5. Fundamental reason for the failure of the financial systems and economic recession
a. Specific government actions & intervention – Excessive money policy
Current monetary policy contributed in a certain extent to the failure of financial systems and economic recession. For example, U.S. monetary policy since 2002 was too expansionary (Taylor 2009) and was a major culprit to the crisis (Jeroen 2010). The policy makers was also lack of accountability that fail to encourage optimism about the reforming the policy process itself (Adrian & Atkinson 2009). The decision by the U.S. Treasury and the Fed to let a major bank (Lehman Brothers) fail led to a system-wide loss of confidence that exacerbated the crisis. The failure of policy makers to deal with the crisis should be seen as a factor in aggravating the crisis.
(1) Housing market failure - An Economics professor Taylor conducted a research in 2009 and suggested that the financial crisis was due to government policy and intervention that leaded to excessive money and contributed to housing boom and bust (Taylor 2009).
By using the information given in The Economist (October 18, 2007), Taylor indicated that the federal funds interest rate was deviated from the suggested rate based on Taylor Rule – Fed interest rate should be adjusted according to economic situations such as the inflation & employment level. The actual rate was far below the suggested rate from 2001 to 2006 (Please refer to Figure 2), so it suggested that the monetary policy was too loose.
In order to prove that abnormal interest rate contributed to housing marketing failure, Taylor decided to implement the following model to indicate that if the suggested rate (counterfactual) was applied, fluctuations of housing price would be reduced significantly (Please refer to Figure 3).
While loose monetary policy created a bubble in real-estate market, price development was fuelled by supporting home ownership policy and the anticipations of capital gains on housing property. The tendency to extend credit to borrowers with low credit ratings (subprime market) also advocated the development. Mortgages were sold to other financial enterprises which tailored a range of saleable financial assets based on the underlying credit claims (Tobias 2010). When speculative price increased the U.S. housing market began to crumble, greater number of borrowers defaulted and failed to make the payments to in their loan contracts.
The US government was blamed for the failure of recognizing the shadow banking system, while Federal Reserve was blamed for creating and fueling the crisis, starting with the incredible monetary expansion of 2002–2003, followed by the excesses of the expansion of government encouraged Fannie Mae and Freddie Mac and purchase of mortgage-backed assets by sponsorship (Taylor 2009). Government interventions contributed to housing market failures which leaded to real estate loans default, translated immediately into a...