Financial Crisis in 2008

Topics: Subprime mortgage crisis, Financial crisis of 2007–2010, Monetary policy Pages: 9 (2021 words) Published: April 22, 2013
Identify the main macroeconomic and microeconomic causes that resulted in the above mentioned crisis and make an assessment of the success or otherwise of the actions taken by the U.K government to resolve the problem.

A serious financial crisis has swapped throughout the world since 2007, of which the consequences have continued till today. This worst financial crisis originated from the failure of subprime mortgage lending and related securitised products in 2007, followed by recession of numerous industries on a large scale. (Valdez et al, 2010). Governments took actions immediately to rescue the hardest hit industries, but it was still insufficient to resolve the problem. Therefore, the study regarding causes and solutions to this financial crisis is extremely significant. This essay aims to demonstrate the microeconomic and macroeconomic causes of this recession at the beginning. Then it moves to deep exploration of UK government’s actions dealing with the crisis.

Macroeconomic factors
At the core of the crisis, the historical global financial imbalance is one of the main macroeconomic factors. During the past 10 years (Chart 1), large surpluses occurred at emerging market countries and oil exporting countries. In contrast, a number of advanced economies, most notably the US, experienced growing current deficits.

Theoretically, when a particular country has a high investment rate of return, it seems that it may attract more capital from abroad. (Astley et al, 2009) As is shown in chart 2, low national saving rate reflected the U.S. deficit by 2000 due to high investment during the late 1990s. Afterward United Sates external borrowing was growing to approximately 6 percentage of GDP by 2006 before gradually falling based on U.S. Bureau of Economic Analysis (BEA). With capital pouring from EAEs, the real interest rates of US were declining consistently, which resulted in more residential mortgage and the boom of housing market bubble.

Chart 1 Global imbalance in the run-up to the crisis

Source: IMF April 2009 WEO.

Then another macroeconomic cause is the long-term low real interest rates. According to the Federal Reserve Board, federal funds rate fluctuated around 1% for 5 years at 2001 afterwards. Chart 2 shows that real interest rates in UK and US are declining after 2000 before bounce. The long-term low interest rates have driven serious effects. It prompted the rapid extension of credit in developed countries, which result in decreasing in credit standard.

Chart 2 Real long-term interest rates

Source: The World Bank

Low interest rates in US have the biggest effect because US dollar is dominant currency in the global exchange market. So take US as an example, a large amount of capital in domestic market poured into government bonds, which had driven a reduction of risk-free rate. Eventually the credit expanded by participants’ search for yield. It appealed that investors tend to invest in financial instruments with higher returns so as to offset the decline of risk-free rate. Thus this trend stimulated demand for securitised credit. What worth noting is that the risks in mortgage were guaranteed by government-sponsored enterprises (GSEs). People in USA took out the residential mortgage as safe investment, while financial institutions divided subprime mortgage into mortgage backed securities (MBS). The interest rate of subprime mortgage was roughly 2% to 3% higher than prime mortgage with a high marginal profit. (U.S. Census Bureau) After rating these securities, different tranches of MBS are repackaged into collateralised debt obligations (CDOs). The higher the rating is, the higher the risk is. At first, property prices surged so that subprime mortgage borrowers can pay mortgages by the increasing price but finally led to overbuilding of houses. House price fall dramatically, mortgage borrowers were unable to pay. This vicious cycle is the core of the credit crisis. Therefore banks...
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