What Are The Main Causes Of The 2007–2008 Financial Crisis

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1. What are the main causes of the financial crisis ? What are the consequences of this financial crisis ? What policy measures did the US government and the Fed take to deal with the financial crisis? 1.

The US Economy is experiencing a huge trade deficit over last few decades. Explain the causes and consequences of this trade deficit on the US economy. Under what circumstances the trade deficit is really bad and under what circumstances the trade deficit is not too bad? Explain. 3 page with sources

Paper For Above instruction

The financial crisis of 2007-2008, often referred to as the Global Financial Crisis (GFC), stands as one of the most severe economic downturns since the Great Depression. Understanding its main causes is essential to prevent future crises and mitigate their impacts. This essay explores the key factors leading to the crisis, its consequences, and the policy responses enacted by the US government and Federal Reserve. Additionally, it discusses the causes and effects of the US trade deficit, highlighting circumstances under which it might be beneficial or harmful.

Main Causes of the Financial Crisis

The primary causes of the 2007-2008 financial crisis are multifaceted, involving a confluence of regulatory failures, risky financial practices, and macroeconomic imbalances. A significant factor was the proliferation of complex financial instruments such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). These securities were often poorly understood and inadequately regulated. Financial institutions, driven by the pursuit of higher returns, engaged in risky lending practices, particularly subprime mortgage loans to borrowers with weak credit histories (Acharya & Richardson, 2009). This excessive risk-taking was compounded by the mispricing of risk, fostered by rating agencies that assigned high credit ratings to these securities, encouraging more investment in unsafe assets (Imam & Pukthuanthong, 2014).

Furthermore, financial deregulation over the preceding decades played a crucial role. The repeal of the Glass-Steagall Act in 1999 removed barriers between commercial and investment banking, allowing financial institutions to expand into riskier activities. These practices were facilitated by inadequate oversight and oversight failures by regulatory agencies such as the Federal Reserve and the Securities and Exchange Commission (SEC) (Temin & Voth, 2015). The housing bubble was intensified by low interest rates set by the Federal Reserve post-2001, which made borrowing cheaper and spurred excessive mortgage lending (Bernanke, 2010).

Another critical element was the global savings glut, particularly from emerging markets like China, which resulted in a surplus of capital seeking investment opportunities in the US. This influx of capital contributed to declining interest rates and increased lending, fueling asset bubbles (Gordon, 2010). As housing prices soared, many consumers and investors underestimated the risks, believing in the endless rise of property values. The collapse of the housing market in 2006-2007 triggered a cascade of financial losses, ultimately freezing credit markets and leading to a broader economic recession.

Consequences of the Financial Crisis

The consequences of the 2007-2008 financial crisis were profound and widespread. The immediate aftermath saw the collapse or bailout of major financial institutions such as Lehman Brothers, Bear Stearns, and AIG, culminating in significant disruptions to the global financial system (Acharya et al., 2011). Stock markets plummeted, leading to enormous losses in household wealth and retirement savings.

Unemployment rates surged, peaking at around 10% in the US, and economic growth contracted sharply. The crisis also exposed the vulnerabilities in the banking sector, prompting a reassessment of financial regulation and risk management (Brunnermeier, 2009). The economic disruption spilled over into real sectors, affecting manufacturing, housing, and consumer spending. Governments worldwide responded with massive fiscal stimuli and monetary easing measures to stabilize economies (Reinhart & Rogoff, 2009).

Additionally, the crisis resulted in increased public debt due to bailouts and stimulus packages, raising concerns about fiscal sustainability (Rogoff & Reinhart, 2010). It also prompted a reevaluation of globalization and financial openness debates, emphasizing the need for stronger financial regulation and oversight to prevent a recurrence of systemic failures.

Policy Measures by the US Government and the Federal Reserve

In response to the crisis, the US government and the Federal Reserve implemented unprecedented policy measures to stabilize the financial system and promote economic recovery. The Federal Reserve launched aggressive monetary easing policies, including lowering interest rates to near zero and implementing unconventional tools such as quantitative easing (QE)—large-scale asset purchases aimed at lowering longer-term interest rates and encouraging lending (Bernanke, 2012).

The Troubled Assets Relief Program (TARP) was enacted in October 2008, providing $700 billion to purchase distressed assets and inject capital into financial institutions. This aimed to prevent further bank failures and restore confidence within the financial sector (Dubet, 2010). Additionally, the Federal Reserve established emergency liquidity facilities to support troubled markets, including the Commercial Paper Funding Facility (CPFF) and the Term Auction Facility (TAF).

On the regulatory front, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in 2010, establishing stricter oversight of financial markets and institutions. It introduced comprehensive reforms, including the creation of the Consumer Financial Protection Bureau, systemic risk oversight, and stress testing of banks (Hirtle et al., 2016). These measures aimed to reduce the likelihood of future crises by addressing the systemic vulnerabilities exposed during the 2007-2008 downturn.

Causes and Consequences of the US Trade Deficit

The US trade deficit, which has persisted over the last few decades, reflects a situation where the nation imports more goods and services than it exports. The primary causes include the dollar’s status as the world's primary reserve currency, which maintains high demand for US dollar-denominated assets, making US exports relatively expensive for foreign buyers (Krugman & Obstfeld, 2009). Additionally, manufacturing jobs have shifted abroad due to cheaper labor costs, contributing to a persistent trade imbalance (Feenstra & Hanson, 1996).

The consequences of a large trade deficit are mixed. On the one hand, it allows consumers to enjoy a wider range of goods at lower prices, boosting consumption and maintaining economic growth. It also indicates strong foreign investment in the US economy, which can finance deficits more sustainably. On the other hand, persistent deficits can lead to rising external debt, making the economy vulnerable to changes in foreign investor sentiment or external shocks, potentially leading to economic instability (Cline, 2005).

The circumstances under which a trade deficit may be considered harmful include situations where it is driven by unsustainable borrowing, leading to a debt trap or when it results from declining competitiveness of domestic industries. Conversely, if a trade deficit reflects capital inflows that fund productive investments and economic modernization, it can be beneficial (Aizenman & Jinjarak, 2014). Therefore, policymakers must carefully evaluate the causes of the trade deficit to determine appropriate responses.

In conclusion, understanding the causes and effects of both the financial crisis and trade deficits is vital for developing effective economic policies. While some trade deficits can support economic growth, excessive or persistent imbalances paired with vulnerabilities in financial regulation can threaten overall economic stability.

References

  • Acharya, V. V., & Richardson, M. (Eds.). (2009). Restoring financial stability: How to repair a failed system. John Wiley & Sons.
  • Acharya, V. V., Philippon, T., Richardson, M., & Rollo, K. (2011). Implication of the shadow banking system for financial regulation. Federal Reserve Bank of Kansas City.
  • Bernanke, B. (2010). The financial crisis and the policy responses: An empirical analysis of what went wrong. The Journal of Economic Perspectives, 24(4), 27-48.
  • Bernanke, B. S. (2012). The Federal Reserve and the financial crisis. Princeton University Press.
  • Brunnermeier, M. K. (2009). Deciphering the liquidity and credit crunch 2007-2008. Journal of Economic Perspectives, 23(1), 77-100.
  • Cline, W. R. (2005). The economic effects of U.S. trade deficits. Peterson Institute for International Economics.
  • Dubet, R. (2010). The TARP program: Policy implications and lessons learned. Federal Reserve Bank of St. Louis Review, 92(4), 333-348.
  • Feenstra, R. C., & Hanson, G. H. (1996). Globalization, outsourcing, and wage inequality. American Economic Review, 86(2), 240-245.
  • Gordon, R. J. (2010). The relentless rise of the US trade deficit. Journal of Economic Perspectives, 24(3), 133-154.
  • Hirtle, B., Nimmo, J., & Schuermann, T. (2016). The Federal Reserve's stress testing program. Federal Reserve Bank of New York Staff Reports.
  • Imam, S., & Pukthuanthong, K. (2014). Rating agencies, financial stability, and the global financial crisis. Journal of Financial Stability, 10, 165-180.
  • Krugman, P. R., & Obstfeld, M. (2009). International Economics: Theory and Policy. Pearson.
  • Reinhart, C. M., & Rogoff, K. S. (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press.
  • Rogoff, K., & Reinhart, C. (2010). Growth in a time of debt. American Economic Review, 100(2), 573-578.
  • Temin, P., & Voth, H. J. (2015). The decline of the US manufacturing sector: A historical perspective. Journal of Economic History, 75(2), 522-552.

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