The Causes of The Global Financial Crisis - Essay Example

?The Global Financial Crisis Introduction The Global Financial Crisis (GFC) has been a cause of concern for all countries at current times, irrespective of the economic condition of these countries. The GFC has already caused severe tension among the economists and politicians around the world and this phenomenon has been blamed for triggering slowdown of economic growth at the global level. Around the world governments of all countries are making serious efforts to keep the flames of the crisis within controllable limits. Due to this reason governments are making use of both traditional policies and are also devising new polices so as to fight the effects of crisis. However, according to many experts the situation is not yet under control. The world is still passing through the worst economic and financial times. Stock markets are showing sluggish movements and recently there have been sharp decline in the international stock markets. Large financial institutions have collapsed which has been the biggest shock to the financial world. Rescue of these banks have involved huge amounts of money for bail outs. The government of the respective countries have provided lump sum amount of money (that have run upto many trillion dollars in the United States alone) to these failed banks for rescuing them. In the United States the Federal Government has followed the Keynesian theory of economics. As recession set in, policymakers have not left the economy to the forces of the market that might autocorrect the market and improve the condition of low aggregate demand. They have intervened with fiscal and monetary policy changes, so as to augment economic activities in the country. Interest rates were reduced as an immediate response to the crisis (Velde, 2008). This paper looks at the causes of the GFC and the responses of the government to this crisis. The main aim of this article is to research the protectionist activities of the governments in reflex to the harm caused to these economies by recessionary pressure. In this light the preventive measures of the governments have been studied to understand the course of action adopted by the global economy to prevent the recurrence of a situation similar to the Great Depression of the 1930s. Causes of the GFC The causes of the GFC are manifold and analysts have not come to any particular agreement about the actual reasons that have eventually led to the financial crisis of such a huge dimension. Yet it is commonly agreed that GFC has occur due to the combined effect of the shocks faced by the real estate market in the United States and the European countries on one hand, and the increasing risk premia for the corporate firms and the investment banks on the other (Stoeckel, 2009). The shocks in the global financial market have potentially created strong contractions in international trade. The root to the financial crisis can be traced to the collapse of a number of large and influential financial institutions in the United Sates and the Europe. Among them, the most notable mortgage bank failures are Lehman Brothers, Northern Rock and Bear Sterns. As these banks filed for bankruptcy, a wave of apprehension ran through the most established financial markets of the western world. In this situation, banks curtailed their lending facilities to other banks which increased the risk premium on interbank borrowing. This rate increased steadily from near 0 to 5 per cent. On corporate bonds this risk increased to more than 6 per cent. In spite of efforts by the government to increase liquidity levels in the market, the financial markets crashed inevitably. The economic slowdown started with the shelving of big corporate projects. Therefore, the primary borrowers in the economy (i.e., the large corporate firms) stopped lending money from the banks. On other side of the coin, obtaining credit for commercial purposes became difficult. This causes the great financial crisis. Since credit facilities dried up, corporate firms had to revise their investment decisions. They faced a situation of financial crisis. Both big and small firms faced this problem according to the breadth of their commercial activities. This affected the normal economic climate in the countries. Since the corporate sector slowed down, production levels in the economy fell, leading to an ultimate fall in the overall income level in the economy. Hence aggregate demand level in the economy started to decline. With the loss in demand the economies around the world slowed down and recession slipped in (Stoeckel, 2009). Protectionism One sticking fact about the concept of protectionism is that, when economists talk about protectionism, they put forth the set of policies adopted by the government in response to certain economic and financial conditions of the economy. However, the word ‘protectionist’ or ‘protectionism’ is not accurately defined (Bernitz and Ringe, 2010). This shows that there is no definite standard of protectionism that might be considered as a bench mark while evaluating the activities of the economies that have been identified as protectionists. Therefore, it gives rise to lack of clarity. According to some experts, it leads to the phenomenon of ‘murky’ protectionism. The most commonly accepted definition of protectionism relates to the policy actions adopted by the state with the aim of improving competitive positioning of the firms operating indigenously (Bernitz and Ringe, 2010). Certain scholars put it in this way that protectionism is “the doctrine of protective taxes as a device to be employed in the art of national prosperity” (Magnusson, 2000). It creates a restrain on trade between two or more countries by way of trade barriers such as, tariffs, quantitative restrictions such as quota and other forms of border closing restrictions designed by the governments to restrict entry of foreign goods into local markets. This prevents the foreign companies to take over the indigenous enterprises and capture the local markets (Bernitz and Ringe, 2010). Protectionism as a safeguard to domestic industries As the countries were getting submerged into recession as an outcome of the severe financial crisis faced by the global economy, the governments started to take proactive steps to restrict the economic downfall of the economies and also initiate new productive activities within the economy. This gave rise to the incidence of extensive protectionism. After 2009 protectionist measures were being adopted by almost all countries in the global economy. However, it has been observed by economists that the level of protectionism after the 2009 financial crisis has not resembled the protectionist activities that had caused the dramatic recession in the mid 1900s (Baldwin and Evenett, 2009). Opinions provided by different experts compete with each other regarding the impact that is going to be envisaged by the world as a result of the protectionist policies. This debate is mainly fuelled by the characteristics of the protectionist measures adopted by the governments. These policies are not uniform. Protectionist policies come in the form of trade barriers that have been introduced newly. Since these are unconventional they are often termed as ‘murky’ (Farhad, n.d.). Lack of transparency makes it difficult for analysts to quantify the immediate as well as the long term impacts of these trade barriers. Governments have taken resort to protectionism in various ways. The developed countries, such as the United States, heavily rely on government subsidies to safeguard their domestic industries. Subsidies help the domestic industries compete with the other multinational industries that are operating in the country. Developing nations, on the other hand, deploy various methods to protect their indigenous industries. The most prevalent policies are border measures such as tariffs and quota restrictions. Some of the countries that have made notable use of tariff restrictions on foreign trade are Russia and Ecuador (European Commission, 2010; European Commission, 2011). These countries raised tariff rates on imports of nearly 900 items; a major item being automobiles. Tariff protection accounts for only half of the protective measures. Import substitution is another policy adopted by the developing countries, like India. Other non tariff measures include trade permits and licensing requirements. Countries that have followed such non tariff measures are Argentina, Indonesia and India. The government of Argentina has put licensing requirements on importers of automobile parts, leather goods, shoes, televisions and other electronic gadgets and toys. Indonesian government has set the rule that five types of imports made by Indonesian traders (that include toys, food and beverages, garments, electronics, and footwear) would be monitored. These items would be allowed to enter the country through five selected airports and ports. These tightened trade barriers slowed down entry of imports in the country. This implied that the exporting countries faced a loss in the export sector. India and China totally banned imports of various items, such as, pork from Ireland, some kinds of chocolate from Belgium, Italian brandy, sauce and other mixes from Britain, eggs from Denmark and dairy products from Spain. India also restricted entry of low priced toys from China (Baldwin and Evenett, 2009). According to some reliable sources, border closing trade barriers have increased significantly during 2010 and 2011 (WTO, 2011; European Commission, 2012). The UK banks have received bail outs from the government, which is an example of redirecting the loan amounts to the home market. Hence this discouraged imports demand by the European countries. This is an example of murky protectionism according to some experts (Baldwin and Evenett, 2009). The problem arises when the governments makes huge amount of spending for bailing out the banks frequently within a short period of time. The exact impact of this phenomenon on international trade front for these countries cannot be not be exactly enumerated since all these activities lack transparency. Exact data regarding the amount of bailouts, the frequency of bailouts and the economic effect of these lending is not available. Due to this fact both politicians and economists find it hard to retaliate against such protectionist measures (Baldwin and Evenett, 2009). These examples of protectionism, although not very transparent, do not directly violate the obligations set by the World trade organization on the member nations. However, these obligations are often abused and the policymakers make use of discretion while making policy prescriptions. These discriminate against goods and services that come from foreign countries. This discrimination is also faced by foreign multinational companies and their workers. This in effect encourages consumers to confine their spending to the domestic goods and services and import demand falls. This hurts the global economy since the happenings of international trade affects the financial condition of the global economy. Protection of international trade The GFC has been able to influence international trade to a large extent. As recession crept into the economies, different national governments as well as the international organizations also made various measures to prevent the international trade from being hampered (OECD, n.d.). According to reports from recent studies, there was a fall in international trade in 2009 by approximately 12 per cent (OECD, 2010). Economists have explained this fall in trade to be the outcome several factors; the down turn in financial conditions that hindered normal functioning of private commercial firms, fall in aggregate demand for commodities and services particularly a significant amount of decline in import demand of high technology manufactured goods, such as, transport equipments and machineries. Since the global supply chains are vertically integrated, these trade barriers cause inefficiency, which is manifested at every level of the chain thereby creating a lag in the international trade front. It necessitates the different policy changes to protect international trade from this situation of economic downfall (WTO, 2010). However, the world had already past experiences of the consequences of austere protectionist policies that had led to the Great Depression of the 1930s. Hence economists had adopted policy changes that has helped the economies to recover, but, has not pushed the international market into a position of unstable equilibrium that might recreate a phase of long lasting depression. It has been deemed important that any policy changes that take place must avoid the policies that had been adopted during the 1900s. The section below presents a discussion on the causes that had created the Great Depression of the 1930s. It also elaborates the actions taken by the governments to prevent contraction of international trade. Great Depression of 1930s During the Great Depression that had its beginning in 1929, the governments of many countries responded fast to protect its indigenous industries and the domestic workers against foreign competition. The governments made import-restrictive policies to restrict imports. One example of this policy is the “Smoot-Hawley Tariff Act of the US” (Ryuhei, 2008). Under this policy, tariffs rates on imports increased by large amounts. This was done to protect domestic employment level, although it went to the extent of trading of the benefits of free trade. This not only affected the quantity of import demand of the countries that have imposed the tariff barrier, but also, other countries that are trade partners of these countries. Since, in this era of globalization countries are closely knitted via their participation in international trade, activities of any country would affect the competitive positioning of the country in the global market. This happened during the 1930s. As a result of strong protectionist measures of the developed countries, like the US, demand for goods and services by the US dampened to such extent that it augmented the effects of recession, which ultimately took the form of the Great Depression. It further led to decline in exports made by other countries to the States. As a natural reaction to this situation, these countries also retaliated by raising their tariff rates on exports made by the US to these countries. This further deepened the Great Depression. Prevention of contraction of world economies Policy makers of the global economy have been precarious about the protectionist ways of the national governments during the period of recession. While most governments have put restrictions on foreign trade (through tariff or non tariff barriers) since 2008, economists have warned about the negative effects of protection. They have taken lessons for the Great Depression of the 1930s. As employment situation degraded and the economies started contracting there was a greater call for the taking protectionist policies. To achieve this end, the global leaders met at the Group of Twenty (G20) financial summit in 2008 and carefully sorted out the particular protectionist policies that led to the Great Depression of the 1930s. It was unanimously agreed in this summit that the nations, in the upcoming twelve months, would refrain from following the protectionist pattern that resembled the 1930s-style. They would not further increase tariff barriers. All import barriers and export restrictions would be consistent with the memorandum laid by the World Trade Organization (WTO) (Ryuhei, 2008). Three strategies were formulated that would help the international bodies to prevent nations from following destructive protectionism and to help nations to choose their policy changes according to the regulations of the WTO. For this, the WTO had been selected to act as a watchdog and oversee global trade. Secondly, it has been found that regional trade agreements (RTAs) are not very efficient in preventing nations from imposing high tariff. Therefore, agreement has been made towards following trade liberalization within a multilateral framework. The world is now following the policy of trade liberalization rather than protectionism. Regional trade agreements can play effective role to reduce trade barriers during good economic times when there is steady economic expansion (Evenett, 2011). However, when there is economic contraction, as it is the case of 2008 financial crisis, regional agreements are not effective since they do not bind the rule on the countries that have not signed in this agreement. Hence, non member countries tend to adopt strong protectionist policies. In order to avoid the chances of developing block economies, general trade liberalization has been emphasized on. Since as a result of financial breakdown the global trade is declining, economists have agreed on this fact that “multilateral free trade negotiations” (Ryuhei, 2008) are more effective in preventing contraction of international trade in post recession period. This also helps in implementing the principles of WTO in protecting free trade. Finally, the monetary policy prescription of the national governments cast significant impact on the activities of these economies while engaging in international trade. Some of the developed nations, such as, Japan, the US and the European Union, have eased their monetary policies as a response to the economic crisis faced by them. These monetary policies have been aimed at stimulating domestic aggregate demand and improving credit facilities such that industrial activities might improve leading to greater productivity. Besides, policy makers would have to abstain from taking discretionary measures in order to support the short run economic activities in their economy. It is necessary to implement the policy of removing all protective policies and follow competitive policies when particular industries are found to be eligible to face the international trade. This is important to prevent across the border regulatory arbitrage. Presence of such arbitrage would actually harm the equilibrium in international trade by providing higher facilities to those countries that are enjoying protection on their domestic industries. Under the current economic and financial conditions, national governments are encouraged to put more emphasis on the demand side and making policies to improve overall demand conditions in the economy rather than restricting demand for goods that have foreign origin. It is more important to increase aggregate domestic demand for encouraging production by domestic industries rather than to restrict demand for foreign goods (OECD, 2010). The macroeconomic issues arising in the developing countries are different in form and features from the developed countries, due to which these problems require separate attention. Problems related to the labour market and unemployment conditions are some of the burning issues in these economies. Specific cures for this problem would only lead to effective cure for the post financial crisis recession. Conclusion The Global Financial Crisis (GFC) has shocked the world economy. The monetary policy adaptations and the other protectionist measures have put considerable strains on international trade. As a response to the economic down turn countries have responded with protectionist policies to safeguard their indigenous industries from foreign competition (Tucker, 2013). The discussion presented above shows that post crisis global economy was faced with a new problem; preventing the international trade from contracting. The world is still facing this problem while economist are continuously devising measures to prevent the global economy from rolling in to a situation like the Great Depression that occurred in the 1930s. The most immediate needs are eliminating trade distorting barriers, encouraging trade liberalization and solving the basic economic issues that hinder normal activities in the country. Reference List Baldwin, R. and Evenett, S., 2009. The collapse of global trade, murky protectionism, and the crisis: Recommendations for the G20. [pdf] Available at: < http://economics.uwo.ca/people/whalley_docs/Murky_Protectionism.pdf > [Accessed 29 July 2013]. Bernitz, U. and Ringe, W., 2010. Company law and economic protectionism: New challenges to European integration. Oxford: Oxford University Press. European Commission, 2010. 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