Economic Differences Between Countries - Essay Example

Should the Global Financial Crisis lead to a convergence or divergence in the monetary policies of developed and developing countries? Key Economic Differences between Developed and Developing Countries Developed and developing countries differ in many areas. Some key differences from an economic point of view are the five major indicators of macroeconomics: GDP growth, Balance of payments, per capita income, inflation rate and unemployment rate. In developed countries GDP and per capita income are high whereas inflation rate and unemployment rate are generally between low to medium. The balance of payments is either in surplus or occasionally in deficit. On the other hand in developing countries, the GDP and per capita income are low whereas inflation rate and unemployment rate are generally between medium to high. The balance of payments is usually in deficit. (Adams, 2002, pp. 53-55) I believe that developed countries predominantly follow the Keynesian school of thought while developing countries, though unintentionally many times, follow monetarist. Fiscal and Monetary Policy All of these factors have an impact on both the fiscal and monetary policies of the government of that country. A country’s fiscal policy is the mix of government expenditure and revenue collection mechanism in an economy. Historically, governments collect revenues from taxes and their expenditures include public sector expenditures. (Auerbach, 1997, p. 88) A country’s monetary policy is a combination of activities by the state bank or central bank, the government and other financial institutions to control the demand and supply of money and interest rates in an economy. In a nutshell, the effect of each is dependent on the other and that is what the monetary policy aims to control. (Walsh, 2003, pp. 9-12) This case focuses on primarily on monetary policy. To gain a better understanding of how a monetary policy works, we first need to understand its two components i.e. money supply and interest rates. Money supply is generally divided into M1 and M2. Further classifications may also exist. The divisions are based on liquidity of the funds. M1 funds are the most liquid funds and include cash, very short term securities or securities equivalent to cash. M2 funds include those funds which are slightly less liquid than cash like current account deposits. As the liquidity decreases, the number after M increases. In my opinion interest rate is basically the cost of money. It is also the cost of borrowing or the return on investment. Interest rates have two components. The discount rate which is set by the central bank and is the rate at which the central bank lends to commercial banks. The other component is the market interest rate. I believe it differs because of bank’s spreads and their portfolio of customers. Historical Monetary Policy Of Developed And Developing Countries In my opinion, the developed nations have always moved towards a relaxed monetary policy as they promote free trade and trade liberalization. In addition the existing well defined systems in these economies allowed for and required that market forces of demand and supply influence the interest rates set in the economy. I think because, developing countries lacked the well defined structure of financial markets present in developed countries their money supply and the interest rate were both controlled or influenced to some extent by the central bank. (Mankiw, 1997, pp. 50-75) In my opinion one major reason why interest rates are closely monitored in developing countries is the direct relation interest rates have on inflation. Inflation is the persistent increase in prices. When interest rates increase, the cost of borrowing increases and the cost of doing business increases as well. On the other hand consumption falls since people choose to spend less and save more. So depending on which effect is more prevalent, the inflation rate is directly impacted. Upon my observation interest rates in developing economies are controlled because they effect exchange rates as well. When the interest rates in an economy rise, this is an incentive for foreign investors who receive higher returns on their investments, thus they purchase local currency more. This leads to an appreciation of the currency. Depending on the host country’s strategy, this can prove to be quite beneficial in both the short and long term. It seems to me that central banks in developing countries control interest rates due to the huge amounts of borrowing that the government does from both the state and commercial banks. (Patrick Artus, 1990, pp. 233-250) Global Financial Crisis: Why, When, Where and How? While the world reels from the global financial crisis which impacted both the developed and developing world, many analysts are working overtime to highlight key factors which led to the economic downturn of the developed world, ripples of which were I feel are felt in the developing world. In my opinion the key reasons for the financial crisis were bad management, lack of regulation of banks, an overall fall in the growth rate of the world and the extreme inter linkages within the banking systems of the developed world. I will discuss them further. I feel that the primary reason for the financial crisis was the bad management of risks by banks. By exposing the bank to customers with lower credit ratings, the banks themselves opened their depositor’s money to the disastrous effects which are now present in the economy. (Soros, 1998, pp. 200-225) A quick summary of bad management in banks: banks receive deposits from customers which they lend out to other customers. The interest banks give to depositors is their cost, while the interest they receive from borrowers is their revenues. The difference between the interest received and interest given is called a bank’s interest spread. The higher the interest spread, the more revenues the bank earns. Now banks have different classes of customers. These classes differ on credit rating. Credit rating depends on the ability of the customer to make interest payments and repay loans. Customers who are considered considerably risky are known as subprime customers and these customers are generally not preferred by banks. However, due to the excess liquidity of funds in the developed economies from 2000 till mid 2005 led the banks to start increasing their customer base. They did so by expanding and giving out loans to subprime customers. Whenever a loan is given, the customer has to keep some asset as collateral. In the US many people take out mortgages on their homes. One reason why customers are classified as subprime depends on their quality of collateral. Many people in US take out 2 or 3 mortgages on their homes. The problem began when interest rates began to increase. As the market forces determine the interest rates in developed countries, the fall in money supply in the economy led to rising interest rates. One of the reasons for the decrease in money supply was the excessive lending by banks to their new found customer base. As interest rates increased so did the interest payments for these subprime customers. As interest rates continued to rise in the free market, many customers were not able to make their payments and hence the banks had to claim their collateral, which was in many cases either housing or property. Banks claim their money back by selling the collateral. As more banks claimed more houses and sold more houses, this led to a decrease in the prices of the houses and real estate in general. As the prices fell, banks were not able to reclaim as much of their initial loans as was preferred. When depositors began to ask for their money back, many banks could not oblige as the money was simply not there. This led to many banks declaring bankruptcy. This was further worsened by the fact that many large corporations have accounts with these large banks. As banks began to default, they called on their insurance companies. This problem did not end here. As more and more US banks defaulted, the impact was felt by the world. In my opinion this was due to three main reasons. One, many foreign banks have accounts with US banks and vice versa. So when US banks began to default, foreign banks deposits were also lost. Two, many international stock brokers have accounts with US banks, so when US banks defaulted, brokers around the world faced a liquidity crisis. And finally, the largest number of MNCs is from the US. So when MNCs faced a liquidity crisis this was faced by many developing countries as MNCs conduct operations in many developing countries. This is known as a domino effect. And this was the global financial crisis. (Shiller, 2008, pp. 39-69) What the Impact of Global Financial Crisis should have been on Monetary Policy of the Developed and Developing World The immediate effect of the financial crisis on the economies of the developed world was, I feel, to suck out all the liquidity from the financial markets. Any country’s economy is highly dependent on the well functioning of its financial markets and the ability of these markets to allocate funds effectively. However, absence of funds brings together a whole new host of problems. One of the reasons for the bailout of some the banks in the US were to protect the economy from going into a downward spiral. I believe banks are regulated for the very reason that it is the public’s money at stake and to lend out that money irresponsibly has repercussions, which are now evident. In my opinion any institution which directly affects such a large audience should be regulated to ensure that any adverse affect is minimized for the very reason that it affects so many people. While many policies were put in place including monitoring of financial sector and bailouts, the missing factor was emphasis on ethics and accountability. This can be achieved by directly pegging the efficiency of the banking sector to the interest spreads. While this is already done, each bank should submit a quarterly average spread and explain any unexpected or unusual hikes in the spread. The liquidity requirements for banks was also increased which meant that banks could lend out less money to customers. In addition, requirements on lending from each bracket of the money supply should also have been implemented e.g. banks can lend 25% of their M1 supply, 35% of M2 and so on. I think the collateral for banks should also have been diversified e.g. banks can accept only 25% of all collateral coming from a similar asset e.g. if a bank lends out $100 million then only $25 million can be secured from a similar asset like housing, the other $25 million from saving certificates and so on. And finally in my opinion the central banks of these countries should limit the dependency of the banking institution on the banking sectors of other countries. This can be done by enforcing a limit on Nostro and Vostro accounts or banking activity of each bank from a particular region. For the developing countries, the central banks should take protective measures to shield the local banking sector from effects of actions of foreign banks. This can be done by limiting the activity of foreign banks in the country or creating partnerships between foreign and local banks rather than foreign banks simply setting up and repatriating profits. Something similar should be done for MNCs, where the MNCs should come into local partnerships to increase their stability in the local arena. Further, the central banks should closely monitor the activities of both local and foreign banks and adopt a conservative rather than aggressive lending approach. Convergence or Divergence? As previously mentioned, developed economies have historically favored free markets and minimal regulations while developing economies have employed various regulations on their financial sectors. One of the reasons why developed economies supported free market was that they felt it led to a fairer distribution of resources and they felt their success could be attributed to the free market. On the other hand developing countries felt they still needed to guide their public and their money. In the wake of the global financial crisis, both the underlying assumptions of the developed and developing economies have been shaken. For one thing as previously suggested by the developed world, the free market did not actually lead to a fairer distribution of wealth, in fact it led to a gross misdistribution of wealth. On the other hand developing countries were not able to protect their citizens from the crisis even though they controlled the money supply and interest rates in the economy. True, effects of the financial crisis were minimized in developing countries because of high regulation of the financial sector but at the same time they could not be eliminated. While the developed countries are moving towards greater regulation of their financial markets, does this mean the beginning of the end of the laissez faire economy as we know it? Were developing economies right all along to enforce higher regulations? Or is it just a stroke of bad luck for the developed world? If so how long will it take before the world can reel from this economic disaster? Or should the developing world see it as an opportunity to learn from the mistakes of the developed world about the do’s and don’ts of free markets? Then should the financial sector be heavily regulated or not regulated at all? Are developed countries adopting developing countries regulatory methods or should developing countries adopt developed countries regulatory methods by altering them for ethics and accountability? In my opinion the world should move towards a new financial order. This financial order should be guided by both the market as well as government intervention. A mixed financial sector is one way to term it. However, this financial sector should not simply focus on the theoretical aspects of economics but should also focus on ethics and accountability. One of the reasons for the global financial crisis was the detachment many managers had from their code of ethics. They did not feel responsible or care where they invested their depositor’s money. Such a mistake should be avoided now at all costs. Bibliography Adams, F. G. (2002). Macroeconomics for business and society. Auerbach, A. J. (1997). Fiscal policy: lessons from economic research. Mankiw, G. (1997). Monetary Policy. Patrick Artus, Y. B. (1990). Monetary policy: a theoretical and econometric approach. Shiller, R. J. (2008). The subprime solution: how todays global financial crisis happened. Soros, G. (1998). The crisis of global capitalism: open society endangered . Walsh, C. E. (2003). Monetary theory and policy. Read More