Unit 1
Unit 2
Global Economic Issues
The Global Financial Crisis
The global financial crisis was the name given to the economic downturn that was experienced simultaneously in almost every country in the world between 2007 and 2009. While contractionary phases are common in the business cycle, it is unusual for so many countries to experience a negative phase at the same time. Similarly, the financial crisis of this period was both prolonged and extreme. Although we did not see the worst of the crisis here in Australia, there is no doubt that for many parts of the world it was the most challenging economic event since the great depression of the early 1930s.
There were many reasons for the onset of the crisis. All economists try to predict the future by looking at current economic trends. If you see any of the following events occur during your life, you should consider this a sign that an economic downturn may be imminent!
Asset Price Bubble
An asset price bubble is notoriously difficult to identify. This occurs when the price of an asset increases “too quickly”. When this happens it is likely that the bubble will eventually “burst”, and when that happens the value of the asset will fall quickly. At this time the people who own these assets will experience a fall in their wealth. This is part of the reason for the global financial crisis.
House prices in the USA increased dramatically between 2000 and 2006, but then values began to fall very quickly. Falling house prices meant that almost everyone in America lost a significant percentage of their wealth. This had a particular impact on those people who had borrowed money against their houses while the prices were over-inflated.
Sub-Prime Mortgages
Many US based financial institutions had engaged in a practice that is now known as the sub-prime mortgage market. In short, this was a situation in which money was lent to people who were unlikely to be able to meet the repayments. (A term that was coined at the time was a “NINJA” loan – a loan made to a person with No Income, No Job or Assets.) These loans were made because the banks believed that the value of the properties would continue to increase. As a result if the person defaulted on the loan then the bank would be able to claim the asset, sell it, and make a profit.
As we now know this didn’t happen. House prices fell, and so did confidence. People stopped spending, and so many workers lost their jobs. This meant that a growing percentage of people were unable to make their mortgage repayments, and so they lost their houses. The banks were able to claim these houses, but when they were sold the business made a loss. As financial institutions began to report losses people in that industry lost their jobs too.
Risk
Every time a bank lends money, they assume that there will be an element of risk involved. To compensate for this risk, banks will charge a rate of interest. If banks are able to borrow money at 5% per annum, then they can lend it to us at 6% per annum and make a profit. However, if they do this and one of the “risky” loans fails, then they will need to make a lot more “good” loans to cover the cost of the failure.
In a highly competitive market, lenders began to ignore the value of risk. This drove interest rates down, which enticed more people to borrow against their houses. In the late 1990s the value of debt to housing in the USA was around 46%; by 2008 this ratio had increased to 73%. In other words, Americans had borrowed $10.5 trillion to fund their spending during this period. The financial sector had made money too cheap.
Contagion
All of these events occurred in the USA. To really understand the crisis, we need to be able to explain how these events began to affect people and businesses in other countries. Broadly speaking, there were two main links. The first was a direct link; US financial institutions had “sold” some of their sub-prime mortgages to banks in other countries. When these loans went bad, the problem moved to the ultimate holder of the debt. The term that was adopted to refer to these loans was “toxic assets”. To give you some idea of the scope of the problem, the National Australia Bank wrote down about $850 million worth of sub-prime mortgages, and banks in Europe lost a combined $1.6 trillion.
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