The Global Financial Crisis from the Financial Perspective - Essay Example

I. Introduction This paper aims to explore the global financial crisis from the financial perspective. By looking at the financial markets and theirdynamics, the players and their roles on the crisis, the bigger picture is understood. Aside from the financial markets, another more plausible argument has been considered—the overcapacity of money supplies by profiting from the financial markets, without real growth in production. This paper also aims to look at the effect of the financial crisis on the Australian economy, as indicated by the exchange rate for the Australian dollar, as well as the interest rates as apparent in the situation of the housing market, and the unemployment situation in the mining industry. Lastly, this paper looks at the current efforts to regulate the financial markets. II. Sources of data / Methodology The sources of data include article from online versions of major newspapers such as the Australian, as well as articles from global financial institutions such as the World Bank and Overseas Development Institute. Other legitimate sources such as the website of the Australian government have been utilized. The bulk of the sources include academic journals such as Financial Management, McKinsey Quarterly, Cambridge Journal of Economics, etc., that tackle the issue of global financial crisis, from databases such as Business Source Premier, Oxford Journals and ABI Inform. III. Findings and Discussion A. Financial Markets and the Efficient Market Theory 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 (Segerstorm 2009, 39). 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. B. The Financial Intermediaries and Their Role in the Crisis The whole global financial system is comprised of users of financial capital, sources of financial capital, and the financial intermediaries. The distortion of information in the market, from the point of view of the sources of financial capital has come from the financial intermediaries. As two global investment banks—Bear Stearns and Lehman Brothers have collapsed, along with the bankruptcy of AIG, the worlds largest insurer, the distortion in the information that investors perceive prior to this collapse started to unfold (Jameson 2009, 499). After these distortions have started to unfold, it caused a capital flight from the major financial markets. The sources of capital have panicked (Financial Management 2009, 20-21). One of the reasons for the global financial crisis have been the low-quality loans without enough collateral offered by banks to consumers with very high credit risks (Acharya & Richardson 2009, 38). This is associated with the housing bubble, where the housing sector in the US, with the availability of credit even to those who could not afford it (Kozol 2009, 12). This is a major fault of the financial intermediaries when they have not done enough credit check to ensure that the borrowers can qualify for a loan. This is due to the lax regulations over the US financial markets by the Fed (Duska 2009, 19). As the financial systems of major industrial countries are entangled due to convenience to global investors with the technology, those which are more entangled with the US financial system can be more affected by this crisis (World Bank 2008). C. The Role of Imperfect Information 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 (Pagano and Rossi 2009, 667). 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. The global credit crunch has been traced by economists and media pundits to be caused by the sub prime mortgage crisis which has disrupted the US financial system, which effect has impacted many of the advanced economies of the world. According to the article by Foster and Magdoff (2008), the ‘financialization’ of the US economy by speculative activities in order to hoard capital is the major reason for the global crisis—where the economy has overcapacity of capital but no increase in production in order to back it up. In order to understand it better, according to Foster and Magdoff (2008) they have linked first the global financial crisis to the subsequent events that has appeared which may have been the trigger, but not the sole cause of it. While according to the article, this financialization process which is caused by speculation of capital increased the supply of capital in the economy, and not because of faster growth of production may have taken place a couple of decades ago, the trigger has occurred when asset bubbles appeared and the Fed has started ‘to make preemptive attacks.’ The trigger starts back after the 2000 stock market crash. There are several policies which aimed to prevent “economic catastrophes” from happening (Foster and Magdoff, 2008). When the housing bubble occurred in 2006 at the same time interest rates are increased by Fed in order to regulate inflation, the housing sector as well as mortgage-backed securities faced a meltdown. This has been the start of the chain of events that lead to the global financial crisis. However, according to the authors, Fed’s efforts in order to address the crisis by bailing out several financial institutions will result in the effect that it aims to promote because the problem lies in a much deeper issue. D. Market Manias, Speculations, and Financial Crashes If we look at history of finance and the events that lead to a situation similar to the global financial crisis, the situation can always be traced back to market manias, as is the housing bubble in the United States. When there is a certain bubble, the invisible hand in the market fails to function in order to regulate efficiency (Perez 2009, 781). When manias occur, the vast speculation on a certain traded commodity creates an illusory wealth in the market. As the prices continue to increase due to the bubble, the government is forced to push more currency into the money supply. The bubble continues and wealth begins to increase due to speculation, which is merely due to ‘financialization’ or profiting from financial capital (Blackenburg and Palma 2009, 531). As more currency flows into the money supply, the economy feels something is wrong. There is so much money in the economy which is only backed by increase in currency and money supply, not by production (Foster and Magdoff 2009). According to Foster and Magdoff (2008), this financial crisis has its roots so much deeper than the perceived roots—that is, it is rooted in overcapacity which is not supported by growth in production. As more and more currency flows into the money supply due to the illusory wealth that speculation brings, monetary inflation becomes a threat associated with it (Carfang & Togni 2009, 58). Some people see through this, and begins hoarding money and wealth in order to hedge their currency from the inflation that is about to happen. This creates panic in the market, capital flights, and then crashes follow. And this calls for more regulation. E. The Australian Economy: The Australian Dollar, House Market and the Mining Industry 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. For Australias 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. 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. F. Financial Market Regulation 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 (Skilling 2009). As these financial markets become more risk-averse, the funds become scarcer thus access to these markets become harder and more competitive (Eichengreen 2009; McKinsey Quarterly 2009). 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).” However, these measures only solve the short-term problem, but increases the long-term risks to investors and creditors (Butler 2009; Duska 2009, 19). As long as the financial markets do not get tighter regulations, investors confidence will not be fully restored. IV. Conclusion There are different lights that are shed in line with the issue of the global financial crisis. From the sub prime mortgage crisis which is related to the house bubble to the US, to the overcapacity of the financial system—the root cause is speculated. By looking at the theory of efficient market, which most financial markets are, and the effect of imperfect information, or distortion—what it can do to the major players of the financial markets are analyzed. Because of lax regulations over financial intermediaries by the way of providing financial capital to those who need to use it, the distortion of information has scared the investors and resulted in capital flights in major financial markets, in order for them to minimize their losses. The interconnectedness of the financial systems of different countries lead to a chain effect all over the world. Australias economy is not immune to the effects of the global financial crisis as apparent in the countrys dollar exchange rates, as well as the apparent effect on the housing sector in line with the interest rates and unemployment in the mining industry. Although certain regulations have been exercised by Australias government, these policies are only good for the short-term. If the financial systems are not more tightly regulated, not only will the investors confidence not fully regained, but it will still pose more long-term risk to the system and could reverse the recovery of the economy from the policies that are being currently taken by the government. Works Cited Acharya, Viral V., and Matthew Richardson.. "State of Corporate Finance: Its Not Over Yet. (cover story)." Financial Executive 25.7 (Sep. 2009): 38-42. Business Source Premier. EBSCO. [Library name], [City], [State abbreviation]. 19 Sep. 2009 . Australian Government. “Global Financial Crisis.” PM.gov.au. 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