Crisis revisted

“Irrational exurbence” was the phrase used by the former Fed Chairman Alan Greenspan to define the boom in 1990s. Today this phrase once again, exactly describes the current situation.
The classic explanation of financial crises, going back hundreds of years, is that they are caused by excesses — frequently monetary excesses—which lead to a boom and an inevitable bust. This crisis arose from the unabated housing boom witnessed in USA in the early part of century. It in turn was the outcome of monetary excesses by the Federal Reserve Bank during the Alan Greenpsan’s tenure.

Unfolding of Crisis

The current economic difficulties have a United States origin. The original underlying assets were houses whose prices were falling. The collapse of the securitized US mortgage market and its related derivative products amplified the weakness of the US housing sector, sending a contractionary shock through the US economy and to the rest of the world. Asset backed commercial paper issued by the special purpose vehicles now in trouble brought weakness to the dollar funding market, causing it to freeze up in August 2007. This market provides large US and foreign multinational financial conglomerates with the short-term monies that they need to finance their investments, including those made daily on their trading floors. It has been more or less frozen ever since, with disastrous consequences for the larger financial system. Its complete shutdown in August 2007 crippled the US banking and financial system, causing it to slowly unravel. Matters got worse in September 2008, or rather, matters came to a head. Little new had happened within the core of the financial system itself, for it had already come to a halt, but the general macroeconomy was weakening and pulling asset prices further down. The freeze-up spread from the interbank to the other short-term US money markets, including those controlled by the major money market mutual funds, causing them to freeze up as well. By November 2008, the entire financial system, and not that of just the money markets of the United States or the United Kingdom, became incapable of carrying out even the simplest of steps involved in the conversion of corporate savings into investment or the financing of home building, personal consumption, or development.

Initially the “Decoupling Theory” was cited for the apparent survival of the emerging economies (especially BRIC countries) from the crisis. This immunity did not last long. The slowdown crept into these economies through the trade route and flight of capital. Soon, countries that had
adopted export-led growth strategies and liberalized their capital accounts (China and East Asian countries to a large extent), found that they were suffering from the effects of a reduction of the aggregate demand of the nations to which they exported. Emerging market and developing countries are now suffering from the same vicious circle that is affecting the developed nations: their weakening economies are interacting with weaknesses in their financial systems.