Roots and Causes of the Economic Crisis - Literature review Example

?Client’s 9 May The Great economic depression triggered off in the year 1930 in the US, it was triggered off by the collapse of the US stock market which is now known as Nasdaq. It was the worst period of the US history, people slept on Hoover blankets and had no money to spend. The economy of the US recovered from this setback only to suffer from a similar setback of a lesser magnitude in the year 2008 which is called recession. This paper will comprehensively throw light upon the roots and causes of the current economic crisis. All the major cause will be expansively presented in this paper. The valuable lessons learnt from the crisis will also be thrown light upon in this paper. Bear Stearns, AIG, Lehmann Brothers, Northern Rock, Goldman Sachs are some elite names that suffered the most because of the economic crisis also known as recession. Lehmann brothers filed for bankruptcy while AIG and a few other elites just hung in there with the skin of their teeth. This economic crisis is still having repercussions on countries like Greece and Spain; the whole of Euro Zone is facing a financial turmoil. There are a few other countries that have been not so severely affected by the same. The crisis triggered off because of unchecked debt, banks kept issuing loans to people who invested heavily in buying assets, several things were taken for granted but when proved otherwise there was hardly a place in the world to hide. Overvaluation in real estate is perhaps the biggest cause of the current economic crisis, it is better known as the subprime crisis in the US. The likes of Lehmann Brothers and other financial services went bust because they kept issuing credit to the people who thought the property price would increase and they would be easily able to pay off the debt that they are borrowing. It did not turn out that way and there was a short of equity, this is exactly why the financial institutions went bankrupt. The overvaluation is the biggest factor that caused the current economic crisis. Factors like bad income tax practices have added insult to injury, bad mortgage lending also contributed heavily to this current economic crisis. “The way to address the root cause is to let house prices drop to where an average house is within the means of an average household.  (Or, alternatively, boost the income of the average household to the point that they can afford an average house.  But that's very hard.  Letting houses prices go on falling, although painful for everyone who owns a house or who has lent money to someone who owns a house, is very easy.)” (Root Cause of the Financial Crisis) Role of Monetary Policy Some of the main plausible reasons that caused the recent financial crisis have been identified in the above sections. According to Brunnermeie (2009), cheap mortgage financing to sub-standard borrowers fuelled the boom in the U.S. housing market. Three factors were primarily responsible for the fall of the housing market in the U.S. (which in essence, constituted a very small segment of the financial market in the country) transforming into a global contagion. First, the “originate and distribute” banking model, together with the high rate of securitization, led to declining lending standards and made it impossible to re-price the complex structured products. This significantly eroded the confidence level of banks, thereby disrupting the inter-bank markets and credit flow. Second, banks relied heavily on short-term funding sources, hence raising the risk of funding. Finally, the ever-growing integration of global financial systems and the increasing interest towards structured financial instruments quickly transmitted the crisis to all the major regions of the world. Gourinchas (2010) focused on the role of monetary policy in the recent financial contagion as well as the role played by exogenous influences, particularly the rising external deficits referred to as ‘Global Imbalances’. According to Gourinchas, both explanations are not satisfactory as the sole reason behind the crisis. This opinion has also been corroborated by Caballero (2009), who suggested that the primary reason for the crisis lied in the “imbalance” between worldwide demand for secured liquid instruments of debt in the U.S. and abroad, and the limited asset supply. Per Gourinchas, the imbalance in safe assets impacted the monetary policy effects and the external deficit patterns of the U.S. (Gourinchas, 2010, p.1). The rosy macro-economic picture that prevailed prior to the year 2005 was blemished by the overheated housing markets and the rising external deficits in the U.S.. During the period between January 1997 and January 2006, the S&P Case Shiller Composite-10 Home Price Index rose by 128% in real terms. The household leverage, i.e. the household debt as a proportion of disposable household income, increased substantially with the rise in the prices of real estate. However, there is a general perception by many economists that the developments on this front were mainly benign for three main reasons. The financial innovations, as evident from the increase in securitization, had a positive impact in the form of low borrowing costs and reduced risk borne by the lenders. Due to the limited supply of houses in the short-run, an increase in housing demand raised the housing prices. According to Greenspan (2005b), though concerns about the boom in the housing market were present, there was a perception that the domestic economy could easily bear the slowdown in the household prices in some highly speculative markets without an impact on aggregate conditions. In addition, central banks stated that they were vigilant and could offset any decline in aggregate demand by adopting a suitable interest rate policy. During this period, the U.S. was facing a current account deficit, (which is measured as the surplus of imports over exports), signifying the weakness in domestic savings compared to national investments. The amount of this deficit increased from 0.5% to 1.9% of global output. A persistent deficit implied an increased reliance of the U.S. economy on outside sources for meeting financing needs. By 2005, a rise in global imbalances was perceived as a serious threat to the stability of the global economy. Gourinchas (2010) states that stable monetary environments do not always indicate a “stable macroeconomic outcome”. According to Obstfeld, (2009) though the pre-crisis period was characterized by stability in the rate of inflation, consumer prices and output, it was marked by an uncontrolled leverage (both on the part of households as well as financial intermediaries), which is believed to be one of the main reasons behind the crisis. The excessive leverage conditions had mainly developed due to low real and nominal interest rates, which ultimately fuelled rising asset prices. After the emergence of the credit crisis, it became ostensible that interest rate regulation policy is not enough to achieve stabilization in output and to nullify any demand contraction. The federal rates rapidly reached levels of less than zero, which called for supplementing traditional monetary tools with vigorous fiscal measures and some non-conventional monetary tools (Gourinchas, 2010, p.1). Effectiveness of the Monetary Policy The strictness of credit standards and the failure of a fall in the cost of credit directed towards businesses and households, gave rise to the view that monetary policy was ineffective in the context of the crisis, despite an eased monetary policy throughout the greater part of the decade. These views have been seconded by Paul Krugman (2008) and have also been affirmed by the minutes of a meeting of the Federal Open Market Committee (FOMC). These views are also in line with the earlier Keynesian discussions regarding failure of monetary policy in during the Great Depression. Based on these views, many arguments exist about the efficacy of monetary policy in coping with a credit crisis. The easing of monetary policies in times of crises, can be counterproductive because it can considerably weaken the ability of regulatory authorities in taming inflation. However, the abovementioned views have been challenged by several economists such as Mishkin (2009), who argues that in order to nullify the effects of the crisis, monetary authorities need to adopt a more aggressive easing of monetary policy. Friedman and Schwartz (1963) have argued that in the absence of sufficient liquidity allowed by the Fed (and an eased set of monetary norms), the impact of the recession would have been even more severe. Their opinions are followed by the logic that monetary policy has been effective during the recent financial crisis. In fact, it is said that monetary policy has been more potent during times of crises (compared to normal situations) because not only did it lower interest rates on default-free or government securities, but it also lowered credit spreads. However, it cannot be said that monetary policy can nullify the contractionary impact arising from a financial disruption similar to the one that the economy most recently experienced. The recent financial crisis resulted in such levels of credit spreads widening and credit standards tightening, that even an aggressive easing of monetary policy failed to put a brake to the crisis (Mishkin, 2009). Lessons to be learned In the aftermath of the crisis it has become increasingly clear that it was not the result of any one factor, rather it originated due to the cumulative impact of microeconomic and macroeconomic factors. From a macroeconomic angle, the crisis was triggered by persistent global imbalances, excessive easing of monetary policy, and ignoring asset prices in the formulation of policies. The major microeconomic issues have been stated to be excessive growth of credit, high leverage conditions, deterioration of credit standards, unregulated financial innovations, absence of adequate corporate governance, and unsuitable structure of incentives in the financial industry as well as sloppy supervisory oversight. In various advanced economies the interest rates remained at low levels for a considerable stretch of time, resulting in risk mispricing and thereby contributing to financial contagion. Source: (Mohanty, 2011, pp. 2-4). The recent credit crisis has highlighted that the monetary policy pursued in advanced economies had a spillover effect on emerging markets. For example, consistent low interest rates in advanced markets increased the interest differential and directed the flow of capital to emerging economies for earning higher returns. The excessive inflow of foreign funds pushed up the asset prices and exerted an upward pressure on the foreign exchange rate. In the wake of the integration of global financial markets, the markets in emerging economies are inter-linked with those in advanced countries. This is the reason these markets could not remain insulated from the repercussions of the financial turmoil that originated elsewhere (Mohanty, 2011, pp. 2-4). It is argued by many that the bubble in the housing market was the result of low interest rates. However, Greenspan, Bernanke and others vehemently argue that it is actually the long-term interest rates that stimulated the prices in the housing markets and not the Fed rates (or the overnight rates regulated by central banks), which has now become conventional wisdom for many. In the U.S. the bubble in the housing market was spurred by the sustained low level of 30-year fixed rate mortgage (FRM), which fell from its peak levels in the middle part of the decade. During the period between 2002 and 2005, the 30-year monthly rate on home mortgages impacted the monthly prices of U.S. homes. Greenspan regressed the mortgage rate and the Federal rate on the home prices. The results yielded a highly significant t-statistic for mortgages of -5.20, but the t-statistic for federal rates was found to be insignificant at -.51. The correlation coefficient in the U.S. between the federal funds rate and the 30-year mortgage rates during 1963 through 2002 was considerably high at 0.83. This implies that in those years, the home prices (the dependent variable), when regressed on overnight rates or long-term rates (as independent variables) would have presumably worked equally well. According to Greenspan, towards the beginning of the century, there has been some sort of delink between the 30-year mortgage rates and the federal funds rate. The correlation between the two factors has dropped to insignificant levels of 0.17 for the period between 2002 and 2005. It is indeed during this period that the price bubble has been the most intense. Simply at looking at correlations, one can infer that while the federal funds rates did have an affect on the housing prices from 1963 to 2002, it did not have that same explanatory effect during 2002 and 2005. This is one of the main points behind Greenspan’s argument. However, it is interesting to see why the strong correlation that existed between short-term rates and the mortgages rates for nearly 40 years, suddenly tumbled during the pre-crisis period. The federal funds rate was dropped from 6.5% in the early part of 2001 to 1.75% by the end of 2001. The rate did not remain at this level and was further lowered to 1% by mid 2003, which was maintained for nearly a year. The main aim of the Federal Reserve behind the low federal funds rate was to safeguard against the declining inflation rate in 2003 (that had similarities with the deflation faced by Japan in 1990’s). At the time, the Fed believed that the chance of deflation was negligible, but in the event of its occurrence, it could prove to be a serious danger. Although Greenspan has acknowledged that holding the federal funds rate too low for a long stretch of time fuels inflation of product prices, he also states that decreasing the rates reflected a means of risk balancing. Per Greenspan, holding federal funds rates at low levels cannot be considered a significant factor in the housing price bubble. Milton Friedman has been one of the staunchest critics of the Federal Reserve in his evaluation of their regime during 1987 to 2005. Yet, even Friedman (2006) averred that, “There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.” (Greenspan, 2010). The view that monetary policy was not the driving force behind the recent crisis is shared by Friedman, Greenspan as well as Lars E.O. Svensson, the Deputy Governor of Sveriges Riksbank, among others. As the world economy is slowly recovering from the after-effects of the recessionary phase, there is an ongoing debate about the factors that precipitated the crisis and the measures that need to be adopted by regulatory authorities to avoid such crises in the future. There is an argument from some sections about the need to modify the current framework so as to shift priority from inflation targeting to focusing more at the considerations of financial stability. Many economists have blamed the aggressive monetary policy expansion exercised by the Federal Reserve after 2001 for instigating the financial crisis. These sentiments are echoed not only by economists, but by several politicians as well. In fact, after the crisis, for the first time, bills were introduced to audit the Federal Reserve (H.R. 1207 and H.R. 459). Conclusion It is fair to conclude that the ensuing debate among economists regarding the factors instigating the credit crisis. The suggested causes of the crisis range from factors like low federal funds rates, distorted incentive structure in the financial system, failure of the supervisory and regulatory authorities, information problems, excessive risk-taking, global imbalances, securitization etc. In fact, following the lines of thought popularized by eminent economists such as Greenspan, Taylor and Minsky (which have been discussed in this dissertation), this very outcome was to be expected. If Minsky’s theories are to be addressed, first, they readily say that a financially unsound economy is likely to fall victim to fluctuating interest rates as the case has actually been during the recent financial crisis as well as during the S & L crisis of the 1990s. Although the subprime mortgage crisis has recently popularized Minsky’s financial instability theory, it must be coupled with a thorough scientific model before it can be considered a part of mainstream economics. This dissertation only took some initial steps in formulizing Minsky’s Financial Instability Hypothesis. Much more complex models are required before any sound conclusions can be reached. Looking at the smaller picture, if the causes of this last crisis are to be considered, both Taylor and Greenspan had been correct in the sense that the short-term interest rates indirectly affected housing prices, rather than influencing them directly. However, interest rates that have been computed by the Fed had been a weak representative of the nation’s monetary policy. Instead, had the institution followed the Taylor rule, the recent crisis could perhaps have been prevented. Given the narrow objectives assigned to the Federal Reserve, one cannot find fault with the monetary policy pursued by the U.S. However, it is said that the Fed missed the broader picture. It was not able to identify the threats exposed by low or negative real interest rates and credit booms to financial system stability. It assumed financial market risk to be innocuous, thereby ignoring the need to manage financial risks and contain the effects of the credit and housing bubble by using tools other than interest rates. There was a global imbalance in the demand for safe and liquid assets that contributed to the falling real interest rates, fuelling the housing and credit bubble. Enticed by high profits, financial markets designed instruments with underlying sub-standard assets which was extremely susceptible in times of systemic distress. The regulatory failures and the global imbalances led to a collapse of financial systems of several advanced economies. The recent financial turmoil is a result of the shock in the housing markets that was intensified by the use of securitized instruments, which eroded investors’ confidence, sending the global indices in a jittery. For further research in the future, it will be interesting to see how Greenspan’s and Taylor’s theories regarding the housing crisis can be applied to previous crises in the U.S. Taylor, himself admitted in his book that the Fed had followed the Taylor rule during times of what he refers to as “The Great Moderation”. In addition, with the continuous emergence of China as a superpower and that country’s strong historical tendencies to save, one cannot help but wonder how the Fed runs monetary policy will be affected in the future. To sum up, the words of Reinhart and Rogoff say it best. “Even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be”. The threat of a financial crisis is always present regardless of how sound an economy may seem. As Hyman Minsky puts it, "In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring.” It is crucial to expand on the existing models of crisis, and learn from history to better recognize the early signs of trouble. As the world becomes more globalized, a financial crisis in a dominant country like the United States will often have a huge contagion effect, making it even more crucial to not repeat the same mistakes of the past by recognizing the red flags immediately and avoiding the “this time is different” mentality that has been associated with nearly all crises in the past. Works Cited Blackburn, R. (2008). The Subprime Crisis. Available at: Board of Governors of the Federal Reserve System. (2010). Statistical and Historical Data. Available at: Cecchetti, G.S. (2008). Monetary Policy and the Financial Crisis of 2007-2008. Available at: Cheung, L. Tam, C. Szeto, J. (2009). CONTAGION OF FINANCIAL CRISES: A LITERATURE REVIEW OF THEORETICAL AND EMPIRICAL FRAMEWORKS. Hong Kong Monetary Authority. Available at: Domash, H. (2002). Fire your stock analyst!: analyzing stocks on your own. New Jersey, USA: Financial Times-Prentice Hall. Dow Jones & Company, Inc. (2011). Did the Fed Cause the Housing Bubble?. The Wall Street Journal. Available at: Federal Housing Finance Agency. (2011). Quarterly Average and Median Prices for States and U.S.: 2000Q1-2010Q2. Available at: Federal Reserve Bank of St. Louis. (2011). Bank Credit of All Commercial Banks. Available at: Federal Reserve Statistical Release. (2011). Charge-offs and Delinquency Rates on Loans and Leases at Commercial Banks. Available at: Gourinchas, O.P. (2010). U.S. Monetary Policy, ‘Imbalances’ and the Financial Crisis. Available at: Lee, S. (2009). It Really Is All Greenspan's Fault. The Forbes. Available at: Marques, B.L. (2010). Interest Rates and Crisis Revisiting the "Taylor Rule". SAIS Review, Volume 30, Number 1, Winter-Spring 2010, pp. 157-160. Available at: Mishkin, S.F. (2009). The Financial Crisis and the Federal Reserve. Available at: Mohanty, D. (2011). Lessons for Monetary Policy from the Global Financial Crisis: An Emerging Market Perspective. RBI. Available at: Palley, L.T. (2011). The Limits of Minsky’s Financial Instability Hypothesis as an Explanation of the Crisis. Available at: Reinhart M.C. & Rogoff S.K (2009). This Time is Different: Eight Centuries of Financial Folly, Princeton University Press Root Cause of the Financial Crisis (2010). Wise Bread, Available at: Svensson, E.O. L. (2010). Lars E O Svensson: Monetary policy after the financial crisis. Bank for International Settlements. Available at: Taylor, B.J. (2011). How Government Created the Financial Crisis. The Wall Street Journal. Available at: Taylpr, B.J. (2009). Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Institution Press Publication U.S Department of the Treasury. (2011). Daily Treasury Yield Curve Rates. Available at Wolfson, M. H. (1994). Financial crises: understanding the postwar U.S. experience (2nd ed.). New York, USA: ME Sharpe. Woodford, M. (2001). ‘The Taylor Rule and Optimal Monetary Policy’. UK: Princeton University. Read More