What Caused the Current Economic Crisis Term Paper

What Caused the Current Economic Crisis - Term Paper Example This meant the very foundations on which our principles and understanding of the whole economic system was based on were shaken and jolted to an extent that people lost confidence in its integrity. It raised questions that directly pointed fingers on the functioning of the global financial markets. The whole crisis began when the US investors lost confidence in the value of sub-prime mortgages resulting in an adverse liquidity crisis. In fear of the effects of the looming liquidity crisis, the US Federal Bank injected huge sums of capital, liquid money, into financial markets in an attempt to prevent several hundred thousand businesses and individuals from declaring bankruptcy. By the end of September of the following year, the economic crisis had worsened as its negative effects started to crash stock markets on all the continents. This made investment highly volatile and investors lost millions of dollars overnight as this continued to spread further. A pinnacle was reached where c onsumer confidence was at its lowest in fear of the inevitable outcomes. Analyses reveal that at a more fundamental level the economic crisis could be attributed to the diligence of massive global imbalances. These imbalances were the outcomes of long periods of excessively loose monetary policy in the major advance economies during the early part of this decade. A major factor in this was the significant increase in the budget deficit of the United States, while at the same time the accumulation of huge amounts of surpluses in Asia, particularly in China and the oil exporting countries of Middle East. The current account balance of US in 2008 as a percent of its GDP was -4.7%, and for China, Saudi Arabia, Russia and UAE was 10%, 28.9%, 6.1% and 15.8% respectively. This showed that even after billions of revenue for the Western Giant United States, the global net flow of money was directed towards the Eastern part. This imbalance was ever growing as the Economic power was slowly and gradually shifting from the West to the East. Experts stated that these imbalances were seen as the consequence of the relative inflexibility of the currency regimes in China and other such countries. According to Portes (2009), prevailing global macroeconomic imbalances were the major underlying cause of the crisis. The gap between the saving-investment function was extensive and this gap was only widening with time since developing countries started relying more heavily on developed economies to provide for their development expenditures. The immediate impacts of these huge cross-border financial flows were seen on the financial intermediation process. (Mohan, 2009) As stated earlier the monetary policy of US was also a contributing factor to the financial crisis of 2008. To understand this we have to visualize the dot com bubble burst in the early 2000’s. This resulted in a reduction of the interest rates and consistent ease in the monetary policy of US and other advanced economies. These rates maintained as low as 1 per cent in US during the period 2003-2004. This gave ample opportunity for new businesses to thrive in the country and huge investments were made during the first half of the decade. Figure 1 clearly demonstrates that during 2008 the effective federal fund rate in the US was around 1 per cent margin. This relatively loose monetary policy meant that transactions were being done on a credit basis more than ever in the history of the country. The effects of this were visible in the credit crunch of 2007 that eventually combined with other factors to bring about the economic crisis. The growing demand from the US consumers and its increasing reliance on cheap consumer goods being imported from Asian countries, mainly China,