Causes of the 2008 Financial Crisis

Subject: 💰 Economics
Type: Analytical Essay
Pages: 4
Word count: 854
Topics: 💱 Macroeconomics, 💵 Finance
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Introduction

Changes in a country’s macroeconomic conditions can have far-reaching consequences, both locally and globally. Adverse macroeconomic conditions in a specific country can have significant spillovers to other countries, depending on their gravity and the interconnection of the regional and global macroeconomic and financial functions. The 2008 global financial crisis is one such event in which the adverse macroeconomic conditions in the United States spiraled to other countries, including Europe, causing a global financial crisis arguably greater than the 1930 great recession (Claessens et al., 2014). Even worse, the recovery from the 2008 crisis was much slower. Despite the financial crisis’s adverse effects, it improved the monitoring and control of local and global macroeconomic functioning. This paper analyzes the causes of the global financial crisis and its repercussions on today’s US economy. It is postulated herein that a series of misjudgments of the US macroeconomic conditions in the run-up to the financial crisis was the primary cause of the financial crisis. Further, the connectivity of the US’s financial market to other countries, especially in Europe, exacerbated the crisis.

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Misjudgment of the US Macroeconomy and the Impact on Risk-Taking Behavior

According to Nenovski and Pamukova (2019), the country’s macroeconomic conditions were favorable a few years after the occurrence of the global financial recession in the United States. The period was characterized by low unemployment, stable and growing gross domestic product (GDP), low inflation, and increased investment and housing prices. The rising house prices were particularly a significant driver of the risk-taking behaviors among investors. As Meier et al. (2021) argue, it was believed that house prices would continue to stay high and even rise further. With the stable and positive economic outlook, households began to borrow imprudently to invest in the housing industry. Many investors took large financial credit to buy, renovate and sell or build new houses and sell. Imprudent borrowing and investment in the housing and property market were also observed in other countries such as Spain, Ireland, Iceland, and Eastern Europe.

Another risky behavior instigated by the stable economic condition and the lucrative housing market was subprime borrowing. According to Nenovski and Pamukova (2019), many financial institutions, especially banks, offered loans to investors despite indications of high default risks. Subprime borrowing was particularly increased by the increase in competition among banks, most of which were willing to offer large amounts of loans to investors in the housing markets.

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The issuance of mortgage-backed securities (MBS) was another risk-taking behavior that most banks and financial institutions committed. According to Meier et al. (2021), the MBS are bonds secured by real estate and home loans. The MBS is formed by pooling together several mortgage loans with similar characteristics. The MBS are then sold or offered to federal government agencies such as Freddie Mac and Fannie Mae (Meier et al., 2021). The issuing organizations, such as the banks, are guaranteed to pay interest on the principal amount offered. Most banks in the US issued the MBS to federal-backed agencies to gain more finances to offer as loans.

When the demand in US housing demand began to fall in 2006, and the prices as well, most investors became unable to service their loans. High defaulting was particularly experienced among the banks that committed subprime borrowing (Hossain & Kryzanowski, 2019). Eventually, most banks could not adequately finance their operations; they ran into bankruptcy, and the problem spiraled to other countries worldwide.

Connectivity of the Global Financial Markets

The connectivity of the global financial markets, especially that of North America, Europe, and other Western developed countries, was yet another major cause of the spiraling effect of the financial crisis (Goldin, 2014). According to Zhang and Broadstock (2020), the financial crisis spread to other countries both financially and through trade. Most banks and organizations and Europe and Asia experienced a significant decline in the value of their assets, both locally and abroad. This led to an increase in their insolvency; and a low capacity to attract borrowings. Furthermore, most financial institutions could not offer adequate financial assistance since they were also experiencing the hit of the crisis. As Li and Liu (2011) observe, the only country not adversely affected by the crisis was China, which became one of the bailouts for countries as they attempted to pull out of the crisis.

The negative impact of the global financial crisis had far-reaching consequences, both negative and positive. On the positive side, Pattnaik et al. (2020) argue that the crisis has significantly increased most financial control systems of many countries. The United States today has more stringent measures on macroeconomic conditions such as inflation, interest rates, and the housing markets. The financial institutions have also adopted more prudent methods of controlling their borrowing and lending behaviors to avoid the 2007 – 2008 crisis recurrence. The housing bubble today is treated with contempt.

Conclusion

Therefore, the global financial crisis of 2008 was caused by a series of misjudgments of the US macroeconomic conditions. Specifically, the rise in housing prices, the stable and growing economy, low inflation, and unemployment rates were some of the macroeconomic factors that influenced financial institutions and investors’ risky borrowing behaviors. The risky borrowing subsequently led to bankruptcy and the inability to sustain the economy through prudent borrowing and lending.

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  1. Claessens, M. S., Kose, M. A., Laeven, M. L., & Valencia, M. F. (2014). Financial crises: Causes, consequences, and policy responses. International Monetary Fund.
  2. Goldin, I. (2014). The Butterfly Defect: Why globalization creates systemic risks and what to do about it. Journal of Risk Management in Financial Institutions7(4), 325-327.
  3. Hossain, A. T., & Kryzanowski, L. (2019). Global financial crisis after ten years: A review of the causes and regulatory reactions. Managerial Finance, 45(7), 904-924.
  4. Li, X., & Liu, S. (2011). The Learning Process of Globalization: How Chinese Law Firms Survived the Financial Crisis. Fordham Law Review80, 2847.
  5. Meier, S., Gonzalez, M. R., & Kunze, F. (2021). The global financial crisis, the EMU sovereign debt crisis, and international financial regulation: lessons from a systematic literature review. International Review of Law and Economics65, 105945.
  6. Nenovski, T., & Pamukova, N. (2019). Roots, causes, effects, and lessons learned from the global financial crisis. Journal of Sustainable Development9(22), 18-33.
  7. Pattnaik, D., Hassan, M. K., Kumar, S., & Paul, J. (2020). Trade credit research before and after the global financial crisis of 2008–A bibliometric overview. Research in International Business and Finance54, 101287.
  8. Zhang, D., & Broadstock, D. C. (2020). The global financial crisis and rising connectedness in the international commodity markets. International Review of Financial Analysis68, 101239.
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