Thursday, May 31, 2012

Global Financial Crisis Research Paper

Global Financial Crisis Research Paper

The financial crisis of 2007 is considered to be the most complex and severe in the history of the world’s economy. In addition to this, it also appeared to be quite unexpected. According to Davis & Karim (2008), “It came as a surprise not only to most financial market participants but also in some degree to the policy community”. The Great Depression of 1929 and its consequences have led to the formation of such international organizations as International Monetary Fund and World Bank. The purpose of these organizations was to try to prevent another Great Depression from happening by issuing new regulations and policies. However, they not only failed to do so, but also appeared to be unable to predict the Global Financial Crisis and to inform the international governments and economies of the forthcoming risks (Rayner, 2008).

The following paper will analyze the causes of the Global Financial Crisis and its effect on the world’s economy (mainly focusing on United Kingdom economy). The first part will examine the failures, which occurred in the world economy’s system. It will discuss the main causes of the Global Financial Crisis of 2007 and will try to illustrate, how these factors affected different countries and economies. The second part the will try to identify the techniques, which could be used both domestically and internationally in order to prevent another crisis from happening. It will consider such organizations as International Monetary Fund and World Bank’s role in the control over the crisis. Finally, the last part will conclude the paper. It will sum up all the important points, which were covered in the paper.

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Global Financial Crisis: Its Causes and Effects 
International Monetary Fund has issued a ‘Global Financial Stability Report’ in 2007, where it was stated that there were some risks in different areas; however, that there was no “direct threat to financial stability” (p. 1). In addition to this, chapter one has discussed the condition of subprime mortgage market of United States. It was aware of the existing problems already then; however, did not give much attention to them and only noted that United States should “tighten underwriting standards” (p. 6). Despite of the facts, which indicated on the forthcoming financial collapse, the overall evaluation of the financial stability was positive. In the report it was stated that the financial situation is stable, and that the further growth in most of economies is expected within next several years.

This and few other reports have shown that international financial organizations were aware of the problems, which existed in that time. Furthermore, they did mention them in their financial observations and gave the suggestions, of how to prevent these risks from spreading to other economies. Nevertheless they failed to recognize the actual threat in the data, which was available to them. This has made the Global Financial Crisis even more complex issue to the governments. Countries and their economies appeared to be unable to cope with the failures in the markets.

There are several causes of the occurred crisis. These causes have affected different countries in various ways. However, the crisis of 2007 has illustrated how one country’s problem can become international and involve many other economies in it. Global Financial Crisis of 2007 is often called a ‘Sub-Prime Crisis’, because its roots go to the sub-prime lending conditions in United States. These new conditions emerged, when banks decided to expand their mortgage lending in order to later resell these loans as securities (Gurria, 2008). This process was called ‘securitization’. An innovation, which seemed to work in the beginning, later became a cause of a serious shift in the real estate market. Eased lending conditions allowed people, who had bad or no previous lending history and did not have enough resources for a repayment, to enter the loans. “Many of the new borrowers did not understand their loans or have enough income to make payments […]” (Gurria, 2008). This has led to the borrowers’ inability to cover their loans expenses.

It took investors quite some time to realize that they are in a dangerous position. The value and the security of the loans were overrated by the banks, which resulted in investors’ assurance of their benefits. Suddenly the markets stopped functioning, since it was impossible to recognize, where the repayment failure had its roots at. Since securitization practices were spread to Europe, most of its markets, consequently, were also damaged. All the lending processes have stopped, and the liquidity level has significantly dropped.

Due to the failure of a large amount of banks to cover their losses, both domestic and international financial operations have stopped. The major threat to the markets became banks’ unwillingness to make loans to the economy. According to Gurria (2008), “To keep the economies moving, bank lending must expand. We have seen that lending standards to both household and business have been tightening and costs of borrowing are going up.” (p. 17). One of the results of the banks’ reluctance to lend was the drop in the world trade. In 2009 world’s output has dropped by 1.7 percent (National Institute Economic Review, 2009). United Kingdom’s real GDP has fallen from 3.0 in 2007 to -4.3 in 2009 (National Institute Economic Review, 2009). Several countries (e.g. Russia), which produce and export oil, had a positive growth in 2008; however, the majority of countries had a significant decline and, therefore, has suffered the most from the world’s economy collapse.

European Union was designed in order to strengthen the economy of its members. Its main purpose was to unite European countries in order for people, goods, services, and money to circulate freely within the union. One of the greatest benefits of European Union is that stronger and more stable countries and economies can support smaller and weaker ones and to create a single market, which could serve as a shield for all the union members. Global Financial Crisis of 2007 has shown that the system, which was built and developed in the course of many years, did not succeed in protecting its participants from the financial collapse. Furthermore, it actually did create circumstances, where several countries have suffered greatly from this union and from being open to other markets. “The strain of the crisis has led to controversial policy responses such as the French and German automotive bailouts, which appear protectionist to other countries- particularly those in Eastern Europe” (Tsuo, 2009). This resulted in governments’ consideration to move automobiles’ production back to their home countries, which would have a negative impact on the Eastern countries, where the production of foreign cars is especially developed. European Union appeared to be under a pressure due to its members’ dependence on each other’s economies.

Steps for reducing the danger of another crisis
As was mentioned before, international financial organizations were aware of the existing problems; however, did not take required actions in order to prevent them from spreading among economies of different countries. In case those threats would be better examined and tried to be eliminated in their early stages, the crisis would either not happen at all or would affect countries with fewer harm. “In parallel with a period of strong economic growth, financial markets and financial innovation have delivered impressive benefits over the past decade. But it is now clear that the dangers and pitfalls were ignored” (Gurria, 2008).

For that reason, financial organization (both domestic and international) must be more careful and precautious about their operations and overall functioning. They should be more sensitive to any, even the smallest, changes, which happen in the markets. In the world, where most of the markets are opened and depend greatly on each other, banks and their systems must be controlled and ruled by, perhaps, even stricter policies. Even during the crisis of 2007 some financial institutions have suffered less than others. This illustrates that certain systems work better and in a more stabilized way than others, depending on their regulations (e.g. lending conditions).

One of the reasons why the borrowers failed to repay their loans was that they were not properly informed about, or, if to be more precise, did not fully understand, the terms of their contracts. They also failed to evaluate their financial stability and conditions. According to Gurria (2008), “Improved financial education is also essential so that consumers and investors will make more informed decisions and not only protect themselves but also help to improve how markets function” (p. 17). Individuals must also understand how the financial system works. They must learn all the details of the contracts, which they conclude with banks or any other financial institutions.

In addition to that, the eased lending conditions, which were set by the banks, were a quite innovative approach. It did show positive results in the first few years; however, was not examined and proofed to be properly working. Still, blinded by the seemingly good opportunity, many investors rushed to the banks to acquire securities. This phenomenon has illustrated that it is extremely risky to invest in the systems, which were not previously proved to be effective and safe. Therefore, investors must carefully think through an offer before accepting it. According to Schwartz (2009), “The lesson for investors’ embrace of mortgage-backed securities and other new types of assets that were profitable to many purveyors of services in the distribution of these ingenious ways of making loans is to be wary of innovations that have not been thoroughly tested” (p. 19).

Credit conditions have already tightened in such countries as United Kingdom and United States (Kirby, Barrell, Fic & Orazgani, 2008). However, a better attention must be paid at the loans, which are being given out to individuals. As was mentioned above, it is important for the financial institutions to be able to support the economies by giving out loans. Despite this fact, new regulations must be introduced in order to reduce the risk of failures to make repayments.

Finally, each government and economy must always be prepared for certain failures in the financial systems to occur. Crises happen often, and there is never a guarantee that it will not happen again. The Global Financial Crisis of 2007 was much unexpected and, therefore, created a chaos and caused a panic in the markets. In case the problems cannot be eliminated in its early stages, governments and financial institutions must always be prepared to withstand the more global events. As in any system, in financial one as well there always should be a recovery plan. The crisis of 2007 has proved that even the power of European Union appeared to be helpless, when it was necessary to protect its members from the financial collapse. In the world of free economy, such as, for example, European Union, it appears to be more complicated to create a policy, which applies to all the countries and their markets. International organizations as International Monetary Fund and World Bank must think of a system, which, in case of the failure in a certain sector, would be able to recover from it quickly and with the minimum damage.

Global Financial Crisis of 2007 has brought many damages to the world’s economy. Its primary causes emerged in the United States, where the sub-prime lending market went out of control. The lending conditions have been eased, which allowed people with limited income to take mortgages from the banks. As a result, in the course of one year majority of the countries have suffered from the significant drop in the GDP and is still recovering from it. Moreover, the forecasts for the next two to three years are not positive and promising.

Systems like European Union have experienced a disadvantage of having open markets. Stronger countries could not recover completely because of the weaker ones, which were pulling them down. Global Financial Crisis of 2007 has shown that these systems must be further developing in order to be able to be functioning normally during the hard times. Since the previously used techniques proved to be ineffective, international financial institutions and organizations must come up with new regulations and policies in order to prevent another crisis from happening.
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