Causes of the Financial Crisis in the US

INTERNATIONAL BUSINESS

During the later half of the 20th century U.S economy was the most powerful economy in the world, they set the rules for rest of the world. They established multinational corporations all over the world which was indeed the heart of world economy. (Davis, 2009). When the U.S economy was rising, all the other countries economy were also growing, at the same time when their economy went down it affected almost all the other importing and exporting countries in the world because of the recent crises which was named as “GLOBAL FINANCIAL CRISIS”. This was meant to be the biggest crises after “THE GREAT DEPRESSION 1930” (Cambridge Journal of Economics, 2009). The crises have already recorded loss of over $150 billion and large number of banking institutions have declared bankruptcy or being sold.(Kregel, 2008) One among the banks filed for bankruptcy was Lehman Brothers, which was Fourth largest investment bank in U.S. (BBC, 2009). Therefore it is important to identify causes of current financial crises and resolution measures. Secondly, UK government should take effective steps in order to reduce danger of further crises (Turner, 2009)

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During later part of the 19th century that is 1973 Daniel bell published a book titled “THE COMING OF POST INDUSTRIAL SOCIETY”. The book was about forecasting to find the changes in economy and society in united state. One of the most visible changes according to him was the work force shifting from manufacturing and agriculture to service based industry which he named as “POST-INDUSTRIAL SOCIETY”. The author was right in his prediction because today only 10% of the total labour force is employed in agriculture and manufacturing industry. Between the period December 2000 and May 2009 US lost more than 5.25 million employees in manufacturing sector. There were many problems in durable goods industry, particularly in auto manufacturing industry. Two or more companies in that sector declared bankruptcy which stated that there was lot more bad news to come. Comparatively, manufacturing jobs were long lasting on an average of 8 years compared to an average of 3 years in service industry. The shift was driven by Wal-Mart. The firm employed about 1.4 million employees in 2009 which was more than that of 20 largest American manufacturing companies together.

This caused changes to occur in pension financing and people started investing in mutual funds. This happened through change in pension financial that took over small amount to mutual fund from large amount of investment savings. This created pressure for high returns and also takes away the option of staying with a single firm. This enabled growth of institutional investors. Huge amount of portable pension funds were managed by banks, mutual funds and insurance firms. Nearly 1000 corporation shares were owned by institutional investors in 2005, with mutual fund taking maximum of 10% or more in hundreds of corporations. For manufacturers the main focus was on share value which spread OME model (Original equipment manufacturer) which means the production is out sourced to other external organizations. Other than manufacturers, functions such as HR and IT etc were also outsourced. This slowly made drastic changes in traditional corporation where it became empty. They were concerned mainly about turning the out-sourced products into branded commodities. This shows that the stock market existed only for intangible assets. (Davis, 2009)

Now we shall discuss about the causes of the Global financial crisis:

One of the main reasons for the crises was the housing bubble. A housing bubble is an economies bubble that occurs in local or international market. The recent financial crises started eventually in 2001 with the busting of U.S housing bubble and reached its peak in 2005.Basically it is said when there is a rapid increase in real estate prises until it touches its peak and reaches unsustainable level. The bubble in the houses was identified in 2006 after the market correction. Former chairman of Federal Reserve Board, Alan Greenspan said in 2007 that they had bubble in housing but it was very late until they realized in 2005 and 2006 (Bianco, 2008)

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Many economists believe that the main reason behind housing bubble was caused by low interest rate set up by the Federal bank. The interest rates were reduced to 1% from 6.5%, this made people to mortgage their property against the loan. The banks in return encouraged everyone to obtain loan against their mortgages because real estate prices were at its peak. [business.cch.com] When inflation began in 2004, US federal withdrew monetary accommodation, they started increasing the interest rate and mortgages payment also started rising apparently. Tight money policy came into play and there was a great demand of money and therefore house prices fell. Banks and other financial institutions financed at very low rate, and when interest rates started raising there were heavy chance of default by the subprime borrowers thus default by such borrowers led to losses. Though the loans were secured and were sold to special institutional vehicles (SIV’s) the losses were still bourn by banks and other institutions (Mohan, 2009)

Deregulation of financial system gave rise to tradable instruments through securitization. Securitization means turning an asset or credit card debt into tradable instrument. This system made household to become both investors and issuers of securities. Thus trading in different form of capital emerged which was unstable and did not last for long which caused the financial crises (Davis, 2009). Apparently US government failed to manage their trade deficit. The housing bubble was mainly caused by cheap credit and low interest rate rates. The main reason for cheap credit was there was a lot Chinese capital in U.S. And that is because US imports most of the products from china and sells it at a cheap rate to its consumers (Weismann, 2008)

Global Macro Economy Imbalance: According to Portes (2009) global macro economy was one of the major underlying reasons of the financial crises. This is because of saving investments and huge cross border capital flow made a lot of pressure on financial intermediation process, these imbalances with flaw in the financial market and instrument together became one of the specific features of crises (Mohan, 2009).

In view of the current crisis, the UK Government can initiate the following actions to prevent another crisis:

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Looking at the long term , we think of what should be done in order to avoid danger of future crises, it is clear that macro economy imbalance was one of the major underlying reason, so it is better UK government try to find the problems which lie at the interface between macro economy policy and financial system regulation.

Few more things that government should consider are they should make sure that they protect the needs of ordinary people when the information is costly to acquire. Next measure is the government should make sure that internalises significant externalities. This is in contrast to the currency regulatory frame work which does not focus on externalities and it also provides incentives for the institutions to become very large to fail or too interconnected to fail, because the larger the institution the more interconnected and higher the risk of escaping during crises.( Brunnermeier, 2009)

The government should also focus on systematic risk contribution because during the financial crises losses tend to spread over other financial institutions also. The government should try to form a regulation that reduces the risk of spreading over the losses to financial institutions. A financial contribution to systematic risk can be large because of its correlation with financial difficulties among the other institutes or causes financial difficulties at other institutes. Therefore new measures should be taken to reduce the risk of both the channels. (Brunnermeier, 2009)

According to Turner (2009), liquidity management and new regulations help to minimize liquidity risk. The future rules and regulations should be monitored effectively (Turner, 2009).

Asset price booms can be regulated by implementing strict fiscal and monetary policies. These policies should take into consideration price stabilization and macro-financial stability. There has to be effective co-ordination between domestic and international policies. The UK Government should try to stabilize all the financial institutions that hold illiquid assets. The regulators have to combine macro-prudential and macro economic analysis by using sectoral analysis (Turner 2009).

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REFERENCES:

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Bianco, K.M., (2008) The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown [Online] CCH Mortgage Compliance Guide and Bank Digest. Available at: http://docs.google.com/viewer?a=v&q=cache:Vf9c_0SfRl4J:business.cch.com/bankingfinance/focus/news/Subprime_WP_rev.pdf+http://business.cch.com/bankingfinance/focus/news/Subprime_WP_rev.pdf&hl=en&gl=uk&pid=bl&srcid=ADGEESj5j4t_00aCZcSuhO6_qF6EZO99uP_P34gAGd2f_A7I_C2MVjlkbSVcFqc6FpAPGyYECW5sPQG6k_k4ja-tXrsL2EsZd8alQZk0U9n7Esqh31V1F9pwowYc1IeTo-U3I5vHAR9K&sig=AHIEtbT1hFiNcXHdS3Y4lgV7AYIRF1xY4g [accessed 28 February 2010]

Crotty, J., (2008) Structural Causes of the Global Financial Crisis: A Critical Assessmentof the ‘New Financial Architecture’ [Online] PERI – Political Economy Research Institute, University of Massachusetts Amherst. Available at: http://cje.oxfordjournals.org/cgi/content/abstract/33/4/563 [accessed 28 February 2010]

Davis, G.F., (2009) The Rise and Fall of Finance and the End of the Society of Organizations [Online] Available at: http://docs.google.com/viewer?a=v&q=cache:ZorkG-ZL1xoJ:webuser.bus.umich.edu/gfdavis/davis_09_AMP.pdf+http://webuser.bus.umich.edu/gfdavis/davis_09_AMP.pdf&hl=en&gl=uk&pid=bl&srcid=ADGEESjziDXUPSnMjim8GZyAz8aK9YRHi-xpS8SYDDv3l4gtQ9hV0ahiOz8oXWhb9zGr-HAAkRmaRdH34zQJu–aoZpLyEv_QopXWxlCvjM7CuFPsiWbmUdqY-b-hZ1KQL4The1skEpD&sig=AHIEtbSoJoJuRiAosw1OGQqy3G2BrQEutg [accessed 28 February 2010]

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Mohan, R., (2009) Global Financial Crisis- Causes, Impact, Policy responses and Lessons[Online] Annual India Business Forum Conference, London Business School. Available at: http://www.bis.org/review/r090506d.pdf [accessed 28 February 2010]

Turner, A., (2009) The Financial Crisis and the Future of Financial Regulation [Online] The Economist’s Inaugural City Lecture, Financial Services Authority. Available at: http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0121_at.shtml [accessed 28 February 2010]

Weissman, R., (2008) Deregulation and Financial Crisis [Online] The Huffington Post. Available at: http://www.huffingtonpost.com/robert-weissman/deregulation-and-the-fina_b_82639.html [accessed 28 February 2010]