The Factors Leading to the Global Financial Crisis of 2008-2010 - Case Study Example

The Factors Leading to the Global Financial Crisis of 2008-2010 The Impacts of the Crisis on Bangladesh 1: Introduction The global financial crisis of 2008-2010 was labelled as the worst economic crisis since the Great Depression by economic experts. Additionally, the concomitant impact of the financial crisis was the demise of established businesses in key industry sectors and consumer purchasing power, which in turn added to increased government fiscal burdens in developing countries (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 (United Nations, 2). From an economic perspective, the global financial crisis has perpetuated academic debate regarding causality and the current application of macroeconomic policy. This paper critically evaluates factors leading to the global economic crisis of 2008/2010 and argues 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 underlying collapse of the US housing bubble. Additionally, this paper will further undertake a contextual analysis of Bangladesh and consider the impact of the global economic crisis on Bangladesh and in particular, the readymade garment industry of Bangladesh, which is the country’s biggest export. In evaluating the interrelationship between the economic crisis and the readymade garment industry in Bangladesh, this paper will highlight the readymade garment industry’s increased reliance on foreign direct investment (FDI) and how in order to compete with India and China as a major export partner, Bangladesh needs to address infrastructure and increase delivery in lead times. However, the major problem for Bangladesh has been the lack of FDI, which has been perpetuated by the global economic crisis. 2. CAUSALITY OF THE CURRENT ECONOMIC CRISIS In understanding the challenges of the financial crisis, it is imperative to address the causal triggers. It is submitted that the immediate trigger was the collapse of the US housing market as a result of the subprime market disaster. The central problem was that the international banking industry had been lending through following trends in the housing market, leading to reliance on a weak foundation for lending (Ambachtshee et al, 2008, p.142). This argument is further supported by Seager and Shiller’s (2008) arguments that liquidity of the US economy had maintained low interest prices on the basis of an artificial national housing bubble (p.22). Additionally, another part of this was that in addition to banks lending based on trends in the housing market, the banking industry was largely unregulated, leading to easy credit conditions and predatory lending practices (Seager & Shiller, 2008, p.22). As a result, this fuelled debt and 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, p.1). This has in turn made refinancing impossible, many leading banking institutions have failed and the stock markets collapsed (United Nations 2009, p.1). Additionally, the UN cites the central challenge of the financial crisis as being the lack of lending in developed countries, which in turn has impacted the developing countries (United Nations, 2009 p.2). This is further compounded by the long term implications of debt and rising unemployment levels. As a result, whilst the US housing market crash triggered the ripple of economic downturn; the economic crisis has lead some commentators to posit that the application of traditional macroeconomic principles significantly contributed to the current economic crisis (Akerlof & Shiller, 2009, p.167). 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 (Akerlof & Shiller, 2009, p.167). A central element of the 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.p 1). However, in re-evaluating classic macroeconomic theory, Akerlof and Shiller (2009) 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” (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 38). To this end, Akerlof and Shiller comment that the conventional application of macroeconomic theory completely ignored the fact that the economy is impacted by socio-political factors and as a result it was these very “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 comments that macroeconomics has shaped economic policy in the past twenty years. 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 (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 (Blundell-Wignall, 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). However, Ormerod argues that there is a false assumption of rationality in this formula, which is supported by the GDP growth estimates for 2009 in Figure 1 below. Moreover, Figure 2 addresses the liquidity projections of the banking sector. Figure 1 Source: www.paulormerod.com/pdf/accsjuly09.pdf accessed November 2010 Figure 2: Source: www.paulormerod.com/pdf/accsjuly09.pdf It is argued that the lack of liquidity as indicated by Figure 2 is arguably central to financial crisis (Ormerod, 2009). For example, UK bank Northern Rock required a bailout because it was unable to refinance loans that had been proffered on the basis of the subprime market. As a result, credit markets became frozen due to instability in the solvency of financial institutions. As a result, Ormerod comments that in the week of 15 September 2008, “capitalism nearly ground to a halt” (2009). From a macroeconomic perspective, it was arguably the false assumptions of rational pricing upon which the increasing accumulation of loans and debts had been offered that perpetuated the financial crisis (Ormerod, 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. 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” which in turn fuelled the lending boom (Ormerod, 2009). A prime example of this is securitisation, which is 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. 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. In turn, this was attributable to a macroeconomic model that underestimated the risk (Ormerod, 2009). On this basis, Ormerod’s arguments would add gravitas to the argument that contemporary macroeconomics’ reliance on the relationship between rational agents and rationale expectations (RARE) was a significant causal trigger in the global economic crisis of 2008-2010. Additionally, the macroeconomic argument highlights the growing interconnectivity between financial institutions and socio-economic infrastructure on a global basis, which in turn has served to exemplify the effects of the recession on a worldwide scale. A prime example of this effect is Bangladesh and in particular the knock on effect on the readymade garment industry, which is considered in section 3 below. 3. BANGLADESH, THE GARMENT INDUSTRY AND GLOBAL ECONOMIC CRISIS. As highlighted above, the garment industry in Bangladesh is the main export industry in Bangladesh and accounts for the majority of foreign exchange income. Furthermore, the readymade garment industry is the sole multibillion dollar manufacturing industry in Bangladesh (Haider, 2007). However, despite the relatively relaxed rules for foreign investment particularly in comparison to competitor garment export giant China; the majority of Bangladesh’s garment firms are locally owned. However, as indicated by the report of Abdin (2009), financing for local and businesses has become very difficult as a direct result of the global economic crisis, thereby requiring a government commitment to driving foreign inward investment (Abdin, 2009). The main export partners for Bangladesh are the United States and the EU, however overall garment exports from Bangladesh have been falling since the 1990s due to significant growth and domination by China and India (Abdin, 2009). China and India present significant challenges to Bangladesh because of the increased diversity compared to Bangladesh (Pan, 2009). This is not only due to the increased sophistication of infrastructure, but the markets of China and India are significantly diverse beyond cotton and manmade fibre group related products (Pan, 2009). Additionally, whilst in the early 2000s Bangladesh’s export earnings from the EU increased, it was unable to match the corresponding earnings of India and China (Haider, 2007). Furthermore, China and India have undertaken significant price cutting strategies to the export garment market, which Bangladesh has been unable to match (Haider, 2007). However, the global economic crisis has pressured the local infrastructure to such an extent that it is difficult for the Bangladeshi industry to justify lower costs. Moreover, maintaining a lead time is important to market position and remaining competitive (Deshpande, 2009). In China the lead time is 40-60 days and in India it is 50-70 days and “shortening the lead time is the most urgent priority task for Bangladesh” (Haider, 2007). Accordingly, Haider argues that significant to this is domestic backward linkages and aim of reducing production and distribution time (Haider, 2007). Therefore, in the long term sustainability needs changes to the deep level competitiveness. However, the main problems facing Bangladesh now is that the industry is struggling with injection of finance at local level and needs strategies to secure inward investment to remain competitive in international markets (Ahmad, 2006). Furthermore, Abdin comments that foreign investment is crucial for economic growth in Bangladesh and that from an international perspective the local infrastructure has not made Bangladesh attractive for foreign investors (Abdin, 2009). This in turn perpetuates the vicious cycle as at local level, foreign investment is needed to improve infrastructure to attract foreign investment. Additionally, this problem is perpetuated by the fact that at local level, foreign investment in Bangladesh is not sufficient and continues to fall, a problem which has been exacerbated by the global economic crisis (Abdin, 2009). Additionally, one of the biggest problems is that Bangladesh’s garment industry is the only multibillion pound industry that Bangladesh offers, however it heavily relied on the pre-2005 export-quota system to thrive. During that period, the lack of development towards future growth and modernisation reduced the viability of Bangladesh for foreign investment and in turn enabled China and India to thrive both as export partners to the US and EU, but also in terms of securing inward investment (Pan, 2009). Now Bangladesh is struggling in a post export-quota environment particularly with regard to deep level competitiveness and desperately needs an injection of foreign direct investment (Ahmad, 2006; Abdin, 2010). However, the reliance on this is difficult due to the global economic situation. From Bangladesh’s perspective, the current financial crisis has reiterated the importance of international trade and foreign direct investment (FDI) to the Bengali economy particularly in the current global economic downturn. Indeed, the fact that Bangladesh is currently struggling in its recovery process is further testament to the local industry’s need for FDI and international trade (Akerloff & Shiller, 2009). It is imperative to the sustainability of the economic strengths of Bangladesh to compete in an increasingly competitive economy as a result of globalisation (Akerloff & Shiller, 2009). As highlighted above, a central trigger for the financial crisis was the sub-prime catastrophe. Prior to this, the significant foreign direct investment to Bangladesh was from the US and liquidity of the US economy. Moreover, on the other side of the spectrum, the artificial economic paradigm of the export quota system buffered the Bangladesh garment industry. However, the resulting economic downturn has impacted Bangladesh and at an economic policy level, (Abdin, 2009; United Nations, 2009). However, the central problem in Bangladesh is that reliance on the export quota system has meant neglect in the local infrastructure (International Monetary Fund, 2007). The global economic crisis has made the Bengali government evasive with economic policies, committing to a long term plan and focusing on a political agenda (Abdin, 2009). However, the problem of not facing the issues in manufacturing head on exacerbates the reality that local business owners are struggling to raise finance and inject money into improving infrastructure (Siddiqi, 2004). This impacts lead times and distribution, thereby making India and China more attractive export partners (Pan, 2009). In turn, the reliance on the export quota system has left gaps in the development of the domestic sector, which is vital to secure international funding (Brooks, 2007). Additionally, with regard to the macroeconomic causality argument, if we consider this proposition contextually in relation to the Bangladesh economy and readymade garment industry, it is evident that the globalisation phenomenon has fundamentally altered the traditional business framework (Brooks, 2007; Abdin, 2009). Additionally, Ahmad highlights that the interrelationship between macroeconomic factors, local infrastructure and government initiatives is the key to attracting foreign direct investment (Ahmad 2006). Therefore on the one hand the increasingly competitive global environment underlines the importance of international trade to Bangladesh and the ability of Bangladesh to effectively compete within the global business paradigm with its main export industry. However on the other hand, it is arguable that the increased reliance on needing international trade and FDI to aid economic expansion, along with the lack of long term government initiatives to address deficiencies in infrastructure to aid economic expansion has also been the underlying weakness in the Bangladesh economic model in the previous twenty years as evidenced by the Bangladesh’s current weakened position in the global economic downturn compared to competitive giants India and China (Pan, 2009). This proposition is further supported by Ormerod’s critique of the macroeconomic model discussed above in Section 2. Additionally Bangladesh’s position as an attraction hub for inward investment has been undermined by a lack of sufficient government initiatives beyond tax incentives, which again highlights the flaws of reliance on the macroeconomic assumptions of rationality. Moreover, 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 and in turn, this has perpetuated the long term sustainability of Bangladesh’s garment industry for deeper level competitiveness due to reliance on the US and EU for export foreign currency income (Abdin, 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, which again presses the importance of FDI to boost the struggling retail sector and provide employment opportunities. From the perspective of the Bangladesh garment industry this is reinforced by the fact that 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 (Abdin 2009). 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 (United Nations, 2009). Therefore, FDI and international trade is not only important to the sustainability of Bangladesh for deeper level competitiveness, it is also imperative in relation to Bangladesh’s recovery in getting out of the economic slump that is now lasting far longer than originally predicted (Rahman, 2008). As highlighted above, the shortcomings of the macroeconomic model upon which the system was based became a significant trigger in the current economic downturn and underlines the conundrum facing Bangladesh’s garment industry in the long term. 4. CONCLUSION The above analysis highlights the interrelationship of complex causal factors that led to the global economic crisis of 2008/2010. Whilst there have been signs of growth, the recent bailouts in Europe and difficult employment conditions in both Europe and the US indicate difficult economic conditions for longer than expected. In particular, the reliance of the banking sector on trends in an artificial housing market triggered the collapse, resulting in a domino effect worldwide. The global impact of the economic crisis has been highlighted by the contextual consideration of Bangladesh. It is evident that the readymade garment industry is fundamental to the overall economy of Bangladesh and how the industry was able to thrive as a result of the export-quota system and the US as a central FDI partner. Moreover, the analysis demonstrates that after the expiry of the export quota system, the failure of the macroeconomic model of Bangladesh’s main export partners, along with deficiencies in government policy and local infrastructure, has increased the need for inward foreign investment. However, the lack of cohesion between regulation, macroeconomic factors and local infrastructure has hindered foreign direct investment, enabling India and China to make significant inroads into the garment market. BIBLIOGRAPHY Abdin, J. Md (2009). Bangladesh: A Good Destination for Investment. Social Science Research Network, May 23, 2009 at http://papers.ssrn.com accessed November 2010. Abdin, J. Md (2009). 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