Understanding the Financial Crisis - Literature review Example

Yu Chen Olmsted ECON 241 UNDERSTANDING THE FINANCIAL CRISIS A financial shock in a single country or region has the ability to spread to other regions around the world, a concept referred to as contagion. There are cross-country linkages that allow for the transmission of such shocks across the world. The financial crisis of 2007/2008 is an example of such a crisis which originated in America and quickly spread to other regions of the world. This research aims at examining the concept of contagion by focusing on the 2007/2008 financial crisis. In addition, based on this crisis, the research will attempt to demonstrate the role of international institutions in minimizing global financial instability. This is based on the article by Kenneth Rogoff (1999) which focuses on some of the international institutions that can be used to minimize the effects of crises. This financial crisis caused a sharp decline in the real activity globally, and changed the world economy significantly. It has been argued by many economists and researchers that there was no single country that was unaffected by this crisis. This brings into sharp focus the idea of contagion. This crisis has necessitated a better understanding of the transmission channels through which economic disturbances move from the source region or country to the entire world. With such information, this research aims at helping countries better prepare for such crises and apply the correct policies to minimize their effects. The global financial institutions need to strengthen in order to avoid a recurrence of what was witnessed during the 2007/2008 crisis. The origin of the crisis The main cause of this crisis has been identified as the increase in support of low housing by the U.S. Congress for the Federal National Mortgage Association (Markowitz, 25). The Congress required that banks lower their lending rates and the lower rates encouraged people who have high incomes to purchase more expensive than they traditionally would. In some cases, people bought speculative second homes and had the option of walking away from these homes if the prices fell. This came on the backdrop of an asset price bubble where the prices for houses had been steadily increasing from the mid 1990s to around 2006. People expected that these prices should continue to increase into the future. Due to the high prices of houses, financial institutions were forced to borrow more money in order to finance their purchases of mortgage-related securities. However, when the value of these houses started to fall, a number of financial institutions which had heavily invested in mortgage-backed securities (MBS) started to report losses. Lenders refused to pay their debts, and this made financial institutions incur heavy losses. The reduced prices of homes meant that their worth was less than the mortgage loan. In addition, the financial institutions had incurred heavy debts in providing loans to the borrowers and did not have adequate financial cushion to handle huge loan defaults. The financial institutions were unable to lend, and this ended up slowing activity in the economy. Analysts and financial bodies had failed to undertake effective assessment on the mortgage-related assets they were holding and trading in. Although the crisis has started from the housing market, other parts of the economy started to feel its effect. The concept of Contagion: How did the Crisis Spread? The causes of contagion are generally divided into two main categories: interdependence between economies and behavior of investors. These two provide the avenues through which a crisis is transmitted from one country to other countries. An analysis of the 2007/2008 financial crisis reveals some of the underlying concepts behind the idea of contagion. First, the link between economies makes it possible for macroeconomic shocks to have international repercussions. Financial institutions play a critical role in the transmission of these shocks (Dornbusch, et al, 180). Due to the concept of globalization, the connection between countries involves financial and trade links. During the crisis, these linkages meant that the crisis had found a suitable channel to move from country to another. Financial institutions are generally sensitive to small changes in asset prices because most of the assets held by these institutions are financed by short-term liabilities (Bussiere, et al, 79). Traditionally, most of the European banks and US investment banks have had their capital/asset rations ranging between 3 and 5 per cent. In addition, most of the US commercial banks have had capital ratios in the range of 7 and 8 per cent (Bussiere, et al, 79). This linkage was a fragility exploited during the crisis. This is because the price in fall in assets in one country greatly influences how these assets are valued in the other countries. During the crisis, most of the financial institutions in America and around Europe were cautious of the asset values, and this led to a general reduction in asset values. This affected the countries in which these institutions were located. In addition, if an investor holds global assets, a fall in asset values in one country is likely to have a ripple effect on how similar assets are valued in another country. In addition, as noted in the article by Rudiger Dornbusch, Yung Park and Stijn Claessens (2000), a crisis in one country affect how firms in another country invest in the affected country. In the end, the financial ties between countries facilitate the reduction of trade and foreign direct investments during a crisis. The 2007/2008 crisis had a great impact on how firms within the US and outside investment and traded with the US. In the end, during the crisis, the value of international trade declines sharply. For example, it has been noted that during the financial crisis of 2007/2008, the value of US imports declined considerably, especially for those sectors and partners where financing conditions were very tight (Bussiere, et al, 78). Due to globalization, financial institutions have become more aware of what is taking place in other countries. A shock felt in one country is likely to reduce the financial activities in these institutions, thereby reducing the value of trade globally. A crisis that was initially felt in a single country was able to move to other countries, and had more or less similar effects. Secondly, the financial crisis spread rapidly because of competitive devaluations and trade links. This is another avenue through which contagion spreads or occurs. When a financial crisis hits a given country, the trading partners of that country experience declining asset prices because the value of currency in that country has dropped (Dornbusch, et al, 180). In this case, the United States has many trading partners, and this made it possible for many countries to feel the negative effects of the devalued US currency (Bussiere, et al, 79). The export competitiveness of the US was reduced, and this put pressure on the currencies of other countries. Investors started to speculate that there was going to be a decline in the exports to the United States, and this led to a reduction in trade. In the end, importing and exporting firms were negatively affected, reducing the world trade. It should be noted that due to the size of the US economy, a slight shock in that country is likely to have a greater impact throughout the world. Thirdly, liquidity and incentive problems have been identified as another cause of contagion. This is an example of how investor behavior may cause a crisis to spread from one country to other countries. During the 2007/2008 financial crisis, liquidity problems were experienced in the United States. Lenders were able to sell off their loans to third parties and take it off their financial books. Fannie Mae and Freddie Mac, which were created by the government allowed for the buying of mortgage loans from banks in order to help in mortgage lending. However, when the value of houses fell, Fannie and Freddie incurred enormous losses because the default rates were high. As noted in the article by Dornbusch, et al (2000), such looses cause investors to sell off securities in other markets in order to raise money in anticipation of bigger frequency redemptions. Finally, contagion results from lack of perfect information and the differences in the expectations of investors (Dornbusch, et al, 183). During the 2007/2008 crisis, there was a general lack of transparency. Investors and households responded to the crisis by cutting back on spending and corporate layoffs (Markowitz, 25). The crisis made investors believe that the crisis could have similar problems in other countries, and this led to an attack on the currencies of other countries. In many cases, investors lack a full picture of the conditions in every country regarding the returns on their investments (Dornbusch, et al, 183). For instance, since Europe is less transparent about bank reporting of off-balance sheet and derivative exposures, this region was greatly affected by the financial crisis of 2007/2008 (Blundell-Wignall & Atkinson, 10). Most of the investors in Europe had to take drastic measures in an attempt to safeguard their investments. This led to a reduction in financial activity in these countries, which quickly spread to other parts of the world. Furthermore, lack of transparency causes a delay in policy action, and this causes heavy losses for taxpayers (Blundell-Wignall & Atkinson, 10). Had there been proper transparency, the crisis could have been arrested earlier. International institutions and the 2007/2008 Crisis In the article by Kenneth Rogoff (1999), the author examines the role played by international institutions in dealing with financial instability. In this article, the author discusses some of the international institutions that can be used to cushion the world against financial instability. Based on the proposals made by Rogoff, this research evaluates how some of his suggestions apply to the 2007/2008 financial crisis. Specifically, this paper examines how the international institutions proposed by Rogoff could be used to deal with the crisis. First, in the article by Rogoff, it is proposed that there is need to have a lender of last resort who will act as an international crisis manager. This institution will help in lending money to countries that are hit by a crisis. As noted in the article by Blundell-Wignall and Atkinson (2009), it is important to have more capital in order to reduce the leverage ratio. The 2007/2008 financial crisis could have been handled well if there was an international lender that would provide capital to banks and other financial institutions in countries that were hard hit by the crisis. If this was done, banks in America and other major economies wouldn’t have run into trouble as was the case during the crisis. In order for countries to better prepare for similar situations in future, there is need to consider having what Rugoff (1999) terms as a ‘deep pocket’ lender who will help cushion local banks and other financial institutions against bankruptcy. Such an institution should help support the efforts made by existing bodies such as IMF and the World Bank. It is however for prudent that countries should continue to exercise their oversight role in order to avoid banks running into trouble. Rugoff rightfully notes that if a lender of last resort is formed, domestic authorities would be more lax in carrying out their oversight role. These authorities will understand that if their domestic banks get into trouble, part of that cost will be shared by other countries through the deep pocket lender. However, if such an institution has to successes, it is necessary to have minimum standards and requirements that should be met in order for a country to qualify for the lending services. For example, each country’s contributions to the lending institution should be assessed before loans are advanced to that country. Secondly, the 2007/2008 crisis came about as a result of people defaulting to pay their loans when home prices dropped. This led banks into incurring massive losses due to the high rate of defaulting. In the article by Ruggof (1999), the author examines the idea of having an international bankruptcy court that would assist debtors in the event of a default. In this case, the courts would help to sell the assets of people who are unable to repay their loans. This way, banks will not suffer high default rates as was the case during the crisis. It is argued that since these courts are used in domestic settings, they should be applied to the international level to help address such problems. For instance, Rugoff gives the example of New York City debt crisis in which the daily finances of the city were run by an outside board. In the modern time however, it is difficult to think of a country submitting to an external authority. In order for this to be effective, debtor countries need to provide enforcement clouts in order to give the court the powers to carry out its duties. Finally, as discussed in the article by Rogoff (1999), it is important to have a global financial regulator whose main responsibility would be to oversee bank and non-bank financial intermediaries (Rogoff, 31). Such a body would help in harmonizing the banking standards across the world. For instance, such a regulatory body might require that banks have enough capital to cover for a given percentage of losses on loans. In the context of the 2007/2008 crisis, such a body would have allowed US banks and other financial institutions to cover most of the losses that resulted from the loan defaults. Had this happened, the shocks that were felt by these banks wouldn’t have been so severe, and the impact of the crisis would have been reduced. In addition, by requiring banks to have capital, managers would be cautious on the investment decisions they make. Banks would be forced to carry out an analysis of having a risky portfolio before any investment decisions are made. Given the extent of the 2007/2008 crisis, it is necessary that countries undertake certain measures to protect themselves against such shocks. One of such measures proposed in the article by Rugoff (1999) is increasing transparency. Lack of transparency was one of the key factors that led to the spread of the crisis. With proper transparency, speculative behaviors by investors will be reduced, and this will help safeguard a country during a crisis. For instance, in the article by Rogoff (1999), it is noted that New Zealand and Australia, which have strong financial regulations, suffered less from the effects of the ‘Asian flu’ compared to other countries that have weaker regulations. This is particularly important for developing nations. This research aimed at understanding the responses that can be taken by international institutions in addressing a financial crisis. One of such financial institutions is the World Bank. The report by the Independent Evaluation Group (2012) highlights some of the responses by the World Bank Group to this crisis. These responses as taken by the World Bank are crucial in understanding the role played by international institutions in addressing different types of crises. According to the report, the World Bank responded to the crisis through financial commitments as a way of laying the foundation for recovery. These commitments reached close to $ 189.1 billion by June 2011. This perhaps underscores the importance of having a lender of last resort as discussed in the article by Rogoff (1999) as one of the institutions that can help address such crises. The report by the United Nations on the 2007/2008 financial crisis and its impacts highlights the origins of the crisis, the responses and the impact on development. This contributes to this research since it helps illustrate the major driving forces behind the crisis. In addition, since this paper focuses on the concept of contagion, the report by the UN shows how weak regulation in the current globally integrated economy led to the spread of the crisis. As noted in the articles Dornbusch, Park and Claessens (2000); and Rogoff (1999) lack of regulation is a weakness explored by a crisis. In addition, this report highlights the role played by the United Nations in addressing the crisis, and this further contributes to the research by highlighting the role international institutions play in such a crisis. To be specific, the UN partnered with the World Bank to provide additional countries to poor countries. The UN also developed initiatives that helped promote trade. In an attempt to put the impact of the 2007/2008 financial crisis in context, the data provided in the article by David Luttrell, Tyler Atkinson and Harvey Rosenblum (2013) published by the Federal Reserve Bank of Dallas gives insights into these impacts. The article gives an estimate of the losses incurred by the society as a result of the crisis, and this is estimated to be close to $ 6 trillion for the United States. This translates to more than 40 per cent of the economic output. In addition, the crisis had unquantifiable costs to the economy. The trauma and psychological effects caused by the crisis had a great impact on capacity and output. These figures contribute to the present research by highlighting the need to regulate such crises in future and develop sound policies to deal with such. Conclusions This research aimed at examining the concept of contagion and the idea of international institutions in dealing with a crisis. The 2007/2008 financial crisis was used to illustrate these two concepts. A financial crisis has the ability to spread from the country of origin to other parts of the world. We live in a globalized society, and this provides avenues through which a crisis spreads. This paper has applied the concept of contagion to the 2007/2008 financial crisis. From the discussion, it is evident that the link between economies facilitated the spread of the crisis. Furthermore, this explains why the crisis affected other sectors of the economy. Financial and trade links between countries provided the cracks that were exploited by the crisis, and this explains why its effect was felt globally. In addition, the behavior of investors further accelerated the spread of the crisis. This was combined by the lack of proper information about the crisis, and this led investors to attack currencies in other countries. Households cut on their spending, and there were massive corporate cutoffs. In order to cushion countries against such shocks in future, this paper has proposed several international institutions that can be used to safeguard the interests of investors, the public and the country as a whole. Based on the experience of 2007/2008, this paper suggests that it is necessary to have a lender of last resort who will help fund banks and other financial institutions that are hit by a crisis. In addition, considering that many of the banks suffered high default rates, it is suggested that an international bankruptcy court be formed to help banks recover some of their loans. Finally, having a global financial regulator who will oversee the activities of banks can help in minimizing shocks or losses suffered by banks during a crisis. Although such international institutions might prove difficult to set and run, effective legislation and goodwill can guarantee their success. Above all, countries need to enhance transparency and proper financial regulations to help reduce the effects of a crisis. Works Cited Blundell-Wignall, Adrian and Atkinson, Paul. “Origins of the financial crisis and requirements for Reform.” Journal of Asian Economics, (2009) 20(5): 536–548 web Bussiere, Matthieu et al . “The Financial Crisis: Lessons for International Macroeconomics.” American Economic Journal: Macroeconomics 2013, 5(3): 75–84. Web Dornbusch, Rudiger., Park, Yung Chul and Claessens, Stijn. “Contagion: Understanding How It Spreads” The World Bank Research Observer, (2000), 15(2): 177–97 IEG (Independent Evaluation Group). 2012. The World Bank Group’s Response to the Global Economic Crisis—Phase II. Washington, DC: Independent Evaluation Group, the World BankGroup. Luttrell, David., Atkinson, Tyler and Rosenblum, Harvey. “Assessing the Costs and Consequences of the 2007–09 Financial Crisis and Its Aftermath.” Economic Letter, 8(7), 2013: pp. 1-4. Federal Reserve Bank of Dallas Markowitz, Harry. “Proposals Concerning the Current Financial Crisis.” Financial Analysts Journal, (2009) 65(1): 25-27 web < http://www.cfapubs.org/doi/pdf/10.2469/faj.v65.n1.4 > Rogoff , Kenneth. “International Institutions for Reducing Global Financial Instability.” Journal of Economic Perspectives (1999), 13(1), 21-42 United Nations United Nations Conference at Highest Level on the World Financial and Economic Crisis and Its Impact on Development. 1-3 Jne, 2009. web Read More