unregulated printing of the dollar and the free flow of goods into the US, local industrial outputs shrunk, hence compounding the problem of overconsumption of imported goods. Additionally, the country borrowed heavily from foreign nations to finance its budget deficits. The borrowed money was used to finance unproductive activities, which precipitated the crisis.

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Conclusion

The 2007 recession refers to a global financial crisis that manifested in the form of high deficits in the trade balances of most countries around the globe. The US was the most affected by the crisis while China reaped big from the crisis. Several factors precipitated the occurrence of the crisis. One of the factors that prompted the crisis is the trade imbalance that was evident in most countries across the world. The imbalance was caused by the increased consumption of China’s products, as opposed to the locally manufactured ones. China successfully lowered its production costs by employing efficient technology, thus making its goods cheaper relative to those produced by other countries. Consequently, most countries imported goods from China to satisfy the local demand, which killed their neighborhood industries while increasing their overall borrowing. Other than trade imbalances, the crisis may have resulted from the deregulation of the financial institutions. Such deregulation increased banking malpractices and the advancement of loans to people with poor credit ratings. Lastly, the strengthening of the dollar against other currencies after the Second World War may have precipitated the crisis. The strengthening of the dollar against other currencies raised its demand, hence fuelling the crisis.

Work Cited

Taylor, John. Getting off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis. Hoover Press, 2013.

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