The Role of Western Governments in the 2008 Financial Crisis - Essay Example

The Role of Western Governments in the 2008 Financial Crisis

Financial policies adopted by Western governments played a key role in the occurrence of the 2008 financial crisis. Economic globalisation, neo-classical monetarism, as well as novel public management prior to the crisis resulted in the liberalisation of entire financial sectors in the West. Notably, neoclassical liberalism led to massive government de-regulation of Western financial institutions paving the way for economic growth and unrestricted capital markets. Chwieroth (2011) notes that the 2008 financial crisis was the result of an extraordinary boom in debt, as well as credit. Starting in the 2000s, central banks in the West maintained relatively lower interest rates to keep inflation in check and expand their economies (Chwieroth, 2011). Taken together, the policies and macroeconomic imbalances across the globe created massive liquidity which heightened debt levels and increased financial risk for intermediaries, borrowers and investors (Chwieroth, 2011). This ultimately led to an asset price bubble of epic proportions. Western governments ignored clear signals that a financial crisis was approaching in the run-up to the 2008 financial crisis and so were responsible for it.

Western Governments and the 2008 Financial Crisis

Western governments advertently ignored clear warning signs of an impending financial crisis in the face of massive deregulation brought about by neo-classical liberalisation. It is worth noting that the deregulation of the financial sector in the West paved the way for financial activities that should have served as warning signals for the onset of an impending financial crisis. While subprime mortgages in the United States were the ultimate trigger of the crisis, precedents for the crisis were rooted in flawed institutions, as well as the institutionalisation of market-based regulations in Western countries such as Iceland. Crotty (2009) posits that since the 1980s, accelerated deregulation, in addition to swift financial innovation ushered in financial booms which almost always culminated in crisis. At the time, governments in the West solved the crises by introducing bailouts which allowed for economic recovery (Crotty, 2009). Over the years, financial markets expanded significantly surpassing the size of the non-financial sector, vital financial products grew increasingly illiquid, complex and opaque, and leveraging gained traction (Crotty, 2009).

Notably, legislation enacted by the US government in particular was instrumental in setting the stage for the 2008 financial crisis. In addition, key legislation such as Basle I and Basle 2 played a key role in the ushering in of a financial architecture that was fundamentally flawed in the run up to the financial crisis. The financial architecture in the early 2000s was based on minimal regulation of investment, easing of regulations on commercial banks, in addition to little regulation of shadow banking systems (Crotty, 2009). During this period, neoclassical liberalisation served to reinforce the lax regulations by claiming that prices of securities in the capital markets were subject to expected returns, as well as risks (Crotty, 2009). Moreover, financial institutions including credit rating firms took advantage of existing financial rules instituted by Western Governments. The Basle I regulation, for instance, allowed banks to retain 8 percent of core capital as a proportion of their cumulative risk-weighted assets (Crotty, 2009). Owing to the fact that credit rating firms had the crucial responsibility of determining a bank’s cumulative risk-weighted assets, they had a massive influence on the capital requirements of banks (Crotty, 2009). High rating for banks meant higher bonuses, leverage and profit, in addition to lower capital requirements and as such, demand for AAA ratings was at an all-time high (Crotty, 2009). As a result, banks offered rating agencies such as Moody’s perverse incentive so as to receive highly optimistic ratings. This should have been a clear warning sign of a possible financial crisis in future but Western governments did little to avert the trend. Crotty (2009) contends that the financial crisis might not have transpired if credit rating firms had not given absurd ratings to non-transparent financial products such as collateralised debt and loan obligations. It is thus pretty apparent that Western governments are partly responsible for the 2008 global financial crisis since they failed to pay attention to warning signs and increase their oversight on credit rating firms, investment banks, as well as commercial banks.

The laxity on the part of Western governments in regulating the mortgage industry particularly in the United States market was a key precedent to the 2008 global financial crisis. Prior to the massive deregulation of the mortgage industry, commercial banks had strict systems in place for mortgage lending that necessitates banks to screen borrowers before lending out money (Allen & Carletti, 2010). In addition, the financial system provided incentives for commercial banks to evaluate the relative creditworthiness of prospective borrowers (Allen & Carletti, 2010). Nonetheless, government deregulation particularly in the early 2000s ushered in a new era that resulted in a process change, in addition to the alteration of incentives. Under the new system, brokers, as well as investment banks took over the role of commercial banks and started originating mortgages (Allen & Carletti, 2010). However, unlike commercial banks which held on to the mortgages and took all the risk, investment banks and brokers packaged the mortgages as financial products and sold them as securities in a process referred to as securitisation (Allen & Carletti, 2010). As such, the fact that investment banks and brokers bore little, if any, risk served as an incentive to sell as many mortgages as they possibly could and thus maximise their profits. This should have served as a clear warning signal for Western governments to bolster existing financial regulation and avert a future crisis. Initially, investment banks involved in the securitisation process retained high risk mortgages pools and sold off the low risk mortgage pools to investors. Nevertheless, overtime the securitisation process became so lucrative so much so that investment banks sold high risk mortgages to unwitting investors with little government intervention. Allen and Carletti (2010) notes that prior to the occurrence of the 2008 global financial crisis, the entire procedure used to check the mortgage securitization process, as well as the quality and creditworthiness of borrowers had broken down. In addition, the failure of the US government to effectively regulate the different players in the country’s mortgage industry served as a precedent to the financial crisis. Evidently, the laxity of Western governments in regulating their mortgage industries was a key antecedent to the 2008 financial crisis.

In retrospect, Western governments ignored all warnings of an impending financial crisis and this in part played a pivotal role in the occurrence of the 2008 global financial crisis. According to Rose and Spiegel (2010), successful early warning systems must be in a position to foresee cross-country occurrence of crises and their timing. Carmassi, Gros, and Micossi (2009) assert that prior to the 2007-08 financial crisis there were warning signs that were ignored by governments in the European Union. One key warning was the high economy-wide leverage, that is, debt to GDP ratio was significantly higher within the European Union as compared to US economy (Carmassi et al., 2009). The increase in debt to GDP ratio from 1997 to 2007 was approximately 100% of gross domestic product for the Eurozone and roughly 80% of gross domestic product for the US (Carmassi et al., 2009). In both the US and the Eurozone, corporate sector leverage rose minimally and households’ leverage registered a significant rise in the US (roughly 40% of gross domestic product) but failed to register a significant increase in the Eurozone. Nonetheless, leverage in the EU financial sector demonstrated a higher increase relative to that of the US financial sector. All of the above factors were clear warning signs of an impending financial crisis in the years leading up to the 2008 global financial crisis. Verick and Islam (2010) contends that the 2008 financial crisis was certainly not the first and the attention surrounding it was as a result of the impact it had on the global economy. In addition, the crisis was preceded by early warning signs such as liberal monetary policies, loose financial regulations, global imbalances, as well as gross misconceptions of risk (Verick & Islam, 2010). It is thus apparent that Western governments paid little attention to numerous warning signals in the run up to the 2008 global financial crisis thus paving the way for the economic meltdown that ensued.

Events leading up to the 2008 global financial crisis demonstrate that Western governments ignored early warning signs, as well as the views of economic experts. As a consequence, the governments’ failure to take any tangible action to negate the trend served to trigger the crisis. The proliferation of new, largely illiquid financial products that were in the form of derivatives, collateralised debt obligations (CDOs), structured investment vehicles (SIVs), in addition to mortgage backed securities (MBOs) was a significant catalyst in the run up to the crisis. Zaman (2010) posits that mathematical modelling allowed for financial engineering that demonstrated how share prices could be employed in the valuation of the different financial products. The new hybrid financial products promised hefty profits to investors and this consequently fuelled heavy demand for the products on the global marketplace (Zaman, 2010). The loose regulation of the speculative securities allowed unscrupulous investment banks with the solid backing of insurance companies to create, insure and market financial products to individual, as well as institution investors (Zaman, 2010). This turn of events should have been the first warning sign of an imminent financial crisis and Western governments should have taken appropriate action to regulate the trading of speculative securities.

Another clear warning sign prior to the 2008 price asset bubble burst was the massive interest shown by financial institutions in the new financial products given their speculative nature. Zaman (2010) posits that the appearance of the highly reticent hedge funds on the financial scene served to complicate capital markets and attract huge amounts of investments from global financial institutions and wealthy investors. Owing to the fact that the trading of derivatives is contingent upon the valuation of bonds, equity shares, as well as notes, it was apparent that the 2007 crisis brought about by sub-prime mortgages was bound to lead to an even greater financial crisis (Zaman, 2010). Nonetheless, Western governments ignored the warning effectively paving the way for the 2008 global financial crisis. The incapacity of the real estate sector to drop off the foreclosed houses in the US market swiftly depleted the prices of securities owned by housing companies, in addition to the prices of derivative securities which ultimately brought down financial colossuses such as Lehman Brothers (Hellwig, 2008). It is thus abundantly clear that Western governments played a key role in triggering the 2008 global financial crisis by ignoring numerous warning signals.

In conclusion, it is evident that western governments ignored clear signals that a financial crisis was approaching in the run-up to the 2008 financial crisis and so were responsible for it. One key signal was the high economy-wide leverage, that is, debt to GDP ratio was significantly higher within the European Union as compared to US economy. Another key warning was the relatively low level of risk taken up by brokers involved in the securitisation process. Ultimately, increased government oversight and response to early warnings could have helped avert the 2008 global financial crisis.

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As a result, banks offered rating agencies such as Moody’s perverse incentive so as to receive highly optimistic ratings. This should have been a clear warning sign of a possible financial crisis in future but Western governments did little to avert the trend. Crotty (2009) contends that the financial crisis might not have transpired if credit rating firms had not given absurd ratings to non-transparent financial products such as collateralised debt and loan obligations. It is thus pretty apparent that Western governments are partly responsible for the 2008 global financial crisis since they failed to pay attention to warning signs and increase their oversight on credit rating firms, investment banks, as well as commercial banks.

The laxity on the part of Western governments in regulating the mortgage industry particularly in the United States market was a key precedent to the 2008 global financial crisis. Prior to the massive deregulation of the mortgage industry, commercial banks had strict systems in place for mortgage lending that necessitates banks to screen borrowers before lending out money (Allen & Carletti, 2010). In addition, the financial system provided incentives for commercial banks to evaluate the relative creditworthiness of prospective borrowers (Allen & Carletti, 2010). Nonetheless, government deregulation particularly in the early 2000s ushered in a new era that resulted in a process change, in addition to the alteration of incentives. Under the new system, brokers, as well as investment banks took over the role of commercial banks and started originating mortgages (Allen & Carletti, 2010). However, unlike commercial banks which held on to the mortgages and took all the risk, investment banks and brokers packaged the mortgages as financial products and sold them as securities in a process referred to as securitisation (Allen & Carletti, 2010). As such, the fact that investment banks and brokers bore little, if any, risk served as an incentive to sell as many mortgages as they possibly could and thus maximise their profits. This should have served as a clear warning signal for Western governments to bolster existing financial regulation and avert a future crisis. Initially, investment banks involved in the securitisation process retained high risk mortgages pools and sold off the low risk mortgage pools to investors. Nevertheless, overtime the securitisation process became so lucrative so much so that investment banks sold high risk mortgages to unwitting investors with little government intervention. Allen and Carletti (2010) notes that prior to the occurrence of the 2008 global financial crisis, the entire procedure used to check the mortgage securitization process, as well as the quality and creditworthiness of borrowers had broken down. In addition, the failure of the US government to effectively regulate the different players in the country’s mortgage industry served as a precedent to the financial crisis. Evidently, the laxity of Western governments in regulating their mortgage industries was a key antecedent to the 2008 financial crisis.

In retrospect, Western governments ignored all warnings of an impending financial crisis and this in part played a pivotal role in the occurrence of the 2008 global financial crisis. According to Rose and Spiegel (2010), successful early warning systems must be in a position to foresee cross-country occurrence of crises and their timing. Carmassi, Gros, and Micossi (2009) assert that prior to the 2007-08 financial crisis there were warning signs that were ignored by governments in the European Union. One key warning was the high economy-wide leverage, that is, debt to GDP ratio was significantly higher within the European Union as compared to US economy (Carmassi et al., 2009). The increase in debt to GDP ratio from 1997 to 2007 was approximately 100% of gross domestic product for the Eurozone and roughly 80% of gross domestic product for the US (Carmassi et al., 2009). Read More