Financial crises arise from the collapse of fiscal markets to the extent that various material goods lose a significant share of their nominal worth. These predicaments can be unsystematic whereby only a few sectors of the market are affected. However, in case of a universal financial crisis, almost all industries realize the consequences of such a catastrophe. As revealed in this paper, while monetary predicaments result from increased interest rates and the failure of banks to regulate their financing or liabilities, the underlying consequences include the loss of wealth and a significant decline in the net household income, both of which were witnessed in the U.S. in 2007 and 2008.
Causes of the Financial Crisis
According to Mishkin, although financial institutions are free to exercise discretion when extending various credit instruments to willing customers, their move to increase interest rates on simple and fixed payment loans can initiate a financial crisis (313). Such excessive charges that are beyond the anticipated time value of money lead to unprofitable business projects, some of which remain uncompleted or end up being repossessed because of loan repayment defaulting cases. Poor financial management decisions also amplify the problem of adverse selection since they discourage reliable money borrowers from seeking credit. Giving an otherwise expensive mortgage exposes banks to the risk of defaulting (Adelson 18). This situation decreases financial institutions’ appetite to lend, hence hindering developments and the growth of a government’s GDP. According to Mishkin, such a state of affairs reveals why the American Federal Reserve Board (Fed) has implemented a monetary policy theory, which aims at ensuring stable rates as a strategy for achieving continuous growth of its GDP (623).
In 2007, the number of mortgage defaulters in the U.S. rose, thereby causing banks to experience massive losses that led to the witnessed financial crisis (Adelson 22). Financial agencies responded by reducing lending rates to avoid cases of insolvency. For advanced economies such as America, this strategy reduced the amount of cash flowing to entrepreneurs and investors (Mishkin 313). Reduced lending implies slowed business operations for banks, a situation that interferes with their balance sheets. Any failure of one bank triggers the collapsing of others. During the monetary predicament of 2007 and 2008, the entire American financial sector lacked adequate cash to meet globally spread monetary liabilities, hence resulting in the famous global recession.
Consequences of the Financial Crisis
A financial crisis leads to the loss of wealth, especially when high interest rates are not held until their maturity period. The 2008-2009 scenario left investment firms and banks with huge deficits arising from mortgage-backed securities (Filbeck et al. 5). It also affected the prices of new homes, thus forcing builders to quit otherwise profitable business ventures. Consequently, a significant share of credit value in America was lost due to the financial predicament. Indeed, instead of paying their mortgages, some homeowners decided to walk away. Hence, investment firms, banks, and people who had taken loans lost their wealth.
Financial crisis reduces net household incomes. During the recession witnessed approximately a decade ago, low sales, minimal returns, and reduced stock prices characterized the United States’ economy. It experienced slowed growth that led to increased unemployment levels accompanied by wages and salaries decrements. The resultant low demand for products and services made firms report losses. As a result, they had to reduce their expenses by decreasing wages and avoiding new hires. During periods of mass layoffs, consumers tend to save, as opposed to spending their money. According to Mishkin, this strategy interrupts monetary supplies (386). Overall, companies in America suffered from reduced demand for their services and commodities due to the financial crisis of 2007 and 2008.
High interest rates and the poor management of various credit instruments are capable of triggering a financial crisis. Upon its occurrence, this paper has presented some remarkable consequences felt by economies, regardless of whether they are advanced or emerging. In particular, governments realize reduced wealth levels and a huge decline in the overall household revenue. These combined losses ruin the stability of all affected economies.
Adelson, Mark. “The Deeper Causes of The Financial Crisis: Mortgages Alone Cannot Explain It.” Journal of Portfolio Management, vol. 39, no. 3, 2013, pp. 16-31.
Filbeck, Greg, et al. “The ABA Top Performing Banks in a Time of Financial Crisis: Can They Outperform the Worst?” Banking and Finance Review, vol. 8, no. 1, 2016, pp. 1-20.
Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 11 ed., The Pearson Series in Economics, 2015.