Free Market Fundamentalism - Assignment Example

Student Name: Instructor’s Name: Title: Economics Case Study Course: Institution: 1. in your own words, summarize the article. What is the main message of this article? [Eight marks] The article, “The God that Failed: Free Market Fundamentalism and the Lehman Bankruptcy by Ferguson and Johnson (2009), debunks the idea that everything was just fine with the economy until Paulsen and Bernanke went to Congress and got the government involved. There are two very important themes running through this article and which revolve mainly around the government controlled free market economy and that with no government involvement. The author is correct and compellingly clear when they point out that letting Lehman fail was the main contributing factor and a turning point in the financial collapse, with significant implications on the price of credit and markets among others. The counter argument as presented by Cochrane, and Zingales is that allowing Lehman’s bankruptcy was appropriate and in the spirit of creative destruction, which they argue, is vital for free market capitalism. For them, government involvement and the resultant bailout funds were the main triggering factor or precipitates to the fall of Lehman. They argue that this was a clear breath of the free market principle citing other failures and bailout like of other big companies but not limited to AIG, Fannie Mae and Freddie Mac and Washington Mutual. However, according to Ferguson and Johnson, the explanations offered by Taylor, Cochrane, and Zingales is not exhaustive or rather not convincing. Secondly, the authors specifically argue for the Keynesian — and Roosevelt an implying that the involvement of the state is the surest and essential for economic stability. Although the authors are right in their argument for a state controlled market economy, this does not mean that the opposing argument cannot be wished away. The two protagonists arguments however merge with a common consensus for the free market and a clearer line between the collapse of Lehman and associated effects of the crisis on new economies based on the global markets. For Ferguson and Johnson, the fall of the Lehman Company triggered a negative impact on the liquidity capital markets of developing countries, world markets, hedge funds, private investments, as well as negative effects on the credit default swaps, interest rates among other things. If viewed with a keen eye, the crisis from the perspective of the two views may have been prevented in one way or another. 2. Explain the free market principle. In your answer, use the supply demand framework to illustrate the efficient outcomes of free markets and spell out key assumptions of the efficient market theory. In addition, explain the implications of the theory on the role of the government and regulations. [8 marks] The most general and basic principle of a free market economy is the recognition of individual rights , liberalism , property and voluntary agreement with very minimal government intervention except reasons of security and defending the individual right in upholding the tenets and ideas of the free market economy. According to Adams (2010), with free markets, prices are determined by what is called the market mechanism, or simply put, the supply and demand. This is illustrated in figure 1. Source: Adams (2010) Figure 1: Diagrammatical presentation of Supply and Demand in a Free Market economy The supply-demand cover are often put in graph presentation with x and y-axis representing the price and quantity of the commodity in a market environment. The point of convergent is known as the point of equilibrium. One advantage of a free market is that it leads to efficient outcome, which is essential for the best outcome. Essentially this means that interference with the free market is bad (Maie and Nelson, 2007, p. 71). One assumption is that of a market with a perfect competitive environment (Mankiw, 2008). It is presumed here that everyone in the market is dealing with exactly the same good and services – in other words, people are involved in homogeneous good making them undergo the same price of goods and services. This is not true in the real world (May and Nelson, 2007, p. 71). Also in the Supply and Demand model, the market seems to clear when the quantity of goods and services supplied is the same with the quantity demanded. The price is illustrated at the point of intersection of the supply and demand curve. According to Sharpe (cited in Dodd, 2002, p. 2), this is an illustration of a perfect market where the prices of securities can be used for prediction purposes because of the available information. However, this is quite rare in the real world situation (May and Nelson, 2007, p. 72). According to Mankiw (2008) in some market economy, one or single buyer or seller may have a market power in controlling the prices in the market. Consequently, this can lead to inefficient market, as the prices will fluctuate in terms of the supply and demand keeping the prices of goods and services distance away from the point of equilibrium (Mankiw, 2008). The other assumption is that the outcome in a given market is only relevant to specifically to buyers and sellers yet in reality, the decision reached by the two business actors may sometimes influence or affect even the non-participants in the market. This can be explained in terms of the externalities or side effects, which is extended beyond the business players making the equilibrium in the market inefficient from the perspective of the whole society (Mankiw, 2008). Generally, the two assumptions, the market power, and externalities when combined constitute one of the contributing factors failures in the market as influenced by the inability to control the hidden forces in the efficient distribution of resources. The implications of the efficient market theory are to justify a complete deregulation of financial markets as well as disapproving the role of government intervention or involvement. Regulation of the market by the government may exert a controlling effect or impact on the firms or business actors freedom either to engage or exit from the business transaction in the market setting, it may also affect their ability to come up with their own prices , control their products and service as well as making their own business deliberations and decisions. However, at the same time, it may affect the different choices reached by an individual in a given market. This argument is supported by Taylor, Cochrane, and Zingales (2009). 3. Explain the concept of ‘Creative Destruction’. Why is the ‘Creative Destruction’ essential to free market capitalism? Explain how this concept is relevant to Global Financial Crisis (hereafter, GFC) ? Do you agree with the concept of ‘Creative Destruction’? [ 8 marks] Creative destruction as coined by Schumpeter (1942) simply relates to the incessant product and process innovation mechanism by which new production units replace outdated ones. According to Schumpeter , this is a vital component and vital fact about capitalism . A simple illustration of this term is the introduction of new technology, which has replaced the old ones. Some people like Taylor, Cochrane, and Zingales (2009) advocate that this process should be allowed to take place since it is very significant for any economy to be stable and thrive . Still others like Furgeson and Johnson (2010) feel that this should not be allowed to take place, as it is detrimental to thethe health the economy.Instead the government should be allowed to chip in in the taking control to avoid the unprecedented impact of the said creative destruction. Creative destruction is thus an important feature of the capitalist market the process allows vital aspects of the macroeconomic outcomes both in the long term and economic fluctuations as well as the operations of market factors while at the same time allows the replacement of the old resources (goods ) by the newer and more efficient or advanced technologies hence playing a major role in the growth of the economy which by extension and with proper management can bring about improvement in income and standard of living. However, this does not mean that it is all beneficial. There are various shortcomings, as would Furgeson and Johnson (2010) say. Such challenges can be significantly heavy on such businessmen and women who may have to bear the direct negative impacts. From the perspective of Creative Destruction, the world financial crisis can be seen as just like any other normal process of a business cycle (Inayatullah , 2010). Although to a very small extent, some regulations may be required, it may not be the permanent solution or measure against the impacts of financial crisis but can only change the private debt to a public one. Proponent of creative destruction allows for the financial crisis as a normal trend and technological cycles allowing the market to play its major role; the market is always allowed to punish those who were not keen in their business endeavors or the words of Inayatullah (2010) the market as justified in punishing those people who have sinned including the corrupt or, like Detroit car companies and other large financial organization especially those who have not mastered the dynamic business environment (p. 113). In the financial crisis, it is always advised not to interfere with the victims but instead, it is recommended that they should be left or not assisted as other players or winners will eventually emerge from the crisis. The new players are more likely to be innovative, creative , will be able to efficiently find new markets (Inayatullah , 2010). In simple terms, the crisis is a learning process, which at the end is able to produce more innovative business actors and new technologies. This can be exemplified by the 2008 2009 financial crisis (as the 1987 market crash) which at the end produced the best buying opportunities and practice; one of the century . For those people ready to take risk, and accommodate the ideas edge funds , research budgets among other strategies, which may appear less promising for their business in the short-term basis, are likely to benefit in the long term (Inayatullah , 2010). 4. according to the evidence presented in the article, and from your own research and the market stability point of view, do you think it was appropriate to let Lehman Brothers go bankrupt? Make sure you justify your answers. [8 marks] From economical point of view, letting Lehman Brothers fall can be justified as a necessary condition for a healthier economy (Taylor, Cochrane & Zingales, 2009) and a warning for the irresponsible behaviour, which would face the dire consequences. Fed and Treasure deemed that allowing Lehman Brothers to fall would not have severely threatened the global financial stability as well as the performance of the US economy. In part, it was also a way of sending a message for the need for companies deal with their own actions and problems. It was necessary to let Lehman Brothers go into bankruptcy as a state based solution or measures proved infeasible at the time . This is because the company could not give the required collateral to be able to get a reasonable guarantee that the Federal Reserve would be repaid. The other reason is that the treasury at the time did not have enough mandate and authority to take or absorb large losses in term of billion of shillings as a result of facilitating Lehman’s equation by another company (Arnon, Weinblatt and Young,2011) and also as part not avoiding further use of the tax payers money. Another reason is based on the Moral hazard, which applies to the behaviour, which generally seeks a maximum gain characterized by the likelihood of risk or very limited care about any eventualities like minimizing further losses and partly because of the feeling that the state would come in and assist (Thomas and Hirsh, 2009). Lastly, apart from the public pressure and as the only moral thing to do considering the circumstances, the timing or period of the company crisis also may have played a major role . Looking at the immediate context of the event, the American Treasury had taken a very huge debt of Fannie and Freddie Mac. Again, immediately, it appeared that the US treasury didn’t want to get involved in Using the public coffers which in the words of Samargy(2008) would have been a case of conducing a form of “financial socialism”, hence it was the only rational thing to do. Although the bankruptcy Lehman Brothers was a necessary yet inevitable, it brought about huge loses and a major shakeup in the economy. Apart from the major and direct impact of the company , it created some sense of fear, which affected the financial economy. Hence, there is a need for a better regulation and control especially at the transnational borders , and more effective crisis resolution or measures in place. 5. ‘Expectation is the main culprit that leads economies to GFC’. Evaluate this statement in the light of this article; and provide an appropriate diagram to support your argument. In this respect, our best guide is Keynes, do you agree? [8 marks] It can be said that expectation is one of the contributing factors to the current Global Financial Crisis. This can be illustrated by the fact that in a free market economy, for instance it is expected that financial deregulation and privatization as enhanced by the philosophy that this encourages innovative ideas in relation to financial tools which are quite detached from the main producers in the real economy. This is often based on speculative information or ideas far from the real world situation. Sometimes, the speculations can only hold for a short period only to backfire later. For example, expectation of high returns make business actors invest most of their resources , or borrowed money , currencies, stock exchange and others for reasonable outcomes . Such expectations are quite risk to the financial sector as some result in destabilization of market prices especially in the modern business environment full of uncertainties . When expectations of financial markets meet the realities of the rather slow paced growing and real economy, an adjustment of the high level of exaggerated expectations of business actors becomes unavoidable. However, the current GFC cannot be exclusively explained as resulting from the expectations but rather because of lack of government involvement in the regulation and timely control of the financial sector. It is also a result of allowing the business players to engage in the reckless or careless lending of money in the so-called free market economy. References Adams(2010). The economics of supply and demand, accessed from: http://www.helium.com/items/1822457-the-economics-of-supply-and-demand Arnon, A., Weinblatt, J. In addition, Young, W. (2011). Perspectives on Keynesian Economics, Springer, New YorkSmaghi, L.B (2008). Some thoughts on the international financial crisis available at http://www.ecb.int/press/key/date/2008/html/sp081020_1.en.html Cochrane, John, and Luigi Zingales (2009). Lehman and the Financial Crisis, Wall Street Journal, Available at http://online. wsj.com/article/SB1000142405297020344 0104574403144004792338.html. Dodd, R (2002). The Economic Rationale for Financial Market Regulation, Derivatives Study Center, Washington D.C. Ferguson, Thomas, and Robert Johnson (2009). Too Big To Bail: The ‘Paulson Put,’ Presidential Politics, and the Global Financial Meltdown Part II: Fatal Reversal—Single Payer and Back. International Journal of Political Economy 38(2):5–45. Inayatullah, S. (2010). Multiple Narratives of the Futures of the Global Financial Crisis, Journal of Futures Studies, 14(3): 109 - 128 Maier, M.H., and Nelson, J. A (2007). Introducing Economics: A Critical Guide for Teaching, M.E Sharp, Inc, USA. Mankiw, N.G. (2008). Essentials of Economics, Cengage Learning, USA.Schumpeter, J. 1942. Capitalism, Socialism, and Democracy. New York: Harper & Bros Thomas, E and Hirsh, M. (2009). Paulson’s Complaint. Newsweek. Read More