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The recent financial crisis of 2007-2009 in Europe has been named the worst crisis since the Great Depression, in the 1930’s. While different individuals and organizations view the crisis from different perspectives, it can be considered as a series of policy events proceeding through some stages, which apply different policies and reactions. The financial crisis has deepened over the time. The economic downturn and the financial crisis became reinforcing events, and the international community made efforts to resolve the crisis. According to the reports of the International Monetary Fund (IMF) and the European Central Bank (ECB), many of the factors that led to the financial crisis in the US caused the crisis in Europe. The paper will study the reasons for the European crisis, focusing on the influence of the US financial conditions. It will also research influence of the crisis on the world economic systems.
Reasons for the Crisis
According to Jackson (2010) one of the major causes of the crisis was low interest rates and extension in financial and investment opportunities that arose from antagonistic credit expansion. Among the other reason were growing complexity in mortgage securitization and loosening in bankrolling standards, combined with expanded linkages among national financial centers to spur a broad expansion in credit and economic growth. The rapid rate of growth pushed up the values of goods, commodities, and real estate. Consequently, the combination of high product prices, and raising housing costs strained consumer’s budgets, and they began lowering their spending (Jackson, 2010).
Drop in the consumer’s expenditure resulted in a holdup in economic actions, and, eventually, reduction in the prices of housing (Jackson, 2010). Consequently, the turn down in the prices of housing led to a large-scale downgrade in the ratings of subprime mortgage backed securities and the closing of a number of circumvent funds with subprime disclosure (Jackson, 2010). Issues over the pricing of risk in the market for subprime mortgage-backed securities stretched to other financial markets, including structured securities and the interbank money market. Jackson (2010) indicated that “problems spread quickly throughout the financial sector to include financial guarantors as the markets turned increasingly dysfunctional over fears of undervalued assets” (p. 9).
The financial crisis that began in the US as a result of a downturn in residential property values quickly spread to European banks through effects felt in the market for asset backed commercial papers (Jackson, 2010). Jackson (2010) noted that “studies show that European banks were either openly holding the securities, or they were holding them indirectly through agents and structured venture vehicles with similar holdings” (p. 9). As the ABCP market collapsed, banks holding such securities were forced to step in with additional funding, which squeezed liquidity in the global financial market through the interbank market.
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Over the time, banks and other financial institutions realized that it was impossible to price the value of assets that were used to back up commercial papers. Jackson (2010) claims that during this period, “British government nationalized housing lender Northern Rock and Bradford & Bingley, a mortgage lender” (p. 9). In addition, Jackson (2010) noted that “Belgium, France and Luxembourg governments and shareholders provided capital to Dexia, the world’s largest lender to municipalities and Belgian, Dutch and Luxembourg governments injected $16.4 billion into banking and insurance company Fortis to head off the major bank crisis in the Euro area” (p. 10).
After the build phase, European government attempted to soothe the financial markets by expanding insurance on guarantee for depositors, and, in some cases, securities for banks. Savona, Kirton, & Oldani (2011) state that close economic relationships between Europe and the United States, and the crucial global monetary and financial role played by the City of London were the channels for the crisis aggravation. The crisis was also triggered by the sub-prime mortgage defaults in the US, and the consequent fall in global real estate comprehensive demand in 2008 (Jackson, 2010).
Moreover, the central banks in the United States, the Euro zone, the UK, Canada, Sweden and Switzerland staged a harmonized cut in the interest rates in October 2008, and declared that they had agreed on a plan of actions, to address the ever widening financial crisis. Nanto (2010), however, claims that “the actions did little to stem the wide spread concerns that were driving financial markets” (p. 54). Nanto (2010)further says that the financial crisis did not just involve the United States institutions it also demonstrated the global economic and financial linkages that tie national economies together in a way that may not have been imagined.
Impact of the Crisis on Financial Markets
Research shows that the consequences of this crisis differed among the euro area countries, among the non-European Union countries, and among neighboring non-members, such as Turkey and Russia (Savona, Kirton, & Oldani, 2011). Nanto (2010) noted that some European countries primarily viewed the financial crisis as a purely American phenomenon. The view changed as economic activity in European countries has declined at a fast rate over a short period of time. Nanto (2010) says that “global trade has declined steadily; eroding prospects for European exports, providing a safety valve for domestic industries that are cutting output” (p. 54).
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According to Savona, Kirton, & Oldani (2011), in Europe, the impact on real economic activity was more severe in manufacturing, as its growth model was based on exports. In their studies, Savona, Kirton & Oldani (2011) noted that financial markets suffered as a result of the decline in global demand of stocks, which was caused by decreased domestic consumption. Eventually, the most vulnerable financial markets, apart from those in the UK, were Spain, Austria, and Ireland in the Euro area, Poland among the other EU member states, Turkey and Russia outside the EU (Savona, Kirton, & Oldani, 2011). It was noted that the initial drop of financial wealth in the euro area was half the value of European stocks. The decline in real economic activity averaged 5.8% in 2008, with 8.2% in Germany, and 7.5% in Italy. In France, the economy contracted by 4.6% (Savona, Kirton, & Oldani, 2011). The real cost of the financial crisis increased public debt as a result of lower revenues and higher public expenditures (Nanto, 2010).
As a result of the financial crisis, European countries were concerned about the impact the financial crisis and the economic recession had on the economies of Eastern Europe and prospect for market reforms (Savona, Kirton, & Oldani, 2011). Deteriorating economic situation in East European countries resulted in the emergence of the current problems, which are facing financial institutions in the EU today. Governments in European countries, such as Iceland and Latvia, collapsed as a result of the public protests over the way their governments handled their economies and financial markets during the crisis.
Moreover, the financial crisis accentuated the growing interdependence between financial markets and between the United States and European economies (Nanto, 2010). The synchronized nature of the economic downturn meant that neither the United States nor Europe was likely to come out of the financial crisis alone. Nanto (2010), therefore, indicated that “the United States and Europe shared a mutual interest in developing a sound financial framework to improve supervision and regulation of individual financial institutions and international market” (p. 53).
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Nanto indicated that approximates, developed by the International Monetary Fund in January 2009, provided a rough indicator of the impact the financial crisis and economic recession had on the performance of major countries (2010). As a result of the crisis, economic growth was expected to slow by about 2% in 2009 to further 0.2% drop in the rate of economic growth, while the threat of inflation was expected to lessen (Nanto, 2010). In addition, Nanto (2010) determined that the economic growth, as represented by gross domestic product (GDP), was anticipated to register a negative 1.6% rate for the United States in 2009. On the other hand, the euro area countries could experience a combined negative rate of 2.0%, more than the projected rate of growth of 1.2% in 2008. The steady drop in the prices of oil and other commodities in the second half-year of 2008 may have helped to improve the rate of economic growth. The length and depth of the economic downturn, however, meant that the IMF projections were too positive when the final data for 2009 were published (Nanto, 2010).
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The financial crisis led to increased fiscal pressures on financial markets and even higher deficits. Bugajski, & Balaj (2010) say that “as a result of the crisis, public revenues, the value added tax and import duty collections declined sharply and public borrowing became more difficult” (p. 39). According to Jackson (2010), “lack of confidence in credit markets and lack of liquidity also sparked concerns over the adequacy of capital provisions of financial institutions and concerns over the solvency of banks and other financial firms” (p. 13). During the crisis, financial markets attempted to deleverage by reducing the amount of troubled assets they held on their balance sheets. Jackson (2010) states that due to the crisis, the stocks of financial markets firms in the United States of America and Europe dropped noticeably, and the value of their assets depreciated. This proceeds weakened the financial position of even larger number of businesses.
Impact of the Crisis on the Global Economy
The financial crisis cut a wide swath across the global economy. Bugajski & Balaj (2010) says that “the impact of the global financial crisis is evident when examining trends in global growth and trade, private capital flows and foreign direct investment, remittances and development assistance” (p. 35). As a result of the European financial crisis, the global rates of gross domestic product (GDP) declined by 6.8 % in 2008; and by 2.2% in 2009 (Bugajski, & Balaj, 2010). The financial crisis made global trade experience its most severe contraction since the Great Depression, declining by 12.2% in 2009. Bugajski, & Balaj (2010) claim that “this resulted from declining demand for goods and services and to a liquidity crisis with an attendant decrease in the availability of trade finance” (p. 35). This was coupled with some increases in trade protectionist measures, such as higher tariffs and subsides, and introduction of some nontariff barriers (Bugajski, & Balaj, 2010).
According to Bugajski & Balaj (2010), because of the financial crisis, say that private capital that flows to developing countries fell from $1.2 trillion in 2007 to about $363 billion in 2009. Capital flows to emerging market economies declined from $1.2 trillion in 2007 to $780 billion in 2008 and $425 billion in 2009. Bugajski & Balaj (2010) noted “that financial crisis in Europe adversely affected global flows and foreign direct investment (FDI), which fell by 39 percent in 2009 relative to 2008 from $1.7 trillion in 2008 to $1.0 trillion in 2009 according to the UN Conference on Trade and Development (UNCTAD)” (p. 35).
Another major impact to the global economy, caused by the crisis, is that it resulted in high unemployment rates. The concerns over the growing monetary and economic turmoil increased the political stakes for European governments and their leaders (Jackson, 2010). The global economic crisis was straining the relationship that tied the members of the European Union together, and offered an essential challenge to the ideals of cohesion and common interests. Jackson (2010) asserts that it was foreseen that if the increasing economic downturn could have persisted; the international pressure would mount against those governments that were identified as not carrying their share of accountability for inspiring their economies to extent that is commensurate with the size of their economy.
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Global remittances were also negatively affected by the crisis. Bugajski & Balaj (2010) indicated that “remittances to developing countries in 2009 declined by 6.1% percent from 2008 levels from $317 billion in 2009” (p. 36). The global development assistance flows were negatively affected by the crisis. Bugajski, & Balaj (2010) say that the levels were comparatively static at $120 billion in 2008, $121 billion in 2009, and only $107 billion projected for 2010.
Banking crisis in donor countries were associated with a significant fall in aid flows. Aid flows from crisis affected countries fall by an average of 20 to 25 % (Bugajski & Balaj, 2010). The financial crisis in Europe resulted in the growth of the unemployment rates. According to Bugajski & Balaj (2010), a total of 212 million people globally are now unemployed as a result of the financial crisis. Statistics indicate that global unemployment rose from 5.8% in 2008 to 6.6% in 2009 (Bugajski, & Balaj, 2010).
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In conclusion, the financial crisis started as the credit worthiness problems in the United States in the 2007. European credit markets were influenced severely by difficult economic conditions in the US. The financial crisis has shown a growing interaction between the financial sector and the goods and services sector of economies. The consequences of the global financial crisis have varied from one country to another; this partly was caused by differences in countries’ policies. The effects also varied by exposure to two major risks, which were the degree of dependence on the US economy and reliance on commodity exports. The crisis highlighted the growing interdependence between financial markets, and between the US and European economies.