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The global financial crisis began to show its effects mid 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and even the wealthiest of governments have had to develop rescue packages to bail out their financial systems. Many people are concerned that those responsible for the financial problems are the ones being bailed out. However, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. This problem could have ultimately been avoided if ideologues supporting the current economics models weren’t so vocal, influential and inconsiderate of others’ viewpoints and concerns.
Globalization in the 21st Century
Recent decades of globalization have created a more inter-connected, interdependent and complex world than ever witnessed before. While global policy has focused on facilitating integration, the implications of growing interdependence have been largely ignored. The acceleration in global integration has brought many benefits, but it also has created fragility through the production of new kinds of systemic risks.
As the turn of the 21st century, liberalization of capital markets and technological innovation resulted in the development of an increasingly complex “financial network”, where the speed, value and volume of financial transaction had increased sharply both domestically and internationally. In particular, the pace of change and innovation in financial markets between 1998 and 2007, known as the “Golden Decade”, saws the explosive growth of sophisticated financial instruments such as credit default swaps, collateralized debt obligations and an increase in resale markets for capital. Whereas the trading of derivatives had been marginal in the three previous decades, by the turn of the century the global over the counter derivatives market had reached $1 billion of outstanding deals. By the end of the “Golden Decade” in 2007, the market had expanded to $6 billion; 16 times the global equity market capitalization and 10 times the global gross domestic product. Global integrated markets and innovation had led to a transformation of the financial landscape. (Ian Goldin, 2010)
The financial crisis can be described as a systemic risk that began with the advent of an unregulated subprime mortgage market in the US, which ultimately destabilized the market for credit default swaps, collapsed markets for securitized instruments across global financial systems and triggered a globe liquidity crisis. Despite increasing capital markets liberalization since the Second World War, lobbyist and new economist theories convinced government that global finance required only limited regulation. As the governance gap widened, private financial institutions began taking advantage of these lighter regulations. “The regulatory system in the US, UK and other G8 countries fell victim to regulatory capture by large international banks, which allowed these institutions to influence and lobby regulatory outcomes to their individual advantage to the detriment of systemic financial stability.” (Shah, 2010)
Many blame the financial crisis on the real estate market tanking; however few have explored how a deregulated environment with economic integration and financial innovation could create a financial network vulnerable to systemic risk. “Governance gaps at all levels of the financial system, from global to individual actors allowed regulatory arbitrage, bonus gouging and other corporate governance failures to spiral out of control. The failure at all levels of financial governance reflects the inability to understand the deep structural changes in globalization and how increased integration and innovation have given rise to new systemic instability.” (Ian Goldin, 2010)
Trade growth to slow
In the beginning of 2011 forecaster’s prepared the world to expect a significant slowdown of trade expansion for the coming year. Due to multiple economic setbacks throughout the year growth dampened beyond expectations leading to a greater than anticipated reduction by year end. Following two years of anemic and uneven recovery from the global financial crisis, the world economy is teetering on the brink of another major downturn. Output growth has already slowed considerably, especially in the developed countries. The baseline forecast foresees continued anemic growth during 2012 and 2013. Such growth is far from sufficient to deal with the continued jobs crisis in most developed economies and will drag down income growth in developing countries. The World Trade Organization (WTO) has so far deterred economic nationalism, but the sluggish pace of recovery raises concerns that a steady trickle of restrictive trade measures could gradually undermine the benefits of trade openness. Even this somber outlook may be too optimistic. (Nations, 2011)
A looming persistent weakness in the major developed economies has effectively is re-surging a global downturn relating to problems left unresolved in the aftermath of the great recession of 2008-2009. The continued jobs crisis and the declining prospects for economic growth are the most pressing challenges, especially in the developed countries. As unemployment remains high, at nearly 9 percent, and incomes stagnate, the recovery is stalling in the short run because of the lack of aggregate demand. But, as more and more workers remain out of jobs for a long period, especially young workers, medium term growth prospects also suffer because of the detrimental effect on worker’s skills and experience.
The European sovereign debt crisis and fiscal problems cause and effect have been due to the rapidly cooling economy. The second half of 2011 for a number of European countries worsened which only weakened bank balance sheets of banks sitting on related assets. As governments bold steps to reach order, Greece and Italy were met with continued financial market turbulence which only heightened concerns of debt default. “The fiscal austerity measures taken in response are further weakening growth and employment prospects, making fiscal adjustment and the repair of financial sector balance sheets all the more challenging.” (Nations, 2011) All while the United States continues to battle high unemployment, shaky consumer and business confidence, and financial sector fragility. (Nations, 2011) “The European Union (EU) and the United States of America form the two largest economies in the world, and they are deeply intertwined. Their problems could easily feed into each other and spread to another global recession. Developing countries, which had rebounded strongly from the global recession of 2009, would be hit through trade and financial channels.” (Nations, 2011)
“WTO economists cautioned that preliminary trade figures for 2011 and forecasts for 2012 (chart 1 and Chart 2) were difficult to gauge due to the extraordinary levels of volatility in financial markets and in the broader economy for the last few years. The preliminary figure of 5.0% for world merchandise trade growth in 2011 is down 0.8 points from their most recent forecast update in September 2011. These figures are in “real” terms, i.e., adjusted to account for inflation and exchange rate fluctuations.” (Organization, 2012)
Chart 1: Growth in volume of world merchandise trade and GDP, 2005-13 a
(Annual % change)
a Figures for 2012 and 2013 are projections.
Source: WTO Secretariat.
Chart 2: Quarterly World exports of manufactured goods by product, 2008Q1-2011Q4
Year-on-year % change
Source: WTO Secretariat estimates based on mirror data for available reporters in the Global Trade Atlas database, Global Trade Information Systems.
“Down from 2.4% in 2011, the present trade forecast of output growth for 2012 is only 2.1%. This growth rate could be plagued with even greater negative consequences for trade if the downturn in Europe is steeper than expected, financial infection related to the sovereign debt crisis, rapidly rising oil prices, and geopolitical risks”. (Organization, 2012)
Economic prospects have improved in the United States and Japan as labor market conditions improve in the former and business orders pick up in the latter, but these positives will only partly make up for the earlier negatives. Recent production data suggest that the European Union may already be in recession, and even China’s dynamic economy appears to be growing more slowly in 2012. Several adverse developments disproportionately affected developing economies, including the interruption of oil supplies from Libya that caused African exports to tumble 8% last year and the severe flooding that hit Thailand. The Japanese earthquake and tsunami also disrupted global supply chains. These disruptions penalized exports from developing countries like China, as reduced shipments of components hindered production of goods for export.
During the year there were significant exchange rate fluctuations, shifting the competitive positions of some major traders and prompted policy responses in Switzerland and Brazil. In large these fluctuations were driven by attitudes toward risk related to the euro sovereign debt crisis. According to Federal Reserve data, US dollar fell 4.6% in nominal terms against a broad basket of currencies, and 4.9% in real terms according to data from the International Monetary Fund, making US goods generally less expensive in export. Nominal US dollar depreciation also would have inflated the dollar values of some international transactions.
“The WTO’s projected 3.7% growth rate for world merchandise trade in 2012 is below the long-term average of 6.0% for 1990-2008, and it is even below the average over the last 20 years including the period of the trade collapse (5.5%). Should it come to pass, the baseline forecast for 2012 and 2013 would not bring the volume of world trade any closer to its pre-crisis trend. In fact, the gap should grow larger as long as the rate of trade expansion continues to fall short of earlier levels.” (Organization, 2012)
Chart 3: Volume of world merchandise exports, 1990-2013a
a Figures for 2012 and 2013 are projections.
Source: WTO Secretariat.
“Eliminating this divergence would require faster than average growth at some point in the future. Conceivably, this could happen after governments, businesses and households in developed countries reduce their debt burdens to more manageable levels, but this process of deleveraging (reducing reliance on debt) and fiscal consolidation (reducing budget deficits) is likely to take years. In the meantime, the world may have to resign itself to a long period of slower-than-average growth in international trade.” (Organization, 2012)
Lessons from the Financial Crisis
Governance gaps at the global, national and individual level stemmed system fragility. This fragmented surveillance system created a space within which regulatory arbitrage could grow out of control of regulators and most traders who did not properly understand the systemic vulnerabilities caused by increased complexity and homogeneity. The financial crisis emphasizes the need to adapt our fundamental understanding of economic networks to include the systemic complexities characteristics of the new 21st century networks. Understanding the topological robustness and complexity of a network depends on the dynamics of how these systems are formed and will fall apart, (their assembly and disassembly processes). This involves an understanding that entities cannot be analyzed in an additive manner, nor can they be analyzed isolated from their interactions with other entities within the broader network. Systemic analysis must examine each entity, pathways and the relationships between them since catastrophic changes in the overall state of a system can ultimately derive from how it is organized from feedback mechanisms within it, and from linkages that are latent and often unrecognized. (Nations, 2011)
The second lesson draws on the tension within and between levels of financial governance ranging from the global to the local. In many ways, the subprime crisis occurred because the global ignored the complexities of local. The global financial architecture of a fragmented surveillance system resulted in information asymmetry, where traders developed models that scored risk in a complex, poorly understood way which confused regulators and attracted global investors by eschewing local knowledge in favor of formula based risk management on a global scale. Market prices therefore did not reflect the reality of the underlying risk and self-reinforcing tendencies of markets, in what is referred to as reflexivity. In the absence of adequate global or national regulator standards governing the intermediation process, the innovation and use of US collateralized debt obligations allowed local subprime mortgages to be repackaged and sold globally in an integrated financial system. The robustness born out of greater integration and connectivity of the global financial network also created greater fragility in the network which facilitated contagion upwards and downwards through the global local continuum by a liquidity crisis. These relationships between local and global forms of governance were largely ignored, the systemic consequences of which amplified a local crisis into a systemic and global crisis. Governance of the global financial system at all spatial scales must work together to coordinate and collaborate, because no level of governance is sufficient as an island of regulatory control. The high degree of integration and interconnectedness across the financial system calls not only for vertical regulation, but also horizontal regulation that looks between and across the spatial silos of governance. (Nations, 2011)
Thirdly, the financial crisis illustrated that globalization has flattened financial hierarchies through the growth and innovation of technologies, and that this greatly increased both the complexity and global scale of interconnectedness. This was facilitated by new technologies, which underpinned an escalation in system traffic and complexity, which was not understood by the users of the system. The financial crisis could not have occurred without the scaled up computing power that facilitated the innovation and transmission of sophisticated credit derivatives, automated underwriting and increasingly complex risk assessment models. Technological change via the acceleration of computer processing has greatly contributed to system fragility because microprocessors facilitate logistical chains, increase connectivity and facilitate the innovation of complex financial instruments, the underlying mathematical theories of which can be flawed, hard to understand and even more difficult to regulate. (Nations, 2011)
The fourth lesson emerges from new pressures and homogeneity in management incentives. The financial crisis demonstrated that deregulation and the advent of innovative new technologies led firms to mimic one another and become less diverse in the pursuit of investment return. What is less understood is the origin of this approach, which has been fundamentally driven by a shift in financial management theory. In recent decades, inventory management strategy and international accounting standards shifted towards the notion that in an integrated global economy no assets should lie idle and every penny should be leveraged capital. This was evident in global financial systems leading up to the crisis, where excess liquidity or capital came to be regarded as a curse, so that innovative bankers sought ways to gain leverage even from capital reserved for regulatory purposes. Eliminating stocks and reserves and tightening the connections between elements will increase efficiency when everything works smoothly but will spread any problems that arise. The drive for returns on a quarterly basis and the quest to eliminate idle capital increased vulnerability to systemic risk and once the crisis was triggered it greatly facilitated global contagion. (Nations, 2011)
Lesson five, modern global financial institutions are inadequate in their response to systemic risk governance and cannot keep pace with innovation and increasing system complexity. The international institutional framework for global finance is the best understood and most sophisticated of the global governance regimes. The unpredicted collapse of the system has highlighted the vulnerability of even the most sophisticated institutions, as profound short comings in the governance system stemmed from a lack of understanding of systemic risk in the 21st century. The failure of the best equipped global governance system, finance, has highlighted the scale and urgency of addressing this challenge. (Nations, 2011)
Globalization in recent decades has been very beneficial. At the same time, a world with growing interdependency and technological progress in globalization, population and economic growth, has added a new layer of complexity leading to the emergence of new systemic risks. As global financial networks have increased connectivity, the speed in changing technology and system management has increased both the strength and weakness of the global financial network. In addition to governance shortcomings between all scales of financial governance, from local to global, as well as the failure of financial institutions to anticipate or adequately respond to the crisis, reflected a breakdown on understanding the underlying systemic risks.
These systemic risks are not isolated to global finance. The financial crisis underscores the real threat of systemic risks in other areas and exposes the alarmingly profound shortcomings of modern global institutions. Current institutional structures and or reformed plans do not appear to be addressing the issues surrounding global systemic risk in the modern century. At this juncture it would be hard to dispute the need for global governance; fundamental structural changes are required given the nature of systemic risk and pace of technological advancement. We have seen even the best outfitted global institutions struggle to keep up with change effectively.
The devastating consequences of the financial crisis unfortunately, have yet to be taken advantage of. The much need changes necessary for global institutions to effectively govern future systemic risk are still lingering. Nonetheless, as pressure continues to grow for a more inclusive, secure and sustainable world, it is likely globalization will be the force for new models, entities, and course of action needed for proactive global governance.
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