Understanding the Impact of the Systemic Global Banking Crisis on Economic Growth - Case Study Example

Understanding the Impact of the Systemic Global Banking Crisis on Economic Growth And How The Central Banks Tried To Resolve The Issue I. Introduction A systemic banking crisis dominated the economic landscape in 2008. Banks from all over the world suffered from tremendous losses that caused downfall of the economy. As a result of the economic downturn, huge financial institutions in the United States, Europe and other parts of the world went out of business. Millions of people lost their jobs and it became almost impossible for these people to another job due to the economic slump. As the banking systems across the globe continue to weaken, dragging the economy down to become the worst recession after World War II, the central banks of different countries came into action. The responses of the central banks present very important economic implications which helped turnaround the economy. The responses of the central banks present some very interesting points that may be very useful for us in the future. Note that the economy follows certain cycles and sooner or later, we will hit again some snags in the banking industry that could lead to another global recession. By examining and learning from the past experiences of the banking system, we may be able to help predict and prevent certain events that could lead to serious financial crisis. Moreover, by analyzing the responses of the central banks, we can learn which responses are effective and which are not. In the light of this, this essay will strive to analyze the problems and events that lead to the economic debacle and then discuss the responses of the central banks to the crisis. II. Literature Review The main literatures used in this paper are the IMF working paper entitled Systemic Banking Crises: A New Database by Luc Laeven and Fabian Valencia (November 2008) and Central Bank Response to the 2007–08 Financial Market Turbulence: Experiences and Lessons Drawn by Alexandre Chailloux, Simon Gray, Ulrich Klüh, Seiichi Shimizu, and Peter Stella (September 2008). The first document which is authored by Laeven and Valencia defined systemic banking crisis. It also presented a vivid picture as to how systemic banking crisis often starts, how the crisis progress and how the central banks respond to the situation. On the other hand, the second document which is authored by Chailloux et al talked about the responses of the central banks to the banking crisis in 2007-2008. It provided an assessment as to how effective and how efficient are the responses of the central banks in resolving the economic problems brought about by the banking crisis. Aside from the two working papers of the central bank, this paper also used the speech of Ben S. Bernake, the chairman of the United State Federal Reserve, given at the Morehouse College in Atlanta, Georgia last April 14, 2009 as well as the testimony of the Vice Chairman Donald L. Kohn before the Committee on Banking, Housing, and Urban Affairs of the United State Senate last March 4, 2008. These two documents contain very relevant information as to how the banking crisis in the United States started. The speech of Bernake presented concrete evidences as to how the banking crisis in the United States started while the testimony of Kohn gave a detailed account about the recent performance of the banking system and the role of the Federal Reserve in regulating banking activities. These two documents are very relevant to this research given the fact that the banking crisis in 2007-2008 started in the United States and its effect spread across the globe. III. Theoretical Analysis This paper will use the Keynesian Theory and the Money Supply Model to evaluate the actions of the central banks in response to the crisis. Keynesian economics served as the economic model during the Great Depression and World War II. Since the banking crisis and the subsequent economic depression that followed in its wake is more less akin to the economic situations during the Great Depression and World War II, the author of this paper sees it fit to use this theory in evaluating the actions of the central banks. To recapitulate, the Keynesian Theory of economic promotes the idea of a mixed economy where private sector and the government work together as economic drivers (Keynes, John Maynard, 1936). The basic argument of this theory is that in solving economic problems such as depression, there is a need to reduce interest rates to force the private sector to invest its money instead of keeping it in the bank. Aside from reducing interest rates to stimulate investment, the Keynesian Theory also suggests that the government should directly stimulate the economy by investing money into infrastructure projects (Keynes, John Maynard, 1936). The idea here is to let the government inject money into the system and stimulate spending (Mattick, Paul (1969). The government stimulus is supposed to create a ripple effect where other sectors will benefit. Technically, this scenario is what governments of the world tried to achieve when they unleashed several stimulus packages in the wake of the global economic crisis. The Keynesian Theory works well with the Money Supply Model. Note that the MS model works by injecting money into the system to stimulate the economy. IV. The Data The data presented herein help prove the impact of the banking crisis on the world economy. The first table shows the growth rates in terms of output and trade from 2007 to 2009. The second table shows the economic conditions of two of the biggest economies in the world at the height of the banking crisis. The third table shows the interventions made by the central banks of different countries to help the economy get back into the right track. These data are used in this paper because they clearly show how the banking crisis slowed down the world economy and how the central banks reacted to the crisis. Table 1 Growth Rates of Output and Trade (Global and Regional) 2007 2008 2009 (forecast) Output Global 5.1% 3.1% -1.4% Advanced Economies (including the US) 2.7% 0.8% -3.8% Central and Eastern Europe 5.4% 3.0% -5.0% Latin America 5.7% 4.2% -2.6% Sub-Sahara Africa 6.9% 5.5% 1.5% Developing Asia 10.6% 7.6% 5.5% World Trade Volume 7.2 % 2.9% -12.2% Non fuel commodity prices 14..1% 7.5% -23.8% Source: IMF World Economic Outlook July 2009 Table 2 Economic Conditions in the United Kingdom and the United States in 2007 United Kingdom United States Crisis Date (year and month) August 2007 August 2007 Initial conditions Fiscal balance/GDP at t-1 -2.56% -2.61% Public sector debt/GDP at t-1 43.04% 60.10% Inflation at t-1 2.78% 2.57% Net Foreign Assets/M2 at t-1 1.4% 0.98% Deposit/GDP at t-1 139.66% 72.01% GDP Growth at t-1 2.91% 2.87% Current Account/GDP at t-1 -3.62% -6.15% Peak NPLs (as % of total loans) 4.80% Government-owned bank (% of assets) 0 0 Significant bank runs (Y/N) N N Credit boom (Y/N) N N Annual Growth in private credit to GDP (t-4, t-1) (in %) 6.06% 5.22% Creditor rights in year t 4 1 Source: IMF Working Paper November 2008 Table 3 Chronology of Key Measures Take by Central Banks Date Central Bank Measures 2007 Aug 9-14 Eurosystem Carried out series of liquidity-providing fine-tuning operations, totaling more than 200 billion euros Aug 10 Federal Reserve Issued statement that it will provide reserves as necessary to keep Fed funds rate at 5.25 percent. Sept 14 Bank of England Northem Rock liquidity support facility announced. Dec 12 Federal Reserve, Bank of England, European Central Bank, Bank of Canada, Swiss National Bank Announced measures designed to address elevated pressures in short-term funding market. First join action by major central banks since financial market recovery needed after 9/11. Dec 17 Federal Reserve Conducted U.S. dollar auction of $20 billion in 28-day credit through its Term Auction Facility. Dec 17 Eurosystem, Swiss National Bank Conducted U.S. dollar auctions of $10 billion and 4 billion respectively, on the same terms as Fed’s Term Auction Facility 2008 Mar 11 Federal Reserve Federal Reserve introduced a Term Securities Lending Facility (TSLF) Mar 16 Federal Reserve Announced the introduction of a Primary Dealer Credit Facility (PDCF) April 21 Bank of Canada Launched a Special Liquidity Scheme Source: IMF Working Paper September 2008 V. Data Analysis According to Ben Bernake, the banking crisis in the United States has been brewing since the 1990s. He pointed out that in the past 10 to 15 years; highly industrialized countries like the United States have been receiving a lot of foreign savings which boosted the powers of the banks in these parts of the world to lend money. As money comes into the coffers of banks, the banks’ lending capacity expands and it is able to lend more money to clients (see Ben Bennake’s Speech April 2009). Although foreign savings can be beneficial if used properly, the misuse of these funds can have severe negative effects. In the United the States, the existence of surplus money lead financial institutions to compete aggressively for borrowers. The surplus money fueled the housing boom in the US in the 1990s and in the early part of 2000 (Ben Bennake’s Speech April 2009). Since regulations were lax and regulators did not do enough to prevent poor lending practices, the economic bubble burst in 2007 (Ben Bennake’s Speech April 2009). The problem with subprime mortgages and falling prices in real estate created an economic debacle which caused major companies in the United States to collapse (see Kohn’s Testimony 2008). The downfall of the Lehman Brothers highlighted the weakness of the US banking system and it sent a strong message to the world that all is not well in the United States (Bathia, Ashok, (2007). The exposure of the many shortcomings of the US banking system sent the US economy into shambles and more companies started to fail. People lost their jobs and were consequently unable to meet their loan payments to the banks. Consequently, banks started to lose money at alarming rate that most banks tightened its lending policies (Bathia, Ashok, (2007). Tight lending policies curtailed the flow of money and chocked the economy. At this point, the US market started to slip alarmingly. As the economic crisis in the United States deepened, the economies of other nations were also affected. Table 1 above shows how the economies around the world plummeted as the crisis deepened. When the crisis started in 2007, the global output was at 5.1% and it went down to 3.1% by 2008. Trade output went into the negative zone in 2009 as more and more countries went into recession. By comparison, the United Kingdom fared a slightly better as compared to the United States. Note that in 2007 when the crisis started, the GDP of the United Kingdom was 2.91% while the United States was at 2.87%. In 2009, the GDP of the United Kingdom contracted to -6.3%1 while the United States contracted by -6.4%2. Both the central banks of the United States and the United Kingdom intervened to bring the economies of these nations back to normal (see Table 3 outlining the interventions made by the Federal Reserve and the Bank of England). At the height of the economic downturn, the governments through their respective central banks intervened by putting money into the system. This situation followed the Keynesian Theory that the government and the private sector need to work together to bring economic development. The close coordination between nations in the effort to bring the economy back on the positive side also followed the principles promoted by Keynes. Note that Keynes advanced the school of thought that coordinated economic policies of different nations can bring about economic progress. The market support system established in most countries around the world averted a major economic collapse. The pricing incentives which were put in place to motivate the market to return to normal functioning highlighted the central banks’ efforts to stimulate the market. The same pricing incentive strategy also served as the exit strategy of the central banks. The exit strategy of the central banks also worked well to preserve the stability of the market (see Chailloux, Alexandre, Simon Gray, Ulrich Klüh, Seiichi Shimizu, and Peter Stella (September 2008). If we take a look at Table 3 above, we can see that the Federal Reserve of the United States have been infusing a lot of money into the US economy since August 2007. The money which the government put into circulation took the form of infrastructure investment and stimulus packages which involve tax rebates. The Bank of England in the United Kingdom also infused a lot of money into the economy of the United Kingdom which also took the form of infrastructure investments. The infusion of money into the system helped improved the velocity of transactions. As more money enters into the system, businesses start to revive. This situation proved that the Money Supply model is at work. VI. Conclusion The banking crisis of 2007-2008 brought about the worst global recession since World War II. Without the timely interventions of the central banks of different countries, the crisis would no doubt have been worst than it was. Although there are many critics who criticized the interventions of the government, we cannot deny the fact that the infusion of money into the ailing economy by different governments helped stave off further economic problems from cropping up. Looking at the situation using the Money Supply model, we can clearly see that the market direly needed fresh supply of money for it to move. Since private banks have already tightened its purse, it was up to the government to open its coffers and infuse more money into the ailing economic system. References: 1. Bathia, Ashok, (2007), “New Landscape, New Challenges: Structural Change and Regulation in the U.S. Financial Sector.” IMF Working Paper 07/195 (Washington: International Monetary Fund). 2. Bernake, Ben S. (April 14, 2009) Speech given at the Morehouse College in Atlanta, Georgia http://www.federalreserve.gov/newsevents/speech/bernanke20090414a.htm retrieved January 24, 2010 3. Calomiris, Charles, Daniela Klingebiel, and Luc Laeven, (2003), “Financial Crisis Policies and Resolution Mechanisms: A Taxonomy from Cross-Country Experience,” in Patrick Honohan and Luc Laeven (eds.), Systemic Financial Distress: Containment and Resolution, Chapter 2, Cambridge: Cambridge University Press. 4. Chailloux, Alexandre, Simon Gray, Ulrich Klüh, Seiichi Shimizu, and Peter Stella (September 2008) Central Bank Response to the 2007–08 Financial Market Turbulence: Experiences and Lessons Drawn, IMF Working Paper 08/210 (Washington: International Monetary Fund). 5. Keynes, John Maynard (1936). The General Theory of Employment, Interest, and Money. London: Macmillan 6. Kohn, Donald L. (March 4, 2008) Testimony before the Committee on Banking, Housing, and Urban Affairs of the United State Senate http://www.federalreserve.gov/newsevents/testimony/kohn20080304a.htm retrieved January 24, 2010 7. Laeven, Luc and Fabian Valencia (November 2008) Systemic Banking Crises: A New Database, IMF working paper 08/224 (Washington: International Monetary Fund). 8. Mattick, Paul (1969) Marx and Keynes: The Limits of the Mixed Economy, 9. Valencia, Fabian, (2008), “Banks’ Precautionary Capital and Credit Crunches.” Mimeo. (Washington: International Monetary Fund). Read More