The global financial crisis of 2007-2008 was one the
greatest financial crisis in history, not only because it led to a worldwide
economic slowdown but also because its effects are still being felt even today.
Some say that the crisis was caused due to the low interest rate policy by the
US government. That is true but there were a multiple other factors too that
led to this financial meltdown.
Firstly, to achieve the “American Dream” the policy adopted
by the US government was that of a low interest rate so that potential
borrowers could borrow at a lower cost. This also meant that people saved
lesser than before. But the interest rate increased from 2003 to 2006 which in
turn increased the costs of repayment for borrowers which in turn increased
default rates. The availability of credit led to a growth in the home loan
market. This further led to a problem of moral hazard.
From the late 1990s, banks instead of holding loans on their
balance sheet till maturity, began to sell them to third party investors
by re-packaging the loans in the form of securities. These were called
collateralized mortgage obligations or CMOs. The exposure of the banks and
financial institutions to these mortgage backed securities grew dramatically in
the early 2000s. But the value of the CMO bonds started falling and investors
started selling them so that they could minimize losses. Then prevailed a state
of panic which led to the price of bonds to fall even further. Banks incurred
losses and this led to an in increase in the requirement for capital. This
combination of losses and diminished capital led to a crisis in confidence in
the banks and this led to a credit crisis.
Also during the Bush era, the weak dollar policy was adopted
which decreased the demand for US currency making loan assets relatively
cheaper. In order to increase home ownership, the US government also made use
of homeowner subsidies. Appreciating “The American Dream Down Payment Fund”,
former US President Bush stated: “We estimate that this fund will open the door
to homeownership for 40,000 low-income families annually.”
To increase the size of the housing bubble, there was also the
“home mortgage interest deduction act” which allowed taxpayers to deduct their
taxable income by the entire amount of interest paid on their home loan. The
lack of financial regulation within the securitized loan sector along with the
unregulated credit rating agencies also contributed to the financial crisis.
The housing bubble eventually burst leading to a collapse in securitized loan
values.
But to what extent could the financial
crisis have been avoided through the use of central US government economic
policy? In the years leading up to the crisis, there could have been higher
interest rates. That would have meant a stronger dollar which in turn would
have made loans less attractive to foreign investors. The lower availability of
credit would then not have contributed to the housing bubble and credit boom in
2008. Also the marginal propensity to save would have been higher and would
have reduced the risk of the financial crisis.
Also the implementation of the interest deductibility on
home loan payments should have not taken place because this led to many
potential investors to invest in property. This increased the allocation of
mortgages. The same can be said about “The American Dream Down Payment Fund”.
Introduction of tighter controls over loan underwriting
could have helped speed up the recovery. There should have also been higher
minimum capital requirements for financial institutions and banks to increase
the ability of banks to incur losses and to avoid bank runs.
Raghuram
Rajan, governor of the Reserve Bank of India had predicted this global turmoil
in 2008 when he was the economic counselor at the International Monetary Fund.
Today, he predicts a similar situation to prevail in the near future because of
the loose monetary policies pursued by the US Federal Reserve like long-term
low interest rates and quantitative easing. Rajan worries “Have
we artificially kept the real rate of interest somehow below what should be the
appropriate natural rate of interest today and created bad investment that is
not the most appropriate for the economy?” Let us hope for a stable
financial situation in the coming years, if not worse.
Alisha Quadros,
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