The Economic Crisis of the Year 2007- 2009

Introduction

As the world globalizes and trade becomes liberalized, the risks of poor economic decisions affecting other global partners are growing very high. This can be confirmed by the just ending economic crisis of the year 2007-2009. The adverse effects of this crisis were adversely felt in the United States of America before spreading to the rest of the world with Europe being the latest casualty. The effects of the economic crisis in Europe have been felt in countries such as Greece and the Ireland, which has had to seek rescue packages from the European Commission, the World Bank, and the International Monetary Fund in order to prevent their economies from full collapse as it almost happened in the United States of America had the government not intervened in rescuing some of the major banks before they could completely collapse (Nelson, Belkin, & Mix, 2010).

When economic conditions appear favorable consumers, as a basic economics rule, may tend to consume more than they are earning. The search was the claims that were happening in the United States of America during the economic boom of 2006. Individuals tend to consume or spend more with the hope that good economic conditions will always exist. During this period of economic boom Americans were practically saving nothing and the urge by investors for every American to own a home and those who had to own an extra brought about the saving problem. Evidence from the country’s chamber of commerce indicates that the rate of saving was in fact negative and this was not right for the economy. This meant that a problem was slowly developing since most of the American citizens were dipping into their savings or even increasing their rate of borrowing to finance their spending (Crutsinger, 2007).

It was in the year 2007 that the expected among the economics experts and the unexpected from American citizens occurred. The prices of commodities shot up, the interest rates rose as well while the prices of the house fell drastically. This was one of the most adverse economic situations the United States of America has faced in the recent past. The indications that the economic situation was not going to remain sweet appeared in January after the fall of Citigroup profits made its shares lose their value at an alarming rate (Bowler, 2009). In the same month, the shares prices of most companies fell throughout the world followed by several collapses. Several major financial institutions experienced severe losses with some of them filing for bankruptcy as it happened with the Lehman brothers. Then there was the takeover of Merrill Lynch and other institutions taking up bank status in order to be protected by the bankruptcy policy. In the following few days, the other investment banks also went underway in one way or the other. Several causes of the economic crisis will be discussed under broad categories in order to understand the relationship.

Causes of the Economic Crisis

The Decline of the Rate of Profit

The crisis roots can be traced back to 1970. According to Solidarity (n.d), after the 1970s the profits started to decline to bring to an end of the post-war booming of the rising wages. As a matter of fact, Moseley (2009) claims that,

“From 1950 to the mid-1970s, the rate of profit in the U.S. economy declined almost 50 percent, from around 22 to around 12 percent”. (Par 3)

For the employers to increase profits, they shifted the good-paying manufacturing jobs to nonunionized areas of the United States and globally to other places in the world. In order to increase profits, these companies retrenched some of their employees so as to enable them to cut their production costs. The retrenched workers as unexpected did not respond and the companies reverted back to their old days of making supernormal profits. Without any organized unions, wages stopped growing and this in return reduced the workers purchasing power. For the workers to maintain their living standards they had to work for longer hours, sending more household members to work and the other option was using credit to cater for their basic needs and expenses.

Globalization, the growth of capitalism, and the growth of the country’s credit system influenced the financial sector in providing more fluid economic resources that could be quickly moved and be reinvested in other sectors. As a result, most Americans preferred funding their expenses using credit means. This was followed by continued years of government policies favoring the rich at the expense of the poor and this brought about the collapse of the Wall Street institutions. The Federal Reserve through which the government regulates the availability of credit set interest rates at low levels of 0% and this acted as an incentive to most big companies to increase their borrowings in order to finance their new investments since capital was easily affordable at no extra cost. Much of this credit was poured into the building of new homes, which many of the big companies and financial institutions saw as a safe investment full proof against risks involved in a general credit market.

As one of the economic theories, the Marxist theory explains that a fall in profit rates results in two devastating situations to any economy: a high unemployment rate and a higher inflation rate, in return results in low wages, as it has been happening in the United States of America (Moseleyb, 1997). This results in slow economic growth due to the low figures of investment. In order to contain the negative effects that may be brought about by the low profits and high inflation rates, the government through the Federal Reserve, as noted by Moseleya (2009) employed

Expansionary fiscal and monetary policies (more government spending, lower taxes, and lower interest rates). However, these policies generally resulted in higher rates of inflation, as capitalist firms responded to the government stimulation of demand by rapidly raising prices in order to restore the rate of profit, rather than by increasing output and employment (4).

The resulting higher rates of inflation brought about the conflicts between the government and the capitalists in return; this forced the government to enact restrictive policies which could reduce inflation through their impacts were more far-reaching since many jobs were also lost thus the higher employment levels. This has been a major problem in the United States of America even as the economy recovers since most American citizens do not want to understand about the low inflation rates; all they want are jobs and the Obama administration has been doing everything to make sure more and more jobs are created.

Structure of Home Mortgage Market

Another cause of the economic crisis was the mortgage crisis. In the past, the United States of America home mortgage market used to contribute the mortgages to the low-income earners within the country. Commercial banks used to own the mortgages until the last installment was cleared. Banks at that time were restrictive in their offering of credit and they used to make sure that the debtors were creditworthy and also were likely to repay the mortgage payments before they could apply for a mortgage.

It was and has always been a dream for every American citizen to own a home. Thus, as the real estate prices rose in the early years at the beginning of this millennium and securitization provided more working capital for mortgages financing, the financial institutions particularly the lending institutions relaxed the underwriting criteria to make this dream be fulfilled and come true among the American citizens. As observed by Kirk (2009), it is estimated that;

Between 1995 and 2005, subprime mortgages increased from 5 percent to 20 percent of the mortgage market. In 1994, $35 billion in subprime mortgages were originated, and by 2006, that number had increased to more than $600 billion. Further, between 2003 and 2006 AMP originations tripled for residential mortgages (p. 49)

The increased prices of homes made more Americans borrow more money while using their mortgages as collateral due to the ever-rising prices.

“The 1980s, commercial banks relieved their holdings on the mortgage but instead sold these mortgages to investment banks which in turn pooled together hundreds and even thousands of mortgages as “mortgage-based securities” (securitization). The investment banks then sold these mortgage-based securities to hedge funds, pension funds, foreign investors, etc.” (Moseleya, 2009:5).

Securitization as it was often called was a bit risky but no one seemed to care since the economy was too promising. Securitization in return resulted in commercial banks and mortgage companies not investigating the creditworthiness of the homebuyers and the likelihood of repayments rather they even applied perverse incentives by lowering the required credit standards, which were required of the mortgage borrowers. These financial institutions were also even not concerned in investigating the likelihood of repayments fulfillment by these mortgage buyers by checking the credit scores of the mortgage appliers. This was due to the simple fact that they would soon sell these mortgages to other investors who would then carry the burden and also due to the fact that they benefited from origination fees and not by the monthly payments.

“The more mortgages originated, the more income from the originators no matter the creditworthiness of the borrowers might be” (Moseleya, 2009: 21).

The fact that the house prices were going up meant that if the mortgage applier failed to honor his agreement, the house could still be retaken and be resold at a higher price resulting in more profits. This in itself was exposing other parties to more risks but no institution seemed to care. The investment banks to which these mortgages were sold also had similar dishonest behavior in their middlemen’s responsibility since after buying the mortgages from the financial investors they would then sell them to final investors and make their money in the transaction process. This also resulted in the sale of more mortgages pooled together without necessary qualifications since as long as the brokerage firms were earning some income in the brokerage function the path would continue; they were ready to pass the risk to the party above (Madrick, 2010).

In the year 2008, the worst began to happen, the short-term interests of the mortgages rose while the real values of the homes began to drop or lever. Americans were now faced with financial difficulties since they could not refinance or sell their homes whose prices had fallen to pay off the mortgages more suffering was on its way as borrowers suffered when the teaser rates on many of the Adjustable Rates on Mortgages (ARMs) expired and higher variable rates were put to work. This did not auger well with most of the citizens as they could not be able to repay the mortgages while the interest rates were still increasing, defaults became a common scenario and with the increasing defaults, the mortgage investor forced the originators to repurchase back the nonperforming mortgages (Cross, 2009). When the small lenders could not repay they filed for bankruptcy and this was just but the beginning of the crisis as later even the larger lending firms’ followed suit as the burden became unbearable.

Problems That Are a Basic Part of the Capitalist System

Another major cause of the economic crisis still lies in the American capitalist economic system. A pure capitalist system, though hard to observe, is centered in the independence of the markets, and most of the time it is centered in the financial system of a country. An economy where the market is allowed to create the rules and follow them without any government intervention is what clearly described the American capitalist system before the economic crisis and the bailouts of major financial institutions, which followed thereafter. The capitalist system has for a long time been supported by most American citizens since it is an open market system that is free from political interference and corruption as experienced in other economic systems. Capitalism also allows markets to rule by themselves thus the free entry and exit of market players. This allowed free entry of newcomers to access financial resources by creating a level playground (Zingales, 2009). According to Zingales (2009), a healthy financial system is crucial to any working market economy. While in earlier times the government used to regulate financial institutions in the last decade or so this has not been possible, deregulation of the banking sector has been a major achievement of the capitalist regime. A major source to the financial sector power has been the growing power of its profitability as Zingales (2009) indicates;

“In the 1960s, the share of GDP produced by the finance sector amounted to a little more than 3%. By the mid-2000s, it was more than 8%”. (p.31)

The increased rate of profits and the wages that the financial institutions were gaining was the major driver of the economy. With more financial institutions gearing their efforts towards making more profits, most of them began lending money to people who if closely scrutinized, or following the existing requirements would not have qualified for the loans since their credit scores were very poor. With the ever-increasing house prices, these lending institutions assumed that they could repossess the houses and resell them thus making even more profits. To the financiers, who lend out the money to these people, they did not necessarily do it from their own pockets they rather lend out borrowed money from other institutions.

“At each stage, small differences in interest rates for very large numbers of transactions involving very large sums of money meant enormous, apparently effortless, profits”, (Harman, 2008:12).

All the financial institutions literally joined in the new way of making money and though for a period the strategy seemed to be going well with all those involved applauding each other for their new innovative way of making easy money. Eighteen months later the US economy growth declined as a result this caused a high number of defaults among the ordinary American citizens who could not afford the rising interests. The lending institutions repossessed the houses and were ready to resell them but the house prices were also falling. As a result, the lending institutions realized that it was not possible to resell the mortgages and still make a profit after paying what they had borrowed themselves. For the first time, it became a reality for most of the banks to realize that they were going to make huge losses due to the prevailing economic conditions. The problem with many of the institutions was that no one knew how deep the problem was since the system was a more complex one. As a result, the financial institutions across the capitalist system of the United States became afraid to lend among themselves as the certainty of getting the money back was rather minimal and this resulted in the credit crunch (Brunnermeier, 2009).

The effects of a credit crunch are rather a negative experience due to the fact that as it is known to many economists a capitalist system works best through borrowing and lending. The fact that businesses expect to be able to able to buy some goods and services on credit when the credit crunch occurred was like a complete failure of the economy as no activity could run. Since in the last decade the economy of the United States of America had been fuelled by debts as many of the goods produced and sold in the US were done through borrowing and thus if credit dried the US economy would come to a halt (Gokay, 2010). As a result, the United States of America government has been pouring billions trying to rescue the failing institutions against the capitalist philosophy of free markets and noninterference by the government as happened with the case of the AIG group (Luhby, 2008). But did it have a choice?? I don’t think so. If it had not rescued the failing institutions more jobs would have been lost and the economy could have dipped down even further.

If all the above practices were done according to the rules it is still my own opinion that the economic crisis in the United States of America could still have occurred. The increase of oil prices due to its limited supply under the established cartel of the Oil Producing and Exporting Countries was another major cause of the economic crisis in the United States. Most of the world’s economies, the US included, rely on oil and its products as a major driver for the economy. When the prices of oil increased in the United States of America in the year to 145$ per barrel this caused the prices of the houses to crush due to the resulting high costs of living, which Americans were supposed to meet. This in return resulted in the lack of money to finance the mortgages and as a result, the prices of the houses fell. The financial institutions who had invested much from these investments made huge losses that some collapsed causing even the other economic sectors which had invested in the finance sector to collapse and thus all these brought together led to the collapse of the United States of America.

Conclusion

In summary, we can conclude that though the economic crisis can be traced back to the 1950s in the post-war era, the mortgage crisis was a major crisis since as we have seen from the study, the lenders made abnormal lending decisions not caring whether the homeowners had the capability of repaying the loans and which other investment except their salaries and the mortgage could result in if the mortgage applier failed to repay the loan. Rather than holding on to loans these lenders also spread the risk by selling the mortgages to someone else and when Wall Street finally bought these loans they had been repackaged in a pool, which was then sold to different investors thus investigating the creditworthiness of these pools was also very complex.

The assumption that home prices could continue rising was also another major cause of the economic crisis since when the prices started falling most of the mortgage owners had no other options rather than defaulting. From the study we can also conclude that the anticipation that the economy was going to remain stable and suitable made the home valuers, mortgage lenders, banking institutions, and all those other involved departments become reluctant and corrupted by the huge amounts of money; they were making poor decisions.

Capitalism ideologies also resulted in the economic crisis as we have seen from the study in that the regulators and the politicians were blinded by the free market ideologies and the dream that all Americans should own homes. Debts were made available increasingly and acceptable within the country’s culture. Millions of Americans became greedier by taking too much debt than they could be able to repay.

Reference List

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