Macroeconomics: Global Financial Crisis

Abstract

The global financial crisis of 2007 - 2009 reminds many people of the impacts of financial crisis. As a result, different economists have tried to explain the occurrences in respect to their causes and how they can be avoided in future. They can emerge from private or public sectors and the origins could be internal or external. They do not have a standard size or nature, and they are dynamic as they evolve with the flow of time and tend to spread across borders rapidly. Economics bloggers offer wide scope of discussions in relation to this argument that cannot be found in formal journals and books. This essay will analyze the different perspectives of the argument in relation to different economic schools of thoughts. It will also provide a recommendation on what ought to happen.

Introduction

In the current world, the 2007-2009 global crisis acts as a painful reminder of the multifaceted nature of the financial crisis. They do not favor the rich or poor countries or the small or large. As Reinhart and Rogoff describe the financial crisis, they are equally hazardous. They can emerge from private or public sectors and the origins could be internal or external. They do not have a standard size or nature and they are dynamic as they evolve as time goes by creating new forms and spreading across borders rapidly. An argument regarding to financial crisis is available in the monetary freedom blog. Often, they require immediate and comprehensive policy responses.

They call for major alterations in the fiscal policies and financial sectors and in some cases, global coordination of policies is necessary. Since the great depression, the world had not experienced a threat in its economy to a level like the one experienced during the 2007-2009 global financial crises. (Princeton: Princeton University Press, 2009).

Extensive effect of the previous global financial crisis elucidated the importance of understanding the phenomenon of crisis. As the last episode of the crisis showed, the implications of financial crisis can substantially affect the conduct of financial and economic policies. This generates a question that every economist and every economic school of thought is trying to answer. Why do we have financial crises in general and what regulations most effectively deal with them?

While the financial crises have several common elements, they appear in different forms. Often, a financial crisis is associated with one or more of the following phenomena: severe interruptions in the supply of outside financing and financial intermediation to several sectors in the economy; large-scale government support through recapitalization and liquidity support; substantial changes in asset prices and credit volume; and large-scale balance sheet problems in regard to households, firms, sovereign states, financial intermediaries. As such, financial crisis are characteristically multidimensional events and it is difficult to characterize them using a single dimension or indicator. Previous research and literature has identified some of the factors leading to crisis, but the challenge remains in identifying definitively the deep causes of the individual factors.

While fundamental factors such as internal or external shocks and macroeconomic imbalances are often observed, the lingering questions relate to the exact causes of the crisis. Sometimes, financial crisis seems to be driven by “irrational” factors, which include contagion and spillovers among financial markets, fire sales, credit crunches, emergence of asset busts, limits to arbitrage during times of stress, sudden runs on banks, and other aspects related to financial turmoil. In order to understand the issue clearly, this paper will analyze different perspectives of different economic schools of thought.

Keynesian View of Financial Crisis

The Keynesian theory assumes that when the government provides credit to various entities or increases its spending, it adds to the total amount of credit or spending. The Keynesian economists emphasize on significance of interest rates as a lead to the amount of liquidity or money in the economy. These economists assume that confidence takes a leading role in determination of the economic performance. Keynes had a concern for the economic crisis as he was afraid of socioeconomic changes that would result in development of a different society, socialism.

He explained economic crisis as the crisis of insufficient demand. This school of thought uses investment consumption as an important factor. Investment spending has to compensate for insufficient personal spending. Interest rate policy and monetary policy can influence the investment consumption. However, there is a tendency for marginal efficiency of capital to decline as a result of oversupply of the capital, increase in the cost of production and continued increases in the prices during the prosperity phase of the business cycle.

Marginal efficiency of capital (MEC) is one of the fundamentals of Keynesian economic school of thought. The Keynes’ economy tries to cure depression in economic crisis that is caused by marginal efficiency of capital. They argue that a drop in marginal efficiency of capital leads to the closure of factories hence a decline in personal consumption. There must be an establishment of new relations between capital and labor. When there is a depression in the economy, it requires a pro inflationary economic policy. This is where the role of the state in keeping demand increasing becomes important. However, when the economy is managed by demand, it results in full employment followed by inflation and including.

They argue that stagflation cannot be considered as a lasting solution to the economic crisis. It is only able to buy time as proper political and economic measures to combat the crisis are sought. In the modern world, financial crisis in developed countries also includes aspects of structural crisis. The Keynesian economists suggest that, in the long run, the world requires the development of a new social fabric and a suitable economic paradigm.

The Austrian Perspective on the Financial Crisis

The key policy of Austrian economy stipulates minimal or limited role of the government as an administrator, regulator and owner. However, Austrian economists allow for real error, as long as, the error can be committed by both the private and public agents. Austrian economy is not necessarily antithetical to market regulations. In any expression of an Austrian position, markets are a central commitment. In regard to global financial crisis and their aftermath, the Austrian school of thought emphasizes on criticizing interventions by the government. However, they give little regard and offer very little discussion in regard to implications of errors by the private agents. Since the interference by the government and the private sector create issues for the markets structure, it can be argued that the Austrian economists are neglecting a vital section of their traditions, because it has implications for regulation and intervention that most people would opt to evade.

A recent survey on the Arguments of Austrian economists regarding global financial crisis and its aftermath depict several general issues. First, they lay immense emphasis on the role of the government. O’Driscoll (2009), usefully expresses that focus of the Austrian economists. The Austrian economists argue that the boom-bust phenomena in the business cycle is not inherent in the free market, but is rather caused by interference of the government in the credits market, specifically the way it manipulates the interest rates.

The government causes the boom through its injection of new credit into the system and then the non-economic and unstable investment projects put into motion necessitate a bust later in the future. Responses from Austrian economists in regard to the effects of the global financial crisis were to focus on inappropriate monitory policy from Federal Reserve as a prime cause of the boom. They argued that the boom was artificial as it was the impression of creating wealth based on interest rates that are below a natural rate. It induces rapid overinvestment that cannot be utilized appropriately or sustained. The Austrian economists suggest that the state, federal reserves or other central banks should not expand new credit into the system through the reduction of interest rates, and expansionary liquidity procedures.

They also suggest that a recession should be allowed to take its ‘natural’ cause so as to enable correction of previous rounds of capital misallocation. This should allow the resources to be reallocated efficiently based on the forces in the market. The state should also reduce its spending in order to prevent the inflationary effects of credit expansion. Additionally, it should facilitate cuts to money wages in order to free up the labor markets. At a systematic level, the government ought to reassess the role of central bank as a guarantor in the finance system, in addition to considering a new monetary regime.

Modern Monetary Theory and Financial Crisis

The failure of orthodox way of economic thinking has increased interest in heterodox economic ideas. The modern monitory theory has its roots in the 19th century, but it is after the 1970’s widespread fiat currency adoption that generated its relevance. The modern monetary theory shows how the governments borrow money by creating an explanation on the way that central banks or reserves operate in fiat currency systems. This does not involve spending the money it is rather about regulation of the money. The key point in the theory is that when the governments borrow money through the selling of bonds, their purpose is not spending. When they need to spend, they create money.

This creates a question as to why the governments collect taxes. Modern monetary theorists argue that the government collects taxes in order to reduce private demand through the reduction of the disposable income. Taxation reduces demand, therefore, it is an effective inflation control method. Taxes also assist during the setup of a new fiat currency system as it helps in setting the value of the currency. The major disapproval of the theory is that if governments run deficits, inflation will occur. Additionally, when governments run deficits, the exchange rates deteriorate.

Post Keynesian Institutionalism Perspective of Financial Crisis

The Post Keynesian Institutionalism (PKI) school of thought incorporates the assumptions that the basic path of capitalism of the real world is cyclical and that each cycle possesses its own idiosyncrasies. Additionally, such idiosyncrasies are a product of the ongoing revolution in the institutions. The explanation of financial crisis by the post Keynesian institutionalism draws attention to underlying tendency towards financial instability and adding and element of institutions. Over a period of prosperity, the financial structure of an economy becomes fragile.

During the early stages of prosperity, the enterprises that operate in highly profitable sectors get rewarded for taking increased amounts of debt. This success encourages other firms to take on the same behavior. Lenders and borrowers fuel the tendency of borrowing geared towards great indebtedness in an expansion. In addition to lending and borrowing, financial innovation also expands in the boom. After extensive borrowing, some borrowers get to a point where they realize that they must sell assets in order to finance the debts.

When banks decide to lead in the lending, the economy gets into a credit crunch. Upon the emergence of the credit crunch, financial difficulties spread into many sectors of the economy and even affect household consumption. This means that the credit crunch in a single sector could result into an economy-wide recession.

According to the Post Keynesian Institutionalism, financial crisis require two extended economic policy strategies, which are recovery and reform. The government strategy for recovery should have three components that include fiscal policy, financial market policy and monetary policy. In addition to recovery, a reform agenda should be put in place. It should include strict supervision and regulation of the financial system. It should also involve cooperation with other countries globally in order to promote creation of working places internationally and economic stability. There should be an improvement in transparency of industries, broad regulatory oversight and rigorous bank examinations.

If policy makers have adequate information about the extent to which financial institutions make use of exotic instruments, it would prompt them to create policies combating the impact. The examinations on banks should not only generate information on solvency and liquidity of institutions, but also information about financial stability threats. Great scrutiny by the financial system regulators should also be focused on hedge funds, mortgage brokers and other relevant institutions.

Actual Explanation of Financial Crisis and Future Mitigation Strategies

There exist several actual explanations of financial crisis. It is clear that crises occur and affect world economies, and their impacts are clear, but different economic schools of thought give different elucidations as to why financial crises occur, and how they can be combated. Although, the issue has been discussed by many economists before, the 2007-2009 economic crisis renewed the discussion and resulted to development of different explanations in regards to causes and methods of combating financial crisis in the future. The only clear and standard issue in all the arguments is the effect of government involvement, lending and borrowing, and the boom and bust effect.

However, a general explanation of financial crisis offers three stages of the crisis that include: initiation of financial crisis, banking crisis and debt deflation. During the first stage, the balance sheets of financial institutions deteriorate the prices of assets decline and the interest rates along with uncertainty increase. The banking crisis stage results from a decline in the economic activities. The balance sheets of institutions, the shadow banking system such as the investment banks and hedge banks, residential housing market and the global financial markets are the most affected areas. In emerging market countries, financial crisis begins with currency crisis before developing into full-fledged financial crisis. Different schools of thought offer different perspectives towards the mitigation procedures.

Theoretical Explanation of Financial Crisis

In theory, markets and financial institutions enable efficient transmission of resources from savers to best opportunities for investments. Additionally, they offer possibilities for risk sharing giving the investors an opportunity to take risks in order to advance in the economy. They also enable aggregation of information, which provides guidance for more efficient decisions for investments. A financial crisis generates extreme disruptions to normal functioning of monetary and financial systems, hence, affecting the efficiency of the economy negatively. Although, the financial crises have happened in the past, it is highly possible for them to occur again in the future. Three theories have been in use for a while explaining the incidents in the economy that result to occurrences such as the financial crisis.

Normal Accident Theory

In technological systems, serious accidents are inevitable. These result from overoptimistic and unrealistic assumptions underlying organizations risk management. Their preparation for disasters is not more than just window-dressing. Therefore, the main purpose of organizations is not managing risks, but it involves convincing the public, especially pressure groups and regulatory agencies, that taking risks is manageable and that they can control the risks that they face. However, the public accepts the risks on unrealistic assumptions before conducting a reality check. Therefore, there is a structural coupling between the technical realization and the social systems. The social body responds to risk management and control systems within organizations, without a critical reflection of their effectiveness. It assumes that risk management is functional. Consequently, risk management is no longer a private business of organizations, it has a critical external public role. Therefore, it is important to analyze the global financial markets with regard to the integral parts of the standard accident theory.

High Reliability Theory

Some organizations achieve outstanding safety records despite facing complexity and tight coupling. Such organizations are referred to as high reliability organizations. This theory originated in the technical and engineering sector. These organizations ensure that their personnel can respond adequately and rapidly to contingencies without the guidance of a senior person. Such individuals are able to think and have the power to act despite their ranking. However, when an issue gets technical for a single person, an informal network of employees intervenes and assists in solving it. The macro sociological perspective of most societies, especially the American society, shows that high reliability can be applied to explain and understand social systems at a very aggregate level. The high reliability theory offers a way for the society to prevent accidents. Therefore, in most cases, occurrence of the financial crisis depends on the ignorance of people. They can avoid it by analyzing the underlying issues and finding a sound solution.

Disaster Incubation Theory

The initial development stage of a crisis, involves norms and beliefs which people fail to comply with in terms of predetermined precautions. In the incubation period, there is rigidity in the beliefs and perceptions in the society, there are decoys to occurring problems, people ignore the issues happening outside their society; additionally, there is a limitation of information and communication, and people disregard warnings of apparent dangers. In the financial crisis, system exclusivity lays in the large networks of mortgage banks, rating agencies and investment banks. With the increasing risks of default, handling difficulties get passed to other organizations through the means of mass securitization of mortgages, hence, making the problem inter-organizational.

This results to the impact of financial problems in one organization being passed to other organizations and sectors. Which affects the entire economy. Therefore, failures of individual organizations and failures of the financial markets cause the financial crisis. It is difficult to foresee some changes due to structural and technological changes. However, the few issues that can be foreseen should be handled before occurrence of another financial crisis.

In order to avoid future financial crisis, three recommendations can be deducted from the theories. The pressure on the society or investors to make profit has to be reduced. It is important to align the performance with financial stability and long-term interests. This will prevent the brokers from selling mortgages without assessing whether the buyers have the ability to repay them. The global financial markets need to be organized like high reliability organizations. They need to have a desire to avoid another financial crisis. Organizations need good designs and management that allow disruptive intelligence at the personal level. Global institutions should improve their supervisory role. This might result in limited global market failures. In organizations, risk management should not be a symbolic gesture only. Organizations should check underlying assumptions and use risk management to reveal the failures of foresight.

Political Angle of the Financial Crisis

Financial crises have a political angle in their cause and ways of alleviating them. For example, in the 2007-2009 financial crises, there were questions as to whether the political system possesses the ability to fix the crisis. Additionally, questions were raised as to whether it could hold the perpetrators of financial crisis responsible. Involvement of government t in financial markets as a regulator or otherwise affects the way the business is conducted. When the political system does not regulate the lending by financial institutions, the market will be flooded with investors who have borrowed money that they might not repay. This results in the crisis like it was experienced between 2007 and 2009.

Additionally, the government sets up measures to reduce the money in the economy through taxation and fiscal policies as a way of avoiding financial crisis. Therefore, the government has a critical role in the incidence of financial crisis, as well as the possible avoidance of reoccurrence in the future. Politicians should use the arguments by different schools of thought to set up laws that regulate financial institutions so as to avoid future financial crisis. For instance, they should enact laws that will govern lending system by banks in order to avoid excessive lending or a situation that would result in multiple debtors being unable to repay their debts.

The opponents agree on a number of issues. They agree on the fact that the future of financial crisis relies on policies to be outlined and the regulation of financial markets. They also show some aspect of the fact that there are some unknown factors that may still result to another financial crisis. Interest rates are also an issue that rises among the opponents, but they view the issue from different perspective.

Observation

The 2007-2009 financial crises created discussions among economists in different schools of thought as they tried to get to the main cause, and the future of economic crisis. Depending on different economists, financial crisis occurs due to some aspects of government involvement and control of lending and interest rates. Economists have disagreed on the policy implications of their work. Mainstream economists have started reconsidering how their work might affect policies. However, others, like the neoclassicists, have defended their positions. The recent financial crisis was the worst since the 1930 Great Depression, therefore, is a reason for disunity among the economists.

In the 1930s, the principle issue was unemployment. The recent financial crisis caused collapse of banking system as the dominant policy issue. In this light the regulatory agencies ought to regulate the lending and investing procedures by banks in order to avoid having a situation where the debtors cannot pay their debts. Additionally, there should be warnings against strong monetary and fiscal stimuli. The best response ought to have been the use of monetary and fiscal expansion in order to halt contraction. This would have been followed by a focus on the regulations in order to avoid future recurrence of financial crisis. However, economists should unite together efforts and find a common stand on the situation. Probably, neither of the arguments is wrong; however, when there is a common stand, the policy makers can be influenced easily into making policies that will avoid occurrence of financial crisis in the future.