Global Macroeconomic Imbalances And The Financial Crisis
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Published: Thu, 27 Apr 2017
The world experienced the global financial crisis between 2007 and 2008. This crisis led to the threat of collapse of mane large financial institutions, down turns of major financial market in the world and bailouts of banks by difference governments in the world. One of the areas that suffered most from the effects of the global financial crisis was the real estate sector, which most argue that it must have also contributed to the crisis. This crisis also played a significant role in the failure of many key businesses around the world. One of the consequences of these business failures was the rise of high rate of unemployment around the globe. It also contributed to the decline in consumers’ wealth and the down turn in economic activities around the globe, which eventually led to the global recession between 2008 and 2012. Other negative effects of the global financial crisis include the rise of the European sovereign debt crisis and liquidity challenges experienced from 2007 (Obstfeld and Rogoff 2009).
Many reasons have been suggested as the main contributors to the global financial crisis. Some of these reasons include the existence of easy credit conditions in the global financial markets, growth of the housing bubble in the United States of America, predatory lending, over leverage, and incorrect pricing of risks among others (Ferguson and Schularick 2009). Although many controversies remain about the role of the global imbalances on global financial crisis, it is clear that there exists a connection between the two. Those who are against the idea of the role that global imbalances played towards global financial meltdown argue that external pressure could not have played any role in the crisis. The reason they give as the main cause of the financial crisis was the failure of financial regulators to effectively control financial institutions and markets in the United States of America and globally. They also argue that policy errors could also have played a significant role in the crisis. However, those who support the view that global financial imbalances could have played a role in the global financial crisis suggest various mechanisms through which global imbalances could have had a significant role in causing the collapse of the financial system in the world.
Some of these mechanisms include the high savings of china, oil exporters and other surplus countries, which depressed real interest rates globally. The depressed global real interest rate is thought to have led investors to scramble for yield and to under price the risk. The connection between the global imbalance and the global financial crisis may also have originated from economic policies employed in a number of countries globally before the crisis. There was also the existence of distortions that played a role in the transmission of these economic policies through the United States of America and finally through the global financial markets (Ferguson and Schularick 2009). United state of America policies contributed immensely to the crisis. This country had the ability to finance her macroeconomic imbalances from easy foreign borrowing. As a result of this, the country failed to come up with tough policy measures that could have prevented the crisis. This was also the same case with other major countries that experienced deficit before the crisis.
One of the alternatives source sought by the United States of America to finance her deficit was foreign banks, which provided a ready source of external funding. The main source of motivation for these foreign banks was their high appetite for assets. Prior to this period, the United States of America employed loose monetary policies, which allowed the country to borrow in dollars at low nominal interest rates. These policies also created an environment in which the asset-price movement and the exchange rate kept United States of America foreign liabilities growing at a rate that was far below its cumulative current account deficit. The case of the United States of America was similar to what was experienced in many other countries around the globe, which had current account deficit prior to the global financial crisis (Ferguson and Schularick 2009).
Countries with current account surpluses on the other hand, faced minimal pressures to adjust. For instance, China was able to maintain an undervalued currency and therefore, defer to rebalance its own economy due to its ability to sterilize the immense reserve purchases,which it placed in the United States of America’s markets. Therefore, complementary policy distortions kept United States of America artificially far from her higher autarky interest rates and China artificially far from her lower autarky interest rates. It was possible therefore, to either contain or mitigate the global financial crises had low-cost postponement options not been available. The action of china to undervalue her currency may have also played a significant role in the global financial crisis that followed in between 2007 and 2008. This together with the undervaluation of the exchange rate contributed to the global imbalances (Obstfeld and Rogoff 2009).
Therefore, it is clear that external imbalance were a reflection of internal imbalances in many countries. The connection between the global imbalances and the exchange rate undervaluation means that the problem could not be resolved automatically without involvement of significant exchange rate adjustments. The labor rate in china prior to the global financial crisis was far below the country’s Gross Domestic Product (GDP). Cheap relative production costs in China supported the profitability and investment in manufacturing industry. The loss of competitiveness in this country was avoided through the availability of excess labor or organized wage restraint (Ferguson and Schularick 2009). China employed policies that were aimed at promoting export-led industrialization. The policy of real exchange rate undervaluation and reserve accumulation in China could not automatically be collected by inflation due to the pervasive role of the state in the country’s financial sector, large supply of surplus labor and the effectiveness of capital control. All this created an environment that enabled china to accumulate massive reserves of foreign currency as well as create current account surplus. This action of the Chinese country may have contributed to the global financial crisis experienced in 2008.
According to Ben Bernanke, the Chairman of the Federal Reserve, a saving glut in the Asian economy as well as other exporting countries is primarily responsible for the current pattern of global macroeconomic imbalances. In providing support for his argument, Ben argues that the Asian turbulence of 1996 formed the genesis of the global imbalance. He points at Thailand which had for a long time maintained a fixed exchange rate of her currency against the United States of America’s dollar. However, there was a rapid credit expansion in the Asian countries, which fuelled bubble in stocks and real estates (Obstfeld and Rogoff 2009). This credit expansion took place within the liberalized financial system. In Thailand, the current account deficit reached about 8 percent of the country’s GDP as the rising prices of assets reversed the course. The country also experienced a fierce speculation of currency which led to the breaking up of the country’s currency peg against the dollar.
This crisis was contagiously transmitted to other countries in Asia, many of which seemed healthier fundamentally than Thailand. Under this pressure, the Asian banking system faced financial crisis. To avoid eventual collapse of the banking system, most of those countries that faced the crisis turned to the international monetary fund for assistance. The conditions placed by the international monetary fund as the requirement for financial assistance left bitter memories in these countries (Ferguson and Schularick 2009). Afterwards, the developing countries as well as the newly developed countries in the Asian world went into surplus although most of them had weaker currencies than before the crisis.
The dissipation of the recessionary effects in the Asian countries and the boom of dot com led to the rise of commodity prices globally. This further helped to generate surpluses for the oil producing countries in the Middle East and the commonwealth of independent countries. The case was different in the advanced countries which operated on the current account deficit. For instance, the United States of America ran on a deficit of about 4.3 percent in 2000. There was persistent growth of surpluses in the Asian countries and the oil producing countries. However, in this newly industrialized Asia, the gross savings did not change substantially after the crisis although there was a considerable decline in the investment. In contrast, the savings in the developing Asian countries initially returned to the same level as before the crisis. This was followed by rapid growth in savings which peaked at about 47 percent of the GDP (Obstfeld and Rogoff 2009). The case was the same as far as gross investment was concerned. The investment returned to the pre-crisis level and then rose significantly thereafter.
These current account surpluses were supported by the exchange rate policies, which tended to maintain rates at competitive levels different from what was the case in the pre-crisis period. Foreign exchange intervention policy in Asian countries was motivated by the need to pursue export-led strategies for maintenance of high economic growth rates. There was also the need to accumulate substantial stock of international reserves as a buffer against future financial crises. This was considered to be necessary in order to avoid a possible future dependence on International Monetary Fund. Therefore, some countries such as Saudi Arabia maintained pegs to the United States of America’s dollar. This further helped in the growth of the global imbalance that finally was responsible for the global financial crisis in 2008 (Ferguson and Schularick 2009).
Further, these countries devalued their currencies against the United State of America’s dollar. Therefore, these countries remained at depreciated levels compare to the period prior to the crisis. The intervention policies by the Asian countries were responsible for the rapid growth of international reserves in these countries (Obstfeld and Rogoff 2009). Another factor that may have contributed to the global imbalance and eventually the global financial crisis was the speculation against the overvaluation of the dollar during the closing years of Bretton Wood System. This speculation led to the growth in international reserves and the high global inflation that followed thereafter.
The reserve growth in the United States of America also led to the increase in the prices of commodities, housing and other assets in the country and other countries. The Chinese reserve accumulation outstripped even the growing current account surplus. The balance of payment surpluses was further augmented by the strong inward of Foreign Direct Investment (FDI). Therefore, economic policies and market developments played a significant role in the generation of current account surpluses (Ferguson and Schularick 2009). This in turn led to rapid accumulation of private and public claims on industrial countries especially the United States of America. According to Bernanke, the outward shift of emerging market saving schedules was the principle cause of expansion of the United States of America’s deficit starting in the 1990s. This global saving glut led to the worldwide asset price adjustments, which induced a number of advanced economies such as the United States of America to borrow more heavily from foreign sources.
Other economic factors that contributed to the global financial crisis include equity prices. United States of America experienced heavy capital inflow from emerging market savers. This led to a large appreciation of the stock prices and the value of the dollar. This implied wealth and international competitiveness effects and a large deficit in the United States of America’s current account. Saving in the United States of America was further discouraged by the expectations of the rapid future productivity growth. These expectations encouraged investment. Another factor behind the global financial crisis was the falling real interest rates in the United States of America and other advanced economies (Ferguson and Schularick 2009). This low rate of interest contributed to the decline in savings. There was also the fall of long-term interest rates which brought down the mortgage rates in the United States of America and other countries in the world.
Allan Taylor in his article “The Financial Rebalancing Act” argues that even without any government intervention, these global imbalances are likely to stop increasing at the same pace and may even decease. He further argues that the economists and the policy makers’ risk fighting the last battle even as a new post crisis economy emerges with its own set of challenges. According to him, this will happen as a result of emphasizing the importance of these imbalances. For the long-term solution to the imbalances, the view of Taylor is correct. Imbalances will create counterparts conditions in different countries which will eventually bring this countries current accounts into equilibrium(Taylor 2011).
For instance, one factor that has led to the global imbalance is the devaluation of currencies by some countries. This policy has enabled countries that follow such policies to create current account surpluses. It has also contributed to huge capital investment in countries with current account deficit. In the long term, the interest rate in the deficit countries will cease to be attractive and therefore, discourage further foreign investment. The low demand for dollar as a result of this will lead to the depreciation of the dollar relative to the currencies used by the surplus countries(Taylor 2011). This will lead to the reduction in the level of surplus and the deficit in respective countries. Some of the policies that countries can employ to correct global deficit include reorientation and coordination of fiscal policies, addressing financial markets instabilities, alignment of macroeconomic and structural policies for sustainable development and dealing with job crises through global rebalancing.
The EURO Crisis
Economic crisis has on numerous occasions hit the world and the factors that have contributed to the crisis either directly or indirectly. It is worth noting that financial crisis is as a result of a combination of complex factors which include internal trade imbalances, high risk lending as well as borrowing among others. However, one of the financial crisis that shocked the EUROZONE and has had profound impact is the EUROZONE crisis; various scholars as such have come forth with different schools of thoughts concerning the crisis.
One such scholar is Martin Feldstein argues that “the current crisis of the European single currency was an accident waiting to happen”. To him he argued that the development of such economic structure was a ruthless, politically motivated experiment. Similarly the present problems facing member countries as a result of leaving country-specific economic policies and individual exchange rates were predictable by economists politicians chose to ignore them (Feldstein, 2010). The paper will give the views of the researcher whether he agrees or not with Martin Feldstein argument. In doing so, the researcher will critically look into arguments for and against adopting a single currency economy. Additionally the major factors deemed to be responsible for the crisis of confidence in the EURZONE.
Martin Feldstein argument and my views
With regards to EUROZONE crisis Martin Feldstein strongly believed that indeed the adoption of a single currency was an accident waiting to happen. The unpleasant cost of adopting a single currency on a incongruent group of countries were at first concealed by the short-run advantages that the weakest countries enjoyed when they adopted the euro in 1999 and by the favorable global economic conditions that prevailed until 2008 (Feldstein, 2010). In order to support or refute the claim, it is important to first examine the pros and cons of adopting a single currency economic structure. However it is important to understand the beginning of the crisis. The crisis in the zone started immediately the financial markets lost confidence in the creditworthiness of Greece and other periphery countries; this resulted in interest rates on government bonds going higher to levels that compelled the affected governments to ask for bailouts from international community, the European Community and the IMF.
EUROZONE adopted single currency back in 1999 with the aim of empowering the member countries economically as well as politically. This is after the region tracked greater financial integration since 1957. There are two main categories of the advantages that come with the adoption of a single currency in the EUROZONE both leading to gains in economic efficiency. One important importance of such a concept is that the transaction cost will be eliminated. Usually transaction costs are manifested in several ways for instance fixed commission as well as the spread between the buying and selling prices of any given currencies. It is worth noting that for the member countries which operate business with others in the same region, then the currency conversion cost is done away with for the member countries which are vital for both individuals as well as firms doing business with foreign partners (Rose &Wincoop, 2001).
On the same note a single currency ensures that there is a ground to compare prices, making price differences more noticeable as well as equalization across the borders. Scholars in the field of economy have held that the absence of transaction costs as well as transparency in prices creates a deep and more integrated financial market. This type of integration makes it possible for member countries to have various channels used to share risks. For instance when a member country is hit by negative shock, firms definitely make losses which result in lowered stock prices, on the other hand when there is an economic boom in a another country, the stocks of firms in that country will go up contributing to profit making investors from the country hit by negative shock a new lease of life. Thus single currency allows country to share the risks of negative shocks.
It has been argued that the justification for adopting single currency in EUROZONE is to avert the negative effects of exchanges rates. There is no doubt that uncertainty in changes in exchange rates hinders the flow of trade as well as investments. Thus in situations where business people are faced with trade opportunities or investment, they will be more attracted to countries where the risks of currency and interest rate changes are minimal(Artis, Hennessy & Weber, 2000). However Feldstein, 2010 argued that a common currency means that every EUROZONE country has the same exchange rate, stopping the natural rate of adjustments that maintain national competitiveness when there are different trends in productivity and demand. As such he posits that this denies some countries the opportunity to raise the real incomes of her employees. In fact this is what EUROZONE is trying to discourage a scenario where some countries are extremely richer than others.
Despite the advantages mentioned above, single currency has a number of disadvantages. First the system brings costs to firms, individuals and other institutions to adjust to the new currency. Usually these parties have to incur huge costs in changing the invoices, price lists, office forms, payrolls, databases, bank accounts, and meters for postage as well as parking among other things (Rose &Wincoop, 2001). For countries which had weaker financially, they have to engage in excessive borrowing in order to carter for these expenditures. This as explained by economists is a recipe for economic crisis (Artis, Hennessy & Weber, 2000).
Secondly single currency economy means that there is no national monetary policy which has been a vital tool for states to adjust the economic equilibrium in situations where it faces economic shock. Usually economic shocks are unpredictable and unexpected and it characterized with disparity in production, consumption, investment as well as government expenditure (Feldstein, 2010).
Factors responsible for the current crisis of confidence in the EURO zone
There are a number of factors that played substantial role leading to the present crisis of confidence in the EUROZONE. Top on the list the inability of the government to service their debts. The debts resulted in heavy government spending and the desire to help those countries in problem to get out of the economic crisis. A typical example is Greece who received numerous loans for the purposes of bailing itself out of the economic crisis. However it emerged that the country was unable to service their debts (Rose &Wincoop, 2001). Similarly other countries such as Italy and Portugal accrued debts at very high levels making them unable to successfully service their loans. Additionally member countries such as Spain found it difficult to roll-over maturity debt, this coupled with the fact that it was not possible for EUROZONE member countries to raise enough financial resource to rescue member countries such as Italy and Spain was too large contributed to the confident crisis in the region (Yifu, L. &Treichel, 2012).
More importantly financial deregulation and liberalization contributed to the confident crisis. These two concepts enhanced the creation of new financial instruments as well as derivatives which made banks in member countries to raise leverage and to boost funds to be loaned. This in the end spurred a real estate as well as expenditure explosion (Yifu&Treichel, 2012). Similarly another contributor to the consumption bang is the single currency which eliminated currency risk by allowing the interest rates to be lower. The two concepts as well as the decline in interest rates led to increased inflows of money from core fall in interest rates contributed to large inflows of capital from core countries into periphery countries resulting in housing bubbles and surplus consumption.
From the review the paper has critically looked into the assumption that the adoption of a single currency is to blame for the recent EUROZONE crisis. However, looking at the advantages and disadvantages of the economic structure I beg to disagree with Martin Feldstein views that the current crisis of the European single currency was an accident waiting to happen. To my understanding, a host of factors contribute to financial crisis and it is wrong to lay blame on a single currency economy as the sole reason for the crisis. Similarly the major causes of confident crisis in the region include failure of government to service their debts, high level of unemployment as well as financial deregulation and liberalization.
The Asian Curreny/Financial crisis
The East Asia Currency/financial crisis were mainly caused by sudden shifts in market confidence and expectations. Since the macroeconomic in some countries had worsened in 1990s, the depth of the 1997-1998 crisis are not attributed to deterioration in fundamentals, but to panic on the international domestic investors, reinforced by the international financial community and response of the International Monetary fund faulty policy (Poser, 2008). The financial turmoil reflected policy and structural distortions in the countries of that region.
The currency and financial crisis in 1997 was triggered by fundamental imbalances. Once the crisis started, herding and market overreaction caused the plunge of exchange rates, economic activity and asset prices to be more severe than the one which was warranted by the weak economic conditions. The macroeconomic imbalances in East Asia countries are accessed within structural factors: foreign indebtedness and current account deficits, savings and investment ratios, real exchange rates, growth inflation rates, budget deficits, and foreign reserves, measures of debt and profitability and political instability (Roubini, Pesenti, Corsetti, 1999).
Principal factors responsible for the Asia currency/financial crisis
The roots of the Asian crisis are evident on the structure of incentives under which financial sectors and corporate operated in the region, in reference to regulatory inadequacies and close relationship between private and public institutions. The Asia moral hazard magnified the financial vulnerability of the countries in the process of financial market liberalization in 1990s, showing its fragility in the financial and macroeconomic shocks that occurred in 1995-1997 period. This problem lead to the exhibition of three different yet strictly related dimensions at the financial, corporate and international level (Mengkni, 2009).
For the corporate level, political pressures for maintaining high economic growth rates led to long public guarantee to private projects, where some of them were undertaken under control of the government, subsidized directly, or supported policies of credit to favor industries and firms. In the absence of explicit promises of bail out, the strategies and plans of production of the corporate sector overlooked riskiness and costs of the underlying investment projects. Having the industrial and financial policy enmeshed within a business sector network o political and personal favoritism, and with the government being ready to intervene for the troubled firms, markets were operated with the impression that to be back to the investment was some how insured against adverse shocks (Poser, 2009).
This beliefs and pressures represented the underpinnings of a sustained process of accumulation of capital, hence resulting into sizable and persistent current account deficits. As we all know, borrowing from a broad to finance investments domestically should not lead to concerns about external solvency, but it can be the optimal course of action for economies which are undercapitalized with good investment opportunities. According to the evidence for the countries, in 1990s, it highlights that the profitability of the projects which were new was low.
The capital inflows and investment rate in Asia remained high even after the negative signals which were sent by profitability indicators. This result was due to the interest rate which fall in industrial countries lowered the capital cost for inflows and motivated financial flows in these East Asian countries. The crucial factor which underlined the sustained investment was the moral hazard problems in the countries, hence leading the banks to borrow excess finances from abroad and lending excessively at home. The financial intimidation also played a crucial role in channeling the funds to projects which were marginally if not outright unprofitable (Roubini, Pesenti, Corsetti, 1999).
In the Asian pre crisis, there is a long list of structural distortions in the banking and financial sectors. these are: low capital adequacy ratios, weak regulation and lax supervision, insufficient expertise in the regulatory institutions, lack of compatible-incentive deposit insurance schemes, distorted incentives for monitoring and project selection, non market criteria of credit allocation, outright corrupt lending practices, according to the model of relationship of banking that practiced semi monopolistic relations between firms and banks while down playing price signals. The stated factors lead to the creation of severe weaknesses in the undercapitalized financial system, with a growing share of non performing loans (Poser, 2008).
The distortion consequences were magnified by the financial market deregulation and rapid process of capital account liberation in the region during the 1990s, which leads to the increase of elastic supply of funds from abroad. The liberalization of capital markets was consistent with low supply of funds to the domestic corporate and national financial institutions sector. This goal motivated policies of exchange rate aimed at reducing the domestic currency in terms of the US dollar; hence the risk of premium on dollar denomination debt is reduced (Mengkni, 2009).
International dimension of the moral hazard problem was affected by the international banks behavior, which lead to crisis over a period had lent large funds to domestic intermediaries, with the neglect of standards for risk assessment. This over lending syndrome may have lead to short term interbank be effectively guaranteed by a direct government intervention in financial debtors favor, or by indirect bail out through IMF support programs. Again, large amount of foreign debt accumulation was in the form of unhedged, bank related short term, and foreign currency denominated liabilities. In the year 1996, a short term liability in the form of total liabilities above 50 percent was the norm in the countries. Also, the ratio of foreign reserves to external liabilities, which is an indicator of financial fragility, was above 100 percent in Thailand, Indonesia and Korea (Roubini, Pesenti, Corsetti, 1999).
The implication of moral hazard is the adverse shock to profitability which does not induce financial intermediaries to be more cautious in lending and following the financial strategies hence reducing the riskiness of their portfolios. To be opposite, the negative implications of a future bail out gives a strong incentive to act on more risk. On this regard, several countries, specific and global shocks lead to severely deteriorate that the outlook of the overall economy in the Asian region. This exacerbated the distortions in place (Poser, 2008).
Inevitability of the Asia Crisis
The Asian financial crisis was inevitable because before the crisis, the Asia countries currencies were already depreciating and the growth was very slow. There was also a drop of stock markets and real estate, and speculative trends were fueled by foreign capital inflows. This led to outright defaults and wide losses in the financial and corporate sectors. Again, policy uncertainty which was stemming due lack of commitment to structural reforms by the domestic authorities made things worse. The rapid reversals of financial capital inflows on the summer of 1997 lead to regional currencies collapse hence the international and domestic investors panic (Mengkni, 2009).
The timing of the crisis
The timing of the crisis was in line with financial challenges of the East Asia countries. The economy of the countries was stagnant before the crisis began. Before the crisis, there was fundamental imbalance which was triggered by financial and currency crisis. Therefore, the timing of the crisis was in relation with the weak economic conditions experienced (Roubini, Pesenti, Corsetti, 1999).
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