Causes and Effects of Economy Crisis in 2008, Research Paper Example

Not only the U.S. economy but even the economies of many other countries are still recovering which tells us how severe the economic crisis was in 2008. The slow speed of recovery is not surprising because the 2008 economic crisis is considered the worst since the Great Depression of the 1930s (Paletta, Ng and Hilsenrath). Like many major events, the 2008 economic crisis was not caused by a single factor but by many factors though some contributed more than others.

The first factor that probably laid the foundation for the crisis was the Federal Reserve Bank lowering interest rate beginning late 2001. The intention behind lower interest rate was to help U.S. recover from recession. When interest rates are lower, it is cheaper to borrow and consumers and businesses borrow and spend more whether on personal or investment activities. The interest rates remained low until late 2004. One effect of this cheaper borrowing was the boom in the housing market as construction companies started building more projects to meet the equally high demand from consumers. The banks were also willing to loan more to make profits through volume. Home equity loans were $700 billion or five percent of national GDP in the U.S. in 2004. The law of demand and supply says that prices go up when quantity demanded goes up and as a result, property prices rose to very high levels. Because house is an important asset and accounts for a significant proportion of one’s wealth, rising housing prices started making owners feel rich. As they felt rich, they started consuming more. It is estimated that household consumption contributed towards two-third of economic growth (Lim).But the reality is that housing values were inflated and borrowers borrowed more than what they could afford. Sooner or later they were bound to fail to fulfill their obligations. But households were not alone at fault but lending institutions were, too.

When interest rates were low in the economy, lending institutions have to look elsewhere to earn higher returns. Risk and return usually has positive relationship which means there was temptation to take more risk and this is exactly what happened. Lending institutions made it easier for borrowers to borrow so more would qualify. Background checks and data verification regarding loan applicants was poor because lending institutions were eager to loan to earn from volume. The employees of the lending institutions also had targets to achieve so they felt the pressure to approve as many applications as possible (Lim). Once again, borrowers who didn’t qualify for loans were bound to default and once more of the borrowers started defaulting, it contributed to the 2008 economic crisis.

But the financial sector didn’t only solve the problem of low interest rates through volume lending only. They also looked for other ways to earn profit and one solution they came up was new financial products such as securitized products. Securitized products are basically a group of loans from different customers but the customers may have different credit ratings. The idea behind the securitized products was that diversification had been achieved to reduce risk because high risk borrowers are cancelled out by low risk borrowers. This might have been right if the securitized products had been carefully developed but that was not the case. Very few people really understood them because they were not developed by single institution but went through different institutions before gaining their final form. As a result, many actually increased risk and the logic is simple. If you put two risky loans together, the risk doesn’t cancel out but becomes even greater. Since securitized products went through many stages, they became too complex to be understood. In other words, the holders of securitized products had far more risk than they believed (Klarman). We found out through the economic crisis of 2008 that holding more risk than they could afford or thought they were holding imposed huge costs on the financial institutions.

One of the factors behind the 2008 economic crisis was poor judgment and performance from the U.S. Government. One of the greatest mistakes of the U.S. Government was repealing the Glass-Steagall Act which had forbid financial institution from going into certain businesses to avoid conflict of interest. But once the act was repealed, financial institution responded by expanding and entering new lines of businesses such as investment banking (Rickards). But the repeal of the Glass-Steagall Act was not the government’s only failure that created conditions for the 2008 economic crisis.

The U.S. Department of Housing and Urban Development (HUD) didn’t pay attention to warnings from regulators as early as 2004 that financial institutions were issuing loans that were likely to default. In addition, HUD is also guilty of encouraging Freddie Mac and Fannie Mae to purchase subprime loans as a service to the publicc and between 2004 and 2006. The combined subprime loans purchase of the two agencies were $434 billion. This is important piece of information since these two agencies account for about 40 percent of all mortgages in the country (Leonnig).

One of the ways companies increase profitability is by cutting costs and cost-cutting measures become even more attractive in difficult economic times when demand is weak. Not surprisingly, the economic crisis also became worse because of cost-cutting measures by the companies. As many companies found out that their portfolios were worth less or the demand levels were declining due to pessimism in the country, some of them naturally decided to focus more on cost-cutting measures including employee layoffs.  The layoffs were quite common in some industries like manufacturing and hospitality. It is estimated that the U.S. economy lost 2.6 million jobs in the year 2008 which was the highest level in six decades. The job losses were particularly severe during the last four months of the year at 1.9 million (Goldman).  When unemployment level falls, this means few people have income to support spending and overall spending in the economy also falls. In addition, the worsening economy even make those with jobs fearful and they respond by becoming more careful spenders. All of these factors only make things worse and this also caused the 2008 economic crisis to become more severe.

The 2008 economic crisis was not only caused due to the actions of the lending institutions but also other players in the financial sector such as credit rating agencies. The actions of the credit rating agencies also show why it is important to prevent conflict of interests.  The credit rating agencies mostly earned their revenues from companies whose products they rated, thus, they had an incentive to please clients to attract more business. But the ratings given by credit rating agencies had a huge impact on the conduct of the markets who trusted these ratings regarding the risk element of financial products and securities. The credit rating agencies gave high ratings to many subprime mortgage-backed securities, thus, severely understating their risk profile and as a result, many buyers ended up with far more risk than they believed (Jickling).

There were other factors related to the financial sector, too that caused the economic crisis in 2008. First of all, some banks behaved in unethical manner such as off-balance sheet accounting which hid the true risk profile of such banks. Investors rely on financial statements to make investment decisions and if they don’t know about a risk factor, they may overpay or take more risk they are comfortable with. Banks also established off-the-books special purpose entities to engage in speculative activities (Jickling). As a result, when these activities came to light, the markets punished such institutions but the investors unfairly bore the cost. Nevertheless, this low confidence in the markets also contributed towards the economic crisis in 2008. Another way the financial sector contributed to economic crisis by underestimating their true risk profile was to rely on financial models that were unrealistic. These financial models ignored the possibility of some of the worst case scenarios and also used data from few years, thus, decreasing their reliability (Jickling).

So many of the factors behind the economic crisis in 2008 are related to the financial sector that it is not surprise much of the public anger has been directed towards them. Nevertheless, it is clear that the economic crisis in 2008 was not caused by a single factor but many factors many of whom were related to each other in some ways. It is important to understand these causes and their effects so that such crisis can be prevented in the future. 

Works Cited

Goldman, David. Worst year for jobs since ’45. 9 January 2009. 8 April 2014 <http://money.cnn.com/2009/01/09/news/economy/jobs_december/>.

Jickling, Mark. Causes of the Financial Crisis. CRS Report for Congress. 9: April, 2010.

Klarman, Seth. Securitized Products Were Too Good of an Idea to Pass On. 8 April 2014 <http://www.investorwords.com/tips/1101/securitized-products-were-too-good-of-an-idea-to-pass-on.html>.

Leonnig, Carol D. How HUD Mortgage Policy Fed The Crisis. 10 June 2008. 24 July 2011 <http://www.washingtonpost.com/wp-dyn/content/article/2008/06/09/AR2008060902626.html>.

Lim, Michael Mah-Hui. “Old Wine in New Bottles: Subprime Mortgage Crisis – Causes and Consequences.” The Journal of Applied Research in Accounting and Finance 2008: 3-13.

Paletta, Damian, Serena Ng and Jon Hilsenrath. Worst Crisis Since ’30s, With No End Yet in Sight. 18 September 2008. 8 April 2014 <http://online.wsj.com/article/SB122169431617549947.html>.

Rickards, James. Repeal of Glass-Steagall Caused the Financial Crisis. 27 August 2012. 27 August 2012 <http://www.usnews.com/opinion/blogs/economic-intelligence/2012/08/27/repeal-of-glass-steagall-caused-the-financial-crisis>.