The Global Financial Crisis of 2008 was the worst crisis since Great Depression of 1930’s. It emerged on global of the earth after failure of financial giants like Lehman Brothers, Bears Stearns etc. Crisis was a result of series of problems including the subprime mortgage crisis. Economic Crisis propagated through different channels like financial integration, trade. Global Financial Crisis had serious repercussions. Crisis led to liquidity problems. Poor countries were further pushed into poverty trap. World’s total output decreased significantly as real GDP growth rate plunged down to -1.9 % in 2009. World’s capital markets witnessed decline in stock and bond prices. Policy initiatives were taken all across the globe to mitigate the effects of crisis. United States and European countries announced bail-out packages worth trillion of dollars. Pakistan also suffered from Financial Crisis as GDP growth rate came down and it further led to economic instability. Pakistan’s current account deficit and fiscal deficit touched the figures of 8% and & 7% of GDP respectively. The paper takes into account GDP as a dependent variable and potential independent variables such as trade deficit, current account deficit, fiscal deficit and inflation. GDP has been taken as a measure of macroeconomic stability. The paper further highlights and analyzes the discretionary fiscal policy adopted by the government and tight monetary policy being pursued by the State Bank of Pakistan.

INTRODUCTION

History and Background of the Global Financial Crisis

Global Financial Crisis emerged in 2008 as a result of bursting of US housing bubble. Global Financial Crisis is considered to be the worst crisis since the Great Depression of 1930’s. Crisis originated in United States and European countries with the failure of Banks like Lehman Brothers, Bear Stearns.

History of Global Financial Crisis reveals that Federal Reserve was pursuing an expansionary monetary policy well before the crisis. After burst of Dot Com Crisis and 9/11 attacks, advanced economies in an attempt to mitigate effects of the crises pursued an expansionary policies. Low interest rates accompanied by housing prices facilitated credit growth. US Banks started giving loans to the people with poor credit history. The interest rate in US Economy rose from 1 % 5.35 % which rate resulted in reversal of the housing boom. People already faced trouble while paying the mortgage payments and, further rise in interest rate created severe problems and many of them defaulted on their mortgages

Repercussions of the Crisis

Global Financial Crisis spread to the rest of the world through financial integration causing serious unrest across the whole world. Global Financial Crisis had serious repercussions as International Monetary Fund (IMF) reported that world’s economic growth is expected to be -1.3 % in 2009. International Labour Organization reports the rising unemployment and according to ILO 30 million people are supposed to loose employment. According to the World Bank, 40 % of the developing countries are highly exposed to the poverty effects due to Global Financial Crisis .Global Financial Crisis resulted in liquidity problems and financial institutions lost trillion of dollars.

Global Financial Crisis had a severe impact on economies of both developed and developing countries. Global Financial Crisis originated from sub-prime mortgage crisis in 2008 and consequently resulted in financial turmoil all around the world. Confidence in financial institutions eroded resulting in collapse of giant financial institutions and banks. Banks which escaped from bankruptcy were bought in a severe competition at very low prices. Financial Institutions lost billions of dollars due to Global Financial Crisis. According to the Bank of England financial institutions across the globe lost approximately $ 2.8 trillion.

Source: IMF World Economic Outlook, April 2011 (Graph developed by the Author)

Causes of the Crisis

Major causes of Global Financial Crisis which have been identified are increase in asset prices, credit booms and failure of the regulatory agencies.

Asset Prices

Before the onset of Global Financial Crisis, housing prices increased drastically in United States. Increase in housing prices was also seen in other developed countries like UK and Ireland.

Credit Booms

Credit Booms were also the result of different crises which took place before Economic Crisis of 2008. Longer duration and relatively large sizes of Credit Booms result in economic crises soon. Credit Booms accompanied by increased leverage of borrowers fuel such financial crises.

Failure of Regulatory Agencies

Crisis reveals that regulatory agencies were unable to predict financial turmoil. Regulatory agencies showed lack of interest. Agencies responsible for oversight underestimated the crisis.

Channels of Transmission

Sub-prime mortgage crisis spread to other developed economies of the world as advanced economies had direct exposure to sub prime assets and US financial markets. Few other channels of spread of the crisis are given below

Financial Integration

Financial Interconnectedness has increased in past few years. Financial Reforms have been able to bring financial integration. Financial Integration has resulted in greater efficiency of Financial Sector, increased competition and risk sharing. All this is also associated with greater risk of transmitting financial shocks across the countries . Crisis spread to developed and developing countries through financial integration. Developing countries banks were affected as far as they were contaminated by the sub prime mortgages.

Trade

Trade was a major channel of spread of the crisis to both the developed and developing economies. Developing and Poor countries had direct trade relationships with advanced economies which were suffering from serious macroeconomic problems and as a result decline in exports of developing and emerging economies was witnessed.

Reduced Financial Flows

Financial Flows to developing countries which include portfolio investment, FDI and remittances came down as a result of Economic Crisis. Cali, Massa and Te Velde (2008) estimate the decline in financial resources to developing countries to be around US$300 billion.

Inequality

One aspect which has been ignored by different researches pertaining to Global Financial Crisis is the inequality. Rich countries have diverted attention towards saving their financial system while developing countries are under hoards of poverty and macroeconomic instability.

Low Income Countries which were already in poverty trap further suffered in terms of rising unemployment, low economic growth, decline in exports and decrease in remittances. Some of the major factors which were common in both the developed countries and developing countries are contraction in exports, hike in commodity prices and decrease in FDI and the exports. Poor countries suffered at a large scale as investors pulled their capital out of poor economies which pushed these countries further into recession.

Global Financial Crisis also introduced social problems as high unemployment and increase in poverty would give rise to more crime. Poor countries are dependent upon richer nations for aid and as a result of economic crisis; rich economies cannot afford to pay money to poor nations as foreign aid.

Financial Crisis and Policy Resp