Describe about the Causes and Effects of the Global Financial Crisis of 2007-09, With Special Reference to the Impacts on Financial Markets, Institutions and Instruments.
Introduction
The financial crisis depicts a situation in which the financial markets all over the world face a rapid downturn or devaluation in the assets. The impact of the financial crisis is considered so severe that it affects the economies all the around the world. The global financial crisis of 2007-09 affected the world’s strongest and stable economies such as the United States and Australia (Cihak, 2009). The financial crisis triggers as a result of several events happened in sequence and the same was the reason for the financial crisis 2007-09. The financial crisis is not good for anyone as it affects the entire economy adversely and misbalances it. Therefore, it is essential to conduct an enquiry into the causes and effects of the finical crisis of 2007-09 so that its recurrence could be stopped (Cihak, 2009).
In the context developed above, this essay has been presented addressing the causes and effects of the financial crisis 2007-09. In this essay, the focus is on the Australian and the United State economies and thus, the analysis of the causes and effects has been conducted from the Australia and the US economies view point. Further, the essay also explores the impact of the financial crisis on the financial markets in Australia and the United States.
Brief Overview of the Financial Crisis 2007-09
The events started building since the year 2007 when the banks and the financial institutions in the United States started experiencing reduction in the investor’s interest. The banks and financial institutions of the US were found to be overburdened with the debt and the value of the mortgage loan assets were observed to be reduced significantly. The bubble in the financial market in the United States not only destroyed the US economy, but it spread all across the globe including the sound and stable economies like Australia (Claessens et al., 2014). Since, the financial system of the United States was the main culprit of this global crisis, therefore, the US economy hampered more badly than the other economies. The impact of the global financial crisis on the Australian economy was observed to be lower than the other countries. The economies like US and UK got hit by recession on revelation of the financial crisis, but Australian economy was strong enough to fight with the recession (Australian Government, 2011).
Causes of the Financial Crisis 2007-09
Reasons for the financial crisis 2007-09 were many, but the most crucial one is identified as the weak financial policies of the United States and the UK. The fiscal and monetary financial policies of the United States and the UK were observed to be very weak. An example of the weak monetary policies of the United States could be the reduction in the federal fund rates by a big margin. In order to control the recession, the US government reduced the federal fund rates from 6.5% to 1.75% in the year 2001 (Frbsf.org, 2002). Further, the monetary policies of the US also eased up the regulations with respect to the mortgage loans. Consequently, the banks and financial institutions in the US sold out huge amount of mortgage loans without ensuring adequate security for payback (Verick and Islam, 2010). Further, a detailed study into the causes of the financial crisis 2007-09 has been conducted as below:
Low Interest Rates
In order to maintain a proper balance in the inflation rates, it is becomes necessary for the government to adjust the interest rates. However, the adjustments in the interest rates should be made very cautiously and as per the needs, otherwise, the impact could be opposite of what was expected. The US government cut the interest rates by a big margin, which made the borrowings cheaper and the flow of money in the market got increased (Norgren, 2010). The reduction in the interest rates is shown in the figure given below:
Figure 1: Interest Rate Cut by US
The impact of low interest rates was seen more on the housing loans in the United States. Due to cheaper interest rates, the demand of the housing loans increased sharply and banks also lent money as much as they could. However, on revelations of the financial crisis, it came out that the banks allowed housing mortgage debt way more than the value of securities. Since, the value of securities was far lower than the loans given by the bank, the assets of the banks were declared undervalued (Norgren, 2010).
Innovations in the Financial Market
The innovation in the financial market has laid integration of the financial markets not only at the domestic level but at the global level. In the present era of globalisation, the banks and the financial institutions of all the countries are interrelated with each other in such a way that the impact of problems faced by one can be perceived on the others (Norgren, 2010). Further, many innovated financial instruments also came out in the market such as debt securitisation securities and over the counter derivative securities. Although, these innovations were made to diversify the risk of debt lenders, but the market could not succeed in that due to downfall in the investor’s confidence (Thakor and Simon, 2012). Thus, the innovated financial products and the new regulations also contributed in the collapse of the financial markets in the US.
Inadequacies in the Risk Management
Immediately before the financial crisis, the financial market in the United States and the UK were observed to be booming. The banks and the financial institutions relied too much on the past performance without paying required attention to the future outlook. The non consideration of the future outlook while formulating the risk management policies shows inadequacies in the risk management (Norgren, 2010). Further, the stress testing applied by the banks and the financial institutions in evaluating the risk also was claimed to be erroneous. The stress testing failed in taking into account the liquidity in measuring the risk, which was the measure inadequacy found in the system of risk management adopted by the banks in US and UK. Apart from that the credit rating agencies also could not measure the risk adequately in assigning the credits to the debt issuers (Claessens et al., 2012).
Weaknesses in the Regulatory Regime
The weakness in the regulatory regime in the banking and financial industry of the United States and the UK were among the measure causes for the financial crisis 2007-09. The governments and the central banks of the United States and the United Kingdom were found to be the worst in regard to policy framing (Norgren, 2010). The government policies in the US lowered the credit controls and allowed the banks and the financial institutions to lend freely, which resulted into substantial increase in the household debt of the US. Further, the lapses in the supervisory framework of the US and the UK also contributed to the financial crisis. The weaknesses in the regulatory regime also dampen the harmony and coordination among the financial markets at the international level (Spangler, 2012).
Effects of the Financial Crisis 2007-09
The financial crisis of 2007-09 was considered to be the worst ever as claimed by the economists from all around the world. The strongest economies of the world such as the United States and UK got affected severely and the stable economies like Australia also got hit. However, the impact of financial crisis on Australian economy was not that deep as it was on the US and the UK economies. Further discussion in this regard has been carried out in the following paragraphs:
On the Overall Economies of Australia and the US
The gross domestic product is considered to be the representative of the economic growth of a country. Therefore, in order to analyse the impact of the global financial crisis on the economies of Australia and the US, the trend in gross domestic products have been measured during the years of crisis and after the crisis. The trend in gross domestic product has been depicted in the graph shown below:
Figure 2: GDP trend in Australia and US
From the graph shown above, it can be observed that the growth rate in the gross domestic product of Australia dipped down heavily in the year 2009, when the global financial crisis was revealed. However, in the same year US economy was observed to be relatively stable as the decline in the gross domestic product was only 2% (World Bank, 2016). Immediately, on revelation of the global financial crisis, the Australian economy got hampered, but recovery after the crisis was phenomenal. As could be observed from the trend line shown in the graph, the gross domestic product of Australia has been increasing more rapidly than that of the US. Further, it has been observed that though the gross domestic product of Australia was down in the year 2009 severely, but the recession was far still away. The Unemployment rate in Australia was observed to be way lower than that was prevailing in the US. The trend in the unemployment rate could be observed from the graph shown below:
Figure 3: Trend in Unemployment Rate
From the graph, it could be observed that the unemployment rate in Australia increased a bit after the revelations of the global financial crisis. However, in the United States, the recession creeped in the economy and the unemployment rate increased significantly from 5% in the year 2008 to 10% in the year 2011 (World Bank, 2016). The rise in the unemployment rate at a rapid pace shows the severity of the impact of the financial crisis on the US economy.
There are three big reasons that Australia survived from the financial crisis such as demand from china for the Australian goods and services, strict regulatory environment, and stable financial institutions (Hiller, 2010). The demand from china continuously gave a push to the exports of Australia, which helped the Australian economy to maintain a proper trade balance. Further, the regulatory environment in Australia has always been so stringent that the banking and financial sector is rarely left free to do things at their will. As discussed in the sections given above, the loopholes in the banking and finance regulations had been the main culprit of the financial crisis, thus, maintaining a stringent legal and regulatory environment is really important for a stable economy.
On the Financial Markets, Institutions & Instruments of Australia
The impact of the financial crisis 2007-09 was perceived to be drastic on the financial market of the United States. A figure, depicting the performance of Nasdaq from the year 2007 to 2016, has been presented below:
Figure 4: Nasdaq Yearly performance
From the graph presented above, it can be observed that Nasdaq was performing extremely well before the declaration of the financial crisis in the year 2008-09. At the end of 2007, the Nasdaq was observed to be ruling at the levels of 3500 index points. Suddenly, in the year 2008, the market started getting down and then it collapsed completely in the year 2009. From the chart, it can be observed that Nasdaq fell from 3500 in the year 2007 to 1500 in the year 2009, which shows a drastic collapse (Macrotrends, 2016). Due to the collapse of the US capital market, the market indices of other countries all over the world got affected adversely. The Australian capital was also the one that experienced decline on revelations of the financial crisis.
The Australian stock market index, S&P/ASX200 was observed to be falling from 6700 in the year 2007-08 to 3400 in the year 2008-09 (Thangaraj and Chan, 2012). It was the impact of instant change in the market sentiments that the Australian market declined so rapidly. However, later on, it was understood that the impact of the financial crisis on the Australian economy will be lower due to much better position of the banks and the financial institutions in regard to collateralized debt obligations. Thus, it was considered that the recovery of the Australian capital market would be immediate and faster than US and UK. Further, the housing industry of Australia was also observed to be much controlled and in a better position as compared to the United States.
As expected, the ASX200 came back recovering from the shock of the financial crisis in the late 2009, when the index went up to 4870.60 levels in the month of December 2009 (ASX200, 2016). However, in the year 2010, the market again showed a glimpse of downfall at the start of the year, but the situation was under control by the end of the year. The fear in the investors of rise in the debt created negative market sentiments in the start of the year 2010 or at the end of the year 2009.
Conclusion
The discussion carried out in this essay revolves around the causes of the global financial crisis 2007-09 and the impact of it on the Australian and US economy. From the discussion carried out here, it could be analysed that the three broad factors should always be balanced to avoid the crisis situations. Those three factors are the fiscal policies, monetary policies, and the regulatory regime of the financial market. The main causes of the global financial crisis 2007-09 were the lapses in the fiscal and monetary policies of the US government. Further, the weak regulatory environment around the banks and financial markets also contributed to the big mess. In regard to the impact, it has been analysed that the US and UK economies were affected more badly than the others. The Australian economy also got affected adversely, but the impact was not so severe as compared to the US and UK.
References
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Australian Government. 2011. The Australian economy and the global downturn part 1: reasons for resilience. [Online]. Available at: https://www.treasury.gov.au/PublicationsAndMedia/Publications/2011/Economic-Roundup-Issue-2/Report/Part-1-Reasons-for-resilience [Accessed on: 09 September 2016].
Cihak, M. 2009. Financial Crisis (Introduction). Journal of economics and finance, 59(6), pp. 502-506.
Claessens, S. et al. 2012. Crisis Management and Resolution: Early Lessons from the Financial Crisis. [Online]. Available at: https://www.imf.org/external/np/seminars/eng/2012/fincrises/pdf/ch16.pdf [Accessed on: 09 September 2016].
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Norgren, C. 2010. The causes of the global financial crisis and their implications for supreme audit institutions. [Online]. Available at: https://www.intosai.org/uploads/gaohq4709242v1finalsubgroup1paper.pdf [Accessed on: 09 September 2016].
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