Okunlaya Babatunde B 0804954@live.abertay.ac.

uk

Assessment Unit 1:

“ANALYZE THE CAUSES AND

CONSEQUENCES OF THE GREAT
RECESSION OF 2007-2009.”

Prepared By:

Okunlaya Babatunde Badrudeen

(0804954)

Course Title/Code: Global Economy

(EC1013A)

Tutor: Rolfe Mervyn

Okunlaya Babatunde B 0804954@live.abertay.ac.uk

INTRODUCTION

The global financial and economic crisis (great recession) of 2007–2009

began in July 2007 when a loss of confidence by investors in the value of
securitized mortgages in the United States resulted in a liquidity crisis
that prompted a substantial injection of capital into financial markets by
the United States Federal Reserve, Bank of England and the European
Central Bank (Anon 1, n/d)) Although the collapse of America’s housing
is mostly given as having caused the crisis, the financial system has been
vulnerable because of ‘intricate and highly-leveraged financial contracts
and operations, a U.S. monetary policy making the cost of credit
negligible therefore encouraging such high levels of leverage, and
generally a "hypertrophy of the financial sector" – financialization’
(Anon 1. n/d).

The American ‘prime-mortgage’ lending crisis spread to Europe and the

emerging markets of Asia, South East Asia and Latin America, affecting
a wide range of financial and economic activities and institutions, which
includes, the tightening of credit with financial institutions making both
corporate and consumer credit harder to get, devaluation of the assets
underpinning insurance contracts and pension funds leading to concerns
about the ability of the instruments to meet future obligation, devaluation
of some currencies /increased currency volatility and liquidity problems
in equity funds and hedge funds (Ikome, 2008). It was considered to be
the worst financial crisis since the Great Depression of the 1930 (Anon 2,
n/d). It contributed to the failure of key businesses (e.g. Lehman Brothers
etc), decline in consumer wealth, substantial commitment incurred by
governments and a general decline in the global economic activities
(Anon 2, n.d). As a consequence, the United States economy shrunk by
2.7% in 2009 having fell into recession in December 2007 (IMF, 2009).

This coursework will attempt to trace the history of financial crisis from
the past to the present, the relevant theories explaining the causes, the
effects and challenges posed by the recession, and also an attempt will be
in the likely solution to counter the effects by different economy.
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

THE CRISIS IN BRIEF

A financial crisis occurs when there is a disorderly contraction in money

supply and wealth in an economy. It is also known as a credit crunch. It
occurs when participants in an economy lose confidence in having loans
repaid by debtors. This causes lenders to limit further loans as well as
recall existing loans. As opined by Davis (2008), it could be argued that a
key root cause of the crisis has been the decision in the 1980’s and 1990’s
to move away from structural regulation to an almost sole concern with
the efficiency of the financial system.

The large current deficits in the US, UK and other advanced economies
being financed by excess savings of emerging economies and oil
exporters, loose monetary policy, search for yield and misperception of
risk and lax financial regulation are some clear warning signs of the
recession, and which both Krugman (2009) and Galbaith (2009) criticised
economic professionals for, for showing ‘blindness’ to the possibility of
failure in the market economy (by accessing the impact of these signs on
the economy), and which later resulted in an underestimation of the
severity of the global downturn for much of 2008 (Verick and Islam,
2010). Both the IMF and the World Bank made a number of revisions to
its growth forecast during 2008 and into 2009 as the magnitude of the
crisis grow (IMF, 2009) to cushion the effect.

Despite the intervention from governments in both advanced and

developing countries to curb the growing crisis through the injection of
credit into the financial market and nationalising banks, slashing interest
rates, etc, the crisis quickly evolved into a global job crisis as the ‘crisis-
induced credit crunch strangled the real economy and trade flow
collapsed (Verick, et. al 2010).

By the end of 2008, many developing and emerging economies felt the
effect of the US recession with growth deceleration in parts of the
developing world. But both China and India managed to keep a balanced
resistant to the recession with China economy growing at a rate of 8.7%
in 2009, while Indian with its strong domestic demand having growth
falling to 6.7% in 2009, and so also is Ethiopia and Uganda, low-income
countries, which continue to grow strongly despite the downturn – see
appendix 4 (Verick and Islam, 2010).
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

THEORIES EXPLANING THE CAUSES OF THE RECESSION

Numerous scholars have reviewed on the current financial crisis using a

number of traditional theories of financial instability to help understand
the nature of the occurrences both from the past events and the current,
since these theories are relevant to understanding the event. Barrell and
Davis (2008) in their write-up on The Evolution of the Financial Crisis of
2007-8 in the National Institute Economic Review, shows how financial
crisis differ in their respective details but with similar essentials.

The knowledge about the theoretical explanations will assist in gaining an

in-depth understanding of the causes and likely effect of the crisis since
‘no single theory has a monopoly of wisdom (Barrell and Davis, 2008).

Some of the theories are reviewed below:

• Fragility: The debt and financial fragility theory, suggests the

financial crisis follows a cyclical credit pattern, as a normal feature
of a business cycle (Fisher,1933), with an initial shock provoking
rising debt, mispricing of risk by lenders and an asset bubble,
punctuated by a negative shock which then leads to a banking
crisis.
• Disaster Myopia & Credit Rationing: This suggest that, in the
presence of uncertainty, competitive , incentive-based and
psychological mechanisms lead financial institutions/regulators to
underestimate the risk involved in financial instability, thereby
accepting concentrated risks at low capital ratios, causing a sharp
increase in credit rationing should a shock occurs ( Herring,1999
cited in Barrell and Davies, 2008).
• Uncertainty: As opposed to risk is linked closely to confidence, and
helps explain the frequently disproportionate responses of financial
markets in times of stress in response to adverse shocks as
investors change their decision processes and not merely their risk
perceptions (Shafer, 1986 cited in Barrell et. al, 2008).
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

CAUSES OF THE CRISIS

1. The US Housing Bubble

As stated in the introduction of this coursework, the financial crisis (2007

– 2009) can be linked directly with the housing bubble in the United
States. The defaults on subprime home loans led to 2007’s crisis which
caused the entire asset-backed market to freeze “as investors struggled to
gauge their exposure to the so-called ‘toxic’ loans (Hughes, 2010:33).
Typically, the price of America houses between 1997 and 2006 increased
by about 124% (see appendix 1) which resulted in few homeowners
refinancing their homes at lower interest rate or taking out a second
mortgage secured by price appreciation (Financial Crisis of 2007 – 2010,
Wikipedia). The average US housing prices reached its peak in mid 2006,
and by 2008 had declined by over 20% (see appendix 1) where borrowers
with adjustable rate mortgage could not refinance, avoiding the higher
payments (because of the rising interest rate) and began to default.
Lenders began foreclosure proceedings on about 1.3 million properties (in
2007) which increased to 2.3 million in 2008 (an increase of about 81%
from 2007) - Wikipedia.
By 2009, about 14.5% of US mortgage outstanding are either delinquent
or in foreclosure. All these caused the values of the securities tied to real
estate pricing to plummet, damaging the global financial institutions.

2. Securitization

Another identified cause of the financial crisis is the ‘inconsistency in the

way the financial sector is regulated’ (Mihov, 2009). Securitisation – the
practice of bundling individual loans such as mortgages into new
securities backed by the repayments of the loan – was at the centre of the
credit crisis in 2007 (Hughes, 2010:33). While the commercial banks are
regulated and quite closely supervised, both the investment banks and
other financial institutions enjoy very light regulation. Commercial banks
had the incentive to originate mortgage loans and remove them from their
balance sheets by securitising them and selling the new securities to
funds, investment banks or other investors. Since mortgages were
transferred off the balance sheet of commercial banks, the loan officers
had almost no incentives to monitor the quality of borrowers. The fact
that some entities are closely regulated but others are not is a big part of
the problem (www.ft.com).
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

3. Global Imbalances

The significant global imbalance in world trade, especially for example

between US and China, with US having a growing trade deficit with
China of up to $225Bn in 2009 (Mervyn, 2010).

Other identified causes according to Stormy Brain (n/d) includes

 Regulation of the Financial System

 Perception of Risk
 Interest Rate
 Inflation (as a result of rise in oil prices and dollar collapse)
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

EFFECT AND CONSEQUENCES

The economy collapse has had a devastating effect on households due to

unemployment and the increasing rate of poverty. At the same time, some
countries have been affected more than others due to differences in initial
conditions (state of economy, labour market, fiscal space, institutional
framework) and exposure to direct and indirect impact of the crisis via
credit and trade channels (Verick, et. al., 2010).

Generally, looking at the different happenings around the world economy

will give a good picture of what the effects of the recession. In US for
example, a 6.2% drop in its GDP in Q4 of 2008, with the consumption of
durable goods dropping by 22.8%, and also with total consumer spending
falling by 4.3% (BBC News, 2009). In other parts of the world (Europe),
there is a prediction that Latvia economy to slump by about 10%
(Traynor, 2009 in Carrigan, et. al, 2009), the Hungarian currency rate
dropped against the Euro, and France economy has been paralysed by a
wave of continuous strike.

The following have been identified as the current and likely effect and
consequences of the recession:

• Effect on Unemployment: The current recession is expected to

raise the national unemployment rate by between 2.1 – 3.8 per cent
points (Kaur, 2009). Based on historical pattern, both
unemployment rate and the number unemployed will increase
through 2010 to 6.7% or 2011 to 8.4% (Kaur, 2009). Also see
Appendices 2 and 3 for illustration.

• Effect on World Trade: The world trade has been one of the mostly
hit of all economic activities with most impact in the mineral fuel,
crude materials, manufactured goods and machinery and transport
equipment (Keppel, et. al., 2010). Both the world exports and
imports have dropped dramatically since the beginning of the
recession with a slowdown in both China and India, the world’s
fastest growing economies, having enormous impact both at home
and globally (Carrigan and Pelsmacker, 2009). According to IMF
World Economic Outlook 2010, both the global GDP and world
trade volume has shrunk significantly in 2009. The decline in trade
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

volume started in May 2008 hitting the negative in October with

the collapse of Lehman, and by 2009 the global trade has shrunk by
almost 20%! (Keppel and Worz, 2010). Also, in the USA and
Europe, the consequences of a declining retail sales in both
economy, coupled with numerous bankruptcy and store closures,
could be attributed to a necessary scale-down in supplier chain
countries such as India, China, Vietnam, and Pakistan due to
increased input cost, fluctuating currencies and tightening credit
availability which has been a challenge to stay in business, which
will possibly lead to a lower supply chain standard (Chhabara,
2008) thereby ‘undermining commitments to ethical sourcing’
(Carrigan, et. al., 2009).

• Effect on Financial Sector: Another feature of the recession is a

breakdown in certain financial market, such as the markets for
asset-backed securities, commercial paper, and interbank lending,
and also the failure of several large financial firms (Labonte,
2010).

• Effect on Standard of Living: With the disappearance of a

combination of low prices and an easily available credit which
allowed many, especially low income earners to reduce the
percentage of their income spent on food, heating and travel, the
surge in rising food, fuel and energy prices has made it impossible
but/and only allowed the affected the only option of spending less
on the fundamentals. Many others who under normal
circumstances are expected to at least ‘get by’, would also fall a
risk as their circumstances changes (Anon 3, 2008:1).

• Effect on Oil Prices: Crude oil prices rose from $51/barrel in

January 2007 reaching a peak of $129/barrel in July 2008 (check
LABONTE ).
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

CONCLUDING REMARKS
Looking at the positive economic side effects of the recession relative to
the ones discussed above, we could be able to understand other views of
the effect of the recession.
1. Its been argued that the process of business evolution is speed up
which forces companies adopting new practices and reducing costs
2. Also, it is adjudged that a slowdown in property market creates an
opportunity for new buyers. In 2006 8% 0f properties were bought
by first time buyers which increased to 13% in 2008 (Anon 3,
2008:7).
3. Businesses and individuals are likely more to think in terms of
greater efficiency.
 Okunlaya Babatunde B 0804954@live.abertay.ac.uk

REFERENCES

Amadeo, K. (2010), History of Recession in United States [Online]

Available at About.com Guide, [Accessed on 29 December 2010].

Anon 1, (n/d), Financial Crisis of 2007 – 2009 [Online] Available at

http://www.crisishelper.com. [Accessed on 17 December 2010].

Anon 3, (2008), The Effect of the Recession and those Most at Risk,
Research Summary, October.

Brain, S. (n/d), Causes of Economic Recession [Online] Available on

http://hubpages.com/causes-of -economic-recession/html. [Accessed on 17
December 2010].

Clark, A. and Hopkins, K. (2009), “US economy shrinking at fastest pace

since 1981”, The Guardian, 31 January, pp. 39.

Traynor, I. (2009), “Governments across Europe tremble as angry people

take to the streets”, The Guardian, 31 January.

Carrigan, M. and Pelsmacker, P. (2009), Will ethical consumers

sustain their values in the global credit crunch? International Marketing
Review, Vol. 26 No. 6, pp. 674 – 687.

Herring, J. (1999), ‘Credit risk and financial Instability’, Oxford Review of

Economic Policy, Vol. 15 No. 3, pp. 63 – 69.

Hughes, J. (2010), More Securitisation Deals Wanted, Financial Times

Wednesday November 3, p. 33.

Ikome, F. (2008), The Social and Economic Consequences of the Global

financial crisis on the developing countries and emerging economies: a
focus on Africa.

International Monetary Fund - IMF (2009), ‘from recession to recovery:

how soon and how strong?’ World Economic Outlook (WEO) Crisis and
Recovery, October 2009. IMF, Washington, D.C.

Kaur, J. (2009). Recession: Impact on Unemployment [Online] Available

on http://financial-edge.blogspot.com/2009/04/recession-impact-on-
unemployment.html, [Accessed on 4 January 2011]
 Okunlaya Babatunde B 0804954@live.abertay.ac.uk

Labonte, M. (2010), The 2007 – 2009 Recession: Similarities to and

Differences from the Past. Congressional Research Service.

Mervyn, R. (2010), World Trade Imbalance, Revision PowerPoint Lecture

Note, University of Abertay Dundee.

Mihov, I. (2009), www.ft.com

Keppel, C. and Worz, J. (2010), The Impact of the Global Recession in

Europe – The Role of International Trade.

Shafer, J. R. (1986), Managing Crisis in the Emerging Financial Landscape,

OECD Economic Studies, pp. 56 – 77.

Verick, S. and Islam, I. (2010), The Great Recession of 2008 – 2009:

Causes, Consequences and Policy Responses. Institute for the Study of
Labor (IZA). Discussion Paper No. 4934.
 Okunlaya Babatunde B 0804954@live.abertay.ac.uk

TABLES

Table 1: History of Recession and Its Causes in the US from 1970’s

Date Duration Causes Effect

2007 - 2009 18 months+ Subprime and
Mortgage Crisis
Mar – Nov. 8 months Y2K Scare in Unemployment
2001 Internet(Boom reached 5.7%
& Bust) and
9/11 Attack
July 1990 – 8 months Savings and GDP in Q4of
March 1991 Loans Crisis of 1990 = -3.5%;
1989 -1.9% in Q1 0f
1990
July 1980 – 16 months Iranian Oil Unemployment
Nov. 1982 Embargo rose to 10.8% in
Nov. 1982
Nov. 1973 – 16 months Multiple Causes ‘Stagflation’ and
March 1975 negative GDP
growth for 3
consecutive
quarters.

Source: Data extracted from Amadeo, K. (2010) About.com Guide

 Okunlaya Babatunde B 0804954@live.abertay.ac.uk

APPENDICES

Appendix 1: A graph showing the median and average sales prices of new
homes sold in the United States between 1963 and 2008 (not adjusted for
inflation

Source: www.wikipedia.com
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

Appendix 2: Figure 12: Announced layoffs peaked early in 2009,

monthly data (December 2008 to September 2009)

Source: Extracted from Verick and Islam, 2010 (compiled from various ILO’s
‘Financial Crisis News Alerts’, December 2008 to September 2009 (media-announced
layoffs), http://www.ilo.org/intranet/english/support/lib/about/financialcrisis.htm).
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

Appendix 3: Layoffs and hires in the US during the crisis, monthly data
(December 2007 to January 2010)

Source: Extracted from Verick and Islam, 2010 (Bureau of Labor Studies Job
Openings and Labor Turnover Survey (JOLTS),
http://data.bls.gov:8080/PDQ/outside.jsp?survey=jt).
Okunlaya Babatunde B 0804954@live.abertay.ac.uk

Appendix 4: Economic growth across the world, real GDP growth

(annual % change)

Source: Extracted from Verick & Islam, 2010.