International Financial Crises - Essay Example

International Financial Crises: A Retrospect "I believe one fundamental reason for the crisis is that the political system of the world and the economic system of the world became totally out of phase with each other" Henry Kissinger, 2009 The twentieth century was marked by great political progress, industrial and technological advancements, and a heightened sense of social consciousness. Along with these great leaps forward came nationalistic instability, increased militarism, and periods of economic turmoil. Economic crises were felt at the local, regional, and global level as the nations of the world moved to adjust to an ever-changing environment of monetary standards. The global depression of 1932 caused nations around the world to rethink their economic structure, their relationship to their trading partners, and bring innovative concepts of currency and a greater sense of cooperation through international organizations. The last half of the twentieth century was highlighted by a series of economic crises that saw currencies devalued, credit over extended, and debt defaulted. The countries of Mexico, Brazil, Argentina, and Asia all became saddled with inflation, a low growth rate, and the inability to service their growing amounts of debt. Today, the world sits on the precipice of another growing financial crisis. The liquidity of banks is in question, currencies are in peril of devaluation, productivity is falling in some of the most highly industrialized nations, and public and private credit has reached record levels. Is the current crisis, and past crises, simply a matter of economic policies being out of step with our political goals as Kissinger contends? Or are there underlying economic issues that have been at the foundation of these crises that could have been avoided by altering the economic and monetary policy? The purpose of this paper is to trace the similarities and the differences of the causes of these crises, as well as the national and international response to them. It will uncover the commonalities that characterize a financial collapse, the degree of political influence, and the most effective, or ineffective, response to a financial crisis. Many historians place the beginning of the Great Depression in 1929 and the stock market crash. The first half of 1929 had seen stock prices on Wall Street driven up by speculators and creating an asset bubble. After the crash, the Economist reported on November 2, 1929 that, "There is warrant for hoping that the deflation of the exaggerated balloon of American stock values will be for the good of the world" (qtd. in Bierman 2). This mirrors the effect that speculators have recently had on the real estate and oil markets, both of which have contributed to the current economic crisis. Speculation creates a false demand, a demand without a market for the product. At the point that speculation is no longer deemed attractive, the money is withdrawn and there is a sudden and rapid collapse of the market. Just before the crash of 1929, there was almost $4 billion in borrowed money in the stock market, and many investors were highly margined. Much of this money was from foreign sources in London, Paris, and Berlin. As the government tightened the regulation on public utility stocks, holding companies, investment trusts, and margin buying, the foreign capital was the first to flee the market and drive prices downward (Bierman 139). This set off waves of panic selling and fuelled the continuing crash. The Great Depression of 1932, similar to the current situation, was initiated by the over extension of credit that created a speculative bubble of over priced assets. However, the lingering debt from World War I, and the increasing economic interdependence of the global community, made the Great Depression an international crisis. The Great Depression of 1932 may have originated in the United States, and may have been felt most heavily there, but it was global in scope due to the policies that were set in motion in the aftermath of World War I. Leading theories as to the cause of the Great Depression are the twin nemeses of debt and deflation. Debt was incurred by investors capitalizing on investments that returned a rate higher than the rate of borrowing, the left over war debt, foreign reconstruction loans, and "the low interest policy adopted to help England get back on the gold standard in 1925" (Fisher 348). The debt from World War I was a significant burden for the US and the European countries, and reconstruction and reparations added to their economic problems. John Maynard Keynes remarked to the leaders at the Paris Peace Conference in 1919 and noted that "Reparation was their main excursion into the economic field, and they settled it as a problem of theology, of politics, of electoral chicane, from every point of view except that of the economic future of the States whose destiny they were handling" (Felix 59). These policies based on the politics of the wars aftermath would eventually cause the disintegration of the European economic system. The stock market crash of 1929 initiated a series of monetary policies, such as trade and protectionist tariffs, "which dragged along with it the vulnerable European and world economies—thus the Great Depression" (Felix 61). Trade policies slowed exports and growth, while countries devalued their currency as a means of managing their debt. The major cause of the global Great Depression of 1932 was the massive debt brought on by policies based in ideology rather than sound economic principles. In many ways, the same political roots found in the Great Depression can also be found in the current crisis. Free market ideology has led to a lack of regulation in the banking industry and promoted the risky investments that were responsible for the industrys poor capital position. Speculation, an activity that holds an almost sacred position in capitalism, played an important role in both scenarios. In regards to the current crisis, Crouhy states that "Huge demand from investors for higher yielding assets, such as super senior tranches of subprime CDOs, led to a lowering of lending standards, low-documentation, and even no-documentation loans" (11). Many of the risky investments were made in the housing industry, creating an asset bubble with wildly overpriced real estate driven up by speculation. When the money began to be taken out of the real estate market, the rush to exit caused a collapse in prices and left the banking industry holding worthless assets. The aftermath of the Great Depression would initiate a series of international monetary agreements and currency arrangements that would set the stage for the possibility of future economic chaos. Abandonment of the gold standard, fixed and floating exchange rates, and the acceptability of large public debt give nations innovative methods to manage their growth and maintain their economic standard. However, when used as a political convenience they can result in economic chaos. The exchange rate has at times been used to control inflation, stimulate trade balances, and manage debt. In 1989, Argentina enacted a series of monetary reforms including "tax reform, privatization, trade liberalization, deregulation, and adoption of a currency board" in an effort to control the hyperinflation, rising debt, and economic instability of the 1980s (Hornbeck CRS-1). Most notably, they pegged the Argentine peso to the US dollar, which limited the printing of pesos, controlled inflation, and stimulated foreign investment. However, during the first half of the 1990s, the peso appreciated along with the rising US dollar. Eventually, the peso needed to be devalued, which caused a capital outflow and a decline in Argentinas GDP growth rate (Hornbeck CRS-2). This happened in concert with similar problems in Mexico, Asia, and more importantly its largest trading partner Brazil. Once again we see the negative impact of devaluation and debt on the economic crisis. According to Tonelson, because Argentina was "Unable to earn their way in the world through exporting, they decided to finance healthy private consumption levels and expensive social services by borrowing instead". By the end of 2001, Argentinas currency instability and mounting debt resulted in a federal default that caused a run on banks, national strikes, and rioting. There are some striking similarities between the Argentine crisis and the Mexican crisis of 1994-1995. While many factors contributed to the Mexican crisis, "those with the greatest significance were the combination of the exchange-rate regime with a rapid expansion of credit" (Gil-Diaz 310). According to Finch, "The Mexican government used the exchange rate system as an anchor for economic policy, i.e., as a means to reduce inflation, encourage a disciplined fiscal policy, and thus provide a more predictable climate for foreign investors" (5). This was effectively using the exchange rate to generate political expediency, without a prudent economic plan. A fixed exchange, or semi-pegged, exchange rate may stabilize prices and control inflation, but it runs the risk of becoming a target for currency speculators leading to economic instability (Gil-Diaz 308). In addition, there are similarities in the forces that allowed the crisis to foment in Mexico that were present in the US prior to the current banking crisis. In Mexico there was a rapid rise in easy credit based on future expectations and "poor borrower screening, credit-volume excesses, and the slowdown of economic growth in 1993 turned the debt of many into an excessive burden. Nonperforming loans started to increase rapidly" (Gil-Diaz 304). This mirrors the credit excesses distributed through the sub-prime loan program in the US in the early 2000s. Eventually, "a classic overindulgence in credit, a frenzy of spending, a substantial short-term debt, and the sitting-duck features of a fixed exchange rate combined to set the stage for the 1995 [Mexico] economic crisis" (Gil-Diaz 308). These same signs have routinely been at the foundation of a significant number of economic collapses around the globe in the last three decades. The Brazilian economic crisis of the 1980s occurred in tandem with a crisis in Mexico during the same period and had many of the same underlying reasons. In fact, many countries of Latin America became economically unstable as the emerging world fell into political chaos. The developing countries of Latin and South America had moved from generations of dictatorial military rule towards more democratic forms of government. However, political stability could only be sustained by maintaining economic stability. As an example, authoritarian rule in Brazil came to an end and democratic rule became a reality because of the economic chaos of the early 1980s (Pereira). The industrialized societies largely embraced capitalism and had embarked on economic policies that were viewed as populist and politically popular. Emerging economies were eager to exploit the use of exchange rates, public expenditures, low interest rates, expanding credit, and tariffs that encourage consumption and growth (Pereira). Tax cuts and deficit spending, while promoting growth and controlling inflation, increase the mounting debt and will eventually lead to devaluation of the currency. Pereira reports on Brazil in the early 1980s in regards to the unsustainability of these economic policies: However, this stage proves to be a short-lived paradise as these practices generate distortions in the economy. Disequilibrium appears in the balance of payments as imports increase but exports, which have become unprofitable, decline. The budget deficit, in its turn, soon changes into a fiscal crisis, while devaluation of the currency, in real terms, begins to push up domestic prices and set in motion an (often dramatic) inflationary spiral. This stage of the cycle often leads to a severe crisis, sometimes accompanied by, at the least, a change of ministers if not a coup detat, and inevitably ends with a radical change in economic policy. This phenomena is not restricted to newly emerging free markets, but also can impact well established economies. The low interest rates, tax cuts, and deficit spending all preceded the current economic crisis in the US. In Mexico, the public debt soared as incumbent candidates pandered to the Mexican voter. According to Schlefer, "Public spending soared in pre-election years (27 percent in 1975, 22 percent in 1981), when grupos1 vied to build support for their leaders presidential nomination". The Asian crisis of the 1990s was also characterized by expanding private debt and a jump in short term foreign debt (Mah-Hui 6). Once again, political opportunism created a large private and public debt that eventually results in devaluation, inflation, and economic crisis. The Asian economic crisis of the 1990s was also characterized by the same liberal attitudes toward banking and credit that has led to the current US crisis. The Asian crisis was precipitated by speculative investments in property and stocks creating an asset bubble, a loose credit discipline, and an over leveraged corporate sector (Mah-Hui 5). The International Monetary Fund (IMF) reported that the Asian crisis began when, "a weak financial sector saddled with large nonperforming loans; a heavily indebted corporate sector that overinvested in some sectors, such as real estate; and doubtful corporate governance practices undermined investor confidence and exacerbated the crisis " (Burton, Tseng, and Kang). As time went on, investments became riskier to cover the previous poor investment strategies. This is seen time and again as governments artificially fuel the economy for political purposes without sound economic policies to deal with the consequences. Slashing government spending in the 1980s came too late for Mexico to avert an economic disaster (Schlefer 3). In most cases, once a country has gone down the road of unrealistic asset values, ballooning debt, and an unsustainable exchange rate, recovery will only come through inflation, unemployment and economic hardships. Local, regional, governmental, and international responses to a collapsing economy have varied and have had, as expected, mixed results. When Mexico was unable to meet its debt obligation in 1980, the US led an international aid program that included debt payment moratoriums, loans, pre-payment for Mexican oil, and an agreed upon austerity program (Finch 4). The result was a protracted economic recession. Mexico embraced the concept of freer markets, in the belief that it would facilitate a quick recovery. However, between 1983 and 1988 the economy only grew by an anemic .2 percent and resulted in even greater human suffering (The Debt Crisis R.I.P.). Argentina also took on a multi-faceted economic plan that coupled limited IMF assistance with budget constraints. However, the assistance offered Argentina was not as liberal as was given to other developing countries facing similar crises. The economic crises that impacted Mexico, Thailand, Korea, and Indonesia in the 1990s were largely rescued by aid packages from the IMF and the US, but by 2000 the IMF, under new leadership, had made a decision to limit the amount of direct bailout money available (Marichal 1). Though the IMF did commit more than $40 billion in assistance to Argentina, the growth rate continued in decline and there was an increase in social and political unrest. While other Latin American countries were able to weather their economic downturns, Argentina continued to deteriorate. Economic policies were formed on the political battlefield and "at the root of Argentina’s economic problems lies an irresolvable conflict between the nation’s federal and provincial political powers" (Gallo, Stegmann, and Stegall 195). Economic stability and political stability go hand in hand. The Asian countries of Thailand and Korea formed an economic recovery strategy that involved increased spending and more liberal private credit as a means to spend their way out of the recession. This is in line with the policies enacted during the New Deal, as increased government spending became a means to stimulate the economy. Thailand policy makers enacted a program to make credit card debt more available and contend that this policy shortened the recovery period. Korea took similar steps by offering consumer incentives for the use of credit cards and lifting some long held restrictions on the institutions that issued the cards (Kim and Bhangananda 2). "Korea and Thailand share a broad pattern in that both are recovered economies driven in large part by domestic spending", as 2002 saw credit card use more than double (Kim and Bhangananda 3). The expanded credit was made possible in both countries when the government established Asset Management Companies to purchase the non-performing loans (NPLs) left in the wake of the Asian crisis (Valderrama 2). While this has spurred a rapid economic recovery, it has come at the cost of increased government intervention, an increased personal debt burden, and a significant increase in debtor delinquencies and defaults (Kim and Bhangananda 3). The free market ideologies that propel a country into economic instability are generally discarded in favor of government intervention when the crisis occurs. Thailand and Korea favored some government intervention and engineered a successful recovery program. All of the economic crises discussed have come as the result of capitalism that has been responsible for the low or non-existent regulation that is necessary to protect the public against the excesses of free market policies. Mah-Hui lists several factors that are common to almost all economic collapses. These include deregulation, loose private and public credit discipline, property and equity asset bubbles, nonperforming loans, and lax bank management that result in an erosion of the financial systems capital (3). The crises in the US in 1932, Argentina, Brazil, Mexico, Asia, and the current financial crisis all had aspects of these weaknesses. The result is an unsustainable debt that is eventually serviced through devaluation of the currency and inflation. Allowing the economy to flourish through these short-term panaceas is a politically popular policy, but an unsound economic strategy. In conclusion, since the 1970s liberal democratic economic policies have been used by partisans and governments to stimulate the economy as a means to gain political support. Enacting these short term, and artificial, methods of growth have often resulted in unmanageable debt and exchange rates that eventually induce inflation. For the US in 1932, Argentina, Mexico, Brazil, and Asia the result was a collapse of the economy and a currency devalued. Fixed exchange rates can help manage inflation in the near term, but eventually the currency needs to seek its true value. Government and international intervention may be necessary, though unpopular, in the face of free market politics. If the country is additionally saddled with a huge debt and a low GDP growth rate, the results can be disastrous. Many of the emerging markets have embraced capitalism, but have implemented it as a whatever the market will tolerate policy. Capitalism and free market economics requires a huge amount of personal discipline and public responsibility. Without those principles, countries around the world will be faced with the economic crisis that looms over the globe today. Economics and politics go hand in hand and one cannot sustain stability alone. As Kissinger reminds us, the political system and the economic system are integrated parts of a greater system. Responsible economics begins with responsible government. The civilized world does not accept anarchy as a legitimate form of freedom in society, and they should not accept anarchy in the marketplace as a legitimate economic system. Doing so will perpetuate the economic crises in country after country and prolong the period of recovery. Works Cited Bierman, Harold. Causes of the 1929 Stock Market Crash: A Speculative Orgy or a New Era?. Westport, CT: Greenwood Publishing Group, 1998. Burton, David, Wanda Tseng, and Kenneth Kang. " Asias Winds of Change." 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Kim, Jasper, and Kemavit Bhangananda. "Money for Nothing, Your Crisis for Free: A Comparative Analysis of Consumer Credit Policies in Post-1997 South Korea and Thailand." Pacific Rim Law and Policy Journal 17.1: 1-40. Academic Search Premier. 21 Jan. 2009. Kissinger, Henry. "Kissinger Quotes." New Atlanticist. 16 Jan. 2009. Atlantic Council. 20 Jan. 2009 . Mah-Hui, Michael L. "Financial Crisis -Asian-Pacific Policies & Response." Proc. of High-Level Policy Dialogue jointly organized by ESCAP and Government of Indonesia, Bali, Indonesia. 9 Dec. 2008. Marichal, Carlos. "Argentinas Collapse." Report on the Americas 35.4: 1+. Academic Search Premier. 21 Jan. 200 Pereira, Luiz Carlos Bre. "Populism and Economic Policy in Brazil." Journal of Interamerican Studies & World Affairs 33.2. Academic Search Premier. 21 Jan. 2009. Schlefer, Jonathan K. "Fractured Elites: The Politics of Economic Crisis in Mexico." Thesis. Massachusetts Institute of Technology. Dept. of Political Science, 2003. "The Debt Crisis R.I.P." The Economist 324.7776. Academic Search Premier. 21 Jan. 2009. Tonelson, Alan. "The Real Roots of the Argentine Financial Crisis." American Economic Alert. 6 Jan. 2002. United States Business & Industry Council. 20 Jan. 2009 . Valderrama, Diego. "After the Asian Financial Crisis: Can Rapid Credit Expansion Sustain Growth?" FRBSF Economic Letter 2004.38: 1-3. Academic Search Premier. 21 Jan. 2009. Read More