Links Between Ghoshal's Point of Observation, Agency Theory and the 2008 Global Recession - Term Paper Example

Sumantra Ghoshal Paper Name Subject Date Table of Contents Table of Contents 2 Introduction 3 Literature review 4 Analysis 6 Lower interest rates 8 Over-leveraging 8 Decision Making by Managers 9 Conclusion 12 List of References 16 Introduction Economists have referred to the economic recession of 2007 using other names. The names include the 2008 financial crisis, the financial crisis of 2007-2008 and the global financial crisis. This was the worst financial crisis to affect the world economy since the Great Depression that occurred during the World War II. The recession began in the US and spread across the rest of the world. Various policy factors that favored giving loans to subprime borrowers among other factors led to this crisis. Other factors included banks being allowed to hold inadequate capital that could not support most of the contractual agreements they entered and comparison of compensation structures and in the end giving preference to short-term deal flows against the long-term options that could create value. According to various reports including the Levin-Cobum report, which is an audit by the US senate and Cadieux and Conklin, the financial crisis was a result of various factors triggered by the bursting of the US housing bubble. This problem reached its apex towards the end of 2006. The bursting formed the precursor to the financial crisis by the end of 2007. In 2008, it was clear that the US was the worst hit and was at the core of the recession. The recession posed the greatest threat to the global financial system. Analysis of the crisis from an economic perspective proves that there relations between Ghoshal’s article on the agency management theory and how the causes of the crisis. This paper seeks to identify the relations between the agency theory and the economic crisis from Ghoshal’s point of observation. Literature review According to Ghoshal, the global financial crisis of 2008/2009 was caused by different factors, some of which could have been avoided. The type of the financial crisis was debt crisis that is caused by increased lending by the financial sector without effective analysis of the credit worthiness of the borrowers. Chossudovsky (2010, p.4) notes that the global financial crisis of 2008 began in the 1980s when the global economy began financial deregulation and macroeconomic reforms and the process ended in 2008 when the stock market crashed as an effect of the restructuring process. Many financial institutions reported losses in terms of billions of Dollars in August 2008 when the subprime residential mortgage crisis reached its climax. As discussed in this paper, speculations played a significant role in the collapse of the stock market. In fact, Chossudovsky (2010, P.5) notes, “powerful financial actors with prior knowledge and access to privileged information prior to the house’s rejection of the bill made billions in speculative trade on black Monday when the market crumbled. Continued borrowing of funds whenever a country faces deficit in the current account is significant to the increase in the debt of the country. Funds borrowed from external sources include the commercial banks among other financial institutions. Despite the borrowing, what matters is the ability of the country to repay the debt. The inability of the country to repay the debt is what results into the crisis since the lenders may have inadequate credit to lend while the borrower is not able to repay borrowed funds. According to Theodore (2012, P. 339), “A COUNTRY THAT FINANCES RATHER THAN ADJUSTS TO ITS CURRENT ACCOUNT DEFICITS MUST BORROW FROM EXTERNAL CREDIT SOURCES AND/OR DECREASE ITS FOREIGN EXCHANGE RESERVES.” The severity of the debt problem depends on the ability of the country to repay them. The liquidity problem is where the country has a temporary problem in repaying the debt while solvency problem results in cases where the country is unable to repay the debt indefinitely. Though a debt crisis may begin as a liquidity problem, it may escalate to become a solvency problem in the end. As noted by Brown, it is only until that time when the borrower is able to service the principle amount or the interest that that the creditworthiness of the borrower can be established. The U.S. is a country that is trapped in a web since its debt has increased to high levels as compared to all debts of third world countries. According to Brown ( 2002, p.273), “LIKE THE BANKRUPT CONSUMER WHO STAYS AFLOAT BY MAKING THE MINIMUM PAYMENT ON HIS CREDIT CARD, THE U.S. GOVERNMENT HAS AVOIDED BANKRUPTCY BY JUST PAYING THE INTEREST ON ITS MONSTER DEBT.” It is important to note that financial institutions have a big role to play to avoid escalation of the debt crisis that always ends up causing the financial crisis. This is because if the financial institutions can act responsibly, the debt crisis can be minimized since the banks will not lend funds to borrowers that have a poor credit record. Despite the responsibility lying with the financial sector, the regulator, which is the government, has a role to play because it only implies that the government has failed in its focus of regulating the industry. The regulator plays a big role in ensuring that financial institutions are doing the right thing by following set regulations and giving funds to credit worthy borrowers. These sentiments were noted by Setster who argued that there is “NO COMPARABLE CONSENSUS EXISTS ON THE ROLE THAT THE MACROECONOMIC POLICIES THAT CONTRIBUTED TO LARGE IMBALANCES IN THE GLOBAL ECONOMY PLAYED IN THE BUILD-UP OF VULNERABILITIES THAT LED TO THE CURRENT CRISIS” Analysis The government housing policy that encouraged home ownership resulted in more than half of the mortgages ending up being defaulted. Ghoshal captured this in his analysis of the agency theory that shifted the focus of management. The default rates had risen to the highest levels by the end of 2006. Around the same time, adjustable-rate mortgages (ARM) started to increase. Housing prices skyrocketed because of the increased rates at which the banks gave loans to possible applicants. The policy reallocated capital without due consideration since more funds were readily available. The housing sector had benefited greatly from the Russian debt crisis and the Asian financial crisis that occurred towards the end of the nineteenth century and in the end the sector experienced a boom. Following on the same, the policy loosened the mortgage standards making credit that financed construction readily available. The credit included auto, mortgage, and credit cards (Haider 2012, p. 126). This increased the housing prices and caused the housing bubble. Poor regulations by the housing policy included reducing the mortgage underwriting standards to increase home ownership. This was in total disregard to the earlier policy that only allowed banks and other mortgage financiers to give loans to clients who could not afford mortgages. Government regulations did not allow the banks to set their own lending standards before the new policy. All this was repealed to allow American citizens to own homes with ease (Albaum 2012, p.54). Investors from the global market got the opportunity to invest in the US housing market through financial agreements such as the collateralized debt obligations (COD) and mortgage-backed securities (MBS) among others. This led to a reduction in the housing prices and ultimately the global institutions that had invested in the same began making loses. The new houses became cheaper than the original loan that financed the construction. The banks and other mortgage lending institutions were given permission to set their lending rates for as long as the housing prices kept skyrocketing. This was a problem attributed to the agency theories. The managers had to change the policies to accommodate the interests of the shareholders who wanted to take the opportunity to gain more profits. Decisions were made following the interests of the stakeholders while at the same time the economic forecasting was overshadowed. This policy tightened the credit. It was called mark-to-market accounting. The effect of this was felt when the lending institutions failed to recover when the housing prices declined and eventually collapsed. Among these regulations, the mortgage securities were concentrated to a few firms, banks were allowed to cut to greater levels their capital positions, and as such, they could not meet the contractual agreements they had signed. Capitalization was based on market value as opposed to real value. Government Sponsored Enterprises (GSE) in addition to the above reasons contributed to an increase in subprime lending by putting a lax on underwriting standards (Kourlas 2012, p. 64). This was coupled with intense competition among the mortgage providers. GSE altered its regulations to enable it to compete effectively with the private banks for a share of the market. Lower interest rates At the turn of the century and shortly before the housing bubble, the Federal Reserve policy lowered the interest rate by a margin of five percent. This is explained in his pretence of knowledge. The rates were exceptionally low as the mortgages could be accessed at an interest rate of one percent. Reasons that were advanced for this action included a fight against the risk of deflation among others. The low-interest rates encouraged borrowing as cheap money and credit was easily available. Economists also argue that lowering the interests was influenced by the US current account deficit that kept increasing. Over-leveraging The period that preceded the financial crisis saw increased leverage by banks and other financial institutions. The institutions were blinded into signing contractual agreements beyond their capital base. The institutions failed to check the risk levels due to complex financial gadgets that included off-balance derivatives. These institutions failed to recover during the crisis forcing the national government to bail out most of them. The financial crisis spread quickly into the global market. The process was financially harsh and resulted in the closure of several banking institutions in Europe. Stock markets were negatively affected as values for commodities largely reduced. The quick spreading was linked to derivatives. The impact of the financial crisis was felt across the world by all organizations in all aspects. The effects were both short-term and long-term. For the eighteen months that the recession lasted, the US stock market tremendously declined. The market fell with over fifty percentage points causing the Wall Street to close several times. The fall progressed and at one time hit a low level of eighty-nine percent (Samuelson 2011, p. 77). The rate of decline was faster than that of the Great Depression. Financial institutions lost a lot of money through bad loans that were written off. The crisis forced most investors to withdraw their shares from the leveraged lending institutions. International trade declined and most national governments came to the rescue of firms, as jobs were lost following increased inflation. Most of these financial institutions recorded losses of more than fifty percent. Most people lost their wealth, this directly affected consumption, and investment as both the disposable income and the income share for investment dropped. Decision Making by Managers The ability by the management of an organization to make the right decisions in different situations relies on the availability of the right information by the right personnel. Ghoshal brought out this idea in his gloomy vision analysis. The Economic theories do affect these decisions in many ways. The pressure from the key stakeholders among them shareholders and the government mainly influenced assumptions that were made by the managers in the periods preceding the crisis. The government for instance thought it would take advantage of the crisis in Asia to help boost the economic power of its people. The same team should give the information at an opportune moment. This is important especially if the company is facing an unstructured problem. In such environments, the managers have little information regarding the problem while at the same time the availed information is ambiguous and as such not sufficient for use. Analysing and predicting consumer behaviour is a very good circumstance that managers will find themselves. For instance, the organization would want to know what customers do in situations where a product such shoes would be priced at $ 499 or $ 510 with an incentive e.g. a shoe polish. Alternatively, a chewing gum packet with four pieces sold at $ 6 and an increase in the pieces to five at $10. (Beth 2002, p. 34)Predicting the outcome is very hard making it the most difficult situation that managers face. In this type of circumstance, managers will be needed to be creative and as such anchoring and adjustment heuristic becomes the most appropriate tool to use. Consumer behaviour might be one characteristic behaviour that might not be known to the stakeholders. However, the same directly affects them. Managers will in many ways use past experience in an attempt to arrive at the best conclusion of how the consumers will behave. Prior information either experienced or thought of the by the manager will inform the manager on how he or she will arrive at the best probability. Production that is anchored on the inputs and the total personnel available is guided by the consumption rate on the market. However, the power of consumption is controlled by the market dynamics whose lead instructor is consumer behaviour. In spite of the fact that the manager might not go to the market to evaluate the behaviour, he has to make a decision to hence the continuity of production. The decision made will inform on the total personnel needed along with the raw materials to be received from suppliers (Mark 2008, p. 47). As a human as the manager is, the decision he makes arises from the assumption that his mind operates well with relative thinking than being forced into using absolute thinking to make decisions. Putting the anchoring effect into perspective will help the manager in getting a short method used by consumers in arriving at decisions. Differences exist in the consumer behaviours of individual customers. Certain clients prefer inter-dimensional procedure of collecting information about the products before making a choice. Others would rather a one-dimensional when in a similar circumstance. The heuristic process of anchoring and adjustment would be necessary in handling the personal pattern of collecting information by consumers. Such models are usually restricted especially in difficult decision-making situations. This was evident when the US was nearing full economic crisis. The manager might be expected to understand that different consumers use the information they get about products on the market differently and at different times (Hass 1998, p. 87). The information collected will help the manager to understand how the market makes choices in complex environments. The organization will be able to evaluate and make an analysis of how the consumers make decisions when the information availed to them is scarce. Changes in market consumption behaviour will henceforth not affect the production processes of the company. This therefore means that the organization will never have excess products that will be disposed, the production process will never be halted to give room for offloading excess production, and the company will not experience delays. Conclusion Following the lessons learnt from the economic recession, economists, managers, and government heads have put measures to curb the occurrence of such a crisis. This means that proper projections are to be made in future. Changing the trend in addition to rethinking the total governance issue carries the solution to curbing future crisis. Strategic management is a process that determines the fundamental aims or goals of the organization, and makes a range of decisions, which allow for the achievement of these aims or goals. These decisions are both long term and short term. The top management directs the process throughout the organization by engaging all the junior staff including those with the duty of satisfying customers. The process entails strategic planning, management of change and capacity planning. The process is concerned with the relationship between the company and the environment within which it operates. The primary components of strategic management process include environmental scanning, strategy formulation, strategy implementation, and evaluation and control. Environmental scanning in an organization precedes strategic formulation. It scans the external environment to spot available opportunities and threats. This includes the strengths and weaknesses of the internal environment (Werbech 2009, p. 121). The external variables directly affect the long-run decisions without influencing the short-run forces. They include economic forces, which regulate the exchange of materials, information, and money. Technological forces generate mechanisms that aid in giving solutions to problems. Another external variable is the political force that puts forward laws and regulations that guide how the whole industry operates. The socio cultural forces regulate morals and customs in the society. Strategy formulation entails developing long-term plans for effective management of the environmental forces that have been scanned. This process defines the corporate mission; it specifies the objectives, develops strategies, and sets policy guidelines. A mission defines the basic and distinctive purpose that differentiates the company from other firms and identifies its scope of operation. It is the reason for the existence of the company. By giving the strategic vision, the mission carries the organization’s philosophy on employee relations (Daft 2009, p. 65). Putting the policies into action through budgets, programs, and procedures covers the process of strategic implementation. Monitoring the results by comparing the actual performance with desired performance falls under control and evaluation as a process of strategic management. The strategic management process is important to a firm because of various reasons. This process is the only way the firm can forecast problems and prepare for the same. (Morden 2007, p. 57) By making long-range decisions, the company averts the syndrome of management by crisis as a usual system of management. The process gives direction and control to the business. It improves corporate communication within the firm among other functions. A strategy could be borrowed from Wal-Mart. The company remains the market leader in the industry because of its strategic management process. The company has adopted a three-tier strategic process. Save and live better is the first. Wal-Mart makes sure that its prices are low to curve its niche in the market. Their consumables advertised at the head office to reduce expenditure. To help consumers to save, the company introduced private labels. The second strategy is the win, play, and show policy. This optimizes the company products in various stores. It also strikes a balance between growth and profit (Castillo 2003, p. 43). This policy includes reducing the number of stock in their outlets but it does not exit the market. The fast, friendly, and clean policy is the third strategy. In this case, the company takes forty-eight hours to replenish its merchandise. It pursues the zero wastes policy by maximizing the efficiency from the manufacturing phase through the whole process. The company has also improved its supply chain to almost perfection. Emphasis is on transportation. These strategies have helped Wal-Mart to control its market share, acquire new customers and blocked other competitors from dominating the industry. List of References Haider, I, 2012, Sovereign Credit Risk in the Eurozone, World Economics Publishers, New York: Kourlas, J, 2012, Lessons Not Learned from the Housing Crisis, The Atlas Society publishers, New York. Samuelson, R, 2011, Reckless Optimism, Claremont Review of Books New York. Werbech, A, 2009, Strategy for Sustainability, Harvard Press New York. Morden, T. 2007, Principles of Strategic Management, Ashgate Publishing New York. Brown, E, 2002, The Shocking Truth about our Money System. 3rd Millennium, Louisiana Chossudovsky, M, 2010, The Great Depression of the XXI Century. Global Research Pub Montreal Setster, B, 2009, Debating the Global Roots of the Crisis journal, Geo-economics journal. Theodore, C, 2012, Global Political economy: Theory and Practice, Pearson Education, New Jersey. Daft, R, 2009, Organizational theory and design, Cengage, New York Castillo, C, 2003, A journey into the future, Liberty pub, New York. Albaum, G, 2011, International marketing and export management, Pearson prentice Hall Beth, Y, 2002, Trade and Finance, South Western College Publishers New York Hass, R, 1998, Bureaucratic Entrepreneur, Brook Institution Press New York: Mark, A, 2000, International Ethics and Concepts, Rowman & Littlefield Publishers, New York. Read More