The Nature and Causes of the Global Economic Crisis

Topics: Economics, Subprime mortgage crisis, Supply and demand Pages: 7 (2114 words) Published: April 29, 2013
1.The nature and causes of the global economic crisis
What is global economic crisis? – The nature thereof.
Global economic crisis refers to an economic situation in which most of the countries of the world go through a period of economic breakdown called contraction or recession or slump, which manifest itself in the decline in aggregate output, usually for two consecutive quarters. During this contraction period, the structure of the economies change, resulting in economic hardships such as, rising unemployment and inflation and the general decline in the countries’ economic performance. The global economic crisis is also characterized by falling stock market, housing market, collapse and bailout of large financial institutions and the economic/ financial suffering of the ordinary people who would experience soaring prices, job losses and the accompanying emotional trauma. What were the causes of the global economic crisis?

The collapse of subprime loans in the US housing market (Case, Fair & Oster 2012:632-638) The phenomenal growth in the US mortgage lending and the securitization of mortgage loans resulted in a spectacular collapse of the residential housing market. During the US property boom, beginning in the early 2000s, banks began securitizing mortgages and selling them in capital markets in the form of mortgage-backed securities (MBS). The demand for high-yield products based on mortgages was so great and bank fees so large that banks and brokers began to even sell mortgages to those who could not afford them. Consumers and financial institutions amassed very high levels of debt. The whole process was driven by accelerating leverage. The subprime mortgage crisis erupted in 2007 on the back of a high level of mortgage loan defaults, and lack insufficient provision for defaulted loans. The crisis began in the US, but since mortgage-based financial products had been dispersed around the world, we soon had a global financial crisis. It all started with the decline in housing prices which then affected the value of mortgage-related financial products held on the balance sheet of many financial institutions. Because US regulatory standards required the financial institutions to mark-to-market their assets, which include the mortgage backed securities, the financial institutions recorded large losses due to marking down the value of the mortgage based securities. Their balance sheets became weak, and that triggered the bank’s non-compliance with regulatory capital requirements, since the markdown had effectively reduced the value of bank’s regulatory capital. Similarly, under the Collateralized Debt Obligation (CDO) mechanism, when housing prices began to fall, the loans secured through CDO could not be repaid, thereby resulting in losses for buyers of securities based on subprime loans. This situation, which could be traced to the uncontrolled expansion of credit, had a devastating financial effect on the financial institutions that had large exposure on housing and housing-related products, and is said to be the major underlying cause of the 2007-2010 recession. The following sketch depicts a visual image of what happened in the US housing market, which later also caused the global economic crisis

The above diagram shows how the subprime lending led to inflated house prices from the 1980s to 2007. The effects of the burst in the subprime bubble can be seen from the latter part of 2007. Inconsistent government policies, deregulation of financial markets and excessive use of innovative financial products Despite its expansionary effect, the Laissez-Faire, invisible-hand, capitalistic approach adopted by the regulatory authorities/states had unfortunately introduced some shortcomings into the financial system. The rather light government regulations have enabled the modern- day financial institutions to engage in aggressive risk-taking practices which, among other things,...

References: 1. Case KE, Fair RC and Oster SM. Principles of Economics. 10th edition. Pearson Education, Prentice hall, 2012.
2. Mohr P, Fourie L, and associates. Economics for South African students. 3rd edition. Van Schaik.
3. Global Journal of Business Research: Volume 4. No3. 2010 “Did FASB 157 Cause the Financial Crisis?” Peter Harris, New York Institute of Technology, Paul R. Kutasovic, NY Institute of Techno)
4. The Global Economic Crisis of 2008-2009 – A. Rapport and A. Gerts. “Sources
and Causes”
5. A. Suetin - “Causes of the Current Financial Crisis”
6. McGraw – Hill – “Effects of the Global Financial Crisis”
7. Wikipedia – Aggregate demand and aggregate supply definitions
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