The Credit Crunch by Nathan Cox
The credit crisis began when US mortgage companies made hundreds of billions of dollars
of inappropriate loans to individuals with poor credit histories. These debts were then sold
to financial institutions around the world, who then sold it on to hedge funds and pension
funds. These ‘bad debts’ are now concealed in the financial system, and until it is known
where they are, banks and other financial institutions are reluctant to lend money, and
investors have doubts about the health of the financial sector. A solution to this would be
to lower interest rates, however global inflation, partially as a result of rising oil and
commodity prices In the UK and US, has made central banks reluctant to lower rates. An
injection of $85 billion by the Federal Reserve in order to tackle the crisis appears to
have had little impact. Mortgage companies are finding it difficult to raise money even to
lend to sound borrowers, and major financial institutions are now revealing losses due to
exposure to the sub prime market, and as a result, shares in the financial sector have
plummeted. Citigroup was one of the worst hit financial institutions, with a $55bn
exposure, bringing quarterly profits down to $1.2bn. Stock markets around the world
have been in turmoil in recent weeks on fears that the crisis could undermine the global
13% of shares in companies on the London Stock Exchange are owned by British
individuals, and so this will directly hit the pockets of many Britons. This will leave them
with less disposable income, and will thus cause a reduction in consumer spending. Other
investors will be holding their money back and waiting for the troubles in the financial
markets to subside, and therefore investment will also be decreased. Less consumer
spending and less investment will lead to lower aggregate (total) demand in the
economy, and slower GDP growth in the UK is expected as a result of this. GDP growth in
the UK could be as low as 1% in 2008 and 2009. Other western countries are likely to
experience much the same.
The UK may well be hit harder than our European counterparts, due to London’s position
as a major financial sector, and the city contributes greatly to our economy. The Centre
for Economics and Business Research predict that there could be as many as 5,000 job
losses in the city in 2008, and a fall in bonuses of up to 15%.
As aggregate demand falls firms will lay off workers across the country, not just in the
financial sector, in an attempt to maintain profit margins. This increase in unemployment
will further depress demand in the economy, as disposable income will fall despite
unemployment benefits. A vicious circle effect could take place as a result of this, which
could spell more serious implications for the economy. There may be fiscal strain, as the
government pays out more for unemployment benefits, yet receives less in income tax
revenue, as unemployment rises.
Debt charities and credit industry bodies have reported a surge in the numbers of people
unable to pay their bills. This is partly due to increased interest rates, but even small life
changes, such as an employer cutting overtime shifts, can have a major impact.
Individuals are feeling the pinch of the credit crunch, and the UK’s trillion pound debt is
starting to impact on our economic performance. It is inevitable that there will be pain in
the short term, and many executives of financial organisations will lose their jobs, as they
shoulder the blame for low profits or in many cases losses.
However some also speak of a positive effect of the credit crunch. Many economists
believe that this is an opportunity for rebalancing the economy, which has been overly
dependent on consumer spending financed by cheap credit and government borrowing.
An increase in household savings, encouraged by higher interest rates for savers, could
lead to more long term investment.
So overall, we are going to see some feeble economic performance, in terms of
unemployment, GDP growth and stockmarket performance. This will inevitably be a
difficult period for many individuals and businesses. However it will teach lenders to be
more responsible in terms of who they lend to, and as already mentioned, it may help to
rebalance the economy. By feeling the pain of the credit crunch now, we may avoid a
more serious crisis in the future. In the long term we may benefit from the credit crunch,
as irresponsible lending will decrease, and we may see more stable growth, although
maybe slower than what we have seen in recent years.