Wednesday, January 28, 2009

What Caused Economic Crisis?

Readers Questions: What are the factors that makes today’s economic crisis? Which of them are the most important in today’s economic crisis?

Some of the most significant factors in causing today's economic crisis:
  • A glut of saving from Asia. A glut of savings poured into US and similar countries like UK. This kept US interest rates low and encouraged high levels of consumer spending in US. It encouraged a large current account deficit in the US. It also encouraged an asset bubble, because it was cheap to borrow and this encouraged unsustainable lending.
  • US interest rates kept too low for too long around 2003-2005. This encouraged an asset bubble, especially in US. The problem was that inflation was low and people felt this was the most important target. In targetting inflation, people ignored the asset bubble. (see: Mistakes of Alan Greenspan)
  • Bad Loans. Probably the biggest cause of the current credit crisis. Banks and mortgage companies made a serious of bad loans especially for subprime mortgages. Basically, people were lent mortgages they had no realistic chance of repaying. Mortgage companies and banks were left with a series of bad debts they had to write off. (see: Subprime crisis)
  • Lack of Capital reserves. In the boom years, banks pursued a reckless dash for growth. This meant lending a high % of deposits. Therefore, when they suffered bad losses. They had no reserves to call upon. This led to a dramatic drop in bank loans which had ripple effects throughout the economy.
  • Reselling of Bad Loans. Most of the bad loans originated in the US subprime mortgage market. However, these were rebundled and repackaged into collaterised debt obligations. They were given triple a ratings and bought by banks around the world. Therefore, when mortgage defaults occured in the US, the losses were felt by the whole global banking system because most banks had some exposure to these bad loans.
  • Boom and Bust in Housing Markets. Starting in the US, house prices shot up and then fell rapidly. Falling house prices reduce consumer spending and consumer confidence. Also banks losses were increased by falling house prices. Asset bubbles and booms are often associated with prolonged recessions (depressions) (see: Boom and bust in US Housing Market)

Who is to Blame?
  1. Banks who made irresponsible loans to people who would struggle to repay (especially in America)
  2. Banks who were irresponsible in pursuing growth at cost of lower capital reserve ratios. especially banks like Northern Rock, RBS. This meant they are requiring bailouts because they have run out of cash.
  3. Regulators who did little to ensure banks were pursuing sustainable lending practicies.
  4. Central Banks / Governments who did little to prevent asset bubble and bust.
See: who is to blame for credit crunch?

1 comment:

Anonymous said...

Where is all the money that Asian countries were investing in western assets now going?