1. The causes of the Great Recession of 2008-10
Introduction
The 2008 global financial recession remains one of the world’s worst financial crisis
in the recent past. According to Taylor (2009), the combined effects of a number of economic
factors lead to the crisis. Analysts see this as a shift of power from US to China, an indication
of the loss of value of the US dollar to the Chinese Yuan. While addressing the 2008-10
financial recession, this paper will discuss the causes and effects of the financial recession,
especially on the US economy. The collapse of financial institutions, particularly the collapse
of the mortgage sector was the main cause of the crisis. Ripple effects of this saw the collapse
of the SME sector, and loss of employment, reduced sales from manufacturing industries, and
the construction industry. Feeling the extending heat of the crisis, the US government had to
bail out majority of these organizations, plunging itself into a huge debt. However, although
the crisis affected all countries, American institutions remain the worst hit, with some of the
countries reporting mild effects, such as China. Following this recession, questions as to the
ability of US to avert such crises and at the same time, its economic power, both internally
and externally arose. This paper will discuss the causes of the 2008-2010 global financial
crisis. It will also address the how this recession marked a shift of economic power from US
to China.
Causes of the 2008-2010 financial crisis
The instability of the US markets
The market instability, coupled with the mortgage sector are the major causes of the
2008-2010 financial recession. However, experts hold that other factors too were critical in
Shalveen Kumar

2. fanning up the crisis. Market instability, created by the inability of the financial sector to
create new lending lines that would replenish the dried up financial system crippled the entire
system (Kenc and Dibooglu, 2010). Mainly, the United States is a credit-based economy and
as such, the housing boom triggered the crisis when majority of borrowers could not meet
their credit obligations. The government provided banks and financial institutions with cheap
money. With the cheap money, more people could afford mortgages and as such, the boom of
the housing sector saw more people seek up house financing. Interest rates flopped, leading to
massive losses from lenders. Mainly, the collapse of various United States sub-prime
mortgage lenders caused immense shock across the globe, the ripples spreading to other
continents. Many of these lenders did not consider credit worthiness of their borrowers, but
instead offered credit at their own discretion. The financial position of many of these
borrowers could not service their mortgages, yet lenders gave those mortgages.
Global trade imbalances
Globalization and trade imbalances saw an increase in money inflows in the United
States from high saving countries as the government borrowed funds to finance its public
projects (Acharya and Richardson, 2009). The availability of disposable incomes increased
consumption levels among the people, thus creating the housing bubble in the US markets.
Notably, majority of the people did not finance their lifestyles using savings or investment
profits, but rather, borrowed money, readily available from the financial institutions. Between
1990 and 2007, the household debt relative to disposable income rose from 77% to 127%
(Brian and Patrick, 2010). Since the 1980s, there was a steady increase in the number of
export oriented countries, among them Japan, Asia and China. The entry of these countries,
especially because of their low production costs created by low wages and heavy
technological production shifted the global supply and demand forces. Americans demanded
more and produced less, because imported goods were cheaper than domestically produced

3. goods (Berkmen, et al., 2009). By early 2000s, excess labor supplies, capital, and productive
demand shifted the global demand forces. The collapse of the consumer credit, coupled with
the housing price bubble brought this trend to a halt, leaving US with a massive debt. For
instance, the US deficit grew by $650 billion from 1.5% to 5.8% between 1996 and 2004
(Brian and Patrick, 2010). To finance these deficits, the country had to borrow huge sums of
money from abroad. To finance its imports, the country used the borrowed funds from the
heavy saving countries. China was one of these lenders, as it had huge savers, some with as
high as 40% in personal savings (Brian and Patrick, 2010). These borrowings crippled the
economy as the government struggled to maintain the high demand for funds to finance the
consumption rates of its people.
Weak underwriting policies
Weak underwriting practices were yet another cause of the crisis. According to
Berkmen, at al (2009) majority of the mortgages purchased during the housing boom were
defective. This means that their underwriting process did not comply with the underwriting
policies. Some did not even have the necessary documents. The greedy nature of mortgage
lenders saw them took shortcuts in the lending process, in an effort to make more money
from the boom. Some placed too much trust on the credit bureaus, some of which did not
have updated information on the borrowers. Since much of these loans were unsecured, when
people could not repay their loans, these institutions ran into losses. One of the worst
mistakes that the banks did was rather than lending all the money they had, they repackaged
the loans into collateralized debt obligations, passing them to other lenders (Cetorelli and
Goldberg, 2012). Consequently, the lender does not have the opportunity to analyze the
creditworthy of the borrower. A big section of analysts believes that the lax underwriting
standards played a big role in the high rate of nonprime loan delinquencies during this period.
Cetorelli and Goldberg (2012) points out that although credit purchasers have the obligation

4. of assessing the creditworthiness of borrowers, many of the borrowers did not appreciate the
level of risk in their portfolios during this housing boom. Further the fact that the investors
relied too much on the judgments of credit rating agencies on credit worthiness of the
borrowers.
The 2001 mild recession
Historical development of the crisis posits that the US economy in 2001 experienced a
mild and short-lived recession, whose effects were not as adverse as the 2008-2010 crisis
(Kenc and Dibooglu, 2010). In fact, many economists warned of a possible financial crisis,
especially fuelled by the mortgage sector. The mortgage sector relies on the policies set by
the government and in the absence of these policies, open market operations prompt investors
to misbehave. Owing to the warning sings by analysts on an imminent crisis, the Federal
Reserve Bank sought measures to stop the crisis from taking place. As such, the Federal
Reserve embarked on a strategy of increasing the liquidity in the economy. Subsequently, it
sliced the Federal Reserve rates by 11 times from 6.5% in May 2000 to 1.75% in December
2001 (Cetorelli and Goldberg, 2012). This plan however worked against the strategy of
averting the crisis. This is because the cheaper the money, the more people misuse it. When it
lands in the hands of greedy bankers and borrowers who previously did not have any forms of
income, job, or assets, ended up putting it into uneconomic use. Contrary to investing the
money into income generating projects, many borrowers took this as an opportunity to
owning homes, fully financed by borrowed funds. The overall effect was an increase in
demand for mortgages, as the number of homebuyers increased.
Availability of cheap money
According to the law of demand and supply, an increase in house demand leads to an
increase in the price levels (Balke and Zeng, 2013). This demand pushed the prices of homes
higher as more people demanded homes. The overall effect of cheap credit was an increase in

5. home prices, consequently increasing the demand for high yielding subprime mortgages
(Balke and Zeng, 2013). Perhaps, because of the low inflationary rates in the country, the
Federal Reserve continued slashing lending rates, and in 2003, it lowered interest rates to 1%.
The entire financial market started selling credit at huge discounts without asking for any
down payments from the borrowers (Scott, et al., 2010). As such, people borrowed and were
to repay later, without any form of investments or down payments for the credit.
Unfortunately, the lenders did not warn these people of the imminent danger of such market
operations.
Interest rates
With the increased amount of money within the economy, interest rates remained low
for the high-end housing. This coupled with the ease of financing with funds from the
Russian debt crisis and the Asian financial crisis pushed the demand high. The government’s
strategy of creating cheap credit targeted at increasing the liquidity and increasing people’s
ability to borrow for investment. Baker (2008) points out that most of the people committed
themselves to a mortgage arrangement of heavy credit borrowings that only went into the
same use of financing housing. There was no diversity in investment of the borrowed funds.
The tremendous growth of the housing sector in the United States placed significant hopes on
people that it was the best form of investment (Scott, et al., 2010). Unfortunately, the boom in
the housing sector, triggered by the cheap funds culminated to inflationary levels. The
availability of the cheap funds automatically pushed consumer prices, not just the prices of
homes. Following the inflation, the credit wells dried up and the price of the houses started
dropping gradually (Sim, Schoenle, Zakrajsek and Gilchrist, 2013: 4). Due to the high
amounts borrowed and the dropping house prices, the mortgage holders were unable to
service the mortgages due to lack of an incentive and the realization that contrary to the

6. actual market rates of mortgage then, mortgage providers had in fact overcharged them
(Laeven and Valencia, 2010: 45).
Does the crisis represent a shift in the centre of global economic power from the
United States to China?
Since the financial crisis of 2008-2010, U.S faces a major crisis due to the economic
challenges created by the crisis. The country now faces stiff competition in global market
with China threatening to overtake its super power status. Analysts projected that by 2014
China GDP would have surpassed that of U.S. The crisis revealed a number of important
issues facing the economy of the United States. The high deficit levels during the crisis prove
that the country is not self-reliant economically and relies on other countries for lending. This
shows that the country is losing its grip in the global market, especially if the numbers of
heavy lenders in the country are anything to go by. Interestingly, as the global demand and
supply shifts changed, China was one of the biggest lenders to the United States. China,
compared to United States is a net exporter, whilst America is a net importer of consumer
products. Additionally, the consumption levels of China remain higher than the United States.
For a country to have a high GDP, it should have high production levels. This translates to
high exports and increased output. If a country imports much of its consumer products, then
its GDP is likely to remain low. This is the main problem facing the United States.
When the financial recession hit the globe and US became the worst hit country,
questions as to the ability of the country to avert such economic crises arose. Analysts sought
to find answers on the main reasons why the country could not stop the crisis, yet it was
aware of its imminent occurrence. The inability of the country to control its economy is
perhaps the biggest cause of the loss of power to China. To measure the superiority of a
country economically, a number of factors are very important. Its economic policies and
performance are very critical. US’s economic policy currently relies on debt financing,

7. reducing its self-sufficiency levels. Debt financing means that the country will have to
borrow to meet its financial obligations, among them the consumer goods. The net effect of
this is that the country has a weak financial muscle compared to one that does not use debt to
finance its operations. As such, US cannot influence global economics, owing to its
dependency nature on other countries.
Currently, the US dollar is the global base currency and used in the international trade
as well as the global reserve asset. As the base currency, all other international currencies
base their exchange rates against the dollar. All international trade is based on the dollar, with
all business transactions being expressed in terms of the dollar. In international trade,
countries and people issuing a reserve currency can make cross boarder borrowing and
purchase imports at a relatively lower price than other countries. This is because they do not
need to exchange currencies to either borrow or pay for imports. On the other hand,
governments hold the US dollar as the reserve currency asset, as part of their foreign
exchange reserve funds. The main reason for holding reserve funds is preventing the
country’s currency against speculative outflows. Foreign countries not only buy the American
treasury as an investment, but also to have dollar dominated asset reserves. Currently, the US
dollar, being the most dominant reserve currency has made it easy for Americans to borrow at
lower rates than the rest of the world. Additionally, the country’s imports are lower than the
rest of the world as it does not need to change the currency into any other currency to conduct
international trade.
However, a number of factors affect the future of the American dollar as the
international trade currency and the reserve asset. The recent budget crisis, the heavy debt,
and downgrade of the country’s credit rating makes the US currency extremely shaky
compared to other currencies. In future, the US dollar will lose its value against the Chinese
Yuan. As China gains more economic power, it will have influence over global interest rates.

8. A high GDP means that China exports more products than any other country globally. As a
net exporter, more currencies will trade against the Yuan compared to the dollar. This will
become the global base currency, where all other currencies will be measured against.
Conclusion
A number of factors lead to the 2008-2010 financial recession. Among these, include
the mortgage crisis of the United States where the country slashed its borrowing rates to
increase liquidity levels within the economy. However, rather than people putting these
investment projects, people decided to buy homes. This pushed the demand for homes, and
thus increasing the interest rates. When people lost their ability to repay, mortgage lenders
made losses, leading to the crisis. Weak lending policies too, especially where there was no
adherence to underwriting policy were yet another cause of the crisis. The increase of the
interest rates on the mortgage borrowers too contributed to the crisis. Finally, the shift in
global demand and supply balances also increased the US debt ratio. The effects of this was a
shift in global economic power from the united states to china as the world develops more
trust on the Chinese economy, being one of the biggest lenders to the US government during
the crisis. This blurs the future of the US dollar as the Chinese Yuan threatens to surpass its
value mainly because China is a net exporter and that the country does not use debt to finance
its public expenditure.
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