Evaluate the Reasons for the Recent Global Financial Crisis - Essay Example

?Evaluate the reasons for the recent global financial crisis The recent global economic crisis has fuelled debate in relation to the causes of financial crisis and the current models of macroeconomic policy. This paper critically evaluates the rationale and challenges of the current financial crisis and posits that recent macroeconomic policy resulted in false assumptions, which failed to account for the actual capital/risk ratio. As a result, lending and investment in reliance on the weak macroeconomic model eventually culminated in a domino effect triggered by the collapse of the US housing bubble; which further raises questions about increased government regulation of the finance industry going forward. The recent global economic crisis has been labelled by economists as the worst economic crisis since the Great Depression and the domino effect of the crisis has culminated in the decline of consumer spending, demise of established businesses in key industry sectors and heightened government burden in developed countries (United Nations, 2009 p.1). Indeed, in the United Nations’ “Global Outlook: Economic Situation and Prospects 2009”, the United Nations comments that “it was never meant to happen again, but the world economy is now mired in a severe financial crisis since the Great Depression” (United Nations, 2009, p.1). Moreover, the global nature of the economic crisis has not only had a domino impact on national economies, infrastructure and the retail sector; it has also served as a barrier to quick recovery (Shiller, 2008). In evaluating the causal triggers and reasons for the recent economic crisis, this paper will evaluate the concept of financial crisis with contextual reference to the current global economic crisis with contextual reference to various academic commentary and discourse pertaining to the reasons for the economic meltdown of 2008. To this end, the analysis will firstly evaluate the challenges of and rationale for the financial crisis, followed by a consideration of macroeconomic theory, which it is proposed is imperative to a wider understanding of causality in the recent global economic crisis. In understanding the challenges of the financial crisis, it is imperative to address the causal triggers and rationale. Academic and media commentary on the crisis has highlighted the point that the immediate trigger was the collapse of the US housing market as a result of the sub prime market disaster upon which the international banking industry had been lending through following trends in the housing market (Ambachtshee et al 2008, p.149). Indeed, the United Nations analysis of the global outlook for 2009 asserted that “in little over a year, the mid-2007 sub-prime mortgage debacle in the United States of America has developed into a global financial crisis and started to move the global economy into a recession” (United Nations, 2009 p.1). Furthermore, in considering the interrelationship between the sub-prime crisis and the economic crisis, the contagion effects of sub-prime asset backed collateralized debt obligations are reinforced by results of the empirical investigation undertaken by Longstaff in “The Subprime Credit Crisis and Contagion in financial markets” (2010). Longstaff utilised data for ABX subprime indexes and found evidence of correlation between financial contagion and the subprime liquidity channels (Longstaff, 2010). However, whilst Longstaff acknowledges that the concomitant impact of the subprime crisis clearly had a direct correlation to contagion effects on other markets; Longstaff’s analysis of the data in his investigation suggests that: “The ABC Index returns forecast stock returns and Treasury and Corporate bond yield changes by as much as three weeks ahead during the subprime crisis” (Longstaff, 2010). To this end, the findings of Longstaff’s analysis undermine the presumption in pre-existing commentary which argued that the subprime assets were intrinsically flawed and unreliable (Longstaff, 2010). Moreover, Longstaff argues that the subprime market collapse actually occurred during the crisis, with the result of financial contagion in global markets (Longstaff, 2010). Accordingly, on the basis of Longstaff’s findings the defaults in the subprime mortgage markets acted as a trigger for losses in the financial markets, which in turn impacted the structured credit market leading to the credit crisis (Longstaff, 2010). As such, Longstaff’s findings suggest that it was the decline in liquidity as a result of the subprime collapse which spilled over causing financial contagion. However, in challenging assumptions about the relationship between the subprime catastrophe and the financial crisis, Longstaff argues that the nature of contagion in financial markets is of fundamental importance (Longstaff, 2010). Moreover, in reinforcing this argument, Longstaff comments that the pre-existing literature on the economic crisis focuses on the: “Frequently adopted definition of contagion in the literature as a significant temporary increase in cross market linkages” (Longstaff, 2010). It is submitted that Longstaff’s findings are particularly interesting in highlighting the interrelationship between the subprime debacle and the financial risk through underlining the intrinsic risk lying with the investor decision makers as opposed to the actual nature of the asset (Longstaff, 2010). For example, Niinimaki highlights the interrelationship between the risk and bank decisions in highlighting the role of the bank in financing risky investment projects against reliance on collateral value (2009). Moreover, Niinimaki highlights that the banks reliance on the value and perceived security of the collateral value continued to be utilised by banks to justify risky investment projects (2009). Indeed, prior to the sub-prime catastrophe, the significant foreign direct investment in the US and liquidity of the US economy had maintained low interest prices within an artificial national housing bubble (Shiller, 2008, p.22). Additionally, another part of this was the problem of policy makers not acknowledging the role of the shadow banking system which remained unregulated (United Nations 1). The credit conditions were easy and fuelled predatory lending, which in turn led to increased debt, over lending and artificial price hikes (Shiller, 2008 p.22). Moreover, Soros (2008) comments that the: “super boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management method of the banks themselves. Similarly, the rating agencies on the information provided by the originators of synthetic producers. It was a shocking abdication of responsibility”. In turn, the ability of government policy initiatives and bank cash injections in the developed countries was unable to avoid the resulting economic crisis (United Nations, 2009, p1). As a result, refinancing has been impossible, many leading banking institutions have failed and the stock markets collapsed (United Nations 2009, p.2). Additionally, the UN cites the central challenge of the financial crisis as follows: “Interbank lending in most developed countries has come to a virtual standstill, and the spread between the interest rate on inter-bank loans and treasury bills has surged to the highest level in decades. Retail business and industrial firms are finding it increasingly difficult to obtain credit” (United Nations, 2009 p.1). This is further compounded by the long term implications of debt and rising unemployment levels. The recent financial crisis has brought renewed academic attention to macroeconomic theory with some commentators arguing that the traditional paradigm of macroeconomic theory contributed to failures to foresee the current economic crisis (Akerlof & Shiller, 2009, p167). The underlying basis of macroeconomic theory is the interrelationship between performance and behaviour in decision making regarding national economies along with a consideration of the various determinants of economic activity (Michl 2002, p.20). A principle macroeconomic model is the dynamic stochastic general equilibrium model, which explains economic growth, business cycles and monetary and fiscal policy, along with consideration of how the economy evolves over time accounting for random shocks (Colander, 2006, p1) However, in re-evaluating classic macroeconomic theory, Akerlof and Shiller question why the current financial crisis was not foreseen and argue that “we didn’t because we were cowed by an economic theory that has reached a high level of academic consensus” (2009, p.178). Moreover, they argue that another central factor was the failure to acknowledge that the housing bubble existed and that consideration of human behaviour is important in macroeconomic theory (Akerlof & Shiller, 2009, p38). To this end, Akerlof and Shiller posit that their central premise pertaining to macroeconomic theory is as follows: “totally absent from conventional macroeconomic theorising: that the economy is affected by variations in the level of trust, by storytelling and human interest, by perceptions of corruption or unfairness, by anger and optimism, by social epidemics causing changes in gut instincts and feelings. Those factors, we firmly believe, are ultimate causes of the boom we saw a few years ago, and the bust we are seeing now” (Akerlof & Schiller, 2009, p.33). Their proposition that macroeconomic policy contributed to the current economic crisis is supported by Ormerod (2009) who posits that macroeconomics has shaped economic policy in the past twenty years. To this end, Ormerod argues that: it is these ideas which the current crisis has falsified. And it is specifically the way in which the mainstream economics deals with the risk and uncertainty which is at the root of the problems, both for the discipline of economics and economy itself”(2009). The central basis of Ormerod’s critique is supported by reference to Knight’s concept of risk and that this is central to the reason for the contemporary business cycle, as well as the peaks and troughs of the capitalist economic model (Ormerod, 2009). As such, Ormerod opines that modern macroeconomic theory has failed in addressing the concept of risk and uncertainty, which is exemplified by the current economic crisis. This further correlates to the point that a consistent trend in the financial crisis has been the failure to match capital to the commensurate risk, which is highlighted by Niinimaki’s discussion of the relationship between assumptions pertaining to collateral value and risk and moral hazard in banking (2009). For example, the equilibrium economic macroeconomic model is derived from microeconomic assumptions of orthodox economic theory based on rational utility maximisation by consumers and rational value maximisation by firms (Ormerod, 2009; Niinimaki). Additionally, these assumptions both operate on the basis that they make economic forecasts rationally (Niinimaki, 2009). Ormerod argues that this is a false assumption as indicated by the GDP growth estimates for 2009 in Figure 1 below. Moreover, Figure 2 addresses the liquidity projections of the banking sector in the UK. Figure 1 Source: www.paulormerod.com/pdf/accsjuly09.pdf Accessed March 2011 Figure 2: Source: www.paulormerod.com/pdf/accsjuly09.pdf Accessed March 2011 It is submitted that the lack of liquidity as indicated by Figure 2 is arguably central to financial crisis (Ormerod, 2009). This is reiterated by the findings of Niinimaki’s study of collateral and moral hazard in the banking industry where Niinimaki asserts that whilst collateral may in certain instances reduce bank risk, the fluctuating values of certain collateral assets challenge assumptions of collateral as security for risky finance deals (Niinimaki, 2009). Niinimaki reinforces this argument with specific reference to loans and how uncertainty over future value of such collateral leads to an intrinsic gamble in bank investments reliant on such collateral for security. For example, in considering the example of UK bank Northern Rock, the central reason it went into financial difficulty was because it couldn’t refinance its loans as a result of the sub prime bubble and Ormerod observes that: “At the height of the crisis, credit markets froze completely because banks simply did not know whether the next institution was solvent or not. In the week of 15 September 2008, capitalism nearly ground to a halt”(Ormerod, 2009). From a macroeconomic perspective, it was the false assumptions of rational pricing upon which the increasing accumulation of loans and debts had been offered that perpetuated the financial crisis (Niinimaki, 2009). This lack of equilibrium in the capital/risk ratio led to artificial interest rates and the applicable interest payments did not cover the actual risk on the loans (Niinimaki). Moreover, Ormerod posits that a central causal factor for this imbalance was the macroeconomic assumption that the “interest payments receivable exactly covered the risks involved on the loans” led to the assumption that there was no need to tie up capital that could be lent out for a profit and therefore portfolio of loans on this assumption” (2009). Additionally, this imbalance was compounded by the fact that the domino ripple of defaults triggered by the collapse of the US housing bubble was not foreseen, which in turn supports the results of Longstaff’s study. To this end, Ormerod expressly refers to Blanchard’s statement that “history teaches us that benign economic environments often lead to credit booms, and to the creation of marginal assets and the issuance of marginal loans. Borrowers and lenders look at recent historical distributions of returns, and become more optimistic, indeed too optimistic about future returns” (in Ormerod, 2009). A prime example of this is securitisation, which are inherently complex and difficult to value assets on balance sheets (Ormerod, 2009). As a result, securitisation assets rendered it inherently difficult to predict future outcomes and its interrelationship with the globalisation phenomenon led to an “increasing connectedness between financial institutions, both within and across countries”(2009). Additionally, Ormerod observes that there were very low liquid asset ratios with which banks were operating, which was clearly a contributing factor the current economic crisis as supported by Niinimaki’s findings on the interrelationship between collateral and banking moral hazard. Moreover, as the leverage continued to increase during this period, Ormerod refers to Blanchard’s argument that financial institutions continued to invest in complex assets to finance portfolios with reduced liquidity in return for a higher profit, which was attributable to a macroeconomic model that underestimated the risk. Accordingly, Ormerod posits that “modern macroeconomics, with its basis in rational agents and rational expectations (RARE) bears a heavy burden of responsibility for the financial crisis” (Ormerod, 2009). The complex causal factors contributing to the financial crisis have created a domino ripple effect on a global basis. From a retail industry perspective, businesses have suffered as a result of lack of consumer confidence and limited disposable income caused by rising unemployment rates (Homann et al, 2007). On the other side of the spectrum, established retail businesses both large and small are suffering from credit and cash flow problems due to the reluctance of banks to lend even to reliable long standing customers (United Nations, 2009, p1). Whilst recent reports suggest slow signs of growth, overall countries such as the US and the UK have emphasised the point that declarations of an end to the economic crisis remain premature. In terms of the recovery process, the United Nations observed that governments of developed countries are implementing more comprehensive measures to address a previously unregulated industry and that “the measures have reshaped the previously deregulated financial landscapes; massive public funding was made available to recapitalise banks, with the governments taking partial or full ownership of failed financial institutions and providing blanket guarantees on bank deposits” (United Nations 2009, p1). However, as a result, whilst it remains too early to predict how far such measures will remedy the economic downturn, it is an important indication of changing policy. Moreover, Moshirian (2011) highlights the point that any previous attempts to introduce a cohesive regulatory framework in financial crises have often failed to achieve their objectives. Moreover, Moshirian asserts that any meaningful framework for regulation requires consistency in enforcement at both national and international level and that failure to do so will continue to ignore the causes of the financial global crisis (2011). In particular, Moshirian highlights the reality of globalised markets and the failure to acknowledge the need to regulate banks on a local and international level risk a repeat of the same mistakes that led to the recent financial crisis. This in turn highlights the point that whilst the failure of specific markets such as the subprime mortgage market clearly contributed to financial contagion in the global markets; ultimately it was the failure of the banks to match risk with capital which resulted in the recent financial crisis. BIBLIOGRAPHY Akerlof, G., & Shiller, R. (2009) Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism. Princeton University Press Ambachtshee, K., Beatty, D., & Booth, L. (2008) The Finance Crisis and Rescue: What went wrong? Why? What lessons can be learned? University of Toronto Press, Blundell-Wignall, A. “The Current Financial Crisis: Causes and Policy Issues”. Retrieved from www.oecd.org/dataoecd/47/26/41942872.pdf accessed March 2011 Colander, D, (2006) Post Walrasian macroeconomics: beyond the dynamic stochastic general equilibrium model. Cambridge University Press, 2006. Homann, K., Koslowski, P., & Luetge, C. (2007) Globalisation and business ethics Ashgate Publishing Longstaff, F, “The subprime credit crisis and contagion in financial markets” (2010) Journal of Financial Economics, 97 436-450. Michl, T. (2002) Macroeconomic Theory: A Short Course. M. E. Sharpe Moshirian, F, “The Global Financial Crisis and the evolution of markets, institutions and regulation”, (2011) Journal of Banking and Finance 35 502-511 Niinimaki, J. P. “Does Collateral Fuel Moral Hazard in Banking?” (2009), Journal of Banking and Finance, 514-521 Ormerod, P. “The current crisis and the culpability of Macroeconomic Theory” (2009) retrieved from www.paulormerod.com/pdf/accsjuly09.pdf accessed March 2011 Shiller, R., (2008) The subprime solution: how today’s global financial crisis happened and what to do about it. Princeton University Press Soros, G, “The worst market crisis in 60 years” (2008). Published in the Financial Times, January 23, 2008. Retrieved from www.georgesoros.com accessed March 2011 United Nations (2009) Global Outlook: Economic Situation and Prospects 2009, United Nations Publications ICTY Read More