A Financial crisis is a situation where the demand for money outstrips the supply of money. This means that liquidity is rapidly evaporated due to the withdrawal of available funds from banks, forcing banks to either sell other investments or collapse. A financial crisis is usually anticipated by the creation of a speculative bubble in one or more connected sectors of the economy, usually generated by investors ‘ herd behaviour. The start of any financial crisis is marked by the ‘ bubble burst ‘ – often due to the abrupt halt of rising trends in prices. The climax of the crisis is widely perceived when the negative impacts of illiquidity create a financial institution to collapse as well as general mistrust in the financial system. In 2007 – 2009, the US experienced this kind of systemic failure. This paper aims to determine the causes, possible consequences, and lessons from the financial crisis of 2007
Political factors were a significant contributor to this crisis. There were structural loopholes in the educational system in the united states leading to economic inequities for the individuals in the society. To curb with the expanding wealth inequality, politicians from both fronts saw it wise to have home ownership broaden (Lumen, 2018). This was passed as an act of law which made it possible for most Americans to access loans from banks and this led to mortgage lending being riskier. The increase in demand for houses raised prices of houses and this led to housing price bubble. Most countries incorporate a regulatory culture which involves three main elements: (1) federal subsidies that are directed to few bank borrowers, (2) Subsidized provision of guarantees of implicit and explicit repayment to bank lenders and fault monitoring and control of the problems caused by the first two elements. These factors undermine the quality of banking supervision and create a financial crisis.
According to (Rosengren, 2009) the united states monetary policy was another contributing factor. Seven years before the crisis occurred the U.S had adopted easy money monetary policy accompanied by the U.S federal reserve which a crucial factor to the boom in price leading to the financial crisis.in the 2007-2009 period decisions linked to actual interest rate went below which was never experienced in the past. These unusually low-interest rates, part of the Federal Reserve’s deliberate monetary policy choice, speeded up the housing boom and ultimately led to housing busses. The impact of low-interest rates on housing prices has been amplified by the incentives provided to lenders by the low-interest-rate environment to make loans riskier (hypothecary). The U.S central bank and other European countries that had adopted easy monetary policy experienced the housing boom.
Economic developments globally were another cause of the financial crisis. Before the crisis, many believed that by diversifying all kind of risks would be cured (David Luttrell, 2013).By pooling (including subprime) loans from different geographies and then issuing securities against those pools sold on the market, the benefits of two types of diversification were believed to have been achieved, geographical diversification of the pool of mortgages and subsequent holding by diversified capital market investors of claims against these pools. Many of these securities, however, were held by interconnected and systemically important financial market institutions,so theprocess focused risk on institutional balance sheets which created greater risk. Clearly, advances in IT and financial innovation have facilitated these developments (Elliot, 2011)
One major consequence is that people lost trust in government institutions and the economic capital system. Fraser Institute’s Index of Economic Freedom global ranking saw the united states drop in ranking from the second spot in 2000 to 18th place in 2012 The lower ranking showed perceptions of less – secure property rights, greater government, increased corporate regulation, and particular interest – giving favouritism. These financial intermediaries, considered “too big to fail,” exhibited lack of discipline and accountability that led to the crisis and were largely immune to their excessive risk-taking downside (Rosengren, 2009).
The meltdown of 2007–09 resulted in a vast downshift in economic output, consumption, and financial wealth. The nation has had additional psychological costs, skill atrophy from widespread unemployment, reduced economic opportunities, and increased intervention by the government in the economy. The loss of national output brought about by the financial crisis, and its consequences are in the range of $ 6 trillion to $ 14 trillion. This range’s high end is almost a year of U.S. output. Including broader and more difficult – to – quantify measures which reflect the persistent trauma experienced by millions of families pushes these costs even higher — possibly as much as two years of forgiven consumption.
Trauma and reduced capacity is another consequence of the crisis. The psychological detrimental implications, though not easily quantifiable, are enormous. Non-farm payrolls have fallen by more than 8.7 million, or 6.3%, and the number of unemployed has risen to 14.7 million throughout the period, peaking at 10% of the nation’s labour force in October 2009 (Singh, 2017). In addition, many workers faced widespread unemployment or left entirely the workforce. The ranks of job seekers who were underemployed and frustrated increased to 12 million, an increase of 94%. Four years after the financial crisis is deemed to have actually ended, underutilization of labour remains intractably high in July 2013: 11.5 million people are unemployed and another 10.6 million are underpaid or frustrated.
The 2007 – 08 financial crisis has taught us that the financial market’s confidence, once completely shattered, cannot be rebuilt swiftly. A seeming liquidity crisis in an interconnected world can very quickly turn into a solvency recession for financial institutions, a sovereign – a country balance of payments crisis, and a full-blown loss of confidence for the whole world. But perhaps the silver lining is that markets have emerged strongly to forge new beginnings after every crisis in the past.
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David Luttrell, T. A. (2013, September). Assessing the Costs and Consequences of the 2007-09 Financial Crisis and Its Aftermath. Retrieved from Federal Reserve Bank of Dallas: https://www.dallasfed.org/research/eclett/2013/el1307.cfm
Elliot, L. (2011, August). Global Financial Crisis. Retrieved from The Guardian: https://www.theguardian.com/business/2011/aug/07/global-financial-crisis-key-stages
Lumen. (2018, February). The 2007-2009 Crisis. Retrieved from Lumen: https://courses.lumenlearning.com/boundless-economics/chapter/the-2007-2009-crisis/
Rosengren, E. S. (2009, February). Making Monetary Policy During a Financial Crisis. Retrieved from Federal Reserve Bank of Boston: https://www.bostonfed.org/news-and-events/speeches/making-monetary-policy-during-a-financial-crisis.aspx
Singh, M. (2017, April 4). The 2007-08 Financial Crisis in Review. Retrieved from Investopedia: https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp