By Devanshee Dave, Parush Arora, Prachi Srivastava and Rohit Mishra
Who would have thought that the world would still be struggling from the aftermath of the financial crisis of 2008? The crisis still casts its shadow on the US banking sector. Ten years ago, the entire financial market collapsed, despite the efforts of the Federal Reserve and the Treasury Department of the US.
On 22nd June 2007, the downfall of US’s fifth largest investment bank Bear Stearns started. The housing bubble burst when the American bank Lehman Brothers filed for bankruptcy on 15 September 2008, prompting worldwide financial stress.
Where did it begin?
It all started when the Federal Reserve slashed the interest rates from 6.5% in May 2001 to 1.75% in December 2001. This created a flood of liquidity in the US economy. Decreased interest rates encouraged the borrowers to borrow more and invest in the housing sector. There were lots of ‘subprime borrowers’ who were given credit by the financial institutions. The real problem started when the Federal Reserve started increasing the interest rates. As the interest rates increased, people started defaulting on their home loans.
Immediately after the crisis, banks refused to lend. Due to the risk of the borrowers defaulting again, the banks lost confidence in customers. Due to less availability of cash, the US economy slowed even further. More loans were being repaid in contrast to the less number of loans generated by the banks. This resulted in a situation where money was being ‘destroyed’ in the economy.
In times of debt, don’t look for bonds
The financial crisis brought with it another problem. Along with plummeting growth rates, the debt to GDP ratio increased severely. Countries affected by the crisis witnessed an increment in the debt to GDP ratio on average of 75%. Given the constraints on using the fiscal policy, policymakers had to come up with some unconventional ways of dealing with the problem.
Policymakers diverted their attention onto the monetary policy. First, the nominal interest rates were reduced to its lowest levels. The intuition behind the move was to make borrowings cheaper, increase the credit growth rate, and hence increase the consumption in the economy. But, there is a limit to which one can reduce the interest rates. So, a new mechanism of quantitative easing came into the picture.
The Central Bank increases the money supply through purchases of bonds and securities from the public. This makes the nominal interest rates plunge even further leading to negative real interest rates. Real interest rates are nominal interest rates adjusted for inflation. This made it profitable for the firms to borrow more and use the extra cash to amplify their investments. It also promotes growth through an increase in exports as domestic currency depreciates with a decrease in interest rates.
Craving for new regulation
Even after the US government backed regulations like bailouts of banks and expansion of fiscal and monetary policy, the recovery pace remained sluggish. The unemployment rate hiked due to the crisis.
Meanwhile, Asia and Africa grew the most with a GDP rise of over 50 percent. Hong Kong, Singapore, South Korea and Taiwan, along with Japan and China achieved an aggregate GDP growth of 48.13 percent from 2009 to 2014. The lowest growth was marked by Europe with only 10 percent hike in GDP, as the UK failed to adopt strict fiscal stimulus plan during the financial crisis.
Basel-III was implemented by the Basel Committee at the G20 London Summit in 2009, which led to new banking regulations and restrictions on the world banking sector through increasing the capital ratios, limits on leverage and reducing the risky financial instruments.
Together we fall, together we stand
The crisis has also changed the pre-recession ideology of aggregate economic growth through free trading with different countries. Like the free trade benefits, the advantages are absorbed by the tops and the cost is left to be absorbed by the lowers due to political showdown.
On January 27, 2010, Barack Obama officially declared the stabilisation of U.S. markets. Most of the stock markets were around 75 percent higher than at the time of financial breakdown. China adopted a serious framework of fiscal policies, which ended in job creation and build up of infrastructure, which led the hike in growth rate rapidly. With this, nations exporting large volume of goods to China like Southeast Asia, Australia, Africa and the Middle East also boosted their financial stability. At the end, everything that fell together rose together.
Featured Image Source: Pexels
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