Adverse Selection and Moral Hazard and How They Affect Economic Behaviour
The world has faced a drastic financial crisis. The crisis has raised concern among the financial and economic fraternity. Many economists believe that with the fragility of the economic system, behavioural financial aspects could be the main issue. The issue of trust or mistrust has played a key role in stirring the global financial system. Lending is a major activity of financial institutions (Carbaugh, 2009). The decisions made by lenders determine prospects of the economy. Lenders stimulate the borrowing behaviour of borrowers who are their customers. Good relationships between a lender and borrowers stimulate conflicts of interest. When there is a conflict of interest, business principles are ignored. As such, both the lender and the borrower agree on terms that lead to conflicts. If the terms are not met, the two parties agree on a compromise of repaying the borrowed amount (Halm-Addo, 2008). The economic recession was caused by disagreement between lenders and borrowers. There are several ways in which the economy can be affected by adverse decisions and opinions.
How Asymmetric Information Problems Can Propagate Adverse Economic Shocks
The economic recession of 2007, which is also known as the great recession, began in 2007 and ended in mid-2010. The great recession had profound impacts on political, economic, and social aspects of the world. The recession affected both developed and developing countries, although developed countries experienced the biggest impact. The recession of 2007 was characterized by high levels of unemployment, a sharp decline in the economic growth, an increased number of poor people, and collapse of businesses. The economic recession of 2007 was caused by financial and economic mismanagement that led to a near collapse of the global economic system (Brezina, 2010).
The economic recession of 2007, which was caused by the mismanagement of the global economy, led to the collapse of major financial institutions and brought numerous problems among ordinary people.
According to the US National Bureau of Economic research, the 2007 economic recession started as a result of poor management of the global monetary system and uncontrolled lending practices by major financial institutions. In developed countries, mortgage funding was competitive, uncontrolled, and opaque resulting in risky lending (Rasmus, 2010). Financial organizations developed valuation systems that encouraged the relaxation of lending standards, thus, prompting immense procurement of substandard loans. Consequently, the subprime lending caused credit boom that eventually started the 2007-2008 financial crisis. Financial and economic policies worked out by America and other developed countries played a key role in the great recession. Governments of developed countries took huge loans and created large budget deficits that caused extensive strain on their economies. These borrowing policies were instrumental in causing the great recession (Hank, 42).
The emergence of the 2007 economic recession took many governments and economists by surprise. There were no emergency mechanisms that would have been employed to combat its effects promptly. The recession raised deep concerns in the world as businesses collapsed and consumer confidence eroded. By mid-2008, the USA was in the midst of a biting recession, while major financial institutions were on the precipice of collapse. The GDP of developed nations started to decline, while many organizations started to show negative financial results. Some financial institutions, such as Lehman Brothers, went bankrupt and collapsed. In the same period, the economic recession spread throughout the world, affecting both developed and developing nations (Peláez & Peláez, 2007). Many economists predicted the risk of a total collapse of the financial and economic systems similar to the great depression that had been experienced in the 1930s. Governments of the affected nations reacted by creating massive stimulus packages to prevent ailing organizations from collapsing. In addition, they increased the supply of money and loosened monetary and fiscal policies. Although the governments’ intervention was instrumental in curbing the collapse of the economic system, it played a major role in increasing national debts and deficits that are currently being experienced by the economies of many countries. By mid-2009, economic pointers indicated that the financial crisis had stabilized, and the good performance of organizations that were on the brink of collapse showed that the global economy was recovering (Colin, 2009). By 2010, the recession had been stopped, and appropriate policies were developed to ensure that the crisis would not recur.
The economic recession of 2007 had several political, economic, and social consequences. The recession resulted in poor performance of economic sectors, leading to low GDP and a decrease in the economic growth. Although the recession started in developed nations, its effects were palpable in developing countries that depended on financial aid from developed nations. A decrease in financial aid to poor countries resulted in increased levels of poverty and frustrations among ordinary people. Governments and organizations started to retrench their employees in order to cut cost, which increased the levels of global unemployment. High unemployment levels affected the productivity of the global economy.
The world experienced political instability because ordinary people experienced many problems caused by the global economic downturn. Some political leaders were ousted from power through revolutions, while others lost through democratic elections. For instance, Tunisian President Ben Ali was one of the victims of revolutions that were triggered by hard economic circumstances that their subjects were facing. The 2007 economic crisis had numerous social consequences that shook the foundations of society. High poverty levels resulted in family break- ups, increased levels of crimes, and other social evils such as child prostitution. As a result of the 2007 economic recession, ordinary people became more careful and analytical in their investment decisions (Diamond, 1991). In addition, people became sensitive and careful about their political decisions, as they were likely to elect leaders whose policies favoured the economic growth. For instance, the economic policies that were presented by each political party’s manifestos were among the major factors that influenced the results of the 2012 elections in the USA.
Potential Solutions to Alleviate Adverse Selection and Moral Hazard Problem
In my opinion, there is a minimal probability that another recession would occur. Governments have developed long-term financial and economic mechanisms that are essential in checking and preventing problems in economic and financial systems. For instance, financial institutions are currently under close scrutiny by regulatory agencies, so they cannot be allowed to develop dangerous financial policies (Siegel, 2002).
One of the best solutions is to develop an economic system that can manage financial and economic behaviour (Colin, 2009). The trust and mistrust culture between the lender and the borrower should be essential in developing a solution to economic problems facing the world.