Financial crisis is defined as “a situation characterized by severe disruptions in the value of financial institutions’ assets, their access to funding or their client’s trust, to the point of endangering the financial system’s sustainability” (Argandona 2009). This essay will discuss the various likely causes of Global financial crisis and the preventive measures that the UK government could take to avoid or diminish the threats of another crisis. Global economic crisis of 2008 resulted due to some fundamental and undesirable changes that took place in the efficient use of resources in America (Davis 2009, p. 1). According to Davis (2009), some changes that could be easily perceived were breakdown of information technology and the ever increasing globalization across the world. He has discussed in his article, the consequences of emergence of Post Industrial Society in US which led to an increase in unemployment as the largest employers shifted from manufacturing organizations to service industry which later contributed as a cause of credit crunch. The essay will first place the possible causes that led to the downturn in the financial position of the various economies across the world and finally it will talk about the methods that UK government can adopt to prevent itself from the hazards of next financial crisis. The essay concludes that while some countries were largely affected by the impact of crisis in 2008, there remain few countries that managed to overcome the shock and survived because of their policies and the best possible steps taken by them.
“The IMF remains bedeviled by philosophical disputes about the scale and scope of its lending and crisis related activities. These disputes distract the institution from its role as a global lender of final resort.”(Truman 2006b, p. 532) Truman (2008) says that at the time of unfolding of economic crisis, members of International Monetary Fund failed to provide any kind of assistance to the economies that required a short term need for external liquid resources. According to him, one of the various possible causes was macroeconomic policies of several countries across the world that jointly holds the responsibility to a great extent for the crisis. He further commented that easy monetary policies and fiscal policies of countries like US, Japan and others reduced the savings rate of these countries and distorted the balance of the financial system and led to a soaring of global credit and elevated the price of houses. “Collateralized debt obligations are bonds ultimately backed by bundles of loans such as subprime mortgages.”(Davis 2009, p. 103) Financial institutions had a good amount of money in the form of foreign exchange reserves so it started lending money to everyone at a very low interest rate (Truman 2008, p. 23) and also to the people who had no capacity to return it back, that is, subprime mortgages came into picture (Davis 2009). After a certain period, when the supply started exceeding demand, housing prices in US began to drop, mortgage holders found that the price or value of their house was less than what they were owing to the banks and so they started defaulting in high numbers and a rise in foreclosures was observed. Emergence of post industrial society, i.e. a shift from manufacturing to service industry in US led to large unemployment. In an effort to improve productivity, companies started cutting down on labour and ultimately small number of skilled labours were left. So the competition for skilled labour increased. With the materialization of defined contribution pension plan, the incentive to stick to a particular company came to an end. And employees started moving from one company to another. This new plan of pension fund led to the growth of mutual fund industry (Davis 2009, p. 31) which resulted in decline in employee attachment with the company and increased participation by financial institutions through mutual funds. “Securitization [altered the traditional pattern of banking by] turning assets into securities traded on markets” (Davis 2009, p. 35). This way of banking allows the bank to lend more amount of money. One form of securitization was mortgage backed bonds (Davis 2009, p. 35). Deboer (2008, p. 5) says that any commercial bank must have approximately 10% of the total amount of loan issued by it, in its capital assets. Many financial bodies issued mortgage-backed financial derivatives and eventually when the housing prices started falling, the value of mortgage backed securities declined too which in turn started making them bankrupt. Realizing this, banks started issuing small number and small quantity of loans. This strapped the credit situation tightly and thus housing prices started narrowing further. In Eastern Europe, the major reason behind the crisis was short term borrowings (Aslund 2009) from many European banks in large amounts because of the security and safety offered by so many countries in Europe by setting a fixed exchange rate. This led to inflation of prices because high amount of money was flowing in. Also the countries like Ukraine started importing goods on high scale and thus fell short of balance payment it owed to other countries. Lack of administration and regulation of the financial sector is another cause identified by Truman (2008, p.24). He says that the overleveraging of the financial system took place gradually in an exponential rising manner over several years, where poor supervision of the policymakers and the others responsible praised the incredible growth of the economy in its early years when the signs of inflation were not noteworthy. After a period of time, (Truman 2008, p. 24) when the financial institutions were left with no money and had no capacity to fund any further investment, the formation distorted and deleveraging began. He believes that another possible reason that might have had altered the market structure was the poorly understood risk associated with the innovations in the formation of new policies in the financial institutions.
Bergsten (2008) says that countries like UK should adopt an economic expansion programme to avoid or surpass the effect of next possible financial crisis. Such programme would involve an effort to increase the domestic demand and thus causing an expansion of the trade in between countries. It also involves reducing the restrictions of trade on the border and inside the country as well. He says “the most positive step the leaders of the G-20 could take would be to pledge to adopt fiscal stimulus programs amounting to at least 1 to 2 percent of most of their national economies.” Leaders should try to think something creative rather than blaming each other for the crisis. Bergsten (2008) suggests that UK along with other countries must assure a support of at least $500 billion each to enhance the resources of IMF (International Monetary Fund) so that it will accumulate good amount of wealth and pledge to support UK as well as other countries at the time of crisis. He also suggests that an efficient working group needs to be formed within the countries to analyse and supervise financial regulations closely. Financial stability report from Bank of England (2009) states that banks should have sufficient amount of liquid assets to lessen its dependence on short term borrowings for funding non liquid assets. The Tripartite Committee comprising of the Bank of England, FSA (Financial Services Authority) and the treasury was held responsible for the crisis of 2008 by the staff of politics.co.uk (2009) in a report. They say that the Bank of England should be held accountable for macro-economic supervision instead of FSA and that all the three should know their exact roles and responsibilities. The report also suggests steps like developing policies to suppress fluctuations in financial conditions, assigning British authorities to constantly monitor UK branches of multinational banks so that if any new policy is formed by them which might affect the financial status of the country in future can be clogged at the right time, increasing the regulations about the capital assets requirement for the bank so that it properly assesses the loan borrower and grant it to him only if he can afford to pay it back. Bergsten (2008) has put forward the idea of a joint work or supervision of the FSA and the Bank. He feels that it would be effective if FSA concentrates on the conduction of the business and Bank focuses on the systemic issues. Amato (2009) expresses his views saying that assets whose value could not be determined were given triple-A ratings by the rating agencies and thus attracted more investors so UK government must ensure that banks don’t over rely on the credit ratings (Bank of England 2009). Amato (2009) says protectionism should be removed so that all the companies across the world can trade easily and freely in other countries without any barriers. Recapitalization scheme has been undertaken by UK banks deliberately to raise capital to provide it with ample amount of insurance against future threats of crisis. (Bank of England, 2008)
Looking at the various causes, we can conclude that there were different reasons for crisis in different parts of the world. If a country forms strong policies and takes decisions that would be beneficial in the long run, then it might be able to protect itself from the adverse consequences of financial instability. Amato (2009) says that a country needs to form policies keeping in mind not only the benefit of its domestic market but also of the whole world. All the countries should cooperate at the international level and support IMF by all means. Countries like China, Malaysia and some Islamic countries were least affected by crisis because of their strong policies, good supervision and regulations, ability to predict or identify financial fluctuations in advance and resistance to outside world’s financial imbalance. The world has lot to learn from these countries.