Turmoil in Global Financial Markets - Essay Example

1. In light of the recent turmoil in global financial markets, many countries have implemented “rescue” packages for ailing financial s. Does this mean that Adam Smith’s “invisible hand” view of the economy is now redundant? Discuss. Adam Smith’s invisible hand view of the economy is not redundant for the current. The invisible hand view of the economy, as explored in the book “Economics” by Samuelson and Nordhaus, will fail to exist under two conditions: when there is imperfect competition and imperfect information, and when there are market externalities. The failure in major financial markets exists because of either of these conditions. Prior to the financial crisis, the financial markets such as stocks, bonds and mutual funds markets are considered markets where the invisible hand operates. The stock market has always been referred to as an efficient market by economists. According to Brealey, Myers and Marcus, “the competition [in this market] to find misvalued stocks is intense. So when new information comes out, investors rush to take advantage of it and thereby eliminate any profit opportunities (2004, 165).” An efficient market, according to Samuelson and Nordhaus in their book “Economics” is defined as “one where all new information is quickly understood by market participants and becomes immediately incorporated into the market prices (2004, 534).” This characteristic of the stock market as an efficient market is attributed to the availability of timely information which is incorporated in the prices of the stocks. The stock market indeed needs investors who believe that the market is inefficient in order to make the market efficient. As investors think that there is a certain degree of inefficiency in the market, these investors’ notion of the stock prices are that they are underpriced, and there is a chance to profit from this situation. Therefore, as investors believe in this inefficiency, and the possible reward of profiting from these undervalued stocks, they are driven to action. When investors are driven to action, they look for more sources of information, analyze the information and push the prices up or down depending on the value of the information as regards the certain stock. When investors are prompted to take action either by driving the prices of the stocks up or down depending on the information, the direction of the prices tend to be that which incorporates the value of the information—thus, eliminating the possible profits from buying and selling the stocks; hence, making the market operate under the invisible hand theory of Adam Smith. The financial crisis has started out due to the exposure of the imperfect information in the market. For a long time, the market operates efficiently as investors have trusted the information that is available for the public. When the inefficiency of the US financial system has been exposed to the public, the imperfect information has led to inefficiencies in the financial systems. This led to the collapse of many financial markets as capital flight from risk has set in, in order for many investors to minimize the potential loss they will experience from the inefficiencies of the countries’ financial systems. Due to this, government interferes with private banks and other financial institutions by providing rescue packages. As the market fails to perform efficiently due to a market failure such as this, the invisible hand view of the economy becomes nonexistent but not insignificant or redundant. 2. The article suggests that the downturn will impact the wealthier countries more than poorer nations. Will this recent crisis impact all developing countries in the same way? Research and analyse. Wealthier countries are more affected by the financial crisis as suggested by the article, and the relative impacts of the crisis on the poorer nations vary, but less than the impact that it has on the wealthier countries. The major reason why wealthier countries are more affected seems to lie in these countries’ economies integration into the global economy. With globalization and integration of financial markets, the financial crisis that stemmed out from the United States’ credit crunch has led many wealthier countries’ financial markets which are integrated to this global financial market have crumbled too. Due to this, the relative impact of the financial crisis among country can really be determined by the integration of a country’s economy to the global economy. The more integrated its trade and financial markets are, financial crisis will be felt with more impact. As Dirk Willem te Velde, in his article points out: “Those countries that have done well by participating in the global economy may also lose out most, depending on policy responses, and this is not the time to reject globalisation but to better understand how to regulate and manage the globalisation processes for the benefit of developing countries. The impact on developing countries will vary. It will depend on the response in developed countries to the financial crisis and the slowdown, and the economic characteristics and policy responses, in developing countries. […] While the effects will vary from country to country, the economic impacts could include: weaker export revenues; further pressures on current accounts and balance of payment; lower investment and growth rates; lost employment. There could also be social effects: lower growth translating into higher poverty; more crime, weaker health systems and even more difficulties meeting the Millennium Development Goals. (Overseas Development Institute 2008 October, p.4).” Poorer nations and integration into the global economy According to a report published by the World Bank, although developing countries have not escaped the effects of the global financial crisis, these countries will not be affected in the same way and magnitude as compared to others. One major factor that will determine the differences is the integration of the poorer nations’ economies into the global economy. According to World Bank “Virtually no country, developing or developed, has escaped the impact of the widening crisis, although countries that entered the crisis with stronger fundamentals and/or less integration into the global economy have generally been less affected (2008).” The integration of the country’s economy into the global economy both in terms of the country’s trade sectors and financial sectors will determine up to what extent it will be affected. Substantial borrowing from foreign banks and poor nations affected As mentioned previously, developing countries that are more likely to experience more of the global financial crisis depends on the country’s economy’s integration into the global economy both in term of the country’s trade sectors as well as finance sectors. The integration of the financial sectors of these countries will determine the relative impact of the crisis on the country. According to the World Bank, the developing countries that would be affected are those who rely more heavily in borrowing from foreign banks. The countries that have more sophisticated financial sectors that are integrated into the global financial markets are more likely to feel the impacts of the global financial crisis. Financial sectors, investments and integration into the global economy The impact of the global financial crisis on the developing countries will also be determined by the extent that the economy supports its growth through international financing through their stock markets and through foreign direct investments (Overseas Development Institute 2008, 3-4). As a country’s aggregate demand is determined by the function of consumption, investment, government spending and net exports, the part of the investments which is supported by international financing will experience slow down as capital flights from risks and credit crunch will decrease the overall level of aggregate demand in the economy. Therefore, those developing countries that have heavier reliance on international financing through their stock markets and foreign direct investments are more affected. Global food and fuel prices to aggravate the effect on the nations affected: importing countries The other criteria that determines the relative extent of the effect of the global financial crisis is a country’s heavy dependence on imports. The more a country is dependent on the import, the more the effect of the crisis is felt in the economy. As commodity prices have started to increase earlier last year, the increase is further aggravated by the global financial crisis. Due to this, countries that rely heavily on import will feel the weight of the higher commodity prices. Affected developed countries which are main markets for exporting countries The last condition that will determine the difference between the effects of the global financial crisis on developing economies is a country’s heavy reliance on exports to markets that are mostly affected by the crisis. Countries which primary markets include the US and the EU regions in terms of export will more likely have a harder time than other developing countries. As recession has set in these markets, the significant reduction in demand will hurt the economies of developing countries that rely more on exporting to these affected countries; hurting the economy of the exporting developing country more. 3. Recently, the Australia government has unveiled measures aimed at insulating Australia from the fallout of these global events. Using the AS/AD model, analyse the intended effects of these fiscal measures. What should be the role of monetary policy given these events? In order to insulate Australia from the effects of the global financial crisis, the government has utilized some measures such as providing guarantee for deposits in all Australian financial institutions, as well as financial stimulus package in order to prevent recession from happening from the country. According to Mike Head in his article in WSWS.org, “The prime minister unveiled a finance industry package that guarantees all bank and finance house deposits and overseas borrowings to the tune of more than $2 trillion. Two days later, he announced a $10 billion economic stimulus plan, allocating half the budget surplus, in a desperate bid to resuscitate consumer spending and prevent the economy sliding toward recession (18 October 2008).” By providing guarantee for deposits in all Australian institution, the government is trying to gain control and stabilize the money supply and push investments outward, as shown in figure 3.1. As the financial crisis threatens the country of further capital flight from risks, the government provides the guarantees in order to “stabilize the flow of market, to support global economic growth (PM.gov.au, 12 October 2008).” Guarantees for deposits are aimed to back up the credit reputation of local banks in order for them to have access to funds from the international market. As these financial markets become more risk-averse, the funds become scarcer thus access to these markets become harder and more competitive. Thus, this guarantee is aimed for Australian financial institutions to gain access to international funds, bringing additional funds that can be channeled to the economy as investments. According to the government’s press release, “Having carefully reviewed international developments, the Australian Government, acting on the advice of the regulators, has decided that it must act to provide the same guarantees for our banks and other financial institutions. If we do not do so, Australian financial institutions could, over time, find it more difficult to borrow in international financial markets. They would become uncompetitive in attracting funds in markets that have become increasingly tight and risk-averse as this global financial crisis has deepened (PM.gov.au, 12 October 2008).” The effect of the additional funds that the government aims to bring to the economy is illustrated in Figure 3.2, where it illustrates the additional increase in investment in the country. With the additional investments, the aggregate demand is aimed to be pushed outward, if not to just maintain the current level of aggregate demand and prevent recession. As for this fiscal measure that is brought by the government, monetary policy is the cause of a major concern. The slump is caused mostly by the monetary policy in the United States, which has affected the other financial systems across the world. This monetary policy should be addressed by the government, in such a way that the financial system of Australia should not be put in peril by bailing out the financial institutions through guarantee of deposits. As previously mentioned, $10 billion dollar is provided by the government as a stimulus for the economy. This will come in the form of increased infrastructure spending, as well as grants for consumers in order to prevent consumption from declining. The stimulus package that the government has provided for additional spending is aimed to either push the aggregate demand outward or to at least maintain the current level of aggregate demand and prevent the economy from entering into a recession. With the stimulus package, the government aims to push the aggregate demand by the amount of the multiplier in the economy. With the stimulus package, the government aims to channel the funds back to businesses and consumers in order to strengthen the consumption and investment functions. This aim to both increase investment and prevent it from declining is apparent from the government’s support for small businesses. As Craig Emerson has put it in his article “Global Financial - Crisis and the retail sector”: “At the National Small Business Summit hosted by the Prime Minister last month, extra initiatives were announced including a $4 million program to assist chambers of commerce, Business Enterprise Centres and other registered business organisations in supporting small businesses. The Prime Minister also announced that the Government will simplify and provide more realistic terms and conditions for government contracts so that small business can compete in tendering processes. That’s good news for small business, it’s good for competition and it’s good for the taxpayer if there are more businesses involved in bidding for those contracts. Small businesses that invoice the Government for services rendered and goods supplied will be paid within 30 days. And if government departments don’t pay on time they will be charged interest. Finally and very importantly for the retail sector and small business development generally is the availability of credit (RetailTimes.com, 21 December 2008).” All these fiscal measures aim to regulate aggregate demand and prevent the economy from getting into recession, by influencing the other elements of aggregate demand, such as consumption and investment through government spending. As aggregate demand is increased or at least maintained in order to prevent the economy from sliding to recession, unemployment and inflation figures are kept under control, despite the global financial crisis. 4. The value of the Australian dollar has declined during this crisis, even though our economic fundamentals are better than most countries. Discuss the likely causes of our currency’s depreciation. The Australian dollar has weakened during the past few months of the crisis even though the country has strong economic fundamentals. As the price of the Australian dollar is determined by in the foreign exchange market by the relative demand and supply forces, the Australian dollar faces a huge decline due to a decrease in commodity prices overseas. In ADB Economics Working Paper Series entitled “The US Financial Crisis, Global Financial Turmoil, and Developing Asia: Is the Era of High Growth at an End?” has pointed out in its article the following: “In contrast to Canada, Australia has been as guilty as the US in living beyond its means with burgeoning current account imbalances reaching over 6% of GDP in 2007 […]. In contrast with the US, the consolidated budget of Australia is in surplus, albeit not a large one […]. The relative size of the current account imbalance is worrisome and has contributed to the recent weakness of the Australian dollar despite the relative strength of the prices of Australian exports in world markets and terms of trade gains arising as a result […]. Falling commodity prices in the latter part of 2008 are deteriorating the outlook (James, Park & Jha 2008 December, p. 17).” The Australian dollar’s exchange rate is a factor of the supply of the AU dollar in the market, as well as the demand for it. As the commodity prices overseas decrease, the global demand for commodity is the major cause of it. With Australia’s economy being integrated into the global economy, a small drop in price can significantly have an effect on the country’s foreign exchange rate. The overall demand for Australian goods declines due to this fall in global demand as well as fall in the commodity prices. As commodity prices decrease and exports decrease as well, the demand for the Australian dollar decreases too overseas. This decrease in the demand for Australian dollar, mainly cause by the falling demand and prices in commodities have caused the Australian currency to weaken against other currencies such as the dollar. As being apparent, trade balances play a huge role in the depreciation of the dollar. Intuitively, we can assume that because of the lower prices of commodities for exports, the country is paying more for the import than it is earning for the export. This means that a greater demand for other currencies too due to higher imports pushes the price of the other currency, which causes the Australian dollar to depreciate further. 5. Briefly discuss the likely effects of these global events on... (i) the Australian retail sector (ii) the Australian housing market (iii) the Australian mining industry. Australian retail sector The Australian retail sector is a major component in Australia’s consumption function. As credit crunch continues, the availability of the consumer financing for consumption will also be affected and will likely experience a significant reduction. As credit facilities have helped boost many economies across the globe in terms of boosting consumption thru deferred payments, the scarcity in international financial funds which the Australian banks have access to will likely affect these credit facilities. Due to these, the consumption function of Australia, like those of the other major industrialized countries will face a decrease. Australian housing market After almost a decade of heated housing prices due to speculation (GlobalPropertyGuide.com, 2008), the market cools down due to the financial crisis. Due to scarcity of funds in the international market, house loans have become less available which results in a lower demand for the housing market. In the past, the availability of funds from the international market has enabled local banks to consider lowering the requirements for loans and mortgages. However, due to the scarcity of funds banks increase their loan requirements, as credit checks have been more intense. As fewer applications are approved for loans and mortgages, the housing market experiences a decrease in demand which leads to falling prices. Australian mining industry Mike Head, in his article entitled “Australian government props up banks as signs of a deep global recession emerge”, makes a point about the mining industry’s situation as regards the grueling impact of the financial crisis in Australia. In his article, he mentions “the vulnerability of the Australian economy has been underscored this week by the collapse of share prices for Australias two mining giants-BHP Billiton and Rio Tinto. BHP shares fell 13 percent this Thursday, taking the price down to almost half its peak, just five months ago. Rio was hit even harder-down 16 percent, taking its loss to nearly 60 percent since May. In its quarterly report this week, Rio admitted for the first time that it was facing a ‘marked reduction in Chinese commodity demand,’ forcing it to lower production, delay projects and defer plans to sell assets to reduce its debt burden. “Over the past three months, the currency and commodity markets have delivered their verdict on the prospects of the Australian economy-the $A has fallen to below 70 US cents, more than a third from its peak, and commodity indexes have dropped more than 40 percent, with signs of worse to come. Spot iron ore prices have declined by more than 60 percent (WSWS.org, 18 October 2008).” According to the Australian, the financial crisis has started to creep into the mining industry as apparent in the laying off of more than 500 workers by mining companies (2008). The financial crisis has resulted in decrease in overall demand for minerals, which results in lower prices and lower revenues for companies. As recession starts to hit many countries across the globe, the overall demand for minerals starts to shrink. This leads to falling prices, hence falling revenues for companies. As revenues start to fall, companies are left with no other choice but to layoff a number of workers to lessen the financial loss. Bibliography Australian Government (2008, October 12). “Global Financial Crisis.” PM.gov.au. Available from http://www.pm.gov.au/media/Release/2008/media_release_0534.cfm . [Accessed 14 January, 2009] Brealey, R. A., Myers, S. C., & Marcus, A. J. (2004), Fundamentals of Corporate Finance. New Jersey: McGraw Hill. Emerson, Craig (2008, December 21). “Global Financial - Crisis and the retail sector.” RetailTimes.co.au. Available from http://www.retailtimes.com.au/index.php/articles/Global_Financial_-_Crisis_and_the_retail_sector. [Accessed 14 January, 2009] GlobalPropertyGuide.com (2008, December 22). “Soft landing for Australia’s housing market.” GlobalPropertyGuide.com. Available from http://www.globalpropertyguide.com/Pacific/Australia/Price-History. [Accessed 14 January, 2009] Head, Mike (2008, October 18). “Australian government props up banks as signs of a deep global recession emerge.” WSWS.org. Available from http://www.wsws.org/articles/2008/oct2008/rudd-o18.shtml. [Accessed 14 January, 2009] Ibtimes.com (2008, September 2). “Australian dollar weakens sharply.” IbTimes.com. Available from http://www.ibtimes.com/articles/20080902/australian-dollar-weakens-sharply.htm. [Accessed 14 January, 2009] James, William E., Park, Donghyun, & Jha, Shikha. (2008 December). “The US Financial Crisis, Global Financial Turmoil, and Developing Asia: Is the Era of High Growth at an End?” Asian Development Bank.org. ADB Economics Working Paper Series No. 139. Available from http:// www.adb.org/Documents/Working-Papers/2008/Economics-WP139.pdf. [Accessed 14 January, 2009] Samuelson, P & Nordhaus, W. (2004). Economics (17th ed.). New Jersey: McGraw-Hill Irwin. Te Velde, Dirk Willem (2008, October). “The Global Financial Crisis and the Developing Countries.” Overseas Development Institute. Available from www.odi.org.uk/resources/odi-publications/background-notes/2008/global-financial-crisis-developing-countries-growth.pdf. [Accessed 14 January, 2009] The Australian (2008, December 16). “Global financial crisis hits mining companies.” The Australian.com. Available from http://www.theaustralian.news.com.au/business/story/0,28124,24808363-5005200,00.html. [Accessed 14 January, 2009] World Bank (2008, December 2). “The Implications of Global Crises on Developing Countries, The Millennium Development Goals, And Monterrey Consensus.” World Bank. Available from http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:21996735~pagePK:64257043~piPK:437376~theSitePK:4607,00.html. [Accessed 14 January, 2009] Read More