Competition Entry | The Root Causes of the Global Economic Crisis

What are the root causes of the global economic crisis?

by Radioactive

These days, the most talked about news is the financial crisis that has engulfed the world economy. Everybody, the main headline of all newspapers is about falling share markets, decreasing industrial growth, high unemployment rates and the overall negative mood of the world economy (Eklavya, 2008).

The global economy crisis which is being experienced today cannot be seen as an event but rather, a process which has been building over time but has become more noticeable since September 2008 when a series of unprecedented events began to reorient the Global financial system.

These series of events has resulted in a global phenomenon called global economic/financial crisis. So what has caused this major economic upheaval in the world? What is the cause of falling share markets in the world and bankruptcy of major banks? In this essay, I intend to explain the root causes of the present day global economic crisis.

Recently, my local bank went bankrupt due to the global financial crisis. I had thought that the crisis would not reach Nigeria since we are relatively under-developed, I never knew that it was truly “global” and that even the rodents who spend some time in my room are suffering same predicament.

According to Professor Joseph Stiglitz, a Noble laureate and Professor at Columbia University, “the current financial crisis, which began in the US and then spread to Europe, has now become global” (Global Research, 2009). If you ask a thousand economists what they think is the root cause/causes of the global economic crisis, you will probably get a thousand answers! That aside, the current financial crisis is believed to have started in the United States of America where there is an imbalance in the circular flow of income.

Households and firms are the two agents in an economy. They make up the national income and national product and an economy can be in balance only if national income equals national product. However, technology improvements in two key areas, telecommunications and transportation, allowed firms in the US to outsource many design and manufacturing jobs to distant locations thus, creating an out of balance in the input and output flows.

Most of the outsourcing of labor has been to developing countries such as China and India, where labor costs are a fraction of the U.S. labor costs. As a result, China and other countries are supplying a portion of the production factors to U.S. firms that was formerly supplied by U.S. households. Money is flowing the opposite way from U.S. firms to China through the factor market.

The great imbalance arises because Chinese households are not closing the loop and buying goods and service from U.S. firms. Instead, they are hoarding most of the money, as much as 50%, and lending it to the U.S. households (Eklavya, 2008).

The U.S. households are then using the loans from Chinese savers to buy goods and services from the U.S. firms. From 2000 to 2008, U.S. households increased consumer spending, without seeing an increase in their household income. The difference has been made up with borrowed funds. In the process, the U.S. households have been building up debt which is owned to the Chinese.

This debt is in the form of credit card debt, auto loans, and the big one, home loans, which were collateralized by the U.S. housing stock. The fundamental problem is that the circular flow of income and output are out of balance. Why? Because Chinese households are selling their labor in the Factor Market, but are not buying goods in the Product Market.

For an economy to work, everyone must be both a producer and consumer. Henry Ford understood this well. His principle was that every Ford employee should afford to own a Ford automobile. If you were in Detroit during the heyday of the motor city, every car in the employee packing lot was a late mode Ford. If you go today to a Ford plant in Shanghai or Nanjing, would you see the same thing? (Eklavya, 2008).

Profligate lending, a macro-economic factor, occurred throughout all markets in the United States. The greater availability of mortgage funding predictably led to greater demand for housing, as people who couldn’t have previously qualified for credit (“sub-prime” borrowers) received loans far larger than they could have secured in the past (“prime” borrowers). When over-stretched, subprime and prime borrowers were unable to make their mortgage payments, the delinquency and foreclosure rates couldn’t be absorbed by the lenders (and those which held or bought the “toxic” paper). This undermined the mortgage market, leading to the failures of firms like Bear Stears and Lehman Brothers and the virtual failures of Fannie Mae and Freddie Mac (Wendell, 2008).

An example of how difficult the situation became in the second quarter of 2007, was when Citigroup, one the largest U.S. bank, lost U.S.$ 9,800 million committed securities because of the mortgages, whose interests were extremely.

Another possible cause of the global economic crisis lies in the compensation structure of the top executives of financial institutions. It was one based on hefty incentives and bonuses. To achieve this, they created innovative financial products that did not meet the risk-return criteria in the long run. These products were great in isolation and got great returns to the investors in the short run. However, they did not stand the test of time.

The executive’s bonuses were not based on long term returns but on short term profits. These guys made a fat pocket and there was absolutely no accountability built into the system to take care of long term failures. To further worsen issues, Auditors and Rating Agencies that supposed to monitor these companies were not ready to make public, shady dealings of these companies since these companies pay for their services (Raja world’s, 2009). You do not expect a man to bite off the fingers that feeds him.

Securitization also played a major role in spreading financial risks globally. One financial asset, such as debts, were securitized into MBSs (Mortgage Backed Securities) and CDOs (Collateralized Debt Obligations) that were sold to central banks, private banks and wealthy investment funds around the world. Virtually all major financial institutions were involved in creating and selling these products.

U.S. government sponsored enterprises, Fannie Mac and Freddie Mac, were a major source of these risky securities as they were legally required ‘to buy the “bad” subprime mortgage loans created by private lenders’. They owned or guaranteed almost half of the $12 trillion of this debt to central banks and other banks around
the world (Morrow, 2011).

Conclusively, from this essay, the basic cause of the global economic crisis is the imbalance in the U.S. circular flow of income. We can’t blame globalization but we should pondering on ways in which this imbalance can be solved. Global financial crisis could have been averted if all nations are developed. Probably what we will be hearing of will be “U.S. financial crisis” and not a global financial crisis.

This is a lesson to the governments of developing countries.


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