Three Potential Causes of the 2008 Financial Crisis
Crisis events, which were observed in the US financial system in the second half of 2008 and affected many countries, were dire, while the measures undertaken to stabilize the situation were unprecedented. The analysis of the aforementioned events allows us to evaluate the effectiveness of the US financial capitalism model and its viability in the global market. A number of key foundations of the financial system caused irreparable damage. Consequently, the system, not being able to function in its present form, was partially nationalized or brought under state control. The crisis was multifaceted, and the emergency measures provided only a temporary stabilization, without eliminating the underlying causes of problems that had led to it. The 2008 financial crisis affected the entire global economy, various industries, and diverse activities. Three potential causes of the crisis were refinancing, lack of control over the operations of the stock market, and the instability of the monetary system.
Several internal and external factors fuelled the first cause of the 2008 financial crisis, namely refinancing. First, the credit bubble played a significant role in the process of refinancing. In the late 1990s, China and other major developing countries, as well as major oil-producing countries, created a large capital surplus that was invested in the United States and the financial markets in Europe, which caused the fall of interest rates (Gregor’ev & Salickhov 2009, p. 41). Credit spreads narrowed, due to which the cost of borrowing to finance risky investments decreased. As a result, the credit bubble was formed in the United States and Europe; its most visible manifestation was the increase in the investment in mortgage loans with high risks (Gregor’ev & Salickhov 2009, p. 43). The US monetary policy may have contributed to the formation of a credit bubble as well, but it did not cause it. There are three main possible explanations for the credit bubble: global flows of capital, risk, and revaluation of the monetary policy.
The second factor that fuelled refinancing was the housing bubble. In the late 1990s and early 2000s, a large and stable housing bubble formed in the United States (Gregor’ev & Salickhov 2009, p. 46). The bubble was characterized by a significant increase in national housing prices and a rapid regional boom-bust cycle in California, Nevada, Arizona, and Florida (Murphy 2008, p. 13). Many factors had contributed to the formation of the bubble in the housing market, and later the bubble caused huge losses to homeowners and investors (Domitrovic 2012, p. 325). The relationship between short-term interest rates and housing is relatively weak; thus, even if the purpose of the Federal Reserve System (FRS) was to reduce lending rates between banks, it is difficult to explain why the rates of their 30-year mortgage loans were too low.
The third factor that fuelled refinancing was mortgage credit lending. There were over-optimistic assumptions regarding the US housing prices, as well as concerning problems in the primary and secondary mortgage markets. Risky trillion dollars mortgage loans were widely implemented through the financial system: mortgage-related securities were collected and sold to investors around the world (Buckley 2011, p. 56). When the bubble burst, the losses of the hundreds of billions of dollars shook the market and financial institutions that had gained a significant amount of mortgage loans and, using them as collateral, had accumulated significant debts (Otter & Wetherly 2008, p. 47). This occurred not only in the United States but worldwide. The aforementioned losses were multiplied in financial derivatives, such as synthetic securities.
The fourth factor that fuelled refinancing was credit ratings and securitization. Errors in credit rating and securitization transformed into bad mortgages, which are unreliable financial assets (Murphy 2008, p. 25). Credit rating agencies mistakenly praised the rating of mortgage collateral securities and derivatives as a safe investment. A securitization is an innovative form of financing that represents a new technique to attract funds (Buckley 2011, p. 98). First, it was widely accepted in the US, and later in Europe. It is a mechanism in which financial assets are written off from the balance sheet, separated from the rest of property, transferred to a specially created financial intermediary, and then refinanced on the money market or capital market (Anonymous 2010, p. 12). Refinancing is performed either by the issue of ABS (asset-backed security) or by receiving an asset-backed loan (ABL).
The problem of refinancing has accumulated over several decades. The world economic system as a whole and in developed countries in particular developed a powerful system of credit to stimulate lending at all levels, namely at the level of the state, individual producers, and the public (Buckley 2011, p. 102). As a result, there is a constant increase in the size of the state internal and external debt and stable fiscal deficits. In recent years, the low-interest rates refinancing of the majority of central banks allowed to implement the policy of cheap money, which, in turn, led to a credit boom.
The practice of unsecured loans granting became widespread, which increased the share of the overdue debt. The registration of mortgage loans to borrowers with unstable credit reputation or without it at all contributed to the issue as well (Murphy 2008, p. 56). As a result, there was an unreasonable rise in property prices, which further spurred speculation on the market and, consequently, led to the need for refinancing. After the collapse of the stock market and the purchasing power of the population had decreased, the volume of transactions in the property market fell, many projects were frozen, and most developers were in a state of technical insolvency.
To prevent the bankruptcy of the largest players in the market real estate, the state was forced to repay debt on issued mortgage bonds. For example, in the US, such a procedure was carried out in respect of the companies Fannie Mae and Freddie Mac, and in Spain, the fall of the volume of transactions in the property market exceeded 50% (Murphy 2008, p. 79). However, the result of such an action was an even greater increase of the public debt in developed countries. The events mentioned above raise the question of confidence in the government securities of developed countries and the possibility of default in them.
Lack of Control Over the Operations of the Stock Market
For several years, there has been a steady and increasing trend in the stock markets of the leading countries of the world, and the Dow Jones index exceeded 14 thousand points, while in developing countries, the annual growth rate exceeded 100% (Murphy 2008, p. 78). The main factor in warming up the stock market was the increased liquidity of the above-named, which allowed punters to accumulate huge amounts of money. Existing laws on the regulation of securities transactions had a rather liberal attitude to the indicators of the financial stability of both issuers and stockbrokers. The exponential growth of the derivatives market led to multiple overselling of this type of securities, which was not confirmed by real assets.
Profits from these operations, reinvested in the same securities, contributed to the growth of the bull market. On the other hand, the system of the capital free flow between countries, the WTO, and the presence of numerous offshore zones, which evaded tax, financial assets of businesses, and individuals, negatively impacted the aforementioned growth (Anonymous 2010, p. 14). The globalization of the world economy contributed to the rapid movement of capital in the economy of the countries that provided the highest rate of return. When the crisis had started, a more rapid outflow of funds occurred, which led to a liquidity crisis and credit crisis on the domestic markets of these countries. For example, Latvia (dominated by the Bank of Sweden), Russia, to some extent, and the majority of developing countries, whose economies showed high growth rates in 2006-2008, experienced the conditions discussed above (Gregor’ev & Salickhov 2009, p. 48). When the first signs of the deterioration of the situation appeared, there was an avalanche of capital outflows to developed countries, despite the fact that the rate of profit in them was significantly lower.
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The Instability of the Monetary System
The instability of the monetary system is related to the previous cause of crisis, and, to a certain extent, it is a logical extension of it. The US dollar has been an international currency for decades, which contributed to the USA’s reputation as a first-class borrower. However, the situation had changed recently, which led to a flow of capital into real assets such as gold, oil, and metals. Their prices rose in spite of the worsening world economic situation and the fall in effective demand. Many countries that had foreign exchange reserves, including China, Australia, and Japan, increased stocks of real assets, thereby giving rise to the erroneous opinion regarding the revival of the commodity market (Buckley 2011, p. 113). However, the data on the consumption of resources in natural units demonstrate a trend towards a serious decline. Thus, the increase in raw material prices was unreasonable, and it spurred inflation and led to the reduced efficiency of the production of goods and services.
Many leaders of the financial sector of the economy, such as Bearn Stearns, AIG, and Merrill Lynch, became bankrupt or were absorbed by other organizations. This led to the collapse of the credit market in many countries, where national credit organizations attracted resources from them at low-interest rates and placed them in the domestic market with own margin (Murphy 2008, p. 79). The loss of cheap credit attraction power led to a decrease in market liquidity and suspended investment projects. In addition, the problems arising from the financial market leaders led to a loss of confidence on the part of financial market players in the financial sphere as a whole. In addition, certain decisions made by developed countries had an impact on economic development, but they were made within the framework of society’s development trends. Moreover, human greed is one of the main factors that cause financial crisis. Psychology rules the world; it is changeable, and when it comes into conflict with the system, the system cannot always resist it. The history of crises shows that the lack of cheap funding aimed at the support of the falling incomes of investors and banks leads to crises.
The answer to the question of whether it was possible to prevent the 2008 financial crisis lies in the causes of the crisis. It would have been possible to limit the spread of instruments, the prices of which were based on complex calculations. It would have been possible to limit the funding provided to buyers of bonds to make them not to buy ten times more than their funds allowed them, thereby inflating demand. All these steps could have been effective if an entirely new control system with qualified and motivated auditors had been introduced.
Refinancing may be considered the main cause of the 2008 crisis, since the stimulation of the economy is done through credit and borrowing rate. To repay a loan, a person, a company or a government needs every year to work better than the previous one to cover the loan costs. It is clear that it is impossible to increase the GDP up to infinity. At a certain time it will stop to grow, which will lead to the inability to pay loans. Thus, economic crises and economic growth have the same causes, which are the loan capital and the monetary model of the economy.