In effect they had bet on themselves with borrowed money, a gamble that had paid off in good times but proved catastrophic in bad. Failures in finance were at the heart of the crash.
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But bankers were not the only people to blame. Central bankers and other regulators bear responsibility too, for mishandling the crisis, for failing to keep economic imbalances in check and for failing to exercise proper oversight of financial institutions. This multiplied the panic in markets.
Suddenly, nobody trusted anybody, so nobody would lend. Non-financial companies, unable to rely on being able to borrow to pay suppliers or workers, froze spending in order to hoard cash, causing a seizure in the real economy. Ironically, the decision to stand back and allow Lehman to go bankrupt resulted in more government intervention, not less.
To stem the consequent panic, regulators had to rescue scores of other companies. But the regulators made mistakes long before the Lehman bankruptcy, most notably by tolerating global current-account imbalances and the housing bubbles that they helped to inflate.
Ben Bernanke highlighted the savings glut in early , a year before he took over as chairman of the Fed from Alan Greenspan.
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But the focus on net capital flows from Asia left a blind spot for the much bigger gross capital flows from European banks. They bought lots of dodgy American securities, financing their purchases in large part by borrowing from American money-market funds. In other words, although Europeans claimed to be innocent victims of Anglo-Saxon excess, their banks were actually in the thick of things. The creation of the euro prompted an extraordinary expansion of the financial sector both within the euro area and in nearby banking hubs such as London and Switzerland.
Recent research by Hyun Song Shin, an economist at Princeton University, has focused on the European role in fomenting the crisis. Moreover, Europe had its own internal imbalances that proved just as significant as those between America and China. Southern European economies racked up huge current-account deficits in the first decade of the euro while countries in northern Europe ran offsetting surpluses. The imbalances were financed by credit flows from the euro-zone core to the overheated housing markets of countries like Spain and Ireland.
The euro crisis has in this respect been a continuation of the financial crisis by other means, as markets have agonised over the weaknesses of European banks loaded with bad debts following property busts. Central banks could have done more to address all this. The Fed made no attempt to stem the housing bubble.
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The European Central Bank did nothing to restrain the credit surge on the periphery, believing wrongly that current-account imbalances did not matter in a monetary union. The Bank of England, having lost control over banking supervision when it was made independent in , took a mistakenly narrow view of its responsibility to maintain financial stability. Central bankers insist that it would have been difficult to temper the housing and credit boom through higher interest rates.
Perhaps so, but they had other regulatory tools at their disposal, such as lowering maximum loan-to-value ratios for mortgages, or demanding that banks should set aside more capital. Lax capital ratios proved the biggest shortcoming. Since a committee of central bankers and supervisors meeting in Basel has negotiated international rules for the minimum amount of capital banks must hold relative to their assets.
But these rules did not define capital strictly enough, which let banks smuggle in forms of debt that did not have the same loss-absorbing capacity as equity. Under pressure from shareholders to increase returns, banks operated with minimal equity, leaving them vulnerable if things went wrong. And from the mids they were allowed more and more to use their own internal models to assess risk—in effect setting their own capital requirements.
Predictably, they judged their assets to be ever safer, allowing balance-sheets to balloon without a commensurate rise in capital see chart 2. And it failed to set up a mechanism to allow a big international bank to go bust without causing the rest of the system to seize up. The regulatory reforms that have since been pushed through at Basel read as an extended mea culpa by central bankers for getting things so grievously wrong before the financial crisis.
But regulators and bankers were not alone in making misjudgments.
Financial Crisis Essay
When economies are doing well there are powerful political pressures not to rock the boat. With inflation at bay central bankers could not appeal to their usual rationale for spoiling the party. The long period of economic and price stability over which they presided encouraged risk-taking.
And as so often in the history of financial crashes, humble consumers also joined in the collective delusion that lasting prosperity could be built on ever-bigger piles of debt.
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Media Audio edition Economist Films Podcasts. New to The Economist? Sign up now Activate your digital subscription Manage your subscription Renew your subscription. Topics up icon. Blogs up icon. Current edition. Audio edition. Construction machinery manufacturer Caterpillar, pharmacy major Pfizer, telecom firm Spring Nextel Corporation and home improvement retailer Home Depot were among the top companies adversely affected.
When the financial crisis erupted in a comprehensive manner on Wall Street, there was some premature triumphs among the Indian policymakers who argued that India would be relatively immune to this crisis because of the strong fundamentals of its economy and a well-regulated banking system even while the other developing countries in Asia clearly showed signs of significant negative impact through domestic credit stringency.
However, the crash in the Indian stock market, triggered by a pull-out of Foreign Institutional Investors FIIs funds, October onwards is not only an indicator of the impact of international contagion but also a sign of the integration of Indian economy with the world economy despite claims of decoupling.
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Global response to the financial crisis has been prompt, and by and large adequate, though it will take some time to have the desired impact. There have been relief plans, bailout packages, etc. Federal Reserve reduced its fund rates six times in from 3. The European Central Bank and the Bank of England have pumped in billions of dollars in the money-market auction.
The unprecedented economic stimulus packages announced by governments will take time to have an effect on economic growth and employment. The recent turmoil has presented a new set of challenges to most, if not all, regions of the world by rendering the achievement of a path, toward sustainable and socially equitable growth, and decent work for all, increasingly more difficult.
Current Global Economic Meltdown
In the current uncertain environment, banks and financial institutions, concerned about their balance sheets, have been cutting back on credit-leading to liquidity crunch and its resultant effects of shelving or delaying of some projects by some large companies, and ,consequent downsizing of staff. There is a strong consensus among observers that the crisis will get worse before it gets better.
While the risk of a total systemic financial meltdown has been somewhat reduced by the actions of the G7 and other economies to backstop their financial systems and provide economic stimulus, severe vulnerabilities remain. It is likely that the credit crunch will get worse as de- leveraging by major institutions and the household sector continues.