Analyzing the Global Financial Crisis of 2007: An Economics Study

This economics assignment delves into the causes of the 2007 global financial crisis, exploring the debate between financial innovations creating safe debt and the collapse of the housing bubble. The paper addresses the economic downturn by answering specific questions related to debt contracts, ...Read More

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ECONOMICS ASSIGNMENT
ECONOMICS FOR MANAGERS

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Executive summary
The recession of 2007 was one of the biggest economic shocks in the world after the great
depression of 1929. The effects of recession spread across the US border to hit different
countries of the world. Some of the countries have not been able to bounce back from the
shock it had experienced. This paper discusses the main reason underneath the global
financial crisis of 2007. The study answers some of the questions and through that, it
discusses the reason for the global crisis.

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Contents
Introduction................................................................................................................................3
Question 1..................................................................................................................................3
Question 2..................................................................................................................................4
Question 3..................................................................................................................................5
Question 4..................................................................................................................................5
Question 5..................................................................................................................................6
Question 6..................................................................................................................................7
Question 7..................................................................................................................................7
Conclusion and recommendations.............................................................................................8
Reference....................................................................................................................................9

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Introduction
Economic depression is known as the phase when the global or national production of the
economy is low owing to the low aggregate demand for goods and services in the market. In
this phase, the unemployment reduces along with production that is not desirable for
economic growth and development. One such economic downturn of this century was the
global financial crisis of the year 2007. The objective of the paper is to discuss the reasons
underneath the global recession that contracted global production in all parts of the world.
The paper will approach the study question by answering a few questions that will lead to the
debate regarding the cause of the global financial crisis of 2007.
Question 1
a) Debt contracts increase the burden for the customers who take mortgages from the bank.
The banks do not incorporate the factor of reduction in the value of the property and hence
this burden is passed on to the customers.
Figure 1: The changes in demand and supply due to externality
(Source: Taillard, 2019)
The figure above shows the standard demand and supply for the mortgages. In this market,
the bank does not incorporate the burden on the customers (Wu, 2015). If the burden is

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incorporated the cost of production will increase and the supply curve shifts upward leading
to a higher price and lower quantity of the mortgage.
b)
In mitigating the problem the coarse theorem can be applied where the banks would pay the
customers for the loss in value of the property proportional to the stake of the banks in the
property (Gorton, 2017). In that way, the banks would incorporate the social cost into the
standard mortgage supply and hence socially efficient outcome would be provided by the
market.
Question 2
Shared responsibility mortgages will have its interest payments and mortgage balance linked
to the house price index in the local market depending on the area zip code. As a result, when
the price of the property will reduce the interest payment and the mortgage balance would
also reduce at the same rate as the reduction the price. Therefore, the burden from the
customer will be shared between the lenders and the borrowers leading to a decline in
negative externality (He et al. 2016). Under this shared responsibly mortgages, the borrower
will also have pay price if the property is sold at a higher value than it was bought so that the
capital gain is divided between the customer and the bank.

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Question 3
Figure 2: securitizing the debt mortgages
(Source: Azzimonti and Yared, 2019)
By securitizing the debt mortgages the government has allowed Fannie Mae and Freddie Mac
to reduce the cost of operation. The figure shows the reduction in the cost of operation of the
companies from P1 to P0. However, the prices to the consumers of the market have increased
from P1 to P2 leading to an increase in the revenue of the company. In addition to that, the
securitization of the debt mortgages have also increased the surplus of the banks and reduced
the consumers' surplus (Yared and Azzimonti, 2017). Therefore, this way the government is
helping the banks at the cost of the consumers of the market. Thus, the government is tilting
the field in favour of debt mortgages in the market.
Question 4
According to the view of Amir Sufi and Atif Mian, the main cause of the depression of 2007
is the debt contract that puts the unbalanced burden on the consumers or the borrowers of the
market (Sufi and Mian, 2019). Due to the debt mortgage and its current practices, the
mortgage balance and its instalment payment is constant irrespective of the price of the
property bought using the debt mortgage. In this case, the price of the property reduced

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keeping the balance and instalment same. As a result, the wealth of the consumers reduced
which reflected in the aggregate demand for goods and services in the market. With the
decline in the value of the property, the purchasing power of the consumers also decline and
consumers started demanding less of goods and services from the market (Yared and
Azzimonti, 2017). That means the aggregate demand curve shifted to the left side with
unchanged aggregate supply and hence the output of the economy reduced. Therefore,
according to, Amir Sufi and Atif Mian, the main reason for the economic downturn is the
reduction in the aggregate demand stemmed from the debt mortgages and its features.
Question 5
Australian government mailed people the checks of $900 each and the interest rates were
slashed. Now the impact of the checks of $900 temporarily increased the disposable income
of the consumers. In addition to that, the reduction in the interest rates made the consumers
withdraw the money from the bank. That means in both the ways the government of Australia
wanted to increase the money supply in the market (Bordo and McCauley, 2017). Now
money supply increases cash in hand of the customers of the market which further reflects in
the demand for goods and the services. Thus, the aggregate demand curve shifts to the right
side with and unchanged aggregate supply curve.
Figure 3: Increase in the money supply and the aggregate demand
(Source: Duchin et al. 2017)
The figure above shows the increase in the money supply from MS1 to MS2 due to the
reduction in the interest rate. This increase in the money supply and the checks provided to

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the families would shift the aggregate demand curve to the right leading to an increased price
level and GDP.
Question 6
According to the articles of Hammad Siddiqi and Ricardo Caballero, the creation of the safe
debt will not prevent any upcoming economic downturn. The reason behind this is that safe
debt creations are not safe for the economy (Gourinchas and Rey, 2016). In the real world
when the banks sell risky loans to the financial companies, only a part of the so-called safe
debt is recovered. The articles also state that demand for safe debt or securitization is
increasing due to the innate nature of the human. However, this approach of the safe debt
creation converting the risky debts as safe debts was linked to the global financial crisis of
2007. He et al. (2019) stated that the safe debt creation or the securitization works as an
incentive to the customers of the market resulting in the creation of huge risky debt.
Therefore, the securitization of the shared responsibility mortgages is still vulnerable and can
give rise to an economic downturn as per the two articles.
Question 7
Caballero et al. (2016) stated that one of the main villains of the economic crisis of 2007 is
the imbalances in the economy. The demand for safe debt exposed the economy of the USA
and its national debt policies. Due to the securitization of the debt mortgages, the companies
were making a profit as shown in the above discussions. As a result, more and more
companies came to the market to meet the demand for securitized debt mortgages. To meet
the gap between the demands for safe debt the banks violated the regulations of debt creation
as well. At the same time, the government of the USA was also pursuing a policy that
ensured home for every citizen of the country. However, Nguyen and Liu (2017) stated that
more than the housing market it is the creation of the debt or the conversion of the risky debt
to "Safe" debt caused the imbalances in the economy.
Siddiqi (2019) stated that the companies sought to profit from the gaps of the market that
eventually pressurised the financial markets of the USA. The safe asset shortages provided
incentives to the sellers of the market to increase the supply. Therefore, forced creation of
risky debt and converting them to safe debts for the private benefits of the companies created
a panic situation in the financial market (Charles et al. 2016). To add to these imbalances in
demand and the supply and the urge for the private firm to capture the existing surplus from

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the market, the inadequacy from the governing bodies and the authorities further made the
situations complex. According to Caballero (2018), the government bodies were the only
hope and option that could have absorbed the pressure stimulated from the excess demand for
safe assets. Nevertheless, the inactivity of the government and the false assumption of
complementing the government policies went in favour of private financial companies. It also
needs to be noted that the imbalances of the global market also plays a crucial role in the
creation of the securitized assets in the economy (Chen and Fik, 2017). The main reason for
the unexpected increase in demand for the safe asset is not only the higher demand for
housing in the US but also the expansion of the middle-class populations in the emerging
economies as well.
Adding to this complexion and irregularities in the financial market of the USA, the housing
bubble further worsened the situation that led to the financial crisis of 2007. The housing
bubble burst in the year 2007 leading to a devaluation of the properties that were bought from
the debt mortgages. As a result, not only the banks and the financial institutions faced severe
cash crunch the demand for other goods and services also plummeted. Feng and Wu (2015)
stated that the burden of mortgages increased after the housing bubble burst and hence
customers of the markets were left with a low level of disposable income. This low level of
disposable income further reduced the demand for the goods and the services in the market
leading to a leftward shift in the aggregate demand. This caused the low output level in the
economy and higher price level.
Conclusion and recommendations
Therefore, to sum up, it is the financial innovations at creating safe debt are the sole reason
for the economic downturn in the year 2007. This imbalances coupled with the housing
bubble is the main cause of the depression. The creation of the securitized debt mortgage led
to the creation of risky debt in the economy which manifested into a failure of the market
after the reduction in the price of properties in the early half of 2007. Therefore, the main
underlying reason for the economic crisis is the financial innovation and housing bubble burst
led to the amplification of the problem. Therefore, based on the finding of the paper it is
recommended to the government and authorities to increase monitoring in the financial
market so that private companies cannot capitalise on the market gap.

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Reference
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