Crisis Economics 2 Essay

Submitted By kegman42
Words: 3177
Pages: 13

Keegan Lawton
May 2nd, 2014
International Political Economy

The Financial Crisis of 2008-2009: The Great Recession

In the first part of their book, Roubini and Mihm provide an overview of economic thought and political events that lead up to the recession. Their thesis for this section is that economic crises are both common and predictable although not all economic crises are the same. “In the history of modern capitalism, crises are the norm, not the exception. That’s not to say all crises are the same. Far from it: the particulars can change from disaster to disaster, and crises can trace their origins to different problems in different sectors of the economy.” (Roubini, 15) The repetitive nature of the crises however, follows a certain set of 5 criteria: asset bubble, cheap and abundant supply of credit, leveraging, expectation changes and margin calls. Roubini says most crises begin with an asset bubble. (Roubini, 17). This is where a particular asset rises far above its underlying fundamental value. “This kind of bubble often goes hand in hand with an excessive accumulation of debt, as investors borrow money to buy into the boom. Not coincidentally, asset bubble are often associated with excessive growth in the supply of credit.” (Roubini, 17). This is due to lax supervision and regulation of the financial system or the loose policies of the central bank. However, asset bubble can develop before the credit supply booms due to technological innovation. “In the last few hundred years, many of the most destructive booms-turned bust gone hand in hand with financial innovation.”(Roubini, 17). As credit becomes increasingly cheap and abundant, the converted asset becomes easier to buy, demand rises and exceeds the supply leading to a rise in prices. This eventually leads to leveraging. “Because the assets at the heart of the bubble can typically serve as collateral, and because the value of the collateral is rising, a speculator can borrow even more with each passing day.”(Roubini, 18) However, this cycle cannot go one forever. Once confidence that prices will keep rising vanishes and borrowing becomes harder, expectations change and de-leveraging begins. The authors give the example of the United States housing market. “The excessive number of homes built during the boom collided with diminishing demand, as excessively high prices and rising mortgage rates deterred buyers from wading any further in to the market.” (Roubini, 19) This is where the unloading of assets originally bought with debt occurs. When unloaded, they originally are done so below fundamental market value. This will eventually trigger margin call. Borrowers have to put up more collateral to compensate for falling prices, which force borrowers to sell off more assets below market value. Supply falls even further and the value of remaining collateral plummets. This causes a move into safer and more liquid assets. This is where panic ensues. Everyone stops spending which drives prices to fall even farther below their fundamental market values. (Roubini, 19) The authors offer different explanations for the crisis by showing the monetarism, Keynesianism, and the Austrian school view. Monetarism blames the crisis due to the instability in the money supply. As an asset bubble ensues, the supply of credit becomes way too big because of leveraging, which caused the money supply to increase too rapidly. The value of assets over time begins to shrink during a liquidity crunch, which then causes the money supply to shrink dramatically. People begin to default which leads to a dramatic drop off in investing and businesses can no longer expand. The low interest rate on the assets fuel the boom because it encourages people to borrow and lend making the access to cheap credit more abundant. To ensure the crises will be averted, the government must discourage borrowing during the boom by gradually decreasing