Economic Crisis - Coursework Example

Contents Introduction Great Depression 3 Analysis 4 Conclusion 6 References 7 Introduction The recent economic crisis has changed the perceptions about our economic and monetary system. This system was a product of capitalism and mostly financial innovations made in the last fifty years. The system was believed in by billions of people all around the world. All financial systems are basically dependent on the belief of people in their effectiveness and sustainability (Madura, 2007). To ensure that this belief is maintained the bodies who govern this system try their level best to ensure a safe environment for investors and other participants. The sustainability is therefore affected when the investors cannot believe that the system is safe and secure (Madura, 2007). The manipulation of this system by factors inside or outside the system can lead to severe negatively consequences for the participants of the system. There are many different types of risks in finance. These types and amounts of risk basically provide the rational framework for making financial decisions (Madura, 2007). Therefore the investors face uncertainty, when a risk surfaces which was not considered before. This uncertainty can lead to a major crisis. Once the general public does not trust the financial system they would not use it. This is system is based on a network of different individuals who keep an equilibrium by inject and withdrawing funds. To further understand this situation image a country whose public does not believe in the local education system (Madura, 2007). The people there would stop enrolling and slowly the system would just collapse as there would not be any students. A similar situation can be seen for the global economic crisis, similar think started the collapse of the American Economy. Great Depression The first recession which eventually turned into the global economic recession should be understood and studied in order to comment on the current global economic crisis. The recession of the 1930s also stemmed from the United States of America just like the current global collapse (Paulson, 2010). Due to the severe amount of damage it caused the entire world. This depression became to be known as the Great Depression. The damage due by this depression was beyond measure. The collapse of economic Europe which later led to the World War 2 was a result of this Great Depression. America had actually lend huge amounts of loans to its allied European nations, however once its own economy came under pressure it asked for the return of its own loans, which in turn led to the collapse of their economies. Thus the entire world financial system collapsed. There are many different reasons associated with this financial collapse. Different reasons have been given over the years, mostly it is however agreed that it was a failure of not only banking institutions but also federal legislations. This depression had been in the works for quite some time due to fast growth that the world markets were seeing. Moreover bad reforms which included both labor and financial reforms gave the final blow (Paulson, 2010). The banks under legislation were allowed to perform both the roles of banking and investment banking. Therefore a lot of banks were involved in securitization. Eventually however the system collapsed and the millions of people with their accounts in the banks were all bankrupt. The stock market immediately went downhill as well. Analysis The recent global economic recession is in many respects similar to the great depression. The fault again lies with the Federal financial body. The regulations were tightened after the great depression. The roles of banking and investment banking were totally separated. This meant that a single body could not be involved with both lines of operations. There were wise reasons behind this restriction. First of all the Great Depression had proved that it was not a wise decision letting both functions and roles being operated by the same body. Moreover the risk associated with deposits is greatly increased by the banks functioning as investment banks as well. This is because the deposits made by a customer are thought to be at a very low risk. This is why the depositors demand a very low rate of return on those deposits. However if the risk associated with a bank’s operations is increased it would definitely also increase that rate of return. Moreover if the risk is increased the banks are no longer a safe option for investment. Therefore the bank can not involve itself in activities which would increase its risk of doing business. This is the very reason that most buy securities which have a very low risk associate with them. The other main investments of the bank are in loans. These loans are also securitized and an effective mix of rate and return is created (Colin, 2009). This return ensures that the loans are not given out on a very high risk. Therefore the over risk of the investments of the depositors is ensured. The depositor therefore can assume that there is no risk associated with making deposits in the banks (Colin, 2009). This assumption was however tested in the recession of 2008. The collapse of banks, made the public nervous. There was a massive withdrawal of money from the banks. The banks however work on an equilibrium system. At any one time the banks cannot pay back all the depositors. This is because the bank assumes that the money coming in will balance the money going out therefore the bank can pay back only a limited amount at a time (Colin, 2009). The property price in the year two thousand sky rocketed. This was because the international economy was doing. This good performance improved the prices of the property (Colin, 2009). The speculation on property prices is not a new phenomenon. There has been speculation for decades. This speculation makes it very difficult to truly predict the prices of real estate. This was repeated in the United States (Colin, 2009). The house prices sky rocketed. The demand for houses however did not match the prices. These houses were being mortgaged by the banks. Subprime mortgages were being made by the banks and further sold off in the market in the form of securities. These securities were further being used to make more loans and thus issue more securities. This was an endless cycle. As the property prices plunged the owner refused to pay back the money. Most of this was not actually property being used (Colin, 2009). These were usually new houses which had yet to go into the market. Therefore when the owner could not pay back the amounts to the banks, they simply asked the banks to acquire the house. On the other hand the banks had no use of these houses. They could not use these houses or sell them off to pay the security holders. As the funds started to dry up, the payments on the subprime mortgages started to dry up as well. The investment banks on inability to pay back the funds had no other choice but to declare bankruptcy. Conclusion The conclusion is very clear. The fault of this economic crisis lies with the investment banks. The appraisal system forces the bankers to make risky decisions. Appraisal systems of loan officers in many banks depend totally on the volume of loans they make. Therefore these employees have a direct incentive to increase the amount of loans made. This is the root cause of the financial crisis. Loans were given out without due diligence. These high risk loans eventually led to the collapse. This greedy attitude of bank officers was the cause of the financial crisis. Therefore it can easily be said that the banks are to be blamed for this financial crisis. To avoid further similar problems in the global economic system the government should ensure that investment banking is kept as far away as possible from depositor money. Moreover the appraisal system in banks should be reviewed. The performance evaluation should not be made on the volume of loan given out. References Eun, C. Resnick, B. (2004). International Financial Management. Singapore. McGraw-Hill Madura, J. (2007). International Financial Management. New York. Daves, P. Brigham, E. (2005). Intermediate Financial Management. McGraw-Hill. Cohan, William D., 2007. The Last Tycoons. The Secret History of Lazard Frères & Co.. New York, Broadway Books (Doubleday), Cohan, William D., 2009. House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, [a novel]. New York, Doubleday Funnell, Warwick N., 2009. In government we trust: market failure and the delusions of privatisation / Warwick Funnell, Robert Jupe and Jane Andrew. Sydney: University of New South Wales Press Harman, Chris, 2009. Zombie Capitalism: Global Crisis and the Relevance of Marx / London: Bookmarks Publications Paulson, Hank, 2010. On the Brink. London, Headline, Read, Colin., 2009 Global financial meltdown: how we can avoid the next economic crisis / Colin Read. New York: Palgrave Macmillan, Woods, Thomas E., 2009 Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse / Washington DC: Regnery Publishing Read More