Financial Crisis - Essay Example

? ECN353 Contents Contents 2 Creation of asset bubbles and large capital flows 4 Financial Crisis 7 Policies to address the effects of global financial crisis 10 Long term growth Prospects 11 Conclusion 12 References 14 Introduction The global financial crisis started to show its impacts from the middle of the year 2007. Economists consider the global financial crisis to be the worst scenario after the Great Depression of 1930s (Chari, Christiano and Kehoe, 2008, p. 1). Initially it was thought the crisis to be one of solidity and would affect only a small number of organizations. But soon the crisis began to show its acuteness which called for involvement of states. The banks and the financial institutions suffered from the crisis. The governments of almost all the nations had to come up with packages that are required to move out from such a situation. The financial crisis will shed its impacts around the globe due to globalization. The livelihood of all people at every corner will feel the heat of crisis (World Bank, 2009). The impact of the failure in the arena of management of risk and the procedures of estimation became apparent after the financial crisis. In order to analyze the effects of the financial crisis the experts took the help of the mathematical as well as sophisticated techniques. The mortgage backed securities failed to measure the associated risk and so the risks regarding the securities intensified. The World is becoming increasingly unpredictable. The World witnessed overnight contraction of the capital market resulting in credit crisis and lending became difficult. There are possibilities as well as challenges for the decision makers. But since the financial crisis is still a fresh in the mind of the decision makers they are probably taking a safer path that will cement the growth curve. The governments of almost all the nations had to come up with packages that are required to move out from such a situation. A variety of problems can result because of budget deficit. Lower national savings rate, higher rates of interest and inflation are some of them. The federal budget is taking an unsustainable path. The debt levels of the federal are expected to grow with the size of the economy. The elevated budget deficit is the cause of increase in federal debt. This will shed its effects on economic downturn. The excess expenditure is financed through borrowing. The federal government takes the policy of issuing securities. The households can make up their budget deficits through loans and credit cards. Some of the measures to curb down the budget deficit are cutting expenditures, levee taxes or a strategy that will involve both. Creation of asset bubbles and large capital flows An economic bubble that takes place in periodical fashion in local as well as in global markets for real estate’s is regarded as the real estate bubble. The bubble is characterized by rapid increase in the valuations of properties until the price rise to an unsustainable level and later on declines. The financial crisis that took place in the middle of 2007 was related to the bursting of the real estate bubble. From the point of view of the shortage of assets the crash in the market for real estate was complex. The crashed comprised of the whole financial sector and by doing so the alternatives closed. In the first phases of the crisis, it exacerbated the asset shortage in the global economy. The shortages triggered a recreation in the commodity market as well as in the oil market. The situation asked for financial assets from the United States as there was an increase in petrodollars. The flows of petrodollars became an important source of stability while the capital outflows played the role of destabilizations. The impact of the crisis was felt in the second phase when it could be anticipated that the economic growth is likely to get slowed sharply. The slowdown contributed to reverse the commodity market conditions which paved the way for the bubble to develop and ultimately destroyed the bubble. The situation of rapid growth after the emerging market conditions in 1990s as well as rise in the prices of the commodities paved the way for inflow of capital to the country from the emerging markets. The emerging markets were in need to sound financial instruments to deal with the newly gathered wealth. The financial market of the United States is believed to be well developed and so they began to dump the wealth in the country. A decline in the interest rates of the country and the rest of the world was necessary for the reallocation to take place along with a boom in the asset prices of the country. The appreciation of the real estate prices of the country halted in the year 2006 and the deficit in the current account started to turn around. Within a few weeks after June, 2007 the funding dried up and the entire segments of the economy began to feel the heat. Even for a year after the crisis the financial markets were not at the path of stabilization. In fact the financial distress gathered pace in the beginning of the summer month of 2008. The situation of the government sponsored enterprises and the Lehman Brothers are mere examples. Till the watershed moment of the Lehman Brothers the crisis was severe but contained within the financial sector of the country. After the collapse of the government sponsored enterprises and the broker-dealer industry, there was seize in the whole sale money markets and the seizing reached to unprecedented proportions. The credit markets of the country got weakened by the strong capital inflows. The degraded performance of the capital market can be sited as one of the reasons for the current crisis. However the weak performance is the part of the endogenous response of the financial market of the country to the financial conditions of the world. The asset market of the country had to deal with the excess demand for assets and the structural problem lies there. The excess demand in the asset market was derived due to the underdevelopment of the financial sector in the emerging markets as well as from the commodity producing economies. The macroeconomic imbalances cannot be held responsible for the excess demand to take place. Excess demand in the asset market can leave the footprints in low rates of interest. The low rates of interest pave the fertile ground for the bubbles to emerge. The bubbles located in the emerging markets migrated into the housing and credit market of the country. The emerging markets were in search for opportunities for investment. In the periods of 2007 to 2008 the price of crude oil increased by 100 percent. The prices of the commodities suffered a drastic collapse as economic growth started to decline and the crisis began to spread. As it has been mentioned the tight market conditions coupled with low equilibrium real interest rates played the role of transforming a commodity into an asset. Accumulation of inventory is made profitable by the low rates of interest. It also drives up the exhaustible resources. In the second phase of the crisis the preconditions of the market disappeared and that in turn destroyed the accumulation of assets incentive behind the rise of the prices of the commodities. Thus the collapse in the price level levels got triggered. In the first phase of the crisis the correlation between the oil and the prices of the stocks is strong and negative which became positive since July, 2008. The explanations driven by demand will anticipate a positive correlation between the assets and the prices of the commodities. The inventories of commodity were initially very low. The net asset creation was small initially as well because of the byproduct of the strong demand arising from the experienced growth in emerging countries. The income of the commodity producing countries experienced sharp rises which resulted in increase of demand which further depressed the rates of interest and contributed to stabilize the outflows of capital for the country in the short run. One cannot be certain of the increase in external imbalances in the second phase of the crisis. The sharp decline in growth reduces the supply for assets. The interest rates depress as a result. The demand for assets also gets reduced after the collapse in the prices of the commodities. In the accumulated inventories are low, the second effect may dominate the first and external imbalances are reduced along with rise in the rates of interest (Caballero, Farhi and Gourinchas, 2008, pp. 1-32). The culprit behind the crisis is the underdevelopment of the emerging markets in the countries of Asia and the oil producing counties. The monetary as well as the fiscal policies of the country had no role play I the scenario of the crisis. The three phenomena that are widely discussed by the experts in the analysis if the crisis include current account deficits of the United States, the financial bubbles as well as the volatile prices of the commodities. However it can be argued that all the three phenomena can exist in equilibrium. In order to highlight the differences in the financial market the role of money as well as government policies have been ignored (Dominguez, 2008, pp. 56-57). Financial Crisis The investment banks were lending to each other at lower rates of interest. The banks want to keep the reserves to themselves and are also aware of the solvency of other institutions. As lending by the bank lowered due to the economical instability, the bank increased the borrowing cost to increase the operational revenue. This strategy was taken by the banks in order to maintain the sustainable business operation in the financial market. One of the prime reasons for the global financial crisis is the collapse of the housing market of the United States. The collapse was the resultant of the surge of the defaults in mortgage loans (World Health Organization, 2009, p. 2). The global markets had to suffer from severe effects because of the collapse of the real estate market and the subprime mortgage market of the United States. The financial system got captured under the threshold of uncertainty. The creditors involved themselves in pulling out their funds as well as cashed out the securities that were issued by the financial institutions. Such actions from the part of the creditors led to failure of many institutions while some of the others managed to survive poorly. The loan and the credit possibilities from the bank dried up (Baily, Litan, and Johnson, 2008, p. 11). The share market experienced a downturn as investors began to dump their holdings. The system lost the confidence. In order to create securitization, the banks started to borrow more money. As long as the banks can pull out money by selling loans on the basis of securities, they did not feel the dependency to rely on the savers (European Commission, 2009, p. 8). Some of the banks even moved into mortgages. The pressure from the government increased to serve the poor and therefore the loans offered to them became risky as the fear of default got accrued. They used to buy the mortgage in order to securitize them and then sell them. Some of the banks started to buy securities as well. The exposure of the banks towards risks increased. After the realization of the problem, the process of lending slowed down. Some of the banks even fell on the verge of the loans that are most risky in nature. The lenders launched upon to take back their loans. The prospects of the banks engaged in investments fell drastically as they were shortage of deposits. They either had very little or no deposits. The problem got intensified and even the banks with large capital reserves began to feel the pressure. Such banks asked for support from the government. The banks began to feel nervous to loan out the injected money and the sick banks sucked money out of the economy. Among the other effects include rise in the level of unemployment, rising in the levels of international and domestic debt, crisis in housing and mortgage, failure of key businesses such as automobile industry of U.S., along with various banks and housing lenders. The wealth of the consumers began to take the declining curve as the share market felt the heat. The volumes of international trade as well as investment declined. The government came up with the measure of stimulatory spending to recover the economy from the crisis. The stimulatory spending was further financed by debt. The other measures included guarantees as well as buyout of the financial institutions and the assistance to the industries. The measures were within the framework of the rules and the regulations of the World Trade Organization. Injection of liquidity into the financial institutions was thought to serve the purpose of revival in order to combat the situation of fall in confidence. The time called for unlimited as well as increased level of deposit insurance. The Central Bank was responsible for the reductions in the interest rates and purchased commercial paper along with money market instruments (Shah, 2010). The government increased the spending and began to provide the provisions of tax cuts. The International monetary Fund also came into the picture by providing aid to the developing countries. The strategists hold the Wall Street to be responsible for the initial stages of the crisis as the large investment banks are located there. The crisis began to show its impact in such a fashion that the administration had to bail out 700 billion dollars for the financial system of the country. The developing world as well could not keep itself outside the purview of the crisis. The economies of those countries were affected by the compounding effect of uncertainties along with some other knock on effects which resulted from the instability of the financial system. The core problem behind financial crisis is a sudden change of the surprises that brings temporary changes in the rules of the game. The resultants are the shocks which may come from the factors that were anticipated but the crisis took place when the shocks while moving through complex networks produces an income that is not expected (United Nations, 2009, p. 1). It is not enough for the economic agents to invest time in finding the root of the problem as a series of systematic events will pull up linkages that was unexpected and distant. The surprise has the potential to turn risk into uncertainty and it is the natural behavior of all to withdraw their assets. A panic gets injected into the system and triggers the asset sales as well as activates the financial multipliers. The Emergency Economic Stabilization Act of 2008 gave the rights to the treasury of the country to buy mortgages as well as some other financial instruments which were believed to be beneficial for the country. But the act failed to recover the lending activities of the banks. The government responded to the situation by implementing the American Recovery and Reinvestment Act. The intension of the stimulus package was to promote new jobs along with investment as well as the spending of the consumers during the turbulence. The Federal Reserve System injected more than 2 trillion dollars into the economy to buy securities from banks. They provided funds to fight against the possible defaults in payments. Therefore the government played the leading role in helping the economy to move out of the recession. The future levels in the debt of the federal is a concerning issue for the budget analysts. They agree upon the fact that current spending and collection of revenue cannot continue at the present pace or at the forecasted pace. Several reports can be found where the path for sustainable development has been shown. The modifications of the tax laws can be effective in dealing with the crisis. Such actions can help to generate higher standards of living for the future generations. The reforms are going to be more costly as time passes by without any planned fiscal future. A situation will arise when the reforms will be forced which will again result in financial crisis. So the reforms need to be well planned. Policies to address the effects of global financial crisis The policies to address the effects of the financial crisis can be summarized into three basic principles. The first principle calls for corporative actions from the nations. The crisis can shed its impact on the crisis on the depth of oil and so it is the time for the nations to come together and face the challenges together. The second principle takes into account the various actions that may be suitable for the various phases of the economic cycle while the third approach call for comprehensive actions across time. The measures to support the level of employment or lower the level of unemployment can be taken as one of the best suited measures to combat the crisis. The measures that aim to increase the level of employment by creating new job opportunities and provide a safety net for the casual workers are the need of the time. The government can leave its footprints by increasing the level of subsidies or benefits to the unemployed. The government can also take the initiatives that will support re-employment as well as provide opportunities that will help to upgrade the vocational skills of the labor force. The programs from the government shall include the persons with disabilities as well. Among the financial measures the policies that aim to provide smooth functioning of the financial intermediary services can be promoted. The financial support systems must consider the small as well as medium sized organizations. The financial support system can also be extended to cover the large organizations as well. Even the stock market requires financial support from the government (Government of Japan, 2009, p. 9). The countries which are rich in resources experienced rapid growth in the periods prior to the crisis. It has been argued that these countries seemed to suffer the most as a result of financial crisis due to deterioration in trade. There was a shrink in global demand and the prices of most commodities took the declining curve. The countries dependent on exports as a result was losing precious foreign exchange. Such losses had huge impacts on the economy. It was anticipated that the countries will find themselves in the stage of recovery in the periods of 2008 to 2009 but such had not been the case. The countries followed the policy aimed towards tightening of finance which had negative impacts on the trade finance and decreased the amount of capital flows to the developing countries. The deficits in the current account will get broadened due to the negative effects of the shocks in trade terms. The external accounts are also likely to face some constraints. Long term growth Prospects Economists are of the opinion that sustaining large deficits can reduce the rate of growth. If the aim is to attain future gains in the standard of living it is necessary to curb down the levels of consumption and take the requisite steps in order to increase the level of savings. The deficit in the federal budget along with the low rate in the savings will cause a gap between the total savings and the investment. Spreading the foreign ownership of assets and mounting payments of investment will result in capital inflows. The same reason can be accounted for the deficits in trade to occur. The trade deficits will keep on piling up with the continuation of capital inflows. The rate of interest is supposed to take the steep rising path if the investors turn down from providing capital in this kind of situation prevails. The value of dollar is likely to be depreciated. The assets of United States will be cheaper relative to the foreign assets and the investment rates will get curtailed with high rates of interest. The price of the imports will rise and the exchange rate will have the tendency to get low. The country will have to increase its reliance on foreign capital. Conclusion It can be concluded that the world economy entered into the grasp of the financial crisis mainly due to chronic excess demand for the financial assets. The subprime development in the conditions of the market lacks the potential to bridge the gap. Taking the perspective into account it can be stated that the sharp rise in the prices of oil just after the subprime crisis was the resultant of the anticipated response to the financial crisis which was aimed towards rebuilding of the supply of assets. The rise in oil also took place in the phase of the recessionary shocks. It can also be stated that the global economy was subjected to multiple implications rather than only been affected by the two separate shocks from finance as well as oil. The persistent crisis in the financial sector along with the multipliers can severely hurt the growth prospects of the country which is triggered by the prices of the commodities as well as by the demand for assets. However when the situation recovers in the normal track the demand for assets is likely to rise back which nullifies the shortage of assets along with the beginning of the economic cycles. If the regulatory measures are not distortionary enough it cannot match the forces of the market. The characteristic of the problem is acute and macroeconomic and it cannot be solved unless the economy of the globe gathers the ability to generate beneficial store of values that has the ability to catch up with the potential growth in income. The distortions prevailing in the market pose increasing challenges for the ability of safe assets. The safe assets include Treasury securities of the United States as well as high grade corporate bonds. The demand for the safe assets is rising because of uncertainty and the regulatory reforms. Recently the supply of such assets has taken the declining curve because the public as well as the private sectors lack the ability to produce such assets. The stability of the financial sector is at stake because of the dwindling world of safe assets as well as the rising demand conditions for the safe assets. The scarcity of the safe assets will raise the price of safety and will force the potential investors to follow down the path of safety scale as they are in need of scarce assets. The scarcity of the safety assets will also lead to spikes in short term volatility as well reduction in collaterals of high graded. A smooth alteration in the markets for the assets which are safe will require flexibility as well as volatility in designs of policies and in implementation. The task of the policy makers will be to strike a balance that will ensure sound financial institutions along with the associated costs with the rapid acquisitions of the safe assets to deliver the goals (Iorgova, Al-Hassan, Chikada, 2012, p.1). References Chari, V., Christiano, L., and Kehoe, P. 2008. “Facts and Myths about the Financial Crisis in 2008”. [Pdf]. Available at: http://www.mpls.frb.org/research/wp/wp666.pdf. [Accessed: 26th July, 2012]. World Bank, 2009. “Financial crisis.” [online].Available at: https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0CEkQFjAB&url=http%3A%2F%2Fwww.worldbank.org%2Ffinancialcrisis%2Fpdf%2FWomen-Children-Vulnerability-March09.pdf&ei=OiKRT7TbKIWnrAf99vGHBQ&usg=AFQjCNFNUYMsKxlB3KlVybWbBmm1BJ-dNQ. [Accessed: 26th July, 2012]. Baily, M., Litan, R., and Johnson, M. 2008. “The Origins of the Financial Crisis”. [Pdf]. Available at: http://www.brookings.edu/~/media/Files/rc/papers/2008/11_origins_crisis_baily_litan/11_origins_crisis_baily_litan.pdf. [Accessed: 26th July, 2012]. European Commission, 2009. “Economic Crisis in Europe: Causes, Consequences and Responses.” [Pdf]. Available at: http://ec.europa.eu/economy_finance/publications/publication15887_en.pdf. [Accessed: 26th July, 2012]. Shah, A. 2010. “Global Financial Crisis.” [online]. 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Available at: http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/press3.pdf. [Accessed: 27th July, 2012]. Read More