The Current Financial Crisis - Assignment Example

 FINANCIAL CRISIS Abstract The current global economic crisis has fuelled debate in relation to the causes of financial crisis and the current models of macroeconomic policy. This paper critically evaluates the rationale and challenges of the current financial crisis and posits 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 collapse of the US housing bubble; which further raises questions about increased government regulation of the finance industry going forward. 1. Introduction The current global economic crisis has been labelled by economists as the worst economic crisis since the Great Depression and the domino effect of the crisis has culminated in the decline of consumer spending, demise of established businesses in key industry sectors and heightened government burden in developed countries (United Nations: 1). Indeed, in the United Nations’ “Global Outlook: Economic Situation and Prospects 2009”, the United Nations comments that “it was never meant to happen again, but the world economy is now mired in a severe financial crisis since the Great Depression” (United Nations, 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). The focus of this paper is to critically evaluate the concept of financial crisis with contextual reference to the current global economic crisis. To this end, the analysis will firstly evaluate the challenges of and rationale for the financial crisis, followed by a consideration of macroeconomic theory. In turn, the paper will critically evaluate the estimated cost of the financial crisis along with a contextual consideration of the ramifications for the retail sector in particular. 2. Challenges & Rationale for the Financial Crisis In understanding the challenges of the financial crisis, it is imperative to address the causal triggers and rationale. It is submitted that the immediate trigger was the collapse of the US housing market as a result of the sub prime market disaster upon which the international banking industry had been lending through following trends in the housing market (Ambachtshee et al: 149). Indeed, the United Nations analysis of the global outlook for 2009 asserts that “in little over a year, the mid-2007 sub-prime mortgage debacle in the United States of America has developed into a global financial crisis and started to move the global economy into a recession” (United Nations 1). Moreover, prior to the sub-prime catastrophe, the significant foreign direct investment in the US and liquidity of the US economy had maintained low interest prices within an artificial national housing bubble (Shiller: 22). Additionally, another part of this was the problem of policy makers not acknowledging the role of the shadow banking system which remained unregulated (United Nations 1). The credit conditions were easy and fuelled predatory lending, which in turn led to increased debt, over lending and artificial price hikes (Shiller 22). Moreover, George Soros comments that “the super boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management method of the banks themselves. Similarly, the rating agencies on the information provided by the originators of synthetic producers. It was a shocking abdication of responsibility” (www.georgesoros.com). In turn, the ability of government policy initiatives and bank cash injections in the developed countries was unable to avoid the resulting economic crisis (United Nations 1). As a result, refinancing has been impossible, many leading banking institutions have failed and the stock markets collapsed (United Nations 2). Additionally, the UN cites the central challenge of the financial crisis as follows: “Interbank lending in most developed countries has come to a virtual standstill, and the spread between the interest rate on inter-bank loans and treasury bills has surged to the highest level in decades. Retail business and industrial firms are finding it increasingly difficult to obtain credit” (United Nations 1). This is further compounded by the long term implications of debt and rising unemployment levels. 3. Macroeconomics of the Financial Crisis The current financial crisis has brought renewed academic attention to macroeconomic theory with some commentators arguing that the traditional paradigm of macroeconomic theory contributed to failures to foresee the current economic crisis (Akerlof & Shiller 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 (Michl 20). A principle 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 1) However, in re-evaluating classic macroeconomic theory, Akerlof and Shiller 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” (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 posit that their central premise pertaining to macroeconomic theory is as follows: “totally absent from conventional macroeconomic theorising: that the economy is affected by variations in the level of trust, by storytelling and human interest, by perceptions of corruption or unfairness, by anger and optimism, by social epidemics causing changes in gut instincts and feelings. Those 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 33). Their proposition that macroeconomic policy contributed to the current economic crisis is supported by Ormerod (2009) who posits that macroeconomics has shaped economic policy in the past twenty years. To this end, Ormerod argues that: it is these ideas which the current crisis has falsified. And it is specifically the way in which the mainstream economics deals with the risk and uncertainty which is at the root of the problems, both for the discipline of economics and economy itself”(www.paulormerod.com/pdf/accsjuly09.pdf). 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 (www.paulormerod.com/pdf/accsjuly09.pdf). 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 at www.oecd.org/dataoecd). 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 www.paulormerod.com/pdf/accsjuly09.pdf). Additionally, these assumptions both operate on the basis that they make economic forecasts rationally (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). Ormerod argues that this is a false assumption as indicated 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 Figure 2: Source: www.paulormerod.com/pdf/accsjuly09.pdf It is submitted that the lack of liquidity as indicated by Figure 2 is arguably central to financial crisis (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). For example, in considering the example of UK bank Northern Rock, the central reason it went into financial difficulty was because it couldn’t refinance its loans as a result of the sub prime bubble and Ormerod observes that: “At the height of the crisis, credit markets froze completely because banks simply did not know whether the next institution was solvent or not. In the week of 15 September 2008, capitalism nearly ground to a halt”(www.paulormerod.com/pdf/accsjuly09.pdf). From a macroeconomic perspective, it was the false assumptions of rational pricing upon which the increasing accumulation of loans and debts had been offered that perpetuated the financial crisis. 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” led to the assumption that there was no need to tie up capital that could be lent out for a profit and therefore portfolio of loans on this assumption” (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). Additionally, 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. To this end, Ormerod expressly refers to Blanchard’s statement that “history teaches us that benign economic environments often lead to credit booms, and to the creation of marginal assets and the issuance of marginal loans. Borrowers and lenders look at recent historical distributions of returns, and become more optimistic, indeed too optimistic about future returns” (www.paulormerod.com/pdf/accsjuly09.pdf). A prime example of this is securitisation, which are inherently complex and difficult to value assets on balance sheets (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). 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”(www.paulormerod.com/pdf/accsjuly09.pdf). 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, which was attributable to a macroeconomic model that underestimated the risk. Accordingly, Ormerod posits that “modern macroeconomics, with its basis in rational agents and rational expectations (RARE) bears a heavy burden of responsibility for the financial crisis” (www.paulormerod.com/pdf/accsjuly09.pdf). 4. Conclusion 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. On the other side of the spectrum, 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 (United Nations 1). 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 3). In terms of the recovery process, the United Nations observes that governments of developed countries are implementing more comprehensive measures to address a previously unregulated industry and that “the measures have reshaped the previously deregulated financial landscapes; massive public funding was made available to recapitalise banks, with the governments taking partial or full ownership of failed financial institutions and providing blanket guarantees on bank deposits” (United Nations 1). As a result, whilst it remains too early to predict how far such measures will remedy the economic downturn, it is an important indication of changing policy. Bibliography Akerlof, G., & Shiller, R. Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism. Princeton University Press, 2009 Ambachtshee, K., Beatty, D., & Booth, L. The Finance Crisis and Rescue: What went wrong? Why? What lessons can be learned? University of Toronto Press, 2008 Blundell-Wignall, A. The Current Financial Crisis: Causes and Policy Issues. Retrieved from www.oecd.org/dataoecd/47/26/41942872.pdf accessed October 2009 Colander, D. Post Walrasian macroeconomics: beyond the dynamic stochastic general equilibrium model. Cambridge University Press, 2006. Michl, T. Macroeconomic Theory: A Short Course. M. E. Sharpe 2002 Ormerod, P. The current crisis and the culpability of Macroeconomic Theory retrieved from www.paulormerod.com/pdf/accsjuly09.pdf accessed October 2009. Shiller, R. The subprime solution: how today’s global financial crisis happened and what to do about it. Princeton University Press, 2008 Soros, G. The worst market crisis in 60 years. Published in the Financial Times, January 23, 2008. Retrieved from www.georgesoros.com accessed October 2009. United Nations, Global Outlook: Economic Situation and Prospects 2009, United Nations Publications ICTY, 2009 Read More