How, If at All, is the Global Financial Crisis of 2007-09 Distinctive - Essay Example

 Contents Introduction 3 Discussion 4 Causes of financial crisis 5 Role of Financers 5 Risk transferred from Houses to money markets 7 Fault of Regulators 8 Effects of Financial Crisis 13 Housing problem 14 Slow Job rebound 16 Low Spending by States 18 Fewer State Workers 18 Conclusion 20 References 22 Introduction The global financial crisis of 2007-08 was one of the most severe crises since the Great Depression of 1930s. During the financial crisis some of the world’s best known financial institutions collapsed or in some cases they were nationalized and there were many others which were able to survive it. The financial crisis affected major financial centres across the world more than any other financial meltdown in the post war period. This financial crisis generated severe collapse of international trade more than any other since the 1930s and it resulted in broader economic downturn which involved all regions of the globe. Many economists questioned the how everyone missed the factors which caused such a large financial crisis. This sentiment generated a wide spread debate among many economists on the specific lessons which can be learned from the crisis. This paper will focus on the main causes of the global financial crisis. There is a vast disagreement on the main causes of global financial resources. The crisis was mainly notable for its impact on the banking sector. Such kind of bank run, like that seen in case of Northern Rock in September 2007, was never seen in UK ever since 1886 Overend Gurney Bank. According to some scholars like Eduardo Pol, 2008 financial crisis can be termed as banking crisis instead of financial crisis. The reason behind that is this crisis resulted in inflamed financial shock which hit the banking sector directly. The period resulted in failure of large banks like Lehman brothers, Northern Rock, Bear Streams and others across UK, US and Europe. The failure resulted in some of the banks by acquired by other large banks which promoted government intervention for rescuing the whole financial system. The financial crisis started when there were sky high home prices in the United States in 2007 and it finally resulted in the worldwide stock market going down, entire US financial sector getting affected and many other things. Questions were raised on the solvency of banks which shook the investor’s confidence and resulted in government bailout of affected institutions which failed. Though the government intervention prevented collapse of the banking system little was done to restore the economic growth and thus US and rest of the world entered into a period of deep recession in 2007. The slow recovery of the global economy resulted in high unemployment. The recovery placed huge pressure on the government’s exchequer around the world as low growth has reduced tax revenues while the claims on government’s resources increased for measures like unemployment insurance. This paper takes a look at the cause of financial crisis along with the effects of it on the global economy and why it is regarded as unique as compared to other financial crisis. Discussion The collapse of Lehman Brothers in September 2008 resulted in the collapse of entire financial system. The government had to bail out to shore up the industry. But still the credit crunch which followed it was nasty and it resulted in worst recession in the history of America in 80 years. Massive fiscal and monetary stimulus prevented the depression but still the recovery remains feeble which is unique as compared to previous post-war financial crisis. In many reach countries like in Europe the GDP still is below the pre-crisis peak and in those regions, the financial crisis transformed into the euro crisis. The effects of the financial crash still have a nasty effect in the world economy. This can be seen in the financial markets as Federal Reserve of America prepares to reduce the effort of increasing the GDP rate through buying bonds by a process called quantitative easing. Causes of financial crisis Half a decade has passed and it is clear that the crisis had multiple causes. The most obvious cause is the financiers themselves, like the Anglo-Saxon sort financers who are irrationally exuberant and claims to have found a way to eliminate risk though in reality they have simply lost track of it. The blame also rest on central bankers and other regulators since they tolerated this whole folly. Focus needs to be put on macroeconomic backdrop also. After the Great Moderation, characterized by years of stable growth and low inflation, everyone became complacent and started taking risk. The saving glut in Asia pushed the global interest rates down. Many researchers have also implicated European banks since they bought greedily in American money markets before the crisis and used the money to buy dodgy securities. All the above factors came together to increase the debt in what seemed to have become a less risky world (Gamble, 2009, pp. 13-35). Role of Financers There was a flood of irresponsible mortgage lending in America in the years before the crisis. During this period loans were given to subprime borrowers who had poor credit histories and struggled to repay them. Thus these were quite risky in nature and these risky mortgages was passed on to financial engineers of big banks who in turn changed them into supposedly low-risk securities by putting huge numbers of them together in pools. The techniques of pooling works when the risk associated with each loan are uncorrelated. The big banks stated that there would be rise and fall of property markets in different American cities independently of one another. But this concept or assumption was later found out to be flawed. American suffered a nationwide slump in house price from 2006 (Mason, 2009, pp. 1-55). The financers used pooled mortgages for backing the securities and this system is termed as CDOs or collateralised debt obligations which were classified into different tranches in terms of extent of exposure or revelation to its default. Investors naturally bought the safer tranches since these were AAA credit rated by agencies by Standard & Poor’s and Moody’s. But this was another mistake. In the real sense the agencies paid them and so beholden to, the banks which created the collateralised debt obligation (CDOs). The banks were later found out to be far too generous in assessing these securities (Gamble, 2009, pp. 49-64). Investors wanted these securitised products since they appeared to be relatively safer than other securities in the market and it provided higher returns in a world of low interest rates. Debates still exist over the whether these low rates were the result of mistakes of central bankers or it was due to broader shifts in the world economy. Many accused the Fed of keeping the short term interest rates too low and pulling down the longer term mortgage rates along with them. But the defender of Feds shifted the blame to the savings glut. According to them the excess of saving over investment in developing countries like China, India was the reason behind this. That excess capital went into safe American-government bonds which eventually pulled down the interest rates (Reinhart and Rogoff, 2009, pp. 199-222). These low interest rates provide incentive for the banks, investors and hedge funds who headed towards riskier assets which promised higher returns. The low interest rate made it profitable for the above market player for borrowing and using the extra cash in order to increase their investments based on the assumption that the returns generated from them will exceed the cost of borrowing the funds. The temptation of leveraging this way was created due to low volatility which existed during Great Moderation. The investors will naturally be wary before leveraging their bets in case the short term interest rates are unstable and low. But the same investors will risk borrowing from the money markets for buying high yielding and longer dated securities if the interest rates appear stable. This is exactly what happened (Reinhart and Rogoff, 2009, pp. 240-274). Risk transferred from Houses to money markets With the American housing bubble coming into the picture there was a chain of reactions in the financial system in America which exposed the fragilities in the system. The investors could not be protected even by the pooling technique and other smart financial securities. The value of mortgage backed securities spiralled down and it became worthless securities at the end. Previously the Collateralised Debt Obligation (CDOs) was considered to be safe, but despite the good ratings from the rating agencies it turned out to be worthless. The financial market brokers found it extremely difficult to sell these assets at low price or instead use them as collateral for taking short term bank financing. Due to mark to market accounting rules the fire sale prices made an instant dent on the capital of the banks. Thus the banks had to revalue their assets based on the current market price and this resulted in acknowledgement of losses on paper which may not actually had incurred (Galbraith, 1955, p. 121). In 2007 all the glue of the financial systems began to dissolve. After bankruptcy of Lehman brothers, many banks questioned the genuineness of their counterparties. This made the lenders stop giving short term credit in the market which resulted in credit crunch in the market. During pre crisis period a complex chain of debt was created in the financial markets between the counterparties and it became vulnerable to just one link breakup. Many financial instruments like credit default swap, where the buyer was supposed to be compensated by the seller in case a third party defaults on the loan, turned out to concentrate the risks instead of spreading it. This resulted in a collapse of American insurance giant, AIG days after bankruptcy of Lehman brothers happened due to massive credit risk protection which it had sold. Thus it was found that the whole financial system was built on shaky foundations. During pre crisis period banks were allowed to inflate their balance sheet figures, but they made too little provisions for absorbing the losses. There were even instances of banks betting with the borrowed money which proved to be a catastrophic error (Helleiner, 2011, pp. 67-87). Figure 1: Risk on Bank assets as % of GDP (Source: The Economist, 2013, p. 1) Fault of Regulators The prime cause of the financial crisis was failure in finance. But it is wrong to put the entire blame on bankers. The responsibility was on Central bankers and other regulators too who mishandled the crisis. They couldn’t keep a check on economic imbalances and eventually failed to be a proper oversight of financial institutions. The most dramatic error of the regulators was letting Lehman Brothers go bankrupt. This had a multiplicative effect in the financial markets. Suddenly in the financial markets nobody trusted anybody and hence no one was willing to lend money (Mullard, 2011, pp. 204-221). Even the non-financial companies, who were considered as another source of money in the market, could not rely on borrowing form market to pay their workers or suppliers. Thus they stopped spending in order to pile up cash thus causing cash crunch in the economy. The decision of the Feds to allow bankruptcy of Lehman brothers resulted in more government interventions. To keep a check on consequent panic situations, the regulators had to rescue many other companies form going bankrupt (Hobsbawm, 1994, pp. 85-108). The long before the bankruptcy of Lehman brothers, the regulators made anther mistake. They tolerated and helped to inflate the current account imbalances around the world and the housing bubbles. Central bankers around the world had voiced their concerns about the big deficit of America and the huge capital inflow from the excess savings of Asia economies. The excess savings was highlighted by Ben Bernanke in 2005, a year before he became the chairman of Fed. But the increase focus on net capital flows from Asia left a grey area for them to look at. They didn’t notice the bigger gross capital flows from the European banks. The European banks bought many doubtful American securities and financed their purchase by borrowing from money market funds of America (Hobsbawm, 1994, pp. 403-432). Figure 2: UK Money Supply (Source: Yueh, 2014, p. 1) Thus though the European claimed that they were victims of Anglo-Saxon excess funds, it was their banks which was one player in the crisis. Following the creation of euro, the financial sector of within the euro area and in nearby banking hubs like Switzerland and London expanded extraordinarily. Many researches were conducted on the role of European Union in causing the crisis. According to Hyun Song Shin, economist at Princeton University, the excess money which resulted in loose credit conditions of America before the crisis was in global banking instead of world savings (Mizen, 2008, pp. 531-567). Further there were internal imbalances in Europe which was later found out to be just as significant as those in America. Studies shows that during the first decade of the euro there was huge current account deficits in southern European economies while in northern European economies had to manage offsetting surpluses (Jablecki and Mateusz, 2009, pp. 301-328). The imbalances in the European Union were balanced by flow of credit from the core of euro zone to the countries like Ireland and Spain where there were overheated housing markets. Thus it is fit to say that euro zone crisis was a continuation of the financial crisis of 2008 since the markets was fragile over the weaknesses of European banks due to its high bad debts following property busts (Carmen and Rogoff, 2011, pp. 1676-1706). Figure 3: UK Banks Sectoral Lending (Source: Yueh, 2014, p. 1) More was needed to be done by the Central banks to address all this. For example the Fed didn’t make any significant attempt to stop the housing bubble. The European Central Bank did little for restraining the huge credit and kept believing that the issue of current account imbalances didn’t matter much in a monetary union. In 1997, The Bank of England lost control over the banking supervision and was made an independent entity. But it took its view of responsibility too narrowly and it didn’t concentrate fully on maintaining the fiscal stability (Carmen, Reinhart and Rogoff, 2012, pp. 121-132). Central bankers insist that it is difficult to keep a check on housing and credit boom by maintaining higher interest rates. This may be true, but they had other regulatory tools at their disposals like demanding more provisioning requirement for the banks, or lowering the maximum loan-to-value ratios for mortgages. The capital ratios maintained by the banks during the period was way below the industry average. Since 1988 a committee of supervisors and central bankers meet in Basel to negotiate international rules on minimum amount of capital which the banks must hold as percentage of their assets. But the above rules were not strict enough and thus the banks smuggle capitals in form of debt which didn’t have the same loss-absorbing capacity as equity. The banks were under constant pressure from shareholders for increasing their returns and thus they operated under minimal equity. Minimal equity means high debt proportion in the capital and this made them vulnerable in case anything went wrong. From mid- 1990s the banks were allowed to use more and more internal models of risk assessment which in effect resulted in setting their own capital requirements (Temin, 2010, pp. 153-161). The Banks made their assets look safer and thus they inflated their balance sheet without proportionate rise in capital. During that time the Basel committee did not made any rules mentioning the share of banks’ assets which needs to be liquid. Thus it failed to establish a mechanism which allowed a big international bank from going bust without making the rest of the financial system to halt (Gros and Alcidi, 2010, p. 153). Figure 4: Weighted average of 17 Global Banks (Source: The Economist, 2013, p. 1) Effects of Financial Crisis Since the Great Depression the effects of financial economic crisis 2008 have forced changes on many state governments around the world along with the US economy to linger on for many decades. According to Federal Reserve estimates, during the financial recession, US lost an amount equivalent to an economic activity of an entire year i.e. nearly $ 14 trillion. Such persistent and deep losses to the state governments forced many of the states to cut spending in regular government activities like public infrastructure developments. For corporations, the recession forced them to make many changes in their strategies like expansion plans and workers compensation. For regular citizen this meant that they had to postpone their dream like buying houses and start family. It has been almost 5 years since the financial crisis but the country is still struggling for recovery (Wade, 2009, pp. 5-24). This crisis is unique since in the aftermath of previous economies, strong recoveries were seen. But similar incident could not be observed this time around and the pace of recovery is more like getting out of Great Depression. Figure 5: GDP from trough of the last three recessions (Source: Bivens, Fieldhouse and Shierholz, 2013, p. 1) Housing problem For many years, housing served as an investment opportunity and also was considered to be the backbone of economic growth which was considered by many generations of Americans as a gateway to be a middle class individual in the society. But the occurrence of housing bubble devastated the real estate market and left many facing foreclosure and millions other underwater. In a sense the housing bubble crisis left many Americans loose years’ of accumulated wealth. The factors which drove the recovery were different than the factors that drove growth during 1990s and 2000s. During the crisis it was found that more than half of the house purchases have been made in cash which signalled that hedge funds and investors were taking advantage of cheap properties. This meant that the average buyers could not purchased the properties and thus those property sales resulted in little economic growth. The effect was seen in the decline in homeownership rates in US and it still continues to decline. According to Census Bureau data, in the second quarter of 2013, the homeownership rate of US was 65.1 % which is lowest since 1995. He homeownership rates topped 69% in mid 2000s which was the highest till date after the financial recession. Figure 6: Homeownership Rate: United States (Source: Hale, 2014, p. 1) It is a challenge for the government to reverse this change since the credit in the market has tightened and the rules of lending have been toughened to avoid the same mistakes which led to housing bubble in the first place. First there was increase in credit and now credit has contracted. Some argue that this tight credit control along with new efforts to regulate financial markets will be the key to improving the housing conditions. But others fear that even easy credit will not help in a full housing recovery without any economic growth for backing it up. It will need growth in part-time employment and low-wage to put the economy back on track. The recent turmoil in the housing markets has changed the makeup of households nationwide. In some states there have been massive decline in homeownership rates, like a decline of 23 % in homeownership in state of Arizona. Figure 7: Home Ownership Rate for Arizona - United States (Source: Trading Economics, 2014, p. 1) Slow Job rebound The financial crisis downturn had most horrible effect on the job market in US. According to a study by Economic Policy Institute, there has been a growth, after inflation is adjusted, of only 1.5 % in the wages of all workers between 2000 and 2007. But following the crisis years, these modest gains have been wiped out and the maximum decline in wages happened for the bottom 70% of the workers. Figure 8: Financial Crisis Employment Loss (Source: Klein, 2012, p. 1) But there are some areas like manufacturing which have seen an increase in jobs from recessionary lows and similar rise has been seen in energy sector as well. But still there are many loopholes like autoworker unions have accepted that new hires will work for lower wages and fewer benefits than those who have held their jobs longer (Ravallion and Chen, 2009, p. 1). Low Spending by States According to National Association of State Budgets Officers the financial crisis have forced many state governments to cut their spending which is a reverse trend of growth of 1.6 % each year. In 2009 the states have cut their spending by 3.8 % and in 2010 by 5.7 %. This is the first time such consecutive declined in spending by organizations happened since the tracking on spending began in 1979. Many states were forced to cut in critical areas like public assistant programs, education and transportation. One of the significant portions of state budgets is education. According to Center on Budget and Policy Priorities in 2012-2013 as many as 35 states had K-12 finding which was found to be below the pre-recession levels after being adjusted for inflation. Some states stumbled from spending cuts by almost 22 % as compared to 2008. Funds for higher education were also slashed. From 2008 to 2013, on a nationwide basis the states cut spending in higher education by more than 28 % per college student. As many as 36 states during the period cuts their spending by more than 20 % and Arizona topped with 50 % reduction in spending. The students faced different consequences due to these spending cuts. The tuition of the colleges skyrocketed and there were cuts in programs like after-school programs, summer programs along with bigger class sizes. Fewer State Workers The reduction in public spending resulted in significant decline of public workforces. The layoffs of state and local cuts were far more than the worst layoffs in private sector. Since August 2008, there has been a layoff of around 681,000 jobs by both state and local governments which is by far the biggest drop in any recession according to Nelson A. Rockeffer Institute of Government. According to Bureau of Labour Statistics In 2012, the wages of local and state government grew by merely 1.1 % as compared to 1.7 % growth in the private sector. There figure below indicates the inflation adjusted media income of regular working households from 2000 to 2011. During the period the income of a regular working households decreased by 9.3 %. But the figure also reveals that United States was already experiencing decline in media wage for more than a decade. From 2001 to 2007 the business cycle expansion was weakest for job growth and this was the first such business cycle where the median household income declined. Figure 9: Real media income of working age households (Source: Bivens, Fieldhouse and Shierholz, 2013, p. 1) But unfortunately this trend of declining of income is expected to continue in the future. According to Economic Policy Institute for at least two decades starting from the year 2000 there will not be much increase in family incomes. It predicts that the average income of the middle income families in 2018 will be around 10.9 percent which is below the 2000 level. According to the projections of unemployment rate by Moody’s Analytics, the average income of the families in 2018 is expected to be 6.5 percent lesser than that of in 2000. Therefore, this situation would be an absolute economic disaster. Figure 10: Change in predicted average real family income, 2000-2018 (Source: Bivens, Fieldhouse and Shierholz, 2013, p. 1) Conclusion The failure of US economy in rapidly making up the ground as it did in other financial crisis is often seen as a vexing puzzle and it has created many theories as to what is holding back the US economy from reaching it potential similar to that of pre-Great Recession level. This indicates that such sharp downturns which persists in-spite of the massive economic support from the central bank indicate that this financial crisis posed a unique danger. In economic terminology it is known as liquidity trap or getting stuck against the zero lower bound of interest rates. It is important for the policymakers to use every macroeconomic policy lever so that they can increase the aggregate demand as fast as they can. Though during the first year of recovery the growth rate of economy was faster than the previous two recoveries, but between the middle of 2010 to 2012 the fiscal policy of Federal Reserve turned contradictory resulting in contraction of 0.5 percentage points. The public austerity measures followed by Federal Reserve didn’t solve the problem and made matters worse. It had a net drag on the economy. The prolonging effect the financial crisis had on the world economy makes the global financial crisis 2007-09 distinctive. References Bivens, J. Fieldhouse, A. and Shierholz, H. 2013. From free-fall to stagnation. Available at: http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/. 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