The 2007-2008 World Financial Crisis

During the close of the 2000s, most major economies were struck by the global financial crisis of 2007-2008. The financial crisis is often known as The Great Recession. It was the worst economic downturn since the Great Depression, which hit the world economy between the two World Wars. Unlike the Great Depression, however, the Great Recession primarily impacted the world’s major economies. The crisis began in the United States, following the collapse of its real estate market. Because many resources invested in this business could not be reclaimed and turned back to money for other purposes, the collapse impacted the economy’s overall liquidity. At its peak, households and investors did not have finances to fund local consumption and investment expenditures. Most money was held in complex securities that had been sold by banks in order to finance the real estate industry. Many jobs were lost and the economy went under crisis. This spread to other major economies and soon became and world crisis. Governments put in varying efforts to redeem the economy. They included direct provision, provision of subsidies and regulation. This paper will look at three countries: the US, UK and Germany. The essay will examine the causes of the great recession in each country, how the respective governments responded to the recession and the effectiveness of the solutions by three governments towards loving the issue and containing the situation.

Causes of the 2007-2008 Financial Crisis

USA

The genesis of the crisis in the US was the sharp decline of the housing market. Towards 2007, securities declined in value because most of them were backed by mortgages at the time. Eventually, the U.S. GDP declined by about 3% before stability could be restored (Laurence n.p). The events leading to this change were mainly related to the increased attention that the financial institutions were giving to the real estate industry. At the beginning of the new millennium, the US market showed increased potential of owning landed property. Initial low liquidity in the early 2000 prompted the federal reserve bank to apply expansionary monetary policies to increase the supply of money. The increase led to the hype in the real estate industry. Towards the mid-2000’s, financial institutions started coming up with ways to finance investments into real estate because of the increasing potential of the industry. Mortgage-backed securities were sold in addition to other financial sophisticated products backed by mortgages (Elsby et al. 19). The people were willing to purchase the products because of the promised returns. Thus, lot of money flowed from the households to banks and eventually to the housing sector. These companies went as far as creating unnecessarily expensive properties such as mobile homes and run-down inner cities.

At the beginning of 2007, financial firms were owning more than $1 trillion worth of securities. These were backed by the mortgages whose borrowers were now defaulting. Though the subprime borrowers were working hard to meet pay these loans, the property in which the money was invested was not offering returns at the expected rate. Financial institutions started seizing property from the defaulters. In August 2007, stakeholders in the financial market realized that seizing property would not solve the existing problem. There was low demand for the property at this time and thus depositors’ money could not be retrieved. Liquidity had been compromised by these investments. At this time, the Federal Reserve Bank had realized its mistake and came in to try and regulate interest rates. In early 2008, the US Government had to collaborate with J.P. Morgan to rescue Bear Steams, one of the major investment banks in the country. J.P. Morgan then became the major shareholder in the company (Talton n.p).

As the crisis deepened, the U.S government continued bringing in more support. In September 2008, the federal government had to salvage two more major mortgage financing entities: Freddie Mac and Fannie Mac. On 15th September Lehman Brothers bank had a total of $600 billion as failed liabilities. The US government had to prove a point that they could not salvage all the troubled institutions. Direct intervention was proving to fail. The Government thus came in with subsidies. President Bush enacted the Economic Stimulus Act of 2008 that gave $600 billion tax refunds, especially to low and middle earning Americans. The enactment of American Recovery and Reinvestment Act of 2009 saw the government implement a number of expenditures to boost investment and consumption by both businesses and households (CNN n.p).

UK

Though the crisis’ genesis was deregulation of the financial markets in the US, Events preceding the crisis in the UK made the country vulnerable to its impact. After the 1970s oil crisis, countries started loosening their oversight on foreign-based investment and insurance companies, stockbrokers, banks and building societies. Initially, these entities were hardly allowed into Britain and strict regulation was implemented when they were let in (Hoffman 29). The UK relaxed these regulations and many of the entities can now raise funds from different parts of the world, and not necessarily from the depositors in the country. This liberalization saw personal debts grow, especially property-affiliated ones.

The deregulation was not only limited to Europe, other countries across the world liberated their property and financial sectors to enable their institutions and individuals to benefit from the expanded market. In the UK, the lenders were anxious about retaining their markets and expanding to new ones. They thus started offering very huge loans, sometimes even bigger than the underlying property (Hoffman 2). They could sometimes be a multiple of the net worth of the borrower. Despite the amount of loans, lenders learnt that they were getting paid back because of the booming property business.

Investors in the property sector seemed to admire the now booming lending business. They entered into this business to offer sophisticated financial products. They would raise funds by selling off parts of their mortgage and loan deals to other lenders in the industry. The secondary lenders were unaware of the complexity of the deals underlying these purchases. This complex process involved in the sale and resale of mortgage and loan deals was known as securitization.

Global oil prices started rising around March 2007 (Hoffman 24). Many countries started anticipating a global recession. In the UK, some firms cut their operations and many employees became redundant. As they were being dropped, they became unable to meet their mortgage payments. The banks started having a closer look at their mortgages and mortgage-securitized investments that they had secured from other institutions. Their worry made them cut lending to other financial institutions, even in the short-term. Inter-bank borrowing is a common practice that helps these institutions in offsetting short-term imbalances.

The paranoia in the UK banking and insurance sectors eroded the confidence that had initially backed support in case of short-term imbalances. Liquidity problems emerged in these companies (Lawrence 7). They could not meet their short-term obligations like in the past when trust existed between them. These problems were eventually made worse by an increase in the price of oil which shot to $147 a barrel in June 2008.

The Bank of England came in and offered financial support to the Northern Rock Building Society. This prevented the much anticipated run on its cash by depositors. The society was nationalized in early 2008, with the government taking up a major proportion of its stake to compensate for the bailout. The government realized that just like their counterparts in the US, many financial institutions were facing a major problem and it was not possible to use taxpayer’s money to salvage all of them. Its decline to offer further direct support to the falling industry marked the genesis of serious liquidity problems in the country. Many financial institutions became insolvent. The economic system could not fund consumption by households and production by the other sectors because of limited money in circulation.

Germany

Unlike in the UK and the US, the end of the Great Recession left Germany as one of the strongest economies. This strength can be attributed to the changes that took place in the country’s economic sectors just before the recession. At the advent of the 20th century, Germany had been nicknamed as “the sick man of Europe.” Dustmann (168) notes that from 1998 to 2005, Germany’s economy grew at an average of 1.1%. In an effort to salvage the economy, the government and policymakers started initiating a series of market reforms referred to as Hartz Labor Reforms. Between 1995 and 2008, Germany experienced a sharp decline in the number of unionized workers. This led to an unprecedented wage restraint. Firm-based work councils were instead formed and the labor market started gaining flexibility again.

The Hartz reforms reduced employment benefits with the purpose of ensuring that as many people as possible remain employed. They reorganized the Federal Labor Agency and reformed the labor market policies. However, they did not affect competitiveness because they were applied uniformly. There were no strong indicators of the Great Recession in Germany as was the case with other major economies such as the US and the UK. Therefore, at the onset of the recession, Germany was in a very competitive position (Dustmann et al. 173). Trade linkages within its economy made the country glaring to take over the world economy, especially in the supply of goods and services.

Germany’s export markets were not much affected by the collapse of the housing market. Therefore, the country showed hope of recovery within a very short period of time. Germany experienced a short recession, which seemed deeper than that of its European neighbors. However, this recess began and ended long before that of the UK. In Germany, there was no significant decrease in the rate of unemployment like the rest of the major economies.

During the economic reformation period, Germany established the tripartite deal. It sought to spread the burden of employment over reduction on workers, taxpayers and employer. There were special collaborations between worker’s unions, policy makers and industrialists. This deal helped mitigate what worsened the rest of the developed countries’ economies during the recession. Germany’s case was a special one considering that there was independence from the political processes. In the other countries, politicians played a major role in the mitigations and reforms (CNN n.p). This compromised the recovery process. Political decisions try to balance between their effect on the popularity of the decision-makers and the effectiveness of the strategies being employed.

In the course of the Great Recession, Germany was on a recovery path. This enabled it take a market share from the adversely-affected economies. Labor-market institutions were efficient to ensure that there existed a balance between the need of households to gain income and the interests of the investors to earn profits. Therefore, production went on as usual, households had the income to finance its consumption and investments remained profitable. Germany established a strong collaborative culture. This feature was very important in enhancing the competitiveness of the country’s industries.

The Reaction of Governments to the Crisis

USA

The recession seemed to have caught the US government by surprise. The initial remedies were through direct financial assistance to the most affected institutions. The Government combined efforts with JP Morgan to rescue Bar Steams in early 2008. This move was meant to ensure that the economy maintained its liquidity. This was followed by the redemption of Freddie Mac and Fannie Mac towards mid-2008. The federal government expected that the financial uplifts would spread to the whole housing and financial markets which would then stabilize with the support of market forces. However, the housing sector continued dwindling with investors unable to retrieve their investments in order to meet financial obligations. People were still investing in the sector with the hope that government redemption would restore its lucrativeness.

The release of the financial statement by Lehman Brothers was an eye opener to the government. The company indicated that it had financial defects surpassing $600 billion. The government realized that direct intervention was not a solution to the existing problem. More entities were expecting favors through tax reliefs and direct financing in order to pay for securities that they had floated earlier. The government announced that it was no longer giving direct financial assistance.

Initially, the Federal Reserve Bank had lowered interest rates several times. This saw a flood in liquidity within the economy. It was this cheap money that had made interest rates skyrocket. In order to maximize on these new interest rates, the bankers became creative and repackaged the loans. They this started selling collaterized debt obligations. Home ownership reached its peak in 2004. This meant that no one was willing to buy more homes and the prices began to fall. The Federal government realized the mistake and slashed discount rates and funds rate to between 1 and 2% to try and counter its effects. The meltdown had already been sparked off and this did little in salvaging the situation.

The government realized that the regulation could work to help the economy regain stability. However, there was need for recovery to ensure that the money in circulation before the recession is recovered. This led to the enactment of the National Economic Stabilization Act of 20087. The act created a corpus of $700 billion that was used in purchasing assets. The corpus was mainly spent on mortgage-backed securities. There were parallel bailout packages in other economies.

United Kingdom

The UK did not anticipate that the events in the US would affect it. However, the government came to a realization that the exposure to the recession did not only emanate from the external economies but also factors within its own economy. The country’s housing sector was facing almost similar problems to its counterpart in the United States. The United Kingdom started calling for fiscal action by all the countries affected in order to stimulate demand again. It cut PAYE tax rates and value added tax. This was meant to ensure that the households which now had reduced income could effectively meet their needs. The government came up with an investment plan meant to utilize £3 billion. £20 billion was set aside for the Small Enterprise Loan Guarantee scheme (BBC, n.p). Apart from the loan guarantee scheme, the rest of the budget dedicated to recovery totaled to about £20 billion during the release of the pre-budget report in November 2008. £5 billion was allocated towards further measures which included helping the unemployed youth gain basic skills. France and Germany had unveiled a program that offered subsidies at purchase of new cars. Britain also rolled out a similar program where £2000 was offered as subsidy for each new car purchased if the older one owned by the individual and family was more than ten years old.

The UK realized that bank bail-outs could have a heavy impact on public finances available. It could compromise provision of important services and other functions instrumental for financial sustainability of the country. The UK had multiple automatic stabilizers that proved to be more effective than that of most of the other developed countries. Thus, the government was left with limited functions that had to be met through discretionary fiscal action.

A new conservative coalition was formed in the course of the recession. It brought together the liberals democrat coalition government. The movement pushed for cuts in expenditure. It also increased indirect taxation. According to The Institute for Fiscal Studies (n.p), the UK is one of the few countries that recognizes the fact that despite the recovery, the effect of the great recession within the population was long-term. Thus, the government has continued with the recovery and consolidation measures almost a decade after the economy showed its first signs of recovery.

Germany

It is valid to observe that Germany did not set up intentional mitigations against the 2007-2008 world financial crisis. The country was on a path of recovery from a long economic slump and this made it less affected by the events surrounding the great recession. Germany’s experiences before and during the recession were in sharp contrast with what the rest of the economic powerhouses were experiencing. Between 1995 and 2008, Germany was facing an economic slowdown because of disorganization in its private sector. The country started set on a path to achieve automation of the economy by creating linkages that were meant to automatically trigger recovery in the main economic sectors (Bellmann et al. 3).

Among the three countries discussed, Germany had the best policies and regulations in place. However, it is important to note that these were not triggered by the recession itself but rather the economic problems being faced by the country since the 20th century. This saw Germany emerge as a stronger economic power from the recession.

The total number of unemployed people fell by two million between 2005 and 2008. Despite the GDP of the country declining between 2008 and 2009, the employment rate was not affected. Germany’s share in the global market continued increasing in the course of the recession. In 2011, the country hit a record 7.7% of the total world exports (Distmann 173). They earned the country $1.738 trillion, which was almost half of the total GDP at the time. This means that the regulations and policies of the country in the course of the recession was much superior than that of the major economic powers.

The government took an initiative to distance itself from the fine details of the economic sector when it realized that regulation was not working to favor growth. This led to the initiation of the Hartz reforms. The planning of these reforms started way earlier but they were first implemented in the mid-2000s (Dustmann 168). The government also set up mechanisms aimed at achieving trade balance within the Eurozone The reforms were used to push for higher production to meet the needs of local households and increase exports. Germany increased her integration with countries in Eastern Europe. This integration saw the economies open up to each other’s’ products. They were also meant to reduce the persisting problems brought by unemployment. The stakeholders took a more active role in solving their own problems (Adda 4).

The wage setting was decentralized during the early 2000s. Labor institutions started allowing for flexibility, especially where there existed some non-usual economic circumstances. The flexibility of the labor market was a thorough mitigation strategy for Germany (Dustmann 185). The wage setting process was gradually decentralized from the industry level to the region and eventually to the single firm level.

The withdrawal of the government in industrial relations left trade unions, work councils and employer association ion full control. These entities have a better understanding of the dynamics in the labor and industrial sectors. Regulation affiliated to legislation and the political process was scrapped off because it had proved ineffective in solving the problem of unemployment. The common currency era (euro) came in 1999 and found Germany on a recovery track. The reforms placed Germany in a competitive status at the advent of the Great recession. The strong labor relations at the firm level insulated the employees against losing their jobs when the recession started. All the stakeholders were willing to compromise in order to ensure that no people lost employment (Dustmann 170). Therefore, though Germany’s policies and regulations/deregulations were not aimed at the great recession, they gave the country a great advantage against other major economic powers. The country seemed braced to take over markets of the affected economies while feeling the least effects at home.

The Effectiveness of Government Response to the Crisis

America was the first badly hit and the most affected economy by the great recession. Financial institutions, households and real estate investors were expecting a larger boom in the housing industry in order to draw their benefits and continue investing. They did not look at other factors such as the level of ownership of homes that had hit a record 70% at the time. The government was also focused on redeeming the sector when it came in. This explains why a lot of money was spent in helping Bear Steams, Fannie Mac and Freddie Mac recover their solvency. The government felt that if the major entities in the housing industry recovered, it would trigger recovery in the whole industry and eventually the economy.

The US government did not seem to recognize the fact that the recession had already done reasonable damage to households and other sectors by the time of its intervention. Therefore, there was need that it focuses on these effects rather than their cause. In any case, the demand of landed property would remain low because most of the Americans now owned houses. Therefore, there was no way that the housing sector would be returned to its state in the early 2000s. The continuous collapse of entities in the financial sector prompted the government to now offer subsidies to households and investments. The Federal Reserve Bank also implemented some regulation on the money market. However, it was too late and many people had already lost jobs with houses losing income.

The strategy of the UK government was more effective than that of the US. The UK seemed to have learnt lessons from the US. It minimized direct financial assistance and started offering subsidies to households straight away. The government realized that direct financial assistance would drain public funds and live it with expensive landed property that was on low demand at the time. Therefore, the UK government chose to deal with the effects of the recession on the households and business entities. For instance, the government realized that due to the recession, many families were not able to replace their old cars. Thus middle and low income households were allowed to apply for subsidies aimed at replacing cars that were older than ten years. Through such plans, the government was able to stimulate consumption again. This led to an increased demand for many goods and services. The private sector was hiring more workers once again in order to meet the demands of the market. The UK came up with a long-term plan aimed at stimulating further demand to ensure that the private sector continues providing more jobs and income.

Germany had the best strategy in place during the great recession. It cushioned the country against the effect of the downturn on its employment. It also enabled it gain a share of the global market. Just like other major world economies, the country experienced a decline in GDP in 2008. However, there was no change in employment because of the private-public partnerships that had been set up. Germany was recovering from its own economic slowdown. The government did not offer any direct provision or subsidy interventions during the crisis. Policies played a key role in the recovery process.

The comparison between these two countries proves that the policy framework of a country is key in preventing economic downturns and cushioning against the influence of external ones. Stakeholders understand the challenges facing the sectors best. The governments should ensure collaboration of all these individuals to prevent the devastating effects of a recess in the economy when it occurs. This ensures that investments and household incomes are protected and that there is an equilibrium in the distribution of resources between sectors.

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