In the period between late 2007 and early 2008, the world experienced economic financial crisis, was one of the greatest economic crises after the Great Depression. The economic crisis started in the US and spread to the rest of the world. Many countries as well as businesses located in different regions of the world felt the effects of this economic crisis. One of the causes of the economic financial crisis was availability of cheap credit (Davis 2). Operators in the financial sector started to offer cheap credit to the borrowers. Lehman Brothers, one of the companies operating the US financial sector during that time started giving many cheap mortgages to potential homeowners.
The competitors in the financial sector had to follow trend by offering cheap credit to their customers. Unfortunately, many people wanted to invest cheaply available money in houses. This made the demand of houses to go up. Increase in demand for houses caused a high inflationary effect. According to Davis (3), mortgage default in the US increased to six percent. This was the highest rate of default that banks and other players in the financial sector have ever experienced. Since many mortgages had been advanced to individuals with poor credit rating and no down payment, the banks were unable to recover the money advanced to borrowers. As a result, the financial sector collapsed.
According to Guina, the financial economic crisis was caused by inability of the financial sector to create new credit lines (2). The cheap mortgages had distorted the flow of money in the economy. There was slow economic growth as individuals concentrated on selling and buying properties. At the end, the financial sector, businesses, as well as individuals were left holding on mortgage-backed assets, whose value by then, had significantly dropped. These assets were not bringing in any money to the financial sector. With no cash inflow, the financial sector’s ability to advance new loans was drastically reduced. In addition, the financial sector introduced credit limits, thus resulting into less money in circulation in the economy.
Moseley (2) states that, the cause of economic financial crisis can be traced back in the 1950s. Between 1950 and mid-1970, the performance of the US economy declined by almost a half. The profit rates dropped from 22 percent to around 12 percent. High unemployment rate as well as high inflation accompanied the declined profit. This is because businesses were unable to make big investments due to the slow economic growth. Government attempts to curb unemployment through expansionary fiscal policies were futile, because the rate of inflation continued to increased. This is because capitalist firms increased the prices of their commodities as a way of making profits instead of increasing employment or output (Moseley 2).
One of the effects of this financial economic crisis on small businesses is limited access to credit. According to Governor Kroszner (5), since the onset of the crisis, credit standards for small businesses have tightened. Players in the financial sector have introduced new and strict standards that businesses must meet for them to be able to access credit. Some of these standards are too high for the small businesses to meet. In addition, the financial sector has increased the cost of credit for small businesses. Given the fact that the financial outlay of small businesses is usually small, they do not have the ability to service highly valued loans. These limit small businesses from accessing credit to help them continue with, and expand their operations. Kroszner states that, the supply of credit to small businesses has declined, because many players in the financial sector fear possible reduction of creditworthiness because of possible drop in demand of their goods and services or weakening of the collateral use to back up their loans (6).
In the US, small businesses account for more than a half of nonfarm gross domestic product (Kroszner 9). They also account for more than a half of employment in the private sector. Due to limited supply of credit to small businesses, their performance and contribution to the economy has reduced. Kroszner explains that the high rate of unemployment was occurred because of limited availability of credit to small businesses, thus causing their activities to slow down as well as their rate of growth (9).
The financial economic crisis has also caused the demand for goods and services produced by small businesses to reduce (Kroszner, 10). This is attributed to low economic activities in the market today. With low demand for their products and services, small businesses are recording lower profits than before. With low profits, small businesses are unable to expand or even to achieve the standards required by the financial sector for them to gain easy access to credit. Low profits among small businesses are also reducing their ability to maintain an adequate number of employees. Kroszner points that since the onset of the financial economic crisis, every small business has had to lay-off between three and five employees (10). This is because their profits are not sufficient to compensate all the employees for work done.
In order to solve the problems of financial economic crisis, the Federal Reserve has started to increase its existing lending facilities through encouraging interbank lending. The Federal Reserve has also increased the quantity of funds that it auctions to banks, in order to enable the banks to accommodate the demand for fund credit by other banks as well as primary dealers (Kroszner 11). These measures have positive effects on small businesses. For example, expansion of lending facilities to nonfinancial firms enables small businesses to access credit with ease because they do not have to look for “backup credit lines from the banks” (Kroszner 11). In addition, interbank fund borrowing helps in restoration of public confidence in banks. With increased public confidence, banks are able to lower their credit cost, thus making credit to small businesses more accessible.