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The impact of the Financial Crisis on NZ

WHAT HAPPENED

The Global Financial Crisis of 2007-2012 is considered by many economists the worst financial crisis since the Great Depression. The crisis played a significant role in the failure of large corporations and businesses, resulted in declines in consumer wealth estimated in trillions of U.S. dollars, and a huge downturn in economic activity. It also resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The housing market was also affected resulting in evictions, foreclosures and unemployment. The deflation of the United States ‘Housing Bubble’, which peaked in 2006, caused the values of investments and securities tied to United States real estate to plummet, negatively affecting financial institutions globally. The financial crisis was partly started by a complex weave of policies that encouraged home ownership, providing easier access to loans for subprime mortgage borrowers, overvaluation of bundled sub-prime mortgages based on the theory that housing prices would continue to increase, questionable trading practices on behalf of both buyers and sellers, and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making.

During a period of intense competition between banks for revenue and market share, and when the supply of trustworthy, creditworthy borrowers was limited, mortgage lenders lowered loan standards and paid out riskier mortgages to less creditworthy borrowers. This was the start of the subprime mortgage catastrophe, which was a major start for the financial crisis. A sub-prime loan is a type of mortgage/loan that is made out to borrowers with lower credit ratings. As a result of the borrower's lowered credit rating, a regular mortgage is not offered because the bank/lender sees the borrower as having a larger-than-average risk of defaulting on the loan.  Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk. 

In the end-up, the banks had expected to receive back what they had lent out - plus interest - to the sub-prime borrowers. Additionally, to entice further borrowers, the financial institutions dramatically lowered the interest rates. When United States home prices declined steeply in mid-2006, it became more difficult for borrowers to repay their loans. As new mortgages began to reset at higher interest rates, mortgage delinquencies soared. Securities/investments backed with mortgages - including subprime mortgages - primarily held by large financial firms globally lost their value. Global investors also reduced their purchases of  securities and investments. 

The worst of the mortgages were started through the ‘shadow banking system’ and that competition from the shadow banking system may have pressured larger financial institutions to lower their own standards and create riskier loans. The shadow banking system is essentially ‘wrong’ practices being conducted by large ‘good’ institutions.

Over time, house prices increased, inflating what is called the housing bubble.

Between 1997 and 2006, the price of the average American house increased by 124%. The United States’ median home price floated at approximately 3 times the average household income. This ratio of house prices to income continued to rise all the way to 2006. The housing bubble resulted in many homeowners taking out loans at lower interest rates - initiating sub-prime mortgages - or by initiating second mortgages backed by the price appreciation.

All of the fixed-income earners taking out mortgages on their price-appreciating homes resulted in a large amount of revenue for financial institutions. This risky yet immense amount of money that had come from borrowers had roughly doubled in size from 2000 to 2007, yet safe, income generating investments had not grown as fast. Wall Street’s financial institutions met this thirst for mortgages with products such as mortgage-backed securities and sub-prime mortgages.

Some smaller countries that had seen strong economic growth saw significant decreases in economic activity. For example, growth forecasts in Cambodia show a fall from more than 10% in 2007 to close to zero in 2009, and Kenya may achieve only 3–4% growth in 2009, down from 7% in 2007.  This had significant implications and has led to a dramatic rise in the number of households living below the poverty line. Small countries with a fragile economy have to fear that investors from larger economies withdraw their money because of the crisis. 

Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. By early November 2008, a broad U.S. stock index the S&P 500, was down 45% from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signalling a 30–35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22%, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion. Since peaking in mid-2007, household wealth is down $14 trillion.

Increases in commodity prices followed the deflation of the housing bubble in 2006. The price of oil nearly tripled from $50 to $147 from early 2007 to 2008, before drastically falling in price as the Financial Crisis started to appear. This is believed to have been caused by a large amount of money from housing and other investments being injected into commodities.

 

ANALYSIS

Because the Global Financial Crisis is essentially a recession of economic activity, a recession and the flow-on effects can be shown on a Business Cycle diagram.

Business Cycles Graph 1.JPG

The Business Cycle is the fluctuating economic activity that an economy experiences over a period of time. The five stages of the business cycle are growth/expansion, peak, recession, trough and recovery. The Business Cycle is very irregular, varying in frequency, magnitude and duration due to the unimaginable variables within the economies of today.

The diagram shows that after a peak, there follows a recession, leading to a trough. The Global Financial Crisis is attributed to a trough on the business cycle, and one that the global economy had dwelled in for a longer amount of time because of lack of economic recovery. 

The peak of the diagram can be explained by the price of oil tripling in 2008. As the Financial Crisis was starting, this caused a recession as shown in the diagram.

This fluctuation of a peak and a recession can be attributed to the majority of the economy, prior to and leading into the Global Financial Crisis. During the ‘Recovery’ stage (upswing) of the business cycle, investment (as well as Government investment) will increase due to producers investing in new production processes in order to meet the growing demand for consumption. Eventually, the investment will slow due to producers meeting their objectives/completing investment - forming a ‘Peak’ on the business cycle -, which will lead to a fall in Aggregate Demand. Producers will now decrease their output, and to increase or continue at the production rate they once were, further investment will need to occur, resulting in the next ‘Recovery/Upswing’.

This further investment/upswing never occurred within the NZ economy, which caused the NZ economy to become more affected by the Global Financial Crisis. This happened because NZ banks/financial institutions failed to supply investment to smaller-scale producers within the NZ economy, which lead to unemployment as well as redundancy and foreclosure of businesses. Because of this decreased income and lack of investment/capital, NZ Aggregate Demand decreased dramatically as well as foreign demand for NZ industries, resulting in redundancies within NZ Export and Import businesses. To combat this, the NZ Government tried to undo damage by giving tax cuts - almost like investment - to consumers and producers to increase consumption in order to bring the NZ economy to an ‘Upswing’. 

New Zealand has a very export-driven competitive economy with exports accounting for about 30% of GDP (Gross Domestic Production). Between 2000 and 2007 - before the Financial Crisis - the New Zealand economy expanded by an average of 3.5% each year as consumption and investment grew. Annual inflation averaged 2.6%, inside the Reserve Bank of New Zealand’s 1% to 3% target range, while the current account deficit averaged 5.5% of GDP. New Zealand’s economy experienced a large decrease in economic activity following the the peak of the Financial Crisis. This meant that consumption within the NZ economy drastically declined. After a 2% decline in 2009, the economy ‘recovered’ (see diagram above, recovery) out of recession. It achieved 1.7% growth in 2010, 2% in 2011 and 3% in 2012. This exponential growth is mostly due to NZ’s large amount of exports. 

The output of goods and services produced by labor and property located in the United States—decreased at an annual rate of approximately 6% in the fourth quarter of 2008 and first quarter of 2009, versus activity in the year-ago periods. The U.S. unemployment rate increased to 10.1% by October 2009, the highest rate since 1983. The average hours per work week declined to 33, the lowest level since the government began collecting the data in 1964.

The collapse of the economic system was more damaging than was initially thought due to overpriced government assets such as the real estate/housing market, inflated by loans from banks and financial institutions. When house prices eventually decreased it caused many homeowners to default on their loans, which happened not only in the US, but here in NZ too. To compound this, consumers started borrowing large amounts of money because at the time it was incredibly easy to take out a loan. Government Expansionary policies and low interest rates resulted in dismal savings, especially in countries such as NZ or the UK. In late 2008, the NZ Government increased their spending, introducing policies such as the NZ Home Insulation grant in order to try and create some economic growth. In the US, the Government ended up having to ‘bail out’ and save large financial institutions, which caused major uproars from many American citizens. National Governments also looked for ways to encourage investment in their economies to continue, such as the NZ Government adding ‘Deposit Guarantees’. 

The impact of the financial crisis on the NZ economy can also be demonstrated using a ‘circular flow’ diagram. The NZ Government was receiving less tax from consumers and producers, but was spending more in effort to create economic growth. The NZ Government is demonstrated on the diagram as ‘Government’. NZ ‘Households’ will use this Government spending in the form of consumption, as ‘Payment for Goods and Services’ given to the ‘Product Market’, shown on the diagram, and in return will receive ‘Goods and Services’ from the ‘Product Market’. The NZ ‘Businesses’ will also benefit from the NZ Government’s spending, as more households/consumers will consume their goods and services they have produced. This increases consumption from the ‘Households’ to the ‘Product Market’ and ‘Resource Market’, which results in increased profit for producers, thus creating more employment for the ‘Households’ giving them increased income. 

A further impact that had occurred on the NZ economy was that not only producers/firms, but households assets were rapidly depreciating. Banks started to lend against households, as they are seen as a safer asset compared to others, but reduced lending to producers/firms, which resulted in further decreased economic growth due to lack of investment (the arrows pointing from the Government to Businesses and Households in the diagram above). 

Because Producers/Businesses and Consumers/Households are different in their needs, they depend on one another. Due to the Global Financial Crisis, numerous NZ producers had to make employees redundant or close down which resulted in NZ consumers decreasing their demand as they had no source or less income because they may have been laid off or affected by a downsize by their workplace (the producer). The producers also lost profits as their output decreased due to losses in productivity because of laid off/cut back workers (households). Because of the decreased foreign demand for NZ goods and services, NZ exporters and producers income also decreased. 

These businesses and producers now relied on investment in themselves from banks and financial institutions in order to survive and contribute to growth (upswing) in the NZ economy. The NZ government saw this and used economic policies - such as tax cuts - to deal with and hopefully mend this problem. These tax cuts, subsidies and lifts on regulations resulted in NZ producers productivity increasing, creating more employment. Yet these tax cuts further contributed to the NZ Government’s deficit to which this day taxpayers are still repaying. 

Overall, I can say that NZ and it’s economy - while still significantly affected - has not been hit anywhere near as hard as most larger economies by the Global Financial Crisis. Although the crisis resulted in many NZ businesses closing accompanied by large increases in unemployment and financial instability within the NZ economy, the NZ Government steered the economy through the worst of it. I believe this is due to the strong NZ banking policies, smart investment and strict regulations of the NZ government and NZ financial institutions.

EssaysRees Vinsen