Explain the different stages of a financial crisis and compare the financial crisis 2007-2010 with that of the Great Depression 1929. * What is a financial crisis? There is no precise definition of a financial crisis. It can be explained as a situation where disruption in financial markets leads to adverse selection and moral hazard problems to worsen, thus preventing financial markets to efficiently direct funds. A financial crisis thus results to a sharp contraction in the economy and may leads to collapse of large financial institutions, bank runs and downturn in stock market.
In order to better understand how financial crisis arises, Misklin and other economists in the US developed a framework where they have identified three main stages that could lead to a financial crisis. * Stages of a financial crisis The first stage is initiation of financial crises . Financial crisis as we have seen from past crises, can arise due to mismanagement of financial liberalization or innovation, asset-price bubble, increase in interest rates, and an increase in uncertainty. With the removal of certain regulations and new advances in technology, financial institutions have usually taken unnecessary risk.
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They introduce new lines of business that is new types of loans and other financial products which automatically lead to more people taking credit where proper monitoring of the risk involved in lending were lacking. In addition to this, government safety net further worsens the problem of lack of risk management leading to increase in potential moral hazard. Depositors, unaware of their bank risk taking activities, do not feel that they should check how their money is being handled. With time, such activities lead to loan losses and defaults causing a decrease in the value of bank assets which have direct impact on bank net worth.
Financial institutions, dealing with these problems, stop lending money. Moreover financial crisis can also be triggered by an asset price bubble. With the credit boom, people buy more assets causing price to rise and exceeding their fundamental prices. This often result in prices to be realigned to their true market value thus leading to a decline in net worth, a possible deterioration of financial institutions balance sheets, and a resulting increase in asymmetric information. An increase in interest rate can also initiate a financial crisis.
It is usually individuals and firms engaged in high risk projects who seek credit from financial institutions even if they have to pay high interest rates. An increased demand for credit or a decline in the money supply can lead to market interest rates to rise. This will result in good credit risks borrowers to stop taking money from financial institutions whilst bad credit risks will still borrow. The increase in adverse selection will cause lenders to be more cautious in giving loans possibly leading to a decline in lending.
There will be a decrease in investment which will have a direct impact on economic activity of the country thus again worsening asymmetric information problems. Furthermore, while all the above factors may contribute in an increase in uncertainty, failure of prominent financial and non financial institution, a recession or a stock market crash, makes it more difficult for lenders to screen out good from bad credit risks. There is thus a decline in lending and investment. The uncertainty also results in banking conditions to worsen due to deterioration in their balance sheets.
For some financial institutions this situation may be severe enough to lead them to insolvency. Depositors seeing the potential threat that their banks may face begin to remove their funds even if banks are healthy. This bank panic triggers the second stage, known as the banking crisis. Seeing their cash balances fall, financial institutions start selling their assets quickly which deteriorates much further their balance sheets. The final stage is the debt deflation. This results if the crisis leads to an unanticipated decline in prices where asset price falls but debt levels remain the same.
The debt burden thus increases as debt levels are typically fixed and not indexed to asset values. Individuals stop repaying their loan in such cases leading to an increase in adverse selection and moral hazard, which is followed by a decrease in lending. * The Great Depression One financial crisis which has largely affected the United States is the Great Depression. It was the longest and most severe economic downturn in American history. The Great Depression began in October 1929. No one really knows what caused the Great Depression.
It was triggered with the crash of the stock market in the United States in 1929. During the 1920s, lots of Americans invested in stock market. This led to stock prices to rise as more people were buying and selling shares to become rich. As long as the stock prices kept going up, the system worked. However, during 1928 and 1929, the prices of many stocks were higher than the companies’ net worth stock they represented. Thus investors started selling their stock leading to stock price to fall. Many investors in the stock market had bought stock on margin.
Brokers seeing this new situation started asking investors to pay their debts which forced investors to sell their stock when they couldn’t repay. This resulted in stock prices to fall even more. Stock prices plummeted because no one wanted to buy stock from the desperate sellers. The stock market then crashed which led directly to the start of the Great Depression. In addition to this, during the 1920s lots of people were buying on credit since it was a period of great economic boom. Many people also bought home appliances, cars etc via the installment buying system.
When the stock market crashed, the credit market also deteriorated due to rise of adverse selection and moral hazard problems. By 1933, the Depression was at its peak, where unemployment??had risen to 25%. Millions of people who had taken credit were left in debt as they lost their jobs. They also stopped buying goods and products produced by American farms and factories. As the farmers and industry leaders realized fewer people were buying, they cut back production which only aggravated the problem of unemployment with the massive layering off.
The Great Depression was the worst economic slump ever in U. S. history. It ended after nearly a decade. In 1932, President Roosevelt’s “New Deal” programs helped alleviate some of the problems during the Great Depression but they did not end the economic downturn. It was the World War II that was really responsible for the change in the economy. * Financial Crisis 2007-2010 The crisis began when the mortgage market in the US started to face an increased rate of mortgage defaults. With the new lines of credit that financial institutions were offering, too many people took home loans beyond hat they could afford to pay back. In addition to this, many homeowners change their mortgage so that they paid it at lower interest which would increase later. This readjustment, called??adjustable rate mortgage, was introduced by loaning companies to convince more people to take loans. Adjustable rate mortgages were also given to people with subprime loans who wanted to get a good price when they refinance later. As more people where buying houses, prices automatically rose creating a housing bubble.
Many big financial institutions who invested massive in mortgages saw deterioration in their bank balance when the housing bubbles burst. This also led to a rise in uncertainty among investors about bank solvency, particularly when financial firms like Bear Stearns and Lehman Brothers went bankrupt in 2008. However, in spite of government initiatives to prevent the collapse of the banking system, it did not help much in restoring economic growth, thus causing the U. S. to enter in recession in December 2007. Credit rating agencies also played a significant role in this financial crisis.
The agencies underestimated the credit risk associated with structured credit products and failed to adjust their ratings quickly enough when market conditions started to deteriorate. Investors who relied on information provided by rating agencies were thus misled. The U. S is still dealing with the repercussions of the financial crisis of 2007. Although the National Bureau of Economic Research stated that the recession ended in June 2009, there has not been great improvement in the economy with a low growth and unemployment level still high.
The slow recovery had thus caused a significant pressure on the federal budget as tax revenues were low and more and more people are claiming the government measures like unemployment insurance. * Similarities between the Great Depression and the financial crisis 2007-2010 During both crises, speculation played an important role. Speculation on the stock led to the stock market crash in 1929 that triggered the Great Depression, whereas speculation on housing prices in 2003-2007 brought on the recent recession. This eventually led to the bursting of the housing bubble.
Another similarity between both crises is that lot of people bought on margin. As there were little regulations on stock purchases prior to the Great Depression, investors were buying stocks on margin. This leveraging caused more people to buy stock which resulted in an increase of stock prices. To prevent same thing from repeating, stock market regulations were put in place during the Great Depression. But seventy years later, Americans once again had another similar greed with the housing market. Lots of people bought houses they couldn’t afford, with money they didn’t have.
Furthermore, during these two crises, Americans faced a banking crisis. When the stock market crashed in October 1929, people panicked and started removing their money from banks. This resulted in many banks to close. The recent financial crisis led to banks failing again due to the large number of mortgage defaults. Both crises also resulted in high rate of unemployment. During the Great Depression the unemployment rate rises 25%. In 2008 and 2009, millions of people lost their jobs. The unemployment rate reached 8. 5% in April 2009. Moreover, in order to recover from both crises, government intervention was needed.
While Herbert Hoover did not take necessary action to stop the Great Depression, Franklin D. Roosevelt started to deal with the crisis??as soon as he took charge of the country in 1933. Among the main initiatives that Roosevelt put in place were the introduction of new regulations to prevent financial crisis from recurring, giving assurance to Americans so as to remove their fears and the investment of billions of dollars in federal funding for job creation. President Barack Obama is practically doing the same thing as Roosevelt but his programs are costing American taxpayers rillions of dollars, not billions. * Differences between the Great Depression and the financial crisis 2007-2010 One of the main differences between the Great Depression and today’s financial crisis is that there was a rather quick response of the government this time. When the stock market crashed in 1929, the government waited for almost four years to do something. This was not the case for the recent financial crisis. The government was fast in introducing more than a dozen economic stimulus packages in 2008 and 2009, to help restructuring the economy.
In 1930s, some states in America suffered from a severe drought. Many farmers lost millions of acres of farmland. This environmental catastrophe contributed to the failure of banks during the Great Depression as many gave loans to farmers which then default. This also contributed to the high unemployment rates as farmers lost their livelihood. So far, America hasn’t experienced such a natural disaster. The Great Depression ended not because of Franklin D. Roosevelt’s New Deal or the numerous government programs and intervention, but because of World War II. The U.
S who supplied Europe with munitions, ammunitions and other supplies for war resulted in millions of workers getting back in factories. The recent financial crisis ended with helped of different government programs. Another difference is that during the Great Depression, the dollar was devalued relative to gold. The gold standard thus served as restriction to how much the money supply can be expanded that is the Federal Reserve was a bit more restricted in how much money it could create. This restriction did not exist during the financial crisis of 2007 as the gold standard was fully abolished in 1941. Conclusion After every financial crisis, the aftershock may be felt for years before the economic activities to become normal again. As we saw, financial crisis can have long lasting consequences on a country’s economy. People are still dealing with the aftermath of the financial crisis of 2007. Due to globalization nowadays; it’s the whole world that gets affected when there is such a crisis. The only way to prevent such crisis to happen again is to learn from past mistakes and avoid making same errors. Number of words: 2133