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Why Too Much Risk Caused the Financial Crisis
The financial crisis of 2008 hit the entire global economy hard. A decade of economic growth was brought to halt. Some of the world’s biggest companies were brought to their knees.
But would it be accurate to say that some of the most affected companies actually brought it on themselves? I am referring to investment bank Lehman Brothers and insurance giant AIG.
How can this be the case?
The financial system had grown radically more complicated in the years leading up to the 2008 financial crash. New financial products were created, such as financial derivatives, in order to make banks more money. As they were so complex, many people didn’t truly understand how they worked. This hid their risk potential.
What is Financial Derivative?
To create these financial derivatives, pools of securities (such as mortgage loans) were used. As banks wanted even more profitability, they would issue yet more financial derivatives. If more derivatives were made from the same security, the greater the risk became.
A way to explain this could be to imagine building a house on a small piece of land. As you are unable to build width-ways to create more space, you decide to build upwards. You add storey after storey to your house and eventually it becomes skyscraper! The physics of the situation dictate that the stability of this house decreases, and the whole structure is compromised.
Furthermore, each new financial product that was made was of poorer quality than the previous one. Returning to our imaginary house, now let’s imagine we use poorer quality materials to build this house. Instead of double-glazed windows, we use single-glazed alternatives. Instead of using bricks, we use plasticine.
Which Countries were Most Affected by the Financial Crash? Developing Countries or Developed?
Which countries were most affected by the crash, then? Countries from the developed world or the developing world? Actually, the developed world was probably the most affected. An example of this is the economies of Ireland and Latvia; they had both opened up their markets in the years before the crash. They suffered enormously; the Irish economy decreased by 7.5% and the Latvian economy by 16%.
In general, the hardest hit were the economies that had the most liberalised markets. This creates yet another argument against the capitalist ideology of free markets.
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