Type: Research Essays
Sample donated: Dianne Valdez
Last updated: August 20, 2019
The global financial crisis of 2008 was a worldwide economic emergency; a predicament which not only affected the UK, but most global economies greatly.
The crisis was undoubtedly on par, if not greater, than the Great Depression of 1929 that caused significant economic shocks to every major economy in the world. The global financial crisis commenced in 2007 due to the situation in the sub-prime mortgage market in the United States of America. The sub-prime mortgage market was a market in which credit was lent to people with questionable credit histories. In order for banks to meet the demand for mortgage backed securities, they sold too many mortgages to anyone, even if their credit history suggested they couldn’t pay it back. Mortgage backed securities are investments that are secured by mortgages given out by banks. Demand for mortgage backed securities rose after the collapse of the bubble in the US housing market, meaning that house prices reduced drastically due to the lower prices.
The crisis in the sub-prime mortgage market occurred because of the decline in home prices after the burst of a housing bubble. The US housing bubble was a real estate bubble that affected the majority of the United States. This is because the prices of houses increased rapidly in the first quarter of 2006 and then started to decline from 2007 onwards until 2012, where the house prices reached new lows. The asset bubble was created in the US real estate in 2005. This was mainly due to the use of credit default swaps. A credit default swap is a contract that guarantees against bond defaults. A bond default is when there is a failure to pay interest on a bond.
Credit default swaps were used as insurance for derivatives such as mortgage backed securities. Most investors use them to protect against the risk of mortgage backed securities. Hedge funds were an important aspect that led to a rapid increase in demand.
Hedge funds are privately owned companies that operate by collecting investors’ money and reinvesting them into other financial assets. Hedge funds purchased many mortgage backed securities, increasing demand for them greatly. As a result of the increase in demand for mortgages, banks gave loans to anybody who requested one, which in turn increased demand for housing.
Many people purchased homes as an investment; an asset that they could sell for huge profits in the near future due to the rising prices. However, after the house prices started to decline, the mortgages defaulted. The burst of the asset bubble led to the subprime mortgage crisis in 2006, and caused a chain reaction of crisis’, eventually leading to the credit crisis in 2007 and then the global financial crisis in 2008. However, initially realtors cheered, as they believed that the housing market which was overheating was returning to normal; meaning that house prices would return to an affordable price. But the realtors failed to realise that the burst of the bubble in the housing market would lead to one of the worst financial crisis’ in history.
While the infamous credit crunch was a bigger problem for the US, who had relaxed controls on their mortgage lending, the United Kingdom also faced the same problem. A prime example of this was the failure of the Northern Rock bank. The Northern Rock was originally a building society but became a bank in 1997. Northern Rock was one of few banks in the United Kingdom that raised finance by giving out higher percentages of risky loans. Once the effects of the Sub-Prime crisis from the United States spread to the United Kingdom, selling their loans in the typical capital market was impossible and thus Northern Rock could no longer gain finance. As a result, Northern Rock had to ask the central bank (Bank of England) for emergency funds.
In light of that action, the consumers grew weary of their own savings in the bank as they no longer saw Northern Rock as a reliable institution to keep their money. 1 Thousands of worried people queued outside of their respective branches in order to withdraw their savings. Northern Rock later failed and was purchased by Virgin Money.
The bank was the most major example of it’s kind in the United Kingdom. It’s failure signalled how substantial the crisis really was. It is argued that the most prominent effect that the financial crisis had on the United Kingdom’s gross domestic product was the effect on the UK banking system. As the housing sector in the United States grew worse, banks worldwide were concerned about the value of their own mortgages and their investments that were backed up by mortgages which they bought from other institutions. Thus, there was a decline in interbank lending as banks lost confidence in each other. This loss of confidence laid the foundations for many other major problems.
For instance, the loss of confidence led to a subsequent loss in liquidity in the banking sector. Liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable prices. The lack of liquidity in the banking sector meant that banks were lending less money to both firms and consumers. This caused a variety of problems for the economy. Firstly, due to the lack of borrowing from firms, there was a lack of investment into their businesses. 2 The massive reduction in business investment effected the economy significantly. After the credit crunch, banks borrowed less money from the Bank of England and therefore had less disposable income to give to businesses.
This is clearly shown in the diagram as it highlights a drop of over 20% in business investment in the UK. It highlights the reduction in capital investment which in the long run led to a reduction in productivity. After the sub prime mortgage crisis, many banks in the United Kingdom lost money after lending out sub prime mortgages and in order to improve their balance sheet, they borrowed less money; thus resulting in less investment. Furthermore, due to the lack of investment came increased levels of unemployment. With a lack of funds to invest with, the firms in the UK were unable to invest into their businesses and as a result employed less workers. “Official figures showed unemployment measured by International Labour Organisation (ILO) standards rose by 164,000 in the three months to August from the previous quarter to stand at 1.
79 million. The rise took the jobless rate up half a percentage point to 5.7%, also the biggest jump since July 1991.
“3 If unemployment increases, this means that more consumers would have less disposable income, meaning that consumption decreases and therefore leading to a reduction in economic growth. Additionally, if unemployment levels increase, this means that the government has to pay more of it’s revenue into benefits such as the job seekers allowance Investment is a major aspect of aggregate demand, accounting for 20% of the UK’s gross domestic product. Therefore, due to the lack of investment, economic activity in the economy lacked stimulation and in the long run was one of the leading aspects that contributed to the recession of 2007/08. 4 As shown in the diagram, the United Kingdom felt the effects of the global financial crisis the worst in comparison to 15 other countries in Europe. Due to a lack of investment, which led to a subsequent reduction in consumption, the UK suffered a huge reduction in their gross domestic product at over -6%. Furthermore, decreases in the levels of investment also has a negative multiplier effect. This is because if the level of investment falls, unemployment follows by increasing and as a result leads to negative economic growth. However, as negative economic growth occurs, unemployment in other sectors such as retail also fall due to the decrease in demand.
To counter this, in 2009 the central bank (Bank Of England) reduced the rate of interest to 0.5%, which was the lowest rate since the bank was founded in 1694. The interest rate affects the cost of borrowing and reward for saving, by lowering the rate they attempted to provide and incentive for consumers and firms to borrow as it was cheaper for them to borrow large amounts of money.
The intended result was to boost the amount of investment in the economy which would in turn increase demand and in the long run economic growth would be achieved. However, their attempt was futile as many businesses claimed they had no access to finance. Furthermore, the confidence of both consumers and firms in the economy was extremely low, meaning that they were initially reluctant to take out loans from the banks and instead save their money. 5 A reduction in consumer confidence is a characteristic followed by all financial crisis’. As the economy declines, the advanced media of the 21st century is quick to spread news of the crisis. Upon hearing this, consumers were more careful with their money as they are weary of the state of the economy.
They saved more money, as opposed to spending like they would usually do. The rapid decrease in consumer confidence follows the same trend as the decrease in gross domestic product. This is because as the confidence of the consumer decreases, so does consumption. This is vital as consumption makes up for 60% of aggregate demand, which meant that such a massive reduction in consumption led to a massive decrease in aggregate demand and therefore reduced the United Kingdom’s value of goods and services produced in the years. Another factor of the global financial crisis of 2008 that affected the United Kingdom’s gross domestic product was the rising levels of unemployment. Unemployment rose due to the decreasing levels of demand and was known as demand deficient unemployment. During the recession, where economic growth was negative, consumption in the economy was extremely low.
This was because of the economic climate, which acted as an incentive to save rather than spend. Consumers were purchasing less goods and services. As a result of the decrease in demand, productivity in the economy was decreased as less goods and services were demanded which meant that less goods and services had to be produced. 6 Unemployment saw a massive rise from March of 2008. As demand decreased, firms required less workers as they didn’t need to produce as much. Keeping a huge workforce for most firms meant losses, because lot’s of the workers weren’t needed and were being paid for nothing.
As a result, firms either laid off workers to compensate for the decreased levels in demand, or they didn’t expand their workforces which means many new immigrants for example couldn’t find jobs. A study conducted by the Chartered Institute of Personnel and Development claimed that “there were 6.2 million fresh claims for jobseeker’s allowance between April 2008 and November 2009 – 7.5 times the rise in the unemployment claimant count during the recession, highlighting the degree to which many people were struggling to find permanent jobs”.7 Also, the “research revealed that 1.31 million people were made redundant during the recession – double the fall in employment and equivalent to 4.
4 per cent of people in work before the downturn.”8 The scale of the amount who fell into unemployment was unprecedented. As well as affecting the confidence of the consumers in the economy, it made them question whether or not their own jobs were safe; levels of uncertainty in the economy were at an all time high. There are many ways in which the rise in unemployment affected the gross domestic product. Most notably, as fewer people had jobs, it meant that there was less disposable income in the economy and therefore consumption decreased; leading to a decreasing in aggregate demand and therefore reducing the gross domestic product of the United Kingdom. Another factor that affected the United Kingdom’s gross domestic product as a result of the great depression was the overall reduction in global trade. The crisis was a predicament that spread throughout the whole world and that many economies suffered from. Globally, consumption was low due to a lack of demand, meaning that firms output less than they previously did.
Furthermore, as there was a lack of demand abroad, it meant that consumers outside of the United Kingdom will inevitably stopped demanding British goods. This meant that firms in the United Kingdom lost their international market and their opportunity to stop exporting abroad. With a lack of exports, the United Kingdom’s trade deficit also increased as a result. The United Kingdom has always been a country that relied on imports, as they have never been rich in commodities such as oil. This meant that although consumers in the United Kingdom also demanded less goods from abroad, they remained in their trade deficit due to insufficient exports and the requirement of commodities. 9 The United Kingdom’s balance of payments deficit increased significantly in 2008; facing an increase of £50 billion. Then increased further in 2009 in which it reached £-110 billion. Furthermore, Daniel Pillmot (an economics reporter), stated that “the UK imported £3.
8bn more in goods and services in May than it exported, the largest deficit since July 2008, while the deficit in the past three months ballooned more than expected to £10.8bn, also the highest in almost two years.”10 And also that “in May, exports grew by 0.
2 per cent while imports increased 2.4 per cent. So far this year exports have risen by 3.7 per cent, while imports have risen by almost 6 per cent.
11 The decrease in exports provided further problems in the United Kingdom such as a loss of jobs due to a lack of demand as well as less trade tax revenue for the government for example. It is clear that the financial crisis took a toll on trade in the United Kingdom as well as affecting many other global economies as well. The United Kingdom’s gross domestic product decreased as a result and highlighted the effect that the lack of trade had on the value of goods and services produced in the United Kingdom. Another factor that had an effect on the United Kingdom’s gross domestic product was the lower wage rates.
Due to the economic climate, firms decided to reduce wage costs in order to maintain profits. Lower wages proved to be deadly during that time mainly due to the existence of cost push inflation. Cost push inflation occurs when the costs of production of goods and services increase. This occurred in 2008 as the cost of importing raw materials was higher. For example oil prices fluctuated throughout the period, as reported by the BBC, “Oil prices hit record highs above $147 a barrel in July 2008″12. This was significant as oil is a important commodity that is used in the creation of almost every good and service, an increase in the price of oil pushes up the costs of production of most firms who are therefore forced to push up the prices of their own goods and services in order to maintain a profit; eventually leading to cost push inflation.
This proved to be troublesome for the consumers who’s wages were reduced drastically. 13 The graph highlights how much the real wages dropped in 2009 at a monthly change of –5.8%. Consumers new lower wage rates couldn’t keep up with the higher costs of goods and services, meaning that they demanded less because they had less disposable income. This meant that consumption in the economy decreased and then the gross domestic product as a result. In addition to this, another factor that caused lower wages was the fact that the amount of workers who were demoted to part time jobs increased dramatically.
This is because it was cheaper for firms to employ their workers on a part time schedule rather than full time. However, this was ineffective as although the employment figures did not change, the workers faced a lower pay cheque to consume with. This also meant that consumption in the economy decreased as consumers had less disposable income to use; subsequently leading to a decease in the gross domestic product in the United Kingdom.
Another factor that affected the United Kingdom’s gross domestic product as a result of the global financial crisis was the fall in government tax revenue. Tax revenue for the government fell for a variety of reasons, most notably, through the fall of consumption. One of the main ways in which the government raises tax revenue is through V.
A.T (value added tax). The value added tax is 20% of the value of the good added on to the price and goes directly to the government. The economy lacked stimulation and there was low consumption which meant that the government received less in revenue from the value added tax. Moreover, as the amount of unemployed rose, the government received less money from income tax. “Income tax is a tax imposed on individuals or entities (taxpayers) that varies with their respective income or profits (taxable income).
Many jurisdictions refer to income tax on business entities as companies tax or corporate tax.”14 As unemployment increased, the amount of taxable income in the economy decreased as well. Instead, job seekers allowance was granted to the unemployed. While job seekers allowance is taxable, the revenue it generated was much less than the income tax they otherwise would have received. This ties in directly to a decrease in corporation tax that the government received. Corporation tax is the tax placed on the governments profits. With less consumption in the economy because of the lower wages and higher amount of people on job seekers allowance, firms also made less profit as a result.
The government therefore gained less revenue from corporation tax in the years 2008 and 2009. The reduction in government revenue effected the gross domestic product in the United Kingdom in many ways. As the government received less in revenue, they were unable to distribute as much income in certain areas. For example, as the government was spending more on things like state benefits, it was unable to distribute as much money in the form of subsidies.
“A subsidy is an amount of money given directly to firms by the government to encourage production and consumption. A unit subsidy is a specific sum per unit produced which is given to the producer.” The main aim of subsidies during the financial crisis was to increase aggregate demand by lowering the cost of production for producers who would in turn reduce the price.
With lower prices, the government aimed to stimulate aggregate demand which would therefore lead to economic growth. However, due to the lack of revenue given out in the form of subsidies by the government, they were unable to stimulate demand in the economy. This highlights how the reduction in tax revenue and inability to redistribute it effected aggregate demand in the economy. The lost output during the financial crisis also lead to a reduction in the United Kingdom’s gross domestic product. Due to the lack of investment during the recession, there was a great deal of productivity lost.
Firms in the United Kingdom produced less for a variety of reasons