February , 2024
A Tale of Two Economic Crises
12:02 pm

Dr. Rajiv Khosla

The global financial crisis that unfolded between 2007 and 2009 did not only impact the financial sector but also extended its reach to banks worldwide. Stemming from the rupture of the housing bubble in the United States, the crisis swiftly proliferated across the globe. Following the terrorist attacks of September 11, 2001, the US Federal Reserve aimed to revive the economy by reducing the interest rate to 1% over the next 2-3 years. Prior to the attacks, interest rates in the United States ranged between 5-6% from 1995 to 2000. However, dissatisfaction among depositors with the low 1% returns led them to seek alternative investment avenues. At this juncture, the housing sector emerged as an attractive option due to steadily rising prices. Capitalizing on the low interest rates, numerous borrowers took out loans to purchase or construct homes. Even those who had never considered loans began to benefit from the low interest costs, initiating a surge in home buying and construction. Consequently, housing prices soared, and the inflation in the housing market spilled over into other commodities. Between 2004 and 2006, the US Federal Reserve had to implement a series of interest rate hikes to combat inflation.

These costly loans acted as a hindrance to growth, initially impacting investment, followed by a decline in employment and income. The inability of millions of unemployed individuals to repay their loans triggered defaults, resulting in losses for banks and financial institutions. This domino effect first affected small banks, followed by larger ones, ultimately engulfing financial institutions worldwide.

Since 2008, numerous changes have occurred globally, and different economies have implemented laws and policies to shield themselves from such financial threats. However, what continues to bind global economies is their interconnectedness through trade and partnerships. Consequently, if a major economy faces a crisis, it tends to reverberate across other economies globally. In 2022, as the world was emerging from the grip of the COVID-19 pandemic, the Russia-Ukraine war pushed global economies into another crisis. This conflict significantly impacted European economies by disrupting their oil and gas supplies, leading to economic disruptions and soaring inflation. Goods supply chains were also affected due to disruptions in ship movements in the Black Sea, contributing to inflation in almost all economies globally. Even a colossal economy like the United States could not remain immune to this inflation. Consequently, when the US Federal Reserve raised interest rates again (after 2008) to curb inflation, the repercussions were felt worldwide, including in Europe, China, Japan, India, Canada, and Australia. Almost every country’s central bank responded to the moves of the US Fed, leading to a substantial increase in interest rates. The low interest rates that prevailed from 2007-08 to 2019-20 allowed economies, both small and large, as well as corporations, to benefit from cheap loans. However, with the rise in interest rates, many economies and corporations faced challenges in repaying their debts, affecting the operations of banks. This resulted in a series of bank failures, including Silicon Valley Bank, Signature Bank, First Republic in the US, and Credit Suisse Bank in Europe.

The global economic recession that occurred in 2007-08 and recurred in 2022-23 persists into January 2024, although fundamental differences exist between the two economic crises. The root cause of the 2007-08 recession was linked to US housing prices, while the 2022-23 recession is associated with banks failing as economies and companies default on interest payments for loans. The 2007 recession was triggered by low interest rates that encouraged people in the USA to take on more loans, whereas in 2022, the rise in interest rates caused many countries and businesses to default on their loans. The 2007-08 recession originated in the USA and later engulfed the world, while the crisis of 2022-23 originated in Europe due to the Russia-Ukraine war. During the 2007-08 recession, growth slowed, and unemployment soared, but in 2022-23, central banks (especially in the US and other developed economies) are attempting to slow down the pace of growth by raising interest rates. This is because the significant stimulus packages provided during the COVID-19 crisis are preventing a reduction in unemployment and inflation. In 2007-08, governments aimed to increase demand, but in 2022-23, governments are seeking to decrease demand. In the UK and the European Union, limits were imposed on the purchase of food items and gas and electricity. China, which played a catalytic role in boosting the world’s economies with a stimulus package in 2007-08, is now facing a slowdown in 2022-23 due to its domestic real estate crisis. After the 2007-08 crisis, debt repayments became easier, but in 2022-23, debt repayments have become more challenging, and economies and businesses worldwide are falling into a debt trap.

Current circumstances indicate that the ongoing recessionary phase could evolve into a deep global depression if the crisis in the banking sector intensifies and engulfs financial institutions, businesses, and sovereign governments. If these speculations materialize, the economic damage to countries worldwide will surpass expectations. This may lead to social and political instability, as high unemployment, economic inequality, and poverty foster mass discontent. To avert such catastrophic situations, governments worldwide should take appropriate steps that prioritize the public interest.

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