According to Booth (2009), the global financial crisis of 2007-08 also referred to as the Great Recession had a devastating impact on both the societies and economies as a whole. The crisis almost brought down the global financial system. The governments turned to bail-outs financed by the taxpayers to solve the problem that was considered as the worst recession to have been experienced in last 80 years. The severity of the world financial challenge compels the political economists to better understand the reasons that informed the occurrence of such crises. According to Bliss and Kaufman (2010), the causes of financial crises revolve around the factors that characterize the financial sector interventions including effectiveness, costs, and policies. There are many financial and macroeconomic explanations given in the debates that explore the causes of the 2007 global financial crisis, which mark the basis for criticizing other financial crises. However, this paper will focus on the political economy analyses which take into account the effect of various political variables on the economic choices as well as the outcomes. The paper will examine the key debates describing different political-economic issues that led to the 2007 world financial crisis.
Political Economy Causes of the 2007/8 Global Financial Crisis
Wade (2011) noted that when investigating the causes of the 2007 world financial crisis, it is important to understand the relationship between economics and politics. The politicians decide on the frameworks for sustaining economic growth in a country. They also initiate reforms for managing financial crises. Moreover, governments are behind the sub-optimal choices of policies that are used to prevent or solve financial crises (Wade, 2011). The concept of political economy holds that development of policies involves strategic interactions between economic agents, voters, bureaucratic actors, and politicians. In this context, the causes of the 2007 crisis can be attributed to the processes through which these variables interacted.
Morris (1999) identified the political economy factors associated with financial crises as greed, money, and risk. These elements can be linked to the case scenario of the 2007 world financial turmoil. According to the scholar, greed, characterized by rampant fraud perpetrated by key political figures in strong economies such the U.S, was one of the motive forces that led to the global financial challenge experienced in the U.S during the 1890s and the 1980s (Morris, 1999). Unfortunately, the greed aspect cannot be substantiated or merited in 2007 case. However, the issues regarding money and risk were part of the aspects that contributed to the financial turmoil in 2007. From Morris’s (1999) view, although the recent financial developments, evidenced through technological advancements, derivative assets, and corporate takeovers, have enhanced efficiency in financial management, they still increase chances of failure risks. The lack of effective relationship between innovators of these systems, the financial institutions, and the governments see the failure to manage financial risks that can emerge from recent innovations. Due to the lack of coordination between these stakeholders, Morris (1999) argued that the problem of government regulation in the financial markets has seen the brutal exploitation of the populace by financial innovators hence creating periodic crises.
There exists a voluminous and rich literature on economic and political dynamics of 2007 financial turmoil that support the position by Morris (1999) pertaining to the regulation issue as a contributor to the problem. Although Muolo (2008) did not refer to the global turmoil of 2007, the case study of the falling U.S mortgage industry described in his piece of literature work emphasized the point of de-regulation. According to the scholar, the ailment of America’s mortgage industry is blamed on the federal bank regulators who did not whistle blow the designing of liar loans by the Wall Street investment banker. Muolo’s (2008) case presents a revelation that financial crises, particularly the 2007 world financial turmoil resulting from the laxity of political authorities to supervise and regulate banks. The most critical dimension for analysing the turmoil in 2007 is the review of functionalities in the banking sector such as changes in looser credit standards and credit volume. According to Calabria (2009), the failure of the regulators in addressing these matters in the world banking industry led to the occurrence of the 2007 crisis.
Roubini and Mihm (2011) observed that the events that led to the crisis began when scarcity and abundance of credit as well as the emergence of varied banking systems, which determine the stability of the global financial system, were subjected political bargains. The notion advanced was that banking systems are "fragile by design," and, therefore, cannot operate without the encouragement of the government. The problem emerged when various legal and political institutions in many countries failed to effectively implement the regulatory policies.
Besides the insufficient regulation of the financial markets, the Great Recession was also caused by increased inequality in income distribution. In the last years leading to the recession, concerns emerged over economic inequality in the developed and developing economies. The United States, which was at the epicentre of the recession, was reported to have the highest variation in terms of income distribution. Inequality in Portugal, Japan, Italy, and Germany was said to be considerable (Frank, 2011). However, almost all countries across the world reported a rising inequality in terms of disposable income during the finance-dominated capitalism period. A small group of households in most societies across the world who held top levels of income distribution benefited from the rising aggregate income. The governments were left with no option but to finance the consumption of middle and lower income groups through rising credit instead of the rising incomes (Frank, 2011). The measures to resolve the inequality were further facilitated through the promotion of credit policies and partly through the deregulation of the financial market. According to Frank (2011), due to the polarised politics in most parts of the world, most of the make politically ‘toxic’ decisions such as the redistribution of income through social spending and taxes when faced with crisis situations. The United States encouraged expansion of lending to low-income earners by deregulating the credit markets and empowering the state-owned mortgage agencies. The saturation of low-income households in the credit markets led to credit bubbles in most of the developed economies hence the subsequent Great Recession.
Wade (2011) also attributed the 2007 recession to the liberalization of international and national financial markets. Excessive and fast financial liberalization in the last decade before the 2007 crisis triggered boom-bust cycles that were fuelled by financial instability. Strong and negative contagion effects were realized on the real side of the world economy following the development of fast liberalized capital markets (Talbott, 2009). Wade (2011, p.119) noted, “liberalisation with an overvalued exchange rate produced serious negative effects on employment in industry and the rise of imported goods broke down many production linkages in supply chains.” The primary objectives behind the liberalisation of financial market including fostering transparency and converging the interests of domestic and foreign investors did not meet the desired expectations. The policies of liberalisation exposed Mexico to vulnerability to external economic constraints rather than foreseeing the country’s economic growth.
The concept of liberalisation extended beyond the financial markets to countries in the global context. The liberalisation of most of the advanced economies in regards to control of financial systems played part in the Great Recession. Governments played an active role in the financial industry due to the value of the financial sector in countries’ economic development (Hill, 2011). Unfortunately, as it was witnessed in the U.S and the UK, the attempt to align the stability of the financial system with short-term objectives meant to benefit the politicians led to the demand for change (Hill, 2011). The governments were forced to lower expenditure and raise taxes to meet the demand for change from the public and politicians hence bursting the economic ‘bubble,' consequently causing the crisis. The unpopularity of bank closures during the crisis saw politicians push for forbearance from the supervisors. To evade the short-term costs, the politicians further pressured the supervisors to organise for bail-outs resulting in worsening of the crisis.
From Wade’s (2011) view, the short-term demand management policies played a role in the occurrence of the 2007 world financial turmoil. The policy-makers based their monetary decisions on insufficient economic variables and indicators. The failure to consider output gap measures and inflation forecasts when making the assessment of monetary policies saw the repeat of measurement errors that led to 1970s Great Inflation. Implementation of low-interest rates for a prolonged period led to financial imbalances whose effects were realized during the Great Recession through non-accelerating inflation-unemployment rate.
Conclusion
From the analysis, it is evident that the global financial crisis of 2007/8 was caused by several political-economic factors. They include greed for money by politicians, deregulation of the financial markets, inequality in income distribution, liberalisation of international and national financial markets, and short-term demand policies. From a political economy view, the decision made by governments to deregulate and reduce supervision of the financial markets was the biggest contributor to the Great Recession. The opinions of scholars describing other causes such as inequality in income distribution and liberalisation of financial markets consent support the argument that deregulation played a critical role foreseeing the crisis. The U.S government resorted to deregulation of financial institutions as a measure to solve the inequality problem. The theory of political economy assumes the interaction between power and institutional variables is essential in achieving desired outcomes in most markets. Reduce involvement in supervision and regulation of the financial markets meant that banks and other special interests, especially the politicians, would seek to achieve their own interests using the financial system. Reduce supervision provided room for political bargains which led to instability of the financial system.
References
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