The Global Economic Crisis - Case Study Example

Introduction The global economic crisis has created many new areas of studies finance. Many new theories are being studies and current theories are being revaluated. The subprime mortgage and the events that followed have really shaken the financial horizon. The emergence of different theories alone suggests that the financial crisis was a combination of different factors rather than just one. The varying opinions from financial and economic theories are also understandable. Some new theories have emerged after the financial crisis which will have long lasting effects on the financial sector. It is important to study these theories not only to repair the damage done but also to prevent similar recession in the future. Some of these theories have been compares and contrasted for this purpose. Question One: Hyman Minsky, a little know economist gained huge popularity after the recent financial crises. This is because Misnsky had developed a hypothesis about financial crises or why markets fail, that seemed reflect the realities. The crux of his theory was that stability is destabilizing. Minskys core model is known as "Financial Instability Hypothesis" (FIH), which simply declares stability is inherently destabilizing (Thomas Tan, 2008). When the economy is doing well, the corporate cash flows rise above what is required to pay off debt. This leads to speculative euphoria where this borrowing and lending goes on till a point where the borrowers are no longer able to pay off the debt. As borrowers are no longer able to pay back, it leads to financial crises where banks do not have liquidity. This can also be Irving Fisher’s theory of debt deflation. According to him a state of debt deflation can occur when there is over-indebtedness in market. This bubble of over-indebtedness can be burst any trigger from lenders of borrowers. Therefore leading to a chain reaction as was seen in the financial crisis. According to Minsky in such situation as the borrowers default, banks further tighten their lending, which means that even deserving borrowers that could pay back do not get access to capital. According to Minsky, these swings are a part of free market economy and cannot be avoided unless there is government enforced regulation. Mishkin on the other hand focused on the role of asymmetric information in the financial system. Asymmetric means one party in the transaction has less information than the other party. For example a lender does not know how the borrower is going to use the money, but if the money is lost, the lender will have to suffer. This asymmetric information creates two problems, adverse selection and moral hazard. Adverse selection is a trend in which lenders choose borrowers who can pay a higher interest, however they can pay higher interest because their business is riskier and hence a greater chance of losing the money. Moral hazard occurs when the borrowers may chose to invest the money in activities that are undesirable from the lenders point of view or simply not work. As this loss will be borne by the lenders, they will refrain from lending thus causing a financial crisis. According to Mishkin another phenomenon of asymmetric information is free riding. A customer is involved with many different banks at the same time. Therefore when making the loans the banks assumes that the customer is already being monitored. Therefore the bank allows the customer to take on more risk than should have been allowed if proper monitoring was in place. The availability of information technology played a role in the subprime mortgage crisis. The lenders using this technology could better study the credit rating of their borrowers and therefore take on more risk. In theory this might seem correct however coupled with moral hazard and free riding it further created a problem. The securitization of debts made it easier for financing companies to extend more debt. Therefore extra availability of funds allowed them to extend funds to clients, who couldn’t even service a single debt. The financing companies were free riding and expecting each other to monitor the clients. Question Two: Mishkin concentrates on interest rates to develop a theory of liquidity preference. According to this theory the investors demand a maturity risk premium. Therefore the investor would ask for a larger risk premium on a long term bond as compared to a short term bond. The curve therefore increases at a decreasing, rate this is because volatility in interest rates reduces over maturity. According to this theory liquidity preference can be gauged from the interest rate cycles we see in the industry. When there is a depression, there is no demand for money as it cannot be used in an effective manner, which causes the interest rates to decrease. On the other hand the opposite effect can be seen when the economy is performing at its best. The liquidity preference framework thus generates the conclusion that when income is rising during a business cycle expansion (holding other economic variables constant) interest rates will rise. (Mishkin Frederic, 2009). Keynes theories have preached for a mixed economy where the government intervened for macroeconomic stability. The money multiplier developed by Keynes shows how a small government spending could lead to a multiplier effect in the economy. This is because if we look at the money demand and money supply graphs we can see that supply of money is a vertical line. This is because the supply of money is controlled by the government and its institutions. Therefore to match the variations in demand the government can change the money supply to stabilize interest rates. There are a number of ways by which the government can change supply. Increasing or decreasing the reserve ratio is a method of changing money supply. Moreover the government can also increase or decrease spending. For example when government gives financial stimulus, it goes to individuals or corporate. The money which goes to individuals could be used for consumption or when the corporate get this money they would hire new people who in turn spend their salary on consumption. Thus, this process continues with the effect decreasing incrementally at each step. According to Keynes theory, it was not the funds available that decided investment, rather the corporate invested when they had long run profit expectations. What this means is that rather than focusing on interest rates, government could regulate the economy through its monetary policy, that is, by varying the money supply. Question Three: Mishkin’s orthodox interpretation of aggregate demand and aggregate supply highlights the link between inflation and unemployment. The theory also suggests that markets are very quick to adjust to new factors caused by changes in the government policy. This basically means that anticipated policy and actions will have no effect on the aggregate demand or employment levels. The reduction in unemployment without a change in inflation can happen only when the changes in policy are unexpected. Thus, Mishkin’s orthodox interpretation places importance on the market expectations. Thus according to Mishkin, anticipated policy actions or any changes to the fiscal policy will not influence the aggregate demand and unemployment. This assumes that the markets are efficient and information is readily incorporated into the market. The view of Mishkin therefore implies that government should not try to control the market by changing spending or money supply as suggested by Keynes. On the other hand Keynes has a quite different view on this topic. According to this theory several wrong decisions by firms at the microeconomic level will cause a bad effect at the macroeconomic level. This view believes that the government can and should get involved to control the productivity and employment in the economy. It states that government policies can be used for increasing aggregate demand which in turn will reduce unemployment. There is not a significant emphasis on expectations, as the interpretation believes that positive outcome is possible even when the policy changes are expected. The role of government in fiscal and monetary policy can both affect the economic activity. The Mishkin’s theory ignores the fact that government can alter the money supply by monetary tools to create a positive impact for the market. The stabilization of interest rates can also reduce inflationary effect and increase unemployment. Question Four: The modern money view identifies two main reasons for the global financial crises. These are the repression in real wage rates in the developed world and the conservative fiscal policies adopted by national governments. The government increasingly try to reduce to money supply and implement tight monetary policies. The resulting policy of fiscal withdrawal has sucked real wealth out of national economies (James Juniper). As productivity has continued to increase in the developed world, the wage rate has not seen a similar increase. This has meant that a lot of consumption was being done on credit. The availability of cheap credit increases the attractiveness of using this facility. Moreover concepts such as multiple mortgages and credit cards have made credit an essential part of a society which believes in spending more than it is earning. Similarly, there has been very little government spending or efforts aimed at lowering the unemployment rate. Government investment was avoided as it was seen as increasing the national debt. The very high United States national debt was also a factor in this policy. Moreover it cannot be ignored that for many years the US has faced a very high trade deficit, which further increased fiscal pressure for tight policies. In accordance with the modern money perspective, governments do not need to ‘finance’ their deficit spending (James Juniper). The different outcome to the global financial crisis in the US and Australia has been due the difference in policies adopted. The Australian government chose to quickly increase government spending and increase the government sector jobs, till the economy was back on its feet. This has led to better outcomes for the country. On the other hand there was not significant government public spending in the US. The orthodox model of financial crises underestimated the difference that government policy can have on the economy. Some of the orthodox models argue that the core of the problem lies in the banking system but is silent about major structural reform. The main factors of the crisis are exogenous, such as, trade deficit, industrial problems etc. But money and uncertainty are not given due importance. As has been shown the monetary policies and fiscal policies can have a huge impact. This impact is not only limited to the initiation of the financial crisis but also the management and reduction of recession impact as has been shown by the Australian government. Question Five: Inflation and unemployment has always been two opposing targets. A higher inflation level is undesirable in an economy and mainstream economists target a steady low rate of inflation. Inflation levels are controlled through monetary measures and changes in interest rates. The government can increase the reserve ratio to reduce shrink the money supply. The reduction in money supply will thus result in higher interest rates. Therefore the inflation will also be affected. When the government increases spending there would is a positive impact on employment; as more job opportunities would be created. These changes in employment level will be as a result of the multiplier effect of government policies. The mainstream view belies that there has to be a trade off between unemployment and price stability and inflation as can be seen from the Phillips curve shown above. The modern money view tries to achieved a target inflation rate and maintain full employment at the same time through job guarantee scheme. Therefore the changes in inflation rate would not adversely affect the people. In this scheme, the pool of people who would be temporarily unemployed during low inflation will be provided work by the government. It provides the protection against inflation without the ill effects of unemployment. The people employed in this scheme get a minimum wage and will be gradually absorbed by the private sector when the conditions are favourable. Therefore it does not follow the Phillips curve trade off between price stability and unemployment. Moreover, it provides a fixed in built mechanism to control inflation level without the need for continuous policy changes by the government. A balance should therefore be reached between unemployment and inflation as is shown by the Phillips curve. Conclusion Theories give by Minsky and Mishkin gives their own view of the causes for recent financial meltdown. Where Minsky believes that recessions are an inevitable due to economic cycles, Mishkin on the other hand believes that financial crises are due to asymmetric information in the market. The views are very different and it can be said that the present financial crisis was a result of both factors i.e. information asymmetries and economic cycle. The model provided by Keynes’s gives an effective insight in establishing a balance between money demand and supply. The monetary and fiscal tools should be used to control the current recession. Following the leanings from the Phillips an effective balance between inflation and unemployment should be targeted. The initiatives by the Australia government are a successful example of positive measures taken by the government. References: 1) Thomas Tan (2008), Introduction To Minsky Theory retrieved on 8/12 from http://www.gold-eagle.com/editorials_08/tan050608.html 2) Mishkin Frederic (2009), The Economics of Money, Banking and Financial Markets Prentice Hall 3) James Juniper, A Modern Money View of the Global Financial Crisis retrieved on 8/12 from http://www.pol.mq.edu.au/apsa/papers 4) R. Wray (1998) Understanding Modern Money: The Key to Full Employment and Price Stability, Edward Elgar Read More