Global Macroeconomic Imbalances as the Cause of the Crisis - Essay Example

Macro & Micro economics Table of Contents Introduction 3 Global macroeconomic imbalances are the cause of the crisis 4 Critical Assessment 4 Conclusion 11 Reference 14 Bibliography 15 Introduction There have been immense disruptions associated with the financial crisis across the world which has consequently raised immense analysis of the international policies of nations and academic circles which have led to the crisis with people trying to analyze the root causes for the same. The most common and unanimous point presented by all is the failure of the financial regulatory frameworks across the world, with nations increasingly seeking to address them. The question is to discover whether micro-economic imbalances were the main cause behind the financial crisis. Different researchers have put forth different opinions regarding the same. Various influential figures have also argued that there has been extensive inflow of foreign capital into the American economy which acted as the main triggering factor behind the crisis. However, there has been counter arguments that the inflow of capital in the US economy was not the prime factor which increased the foreign purchases of the US toxic assets. This is because the so called ‘global savings glut’ was not considered as significant as was presented by many. It is argued that macro-economic policies could have been adopted by nations in order to reduce the global imbalances; however they were not considered to be sufficient to prevent the crisis from occurring. The project seeks to present the wide variety of views generated on the subject. There have been views that the global policies aimed at preventing the occurrence of another crisis must primarily need to emphasize on improving the banking regulations. Reducing the global imbalances is considered to be secondary to them. This assignment seeks to present the various views of researchers with regards to the fact whether the micro-economic imbalance account for the main cause behind the crisis. Global macroeconomic imbalances are the cause of the crisis The economic researchers have been increasingly involved in providing the basis and context for the occurring of the global financial crisis. Richard Portes have been particularly active in the media for his research on the origin as well as the implications of the recent credit crunch in the world economy. Richard has identified the main root and origin of the financial crisis as the world’s macro-economic imbalances which were responsible for bringing about huge inflow of capital across borders. This phenomenon was particularly overwhelming for the sophisticated financial systems present in the United States and the United Kingdom which was consequently responsible for the creation of asset price bubbles. This was also responsible for provoking ‘search for yield’ which with the support of the credit rating agencies resulted in the creation of ‘toxic assets’ in the economy. Moreover during the break of the crisis coordination from the Central Bank was inadequate or not sufficient. This was considered to the main reason behind according to inference of Richard Roberts. He has also proposed a suitable solution to the problem as identified as above. His suggestion to the world economy was to deal with the macro-economic imbalances and also the remove the weaknesses of financial regulatory system. According to him the combined impact of the two solutions simultaneously would be the solution to the financial crisis (London Business School, 2008, p.1). Critical Assessment Following are some of the findings of the London Business School. The Russian Default occurring in August 1998 and the near death experience of LTCM was one of the main causes of imbalance in the financial markets. There were pervasive fears across the global economy during the month of September in the same year and by the beginning of October the US Treasury became liquid to a certain extent. This resulted in the fall in the dollar by about 15% in relation to the Yen in three days in the same month. Moreover all of the financial assets confronted with increasing volatility. In most of the major banks in the US economy there was much higher leverage in third quarter of 1998 as compared to the third quarter of 2007. Deleveraging was much further in 1998 as compared to that in 2007. However, this crisis was said to have virtually no impact on the real economy. It got transferred to Brazil, but even there it did not result in any kind of disaster. The main difference with that of the last six months was that there was no occurrence of any large scale macroeconomic imbalance then apart from the weakening down of the yen. Moreover, financial engineering was not yet created the different structured products that were evident between 2005 and 2007. The banks were also not holding such instruments like off-balance-sheet vehicles. It is a firm belief that the global imbalance that was created since the last decade mainly allowed for and triggered the dysfunctional aspects associated with the financial markets in economies and the various other instruments that have been troubling the world since then. It resulted in the creation of low rates of interest, the increasing lookout for yield, as well as an increasing extent of financial intermediation, which was even impossible for some of the most sophisticated financial systems of the world like United Kingdom and United States to tackle responsibly (Portes, 2009, p.1-3). Here it is crucial to understand the two features of global imbalances separately. First is the greater dispersion of current accounts or absolute values. This is known to create burden on the financial systems which intermediates the flows. In the years 1996, the current account in the United States and the emerging markets and also the current account of the developing economies were almost zero. In the year 2008, the current account deficit in the United States was amounted to $ 600 bn, while in the emerging economies and the developing countries of the world there were current account surpluses by an amount of $ 900 bn (Portes, 2009, p.2). As proposed by Gourinchas and Jeanne, 2008, it must also be understood that capital has been flowing from the emerging markets and the developing economies of the world to the more advanced economies. Most of the deficit and surplus advanced economies prefer to make investments in other economically advanced nations of the world. Additionally economies which are developing with fast productivity growth rate tend to show greater outflow of capital while those economies having lower and slower productivity growth are the major attractors of capital or in other words they have greater capital inflows (Portes, 2009, p.3). Even though much of the focus of discussion has been on the US deficit and the surplus in China, it is true that the phenomenon of global imbalance is much greater and an in-depth phenomenon. There is existence of a large number of major developed economies of the world which has suffered huge deficits such as Spain, Australia and the United Kingdom. There are also a number of major Asian emerging market economies in the world and commodity exporters having huge surpluses such as Germany and Japan (Portes, 2009, p.3). Till the financial crisis the major concern appeared to the sudden unravelling of the macro-economic imbalances and also the risks associated with the sudden depreciation of the dollar. Apart from the Bank for International, which is a noteworthy exception, researchers have rarely tried to focus on the issues like the consequences of falling rates of interests and also the ‘search for yield’. Neither have they focussed on the consequences or implications of the global macro-economic imbalances for the financial intermediation of the economically advanced economies of the world. In fact the latter was seen to be turning out to be much more important and crucial. As a matter of fact there were no strategies to stop the crisis or an attempt to reverse the flow of capital. There were no such steps taken. Moreover, the world has not yet even encountered with a dollar crisis. So far the major exchange rate move has been large appreciation in the yen (International Monetary Fund, 2005, p.1). With regards to the financial intermediation before the year 2007, much of the attention focussed on the volatilities occurring in the foreign exchange rates in the advanced economies, equities ad bond markets which had been moving very slowly since the middle of 2004 considering the risks that were associated with the volatilities. It is seen that the global macro-economic imbalances posed a serious impact in reducing the volatilities. They made a major contribution to the huge increase in the volume of financial transactions and also contributed largely to the increase in global liquidity. Both of these contributed towards lowering of the volatility. Moreover low volatilities coupled with the stable rates of inflation and interest rates encouraged the ‘search for yield’ which increased the financial excesses. Increase in volatility in the year 2007 has been a major part of the financial crisis even though the volatility increases have not been as extreme as that of the historical experiences until 2008. But, before that increases in volatilities had ruined some of the carry trade in Turkey and Iceland (Portes, 2009, p.3). Two main stories emerged with regards to justifying the patterns of inflow of capital which is better known as imbalances. They have perceived imbalances as being a sustainable equilibrium. The Bretton Woods II argument regarding the fact that the world’s major emerging and developing markets, particularly China were purposely keeping their rates of exchange below the actual value as being a part of their export led growth strategies. In the case of China, this phenomenon was particularly done for the purpose of absorbing surplus labour which was coming out from the agricultural sector. They were particularly willing to make investments through the resulting reserves of foreign exchange in United States. The vendor finance could be continued for more than a decade. However this analysis did not understand the reasons or the rationale behind the cause of trade surpluses. The surpluses were supposed to create precautionary reserves for countering or dealing with the sudden stoppage in the capital flows. However, the policy makers of the international agencies and the developing countries continued to encourage this. Although the final effect might be similar, it is crucial to understand that the implications of the global imbalances and the policy implications of the same are considered being totally different from each other. Excess reserves act as safeguards or a shield against both the sudden stoppage as well as the flight by domestic savers. Thus the Bretton Woods II agreement was said to over-emphasizing on the exchange rate policies. It was also said to include numerous awkward views with regards to the foreign exchange reserves acting as collaterals for the forthcoming FDIs coming from the United States. Thus it was possible for the United States to expropriate these reserves in cases of expropriation of foreign direct investments (Portes, 2009, p.4). The worldwide global imbalances along with the savings glut coupled with the loose monetary policies existing in the United States and some of the advanced nations of the world are considered to be some of the major suspects for the reasons for poor rates of interests and consequently the increasing search for yield. In the global scenario, after the year 2000, the IS curve made a shift to the left while the LM curve moved towards the right. Thus consequently both of these moved downwards. Thus there was a sharp rise in the worldwide global liquidity, partially because of the monetary effects out of the accumulation of reserves in the world. Outputs tended to be maintained at low rates of interest. However, the rates of interests were not as low as compared to that in the 1970s, when the ex post real rates of interest on sovereign borrowings remained at a negative low of 2%. It was much a controversial issue however, when the short term rates of interests rose up, the long run interests rates did not raise. This was considered to be on account of the increase in demand for US Treasuries an US agency securities by the foreign central banks consequently arising out of the global imbalances (Portes, 2009, p.5). In the last few decades there have been extensive policy fuelled market hypes. The emergence of China and India as two of the new global players has considerably purred optimism. On the other hand at the regional level, Dubai demonstrated a remarkable building boom and also various other oil-rich countries showed similar signs. This was primarily driven out of increased oil prices and also the desire and tendency to diversify into those national markets, such as tourism and the banking sector. This was the main reason why the prices of the real estate sector skyrocketed and then dropped down dramatically during the middle of the crisis. Coupled with excessive leverage, this was particularly effective in increasing the extent of downward spiralling of the economies and markets (Hassan & Mahlknecht, 2011, p.362). Against the strong background of increased and abundant credit, low rate of interests and the increasing house prices, the problems were addressed by relaxing the standards. The standards were relaxed to such an extent that it led to people buying houses even if they could not afford the same. With the falling prices, it was realized that the loans began to go bad and consequently this created a big shocking experience to the financial system. With the easy and relaxed monetary polices the Federal Reserve allowed the housing prices to rise till they reached an unsustainable level. Moreover the bubble bursting triggered the crisis even further which was quite obvious (Wiedemer et al., 2006, p.92). It was not possible to identify the bubble till it burst out. The Federal Reserve’s action towards suppressing the bubble aggravated the problem even further and caused extensive damage to the economy. In fact the damage was considered to be of larger extent than it would have been if the Government had waited and responded after the bursting of the bubble (Jickling, 2010, p.4). The global financial flows are seen to be showing very unsustainable patterns recently. Some of the economies of the world, such as Germany, Japan and China demonstrate large surpluses every year. While some other nations like United Kingdom and United States run deficits. The external deficits in the United Kingdom and the United States are being reflected through the internal deficits in the government as well as the household sector. It was not possible for the US to continue borrowing for an indefinite time and thus the consequence was the resulting financial and turbulence which led to the crisis. According to Snow, 2008, throughout the entire chain of housing finance there has been numerous participants which have made a contribution towards creating bad mortgages and the increased selling of bad securities. They apparently felt secure about the fact they would not be blamed for the resulting consequences and would not be hep accountable or responsible for their actions. Lenders were allowed to sell toxic mortgages to the owners of homes without fearing about the repercussions or consequences (Bouchard & Koch, 2009, p.61). They would not be responsible if the mortgages failed. In the same way the traders were also allowed to sell toxic securities towards the investors and that also without having to fear about their personal responsibilities in case of failures of the contracts. And thus it was because of the realtors, brokers and also individual in the rating agencies and various other market participants that each one of them tried to maximize their own gain and tried to pass on the problems down the line. This consequently resulted in the emergence of a huge collapse. Because there was inadequate or lack of accountability of the participants it resulted in becoming a massive generator of risk. To counter the problem numerous contractual agreements tried to provide recourse against the sellers or the ones who were issuing the bad mortgages or the various related securities. There were a number of non bank mortgage lenders who failed completely as they had no other options but to withdraw back the loans which defaulted. Also various lawsuits have been filed against such issuers and others (Jickling, 2010, p.5). Many of the investment and risk managers sought to bring about a boost to their returns through writing options and providing insurance against the low-probability financial events. In this regard credit default swaps are considered to be a favourable example, but not the only one. These strategies are seen to generate only small gains under the normal conditions in the market; however, they end up making huge losses when the economy falls into crisis. When the participants in the market came to know that that the huge losses were being circulated throughout the entire system, though they did not know about the possible reasons, fear and uncertainty spread in them and the markets came under tremendous stress. Conclusion There have been different views by different authors regarding the origin and cause of the global financial crisis. Richard Porte has especially put forth the argument that the crisis was mainly out of the macro-economic imbalances cross the global economy. This was particularly responsible for creating great capital outflow across borders. In this context even some of the most sophisticated financial systems like the United States and the United Kingdom were responsible for the creation of the asset price bubble. This was also responsible for creating the increasing search for yield which consequently created huge toxic assets in the economy. Additionally lack of crisis coordination from the Central Bank was really a major issue according to the view of Richard Porte. Thus he has suggested adjusting and removing the world’s macro-economic imbalances as it is the most important step and then removing the prevailing weaknesses of the financial system for addressing the crisis. Some researchers have also focussed on the increasingly loose monetary policies in the US economy coupled with the savings glut in some of the developed nations of the world which resulted in creating poor rates of interest and increasing search for yield. This means that the IS curve and also the LM curve moved downwards which brought about a sharp increase in the liquidity in the world. Consequently Outputs were also maintained at low rates of interests. According to the opinion of Snow, 2008, the complete chain of housing finances were responsible along with the major participants have directly contributed towards creating bad mortgages and selling of bad securities. This is because they apparently safe about the fact they would not be blamed or held accountable for their actions and its consequences. Thus such loose thinking spread and so spread the irresponsible activities. Lenders freely sold their toxic mortgages to the home owners without the minimum fear about failing mortgages. To counter the consequences actions were taken but they were not adequate or sufficient. Contractual arguments were provided against such sellers or the people who were responsible for selling bad mortgages and other securities. There was also the existence of a large number of non money mortgage lenders who had failed in the process and were consequently required to draw back their loans as their loans were defaulted. Various lawsuits have been filed against these issuers. Moreover there were also a large number of risk managers who provided insurances against such low probability financial events in order to get a boost to their returns. In such cases credit default swaps were done. However such strategies could only make small gains under the normal working of the markets while they made huge losses during crisis situations. When the market participants identified that the losses were spreading across the economy, fears and apprehensions rose and the markets entered into major stress. Reference Bouchard, C. T. & Koch, J. V. (2009). America for sale: how the foreign pack circled and devoured Esmark. ABC-CLIO. Hassan, K. & Mahlknecht, M. (2011). Islamic Capital Markets: Products and Strategies. John Wiley & Sons. International Monetary Fund. (2005). Global Financial Stability Report: Market Developments and Issues, Issue 2. International Monetary Fund. Jickling, M. (2010). Causes of the Financial Crisis. CRS Report for Congress. [Pdf]. Available at: http://www.au.af.mil/au/awc/awcgate/crs/r40173.pdf. [Accessed on January 13, 2012]. London Business School. (2008). The roots of the crisis and its finish line. [Pdf]. Available at: http://www.london.edu/DeansPaper.pdf. [Accessed on January 12, 2012]. Portes, R. (2009). Global Imbalances. London Business School and CEPR. [Pdf]. 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