Credit crunch

what caused the current credit crunch

What were the causes and consequences of the ‘credit crunch'? How effective have the responses of governments been?

1. AIM

The aim of the assignment is as follows

1) To understand the principle causes of the latest economic crisis.

2) To analyse the consequences and the extent of the damage caused by the credit crunch.

3) To critically evaluate the government's response in different countries

2. METHODOLOGY

This assignment aims at providing understanding of the causes and consequences of the current financial crisis and what steps have different governments taken to tame the damage and analyse how effective has the stimulus package been helpful. This assignment has been divided into three part, the first being, identifying the causes of the credit crunch; the second, consequences of the crisis and finally the government responses to the credit crisis. In the conclusion, some of the key findings and some alternate path or recommendations have been provided.

The first part of the essay is about the background analysis of the credit crunch and what were the causes of the financial crisis. This required for one to understand certain banking regulation of the US and their interest rates. The key areas like, imbalance in world economies, the sub-prime loan crisis, shortage of cash, etc. have been drawn-out and explained in detail.

The second part of the assignment is about analysing the consequences and the depth of the crisis and how bad was it compared to the great depression of the 1930's. The crisis had a great impact on number of economies around the world.

The industrial output dropped and unemployment rate increased. The market was insecure and the spending power of the general public decreased and so did the consumer demand.

The third part of the essay brings out the governments responses to the financial crisis and the various stimulus packages being sanctioned by the governments.

3. INTRODUCTION

The greatest financial crises of history, as it's being called came suddenly and it sent shockwaves through the financial sector around the world and like all the other previous bubbles it had disastrous effect on the global economies. The market stopped functioning normal and the governments started to nationalise the financial systems. It looked as though the future of Capitalism was here. The financial crisis kicked-off from the US and spread across number of countries, both developed and developing countries (Brazil, Russia, etc) and low income countries (sub-saharan countries) and the severity and duration of the crisis is still uncertain.(Committee, 2009)

The scene for the latest one, September 2007 crash was set up due to various factors working hand in glove, few of them being, global imbalances in economies, low interest rates in the US, rapid expansion of credit, introduction of new financial instruments into the market etc. All these developments made it very difficult to understand the market, and adding to this, little action was taken to keep the market in control which finally led the bubble to burst. (Farcaster, 2008)

The credit crunch began when the banks around the world lost confidence which led to the short fall of cash as the interbank trading were frozen. Some of the major banks around the world collapsed and the worst hit were the banks in the US. After the collapse of the Lehman Brothers in 2008, the US government started to pump in large amount of money in to the market to bailout banks and insurance companies and this was followed by other governments around the world. The government came to the rescue of some of the giants like AIG, Fannie Mae Freddie Mae, Citi bank etc.

But these came too late as the damage was already done and the crisis ended the low inflation, sustained growth that the developed countries were enjoying and also led to the decrease in the world output and the economy was dropping for the first after the WWII (1945)

The severity of the crisis has been so deep that it could be compared against the great depression. The number of banks that have failed are 57 and the unemployment rate is about 10% in some countries and is expected to remain the same till 2010 compared to the 9096 i.e 50% of banks and unemployment rate was about 25%. The economic decline of the current crisis stands at about -3.3% compared to the -26.5% during the great depression. Short term emergency spending at 2.5 % of GDP compared to 1.5 % of GDP and the biggest decline in Industrial average is -53.8% to -89.2% at the time of great depression. These show that the scale or the magnitude of the current recession is no lesser than the great depression. (Survey, 2009)

The crisis affected various industries and people feared of more job cuts. Firms on the other hand were trying to find ways to reduce cost and in some firms in India (call-centres) reduced the working hours or gave away voluntary holidays to their employees due to the reduced demand in overseas projects especially from the US. Automobile, Oil, Export-Imports business, housing sector, retail industry, education, and various other sectors were hit by the recession.

4. CAUSES OF FINANCIAL CRISIS

There were various reasons for the current credit crunch as there were number of event that were going wrong and the outburst was so sudden that all the problems accumulated to set up the big burst. So, it really depends as to what caused the bubble. Many economists predicted of these a few years ago that such an event was possible and the government should setup measure to prevent any adverse effect but the government failed to learn from the previous occasion. Below are few of the cause for current financial crisis.

4.1 Fall of Financial Institutions

On September 15 2008, Lehman Brother announced their filing for bankruptcy and this had a trickle down effect and kicked of the financial market crisis. Many other banks around the world were nationalised, the stock markets around the world crashed, millions of people lost their job and the economy suffered for the first time since 1950's. US & UK governments saved various other banks by bailout plans.

4.2 Imbalance in Economies

On a macro-economic scale, one of the causes of the financial crisis was the imbalance in the world economies. Middle-East Oil-exporting countries and Asian countries like China had great US dollar reserves and used these to invest in the western economies. China and few other countries were investing and also China had a fixed exchange rate reduced the effect of the natural market smoothness. This averted the currency from being appreciated and the monetary policy relaxed, due to the cheap imports from the Asian countries like Bangladesh, China, India, etc, the inflation was low. Mr Jacques de Larosière told that “The main fundamental cause of what happened was the piling up over ten or 15 years of easy/too easy monetary policies.” (Committee, 2009)

4.3 Sub-Prime Loan

The interest rate in US started to increase very fast pushing the housing price upwards, which lead to a large number of people defaulting their mortgage repayments. The banks stopped to lend not knowing the depth of the crisis in other parts and the credit markets started freezing. Investors suffered heavy losses, which made them unwilling to buy more CDO's[1]. (NEWS, 2009)

4.4 Liquidity Crisis

The banks ran out of cash, which meant that they were unable to support the firms and individuals. No more loans were provided by the banks and they had tightened the mortgage facility. Banks went back to the basic with loans against securities. Lack of credit to other banks, firms and individuals meant that pose a huge threat of recession, bankruptcy, unemployment and rise in cost of living (NEWS, 2009)

5. CONSEQUENCES OF THE FINANCIAL CRISIS

The consequences of the financial crisis were different in different parts of the world. It all started off in the US and has spread across to various countries including the low income countries and to an extent to India and China as well. Inflation

5.1 Fall in Economic Growth/Industrial Output

The economy fell for the first time since 1950's. There has been a step fall in the industrial production around the world. The crisis started from the banking and the real estate sector and spread across various other sectors like automobile industry, fashion industry, etc, bring down the output curve. Many of the developing countries and low income countries dependant on the exports have been hardly hit. (IMF, 2009) Industrial output of Russia fell by about 12 - 13% and gas output fell sharply owing to drop in demand from the European customers.

5.2 Fall in Demand

As explained by Hudson in his papers, “the total demand was at the risk of falling and each fall would reinforce the decline in a vicious circle”. (Hudson, 2008) Hudson came up with the below formula to explain the decline in total demand

Total final demand: = C ↓ + I ↓ + G ↓ + X ↓

Where,

C = Consumer demand

I = Investment

G = Government

X = Exports

The Government will have to do large spending to recovery the banks, which reduces the spending/investments in other areas and ultimately result in increasing the tax. This further reduces the spending power of the consumer leading to the reduction in demand. Firms cut back on the investments due to reduced demand and started focussing on effective sourcing/procurement strategies to survive the crisis. In many of the manufacturing countries like India and China, Joint Venture was seen as a way out of the recession and many small export oriented companies joined hands to fight the recession out. The global demand fell very sharp and the worst affected industry was the automobile industry with the three giants GM, Ford and Chrysler on the verge of bankruptcy. India and China, one of the biggest exporting countries and considered themselves not affected by the recession, also went through one bad patch with the sudden dip in export demand and some of their retail partners went bankrupt which build dead stock. As both these nations had a strong domestic market they were able to come out of the problem swiftly. Also the consumer demand fell sharply and people were holding on to the money they had, as the job market wasn't good and huge laying-off of employees by many

firms made them insecure. All these factors put together led to the drop in total demand and the global economy started falling apart.

The commodity prices also dropped during this period. Price of oil and metals fell very sharp and had a great impact on the middle-east and the Russian economy. Russia had

5.3 Impact of the Currency Fluctuation on Economic Growth

The currency fluctuation had a great impact on the export oriented business and to the big oil countries like Russia. China had a great fear due to the falling dollar price as they had a huge reserve of the US dollar. There has been a drastic devaluation of the reserve which could have an effect on Chinese economy in long term.

5.4 Unemployment Rate

The unemployment rate in the developed nations like US, UK and European nations rose very fast during the crisis. The employers started laying off employees at will and there was a wave of people who lost their job in the last two years. The unemployment rate in UK(at end of 2009) was about 8%, and US it was about 10 % and in Europe it stood at about 9.6%.

5. Other Industries Affected

Automobile Industry

The automobile industry also had a huge impact from the financial crisis. Some of the big names like, GM, Ford, Chrysler, Sauber were on the verge of bankruptcy. The initial few months of 2008, saw no fall in the demand but the later part of the year, there was a huge dip in demand and many of the dealers also went burst, creating a problem in the supply chain. The crisis also has pushed the industry towards effective sourcing/procurement strategies. Automobile industry in Russia saw a drop of about 60 - 70% in output.

Retail Industry

There was a huge drop in the sales volume in the retail sector. This was evident from the decrease in exports from the manufacturing countries. Woolsworth, UK based retailer went bust during this financial crisis. This is a 100 year old company and was somehow able to survive the Great depression but not the great recession. All retailer had to reduce price to stimulate more sales, which further reduced the cost price of the same. Carrefour during the later 2008 and early 2009 i.e Winter 08 & Spring 09 seasons had to slash atleast 2 - 3€ from the selling price on all it apparels to prevent dead stock.

6. GOVERNMENTS RESPONSES TO THE CRISIS

The government's response to the financial crisis is by providing stimulus packages and bailing out key banks and industries to prevent any further damage and bring back confidence in the market again. In defining the long term recovery process, the governments have returned to the Keynesian model to the recovery. Most thought Keynesianism was dead but as it had always been it was always the best option (during the post World War II era and 1990's recession). The governments pumped in loads of money into the market and nationalised the banks and started controlling the financial market.

Governments came out with immediate short-term and emergency responses to the crisis with the bailout plans and stimulus packages. The government responses from various developed countries have been similar. The governments have pumped in a huge sum of money into the market and also drafted out fiscal and monetary policies in a road map to recovery. OECD[2] has been actively working with governments and has come up with a strategic response to the financial and economic crisis for a stronger, cleaner and fairer world economy. (OECD, 2009)

6.1 US GOVERNMENT RESPONSES

The US governments' response had to be fast and they pumped in huge amount of money back into to the market to bring back the confidence in the investors. The US governments had pumped in 787 billion dollars into the market in forms of both government spending and the tax cuts. “Of the $787billion, $584 billion are to be spent in 2009 and 2010, with 19% of the funds allocated toward increases in government spending, 33.4% in transfers to the states, and 47.6% toward tax cuts.” (Leduc, 2009) The governments had both short term as well long term aids in order to bring confidence bank in the financial market and also urged for open the market for investment. US government spent about $350 billion on the troubled asset relief program to remove the bad debts created by the assets and removing the same from

UK Response to Crisis

The UK governments' response was similar to the US, also pumped in money back into the market and also guaranteed loans for the interbank lending and also bailed out and nationalised some of the financial institutes. The UK government also cut bank on the bonus and tax cuts on the patch to recovery but the predictions by IMF are that the UK government will start to recover no later than 2011

Infrastructure and Green Development

Governments in both UK and US are focusing on increasing the government spending in areas like infrastructure development and green technology. The global climatic conditions was giving a top priority status, the reason being that adverse climatic conditions could affect the quality/fertility of the agriculture land which in turn could bring the global economy further down. The whole point of the Copenhagen meet was to discuss on the depleting ozone layer causing global warming and what steps need to be taken by the developed and the developing nations to prevent any disaster in the future.

OECD has also suggested governments should not stop investing on intangible assets like R& D, software and worker skills. Innovation in

7. WHAT COULD BE DONE ?

The government's response has been swift and has showed positive developments on the economy but below is a policy measure that the governments could apply to have banks under control

7.1 BRING MARKET DISICPLINE

Market discipline[3] and creating checks and measures have also been discussed amongst many governments and also using different methods to evaluate riskiness of bonds and share. For a market discipline to be functioning effectively there are certain criteria's that have to be satisfy. The first being the information, the participants should have the complete information in order to make a judgment and know that the economic system is such that most of the times the relative information to make effective financial analysis is under supplied. The benefits of these information's are larger and also comes at a relatively high price but they are not easily available. When bad news had to be communicated there were confict of interest between the user and the supplier of information.(Market discipline and financial stability, 2001)

The second being ability to process the information which is relevant to the financial analysis, as valuation and risk is a tough process and also a time consuming one. Previous experience was not necessary in determining future risk and also most of the banks had huge investments, it was difficult to process all the information and reach to concise.

The third is discipline mechanisms for example, legal or financial instruments that the stakeholder could use in order to discipline the institution etc,.

Finally internal bank governance is required to monitor those factors that determine if the banks senior management and board of directors have changed their risk taking behavior in response to changing market signals. The current crisis in the financial markets has highlighted significant lapses in each of these core blocks and this need to be addressed by the government in their respective markets to avoid overheating of the financial market.

CONCLUSION

We can conclude by saying that the impact of the financial crisis was felt in almost every country in some way or other even though they did not have any direct link to the problem. It seems like US is the god father of the world and when they sneezes the whole world gets cold. This situation seems to be changing gradually as China and India have seen growth by about 9% during the periods of recession and seemed to have no effect of the crisis in their respective domestic market.

The current financial crisis had a huge impact on the global economies and governments had a lot to learn. Some of them were

The important thing about the crisis is that the firms have started focussing on efficiency. The areas of procurement, effective sourcing policies have been major developments amongst many of the industries.

As the above picture depicts the recovery of the market but it is too early to predict that things will remain the same as some governments are feared of a second wave of crisis. The US president came up with some stringent actions when the banks started to roll back loan

Works Cited

Cogan, J. F. (2009). New Keynesian versus Old Keynesian Government Spending Multipliers. Retrieved Mar 01, 2010, from http://www.frbsf.org/publications/economics/letter/2009/el2009-20.html

Committee, E. A. (2009). Banking Supervision And Regulation. London: Authority of the House of Lords.

Farcaster. (2008, October). Lending & Borrowing Decisions. Retrieved Mar 01, 2010, from Wikipedia: http://en.wikipedia.org/wiki/File:Lending_%26_Borrowing_Decisions_-_10_19_08.png#filehistory

Farrell, L. B. (2008). Leading Under Uncertaininty. Mckinsy's Quarterly.

Hudson, J. R. (2008, October). The Credit Crunch: Consequences, Globally, Nationally and in the South West. Retrieved March 04, 2010, from Department of Economics, University of Bath: http://www.bath.ac.uk/economics/creditcrunch/index.html

IMF. (2009). The Implication of Global Financial Crisis for Low-Income Countries. Alicia Etchebarne-Bourdin: International Monetary Fund.

Leduc, S. (2009, June 19). Fighting Downturns with Fiscal Policy. Retrieved March 02, 2010, from Federal Reserve Bank: http://www.frbsf.org/publications/economics/letter/2009/el2009-20.html

Market discipline and financial stability. (2001). Banks and Systemic Risk Stability (pp. 1-9). London: Bank of England.

NEWS, B. (2009, Aug 07). Timeline: Credit crunch to downturn. Retrieved Mar 04, 2010, from BBC News: http://news.bbc.co.uk/go/pr/fr/-/1/hi/business/7521250.stm

OECD. (2009). Update on OECD's Strategic Response to the Financial and Economic Crisis. Paris: OECD.

Survey, L. F. (2009). The Impact of the Recession on the Labour Market Availabe in Office for Nation Statistics. Retrieved Mar 04. 2010, from http://www.statistics.gov.uk/downloads/theme_labour/impact-of-recession-on-LM.pdf

[1] Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets.

[2] OECD - Organisation for Economic Co-operation and Development

[3] Market discipline - Market discipline is usually defined as the mechanism or process by which market participants monitor and punish excessive risk-taking behaviour by financial institutions.

[4] BBC NEWS: http://news.bbc.co.uk/1/hi/business/8214272.stm

Source: www.ukessays.com

Category: Credit

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