Thoughts on Economics 1

Thoughts on Economics

Vol. 19, No. 02

Review of Global Financial Crisis 2008-09: Issues,

Analytical Approaches and Interventions

Dr. S. M. Ali Akkas[1]

[Abstract: The whole world is plunging into a deep economic recession. Available and dependable forecasts predict the US recession that began in December 2007 to be the longest in post World War II history. This calls for an immediate mitigation strategy of quick recovery of the US as well as the world economy. Unfortunately, other than the bail-out plan, no sign of long lasting solutions is visible to face the crisis that maylead to another Great Depression.Upheaval of the seeming second Great Depression raises doubts on the effectiveness of the Keynesian, post-Keynesian and the monetarist prescriptions to counter cyclical fluctuations.One interpretation points to rather the policy foundation – trust and confidence on the policy makers having integrity problem withwhat they commit, plan and formulate – aserious social capital erosion issue.Neither the fiscal nor the monetary policy measures can make headway under such apolicy environment, the quarter opines. The other view relates to the likelyfailure of the current bailout/stimulus packages due to the built-in pro-cyclicality of the policy transmission mechanism, particularly the banking system.They are interested to wait for the moment the downturn hits the bottom of the cycle and expect an automatic upturn thereafter. Others consider the present crisis as a systemicfault andpropose a restructuring of the banking system to make it counter cyclical. Some prominent economists interpretthe causation of cyclical fluctuation as: following each economic boom thespread between the fixed payment commitmentsanduncertain cash flow deepensthe cyclical fluctuations.This, according to them, requires restructuring of the current banking system to make it counter-cyclical. They are also in favor of establishing a direct linkage between the banking system and the real sector economy.]

1. Introduction

The global financial crisis that started with the bursting of October 2008 US financial bubble is not an isolated phenomenon; rather it is deeply linked to the recession of US economy following the boom in November 2007.The U.S. recession that began in December 2007 is expected to be the longest in post World War II history, according to the latest survey of business economists by Blue Chip Economic Indicators.[1]The January 5th-6thpoll of 52 economists from top financial firms, manufacturers and academia found that most expected a tepid recovery to begin later this year, with growth returning to more normal levels in 2010. This recession is predicted to be the longest because it will exceed the 16-month long recessions of 1981-1982 and 1973-1975.

The consensus predicts real GDP will contract by 1.6% in 2009, the worst annual performance since 1982, but grow 2.4% in 2010. Although a majority of those polled predict the recession will officially end in the third quarter of 2009, more than half of the respondents said unemployment would peak no earlier than 2010. Inflation-adjusted consumer spending is expected to be especially weak this year, registering a decline of1.1%, the worst performance since 1942. Accompanying the weakness in economic growth will be a much lower inflation. The Consumer Price Index is forecast to fall 0.4% in 2009, the first year-over-year decrease since 1955.

In December 2008, the National Bureau of Economic Research (NBER) declared that the United States had been in recession since December 2007, and will continue to plummet further with no end in sight[2]. In January 2009, Nobel prize winning economist Paul Krugman wrote that "This looks an awful lot like the beginning of a second Great Depression."[3]

In what follows, the possible impacts of the US credit crunch so far on the world economy are discussedin Section-2.This is followed by an analysisof the global economic outlook in 2009 and 2010 in Section-3,the causes of the crisis in Section-4, and policy interventions at national, regional and international levels in Section-5. Section-6 concludes.

2. Collapse of US Financial System: Impact on World Economy

The collapse of the US sub-prime mortgage market and the reversal of the housing boom[4] in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things started to unravel, the trust in the whole system started failing.

The extent of this problem has been so severe that some of the world’s largest financial institutions have collapsed. Others have been bought out by their competitors at low prices and in other cases, the governments of the wealthiest nations in the world have resorted to extensive bail-out and rescue packages for the remaining large banks and financial institutions.The crisis became so severe that after the failure and buyouts of major institutions, the Bush Administration offered a $700 billion bailout plan for the US financial system.

In Europe, a number of major financial institutions have failed, or needed rescuing.For example, some nations have stepped in to nationalize or in some way attempt to provide assurance for people. This may include guaranteeing 100% of people’s savings or helping broker deals between large banks to ensure there isn’t a failure.

2.1 Crisis in the US Economy

2.1.1 Getting into Recession

The United States entered 2008 during a housing market correction, a subprime mortgage crisis and a declining dollar value.[5] In February’08, 63,000 jobs were lost, a 5-year record.[6] In September’08, 159,000 jobs were lost, bringing the monthly average to 84,000 per month from January to September of 2008.[7]

In the early months of 2008, many observers believed that a U.S. recession had begun.[8] As a direct result of the collapse of Bear Stearns, Global Insight increased the probability of a worse-than-expected recession to 40% (from 25% before the collapse). In addition, the financial market turbulence signaled that the crisis will not be mild and brief.Alan Greenspan, ex-Chairman of the Federal Reserve, stated in March 2008 that the 2008 financial crisis in the United States is likely to be judged as the harshest since the end of World War II.[9]

A study released by Moody's in October 6, 2008 found two-thirds of the 381 largest metropolitan areas in the United States were in a recession. The study also said 28 states were in recession with 16 at risk. The findings were based on unemployment figures and industrial production data.[10]

2.1.2 Liquidity Crisis in U.S.

The Financial crisis of 2007–2008 initially referred to in the media as a "credit crunch" or "credit crisis", began in August 2007, when a loss of confidence by investors in the value of securitized mortgages in the United States resulted in a liquidity crisis which prompted a substantial injection of capital into financial markets by the United States Federal Reserve and the European Central Bank.[11] The TED spread, an indicator of perceived credit risk in the general economy, spiked up in August 2007, remained volatile for a year, then spiked even higher in September 2008.[12]

Although America's housing collapse is often cited as having caused the crisis, the financial system was vulnerable because of intricate and overleveraged financial contracts. One example was credit derivatives - Credit Default Swaps (CDS), which insure debt holders against default. They are fashioned privately, traded over the counter outside the purview of regulators.

Excessive lending under loosened underwriting standards, which was a hallmark of the United States housing bubble, resulted in a very large number of subprime mortgages. These high-risk loans had been perceived to be mitigated by securitization. Rather than mitigating the risk, however, this strategy appears to have had the effect of broadcasting and amplifying it in a domino effect. The damage from these failing securitization schemes eventually cut across a large swath of the housing market and the housing business and led to the subprime mortgage crisis. The accelerating rate of foreclosures caused an ever greater number of homes to be dumped onto the market. This glut of homes decreased the value of other surrounding homes which themselves became subject to foreclosure or abandonment. The resulting spiral underlay a developing financial crisis.

2.1.3Developing the Global Financial Crisis

Beginning with the bankruptcy of Lehman Brothers on September 14, 2008, the financial crisis entered an acute phase marked by failures of prominent American and European banks and efforts by the American and European governments to rescue distressed financial institutions, in the United States by passage of the Emergency Economic Stabilization Act of 2008 and in European countries by the infusion of capital into major banks. Afterwards, Iceland almost claimed to go bankrupt. Many financial institutions in Europe also faced the liquidity problem,for which they needed to raise their capital adequacy ratio. As the crisis developed, stock markets fell worldwide, and global financial regulators attempted to coordinate efforts to contain the crisis. The US government threw the $700 billion plan which was attempted to purchase the un-performing collaterals and assets. However, the plan was vetoed by the US congress because a group of republicans rejected the idea that the taxpayers’ money was used to bail out the Wall Street's investment bankers. The stock market plunged as a result; the US congress amended the $700 billion bail out plan and finally passed the legislation. Unfortunately, the market sentiment continuously deteriorated and the global financial system almost collapsed. While the market turned extremely pessimistic, the British government launched a 500 billion pounds bail out plan aimed to injecting capital into the financial system. The British government nationalized most of the financial institutions in trouble. Many European governments followed as well as the US government. The market has recently stabilized. In addition, the falling prices due to reduced demand for oil, coupled with projections of a global recession, brought the 2000s energy crisis to temporary resolution.[13]

As the financial panic developed during September and October 2008, there was a "flight to quality"[14] as investors sought safety in U.S. treasury bonds, gold, and strong currencies such as the dollar and the yen. This currency crisis threatened to disrupt international trade and produced strong pressure on all world currencies. The International Monetary Fund had limited resources relative to the needs of the many nations with currency under pressure or near collapse.

2.1.4 Impact of the Financial Crisis

2.1.4.1 Direct Impacts

Financial crisis of 2007-08 produced a number of direct impacts. On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.

On August 15, 2007, the Dow dropped below 13,000 and the S&P 500 crossed into negative territory for that year. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit.

Mortgage lenders and home builders fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages.

The crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds. Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle." Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which have been invested into food and raw materials.[15]

Beginning in mid-2008, all three major stock indices in the United States (the Dow Jones Industrial Average, NASDAQ, and the S&P 500) entered a bear market. On 15 September 2008, a slew of financial concerns caused the indices to drop by their sharpest amounts since the 2001 terrorist attacks. That day, the most noteworthy trigger was the declared bankruptcy of investment bank Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of America in a forced merger worth $50 billion. Finally, concerns over insurer American International Group's ability to stay capitalized caused that stock to drop over 60% that day. All of these events culminated into a stock selloff that was experienced worldwide. Overall, the Dow Jones Industrial plunged 504 points (4.4%) while the S&P 500 fell 59 points (4.7%). Asian and European markets rendered similarly sharp drops.

The much anticipated passage of the $700 billion bailout plan was struck down by the House of Representatives in a 228–205 vote on September 29, 2008. In the context of recent history, the result was catastrophic for stocks. The Dow Jones Industrial Average suffered a severe 777 point loss (7.0%), its worst point loss on record up to that date. The NASDAQ tumbled 9.1% and the S&P 500 fell 8.8%, both of which were the worst losses experienced since the 1987 stock market crash.

It is also estimated that even with the passing of the so-called bailout package; many banks within the United States will tumble and therefore cease operating. It is estimated that over 100 banks in the United States will close their doors because of the financial crisis. This will have a severe impact on the economy and consumers. It is expected that it will take years for the United States to recover from the crisis .

2.1.4.2 Indirect economic effects

The subprime crisis had a series of other economic effects. Housing price declines left consumers with less wealth, which placed downward pressure on consumption. Certain minority groups received a higher proportion of subprime loans and experienced a disproportional level of foreclosures. Home related crimes including arson increased. Job losses in the financial sector were significant, with over 65,400 jobs lost in the United States as of September 2008.

Many renters became innocent victims, often evicted from their homes without notice due to foreclosure of their landlord's property. The sudden lack of credit also caused a slump in car sales. Ford sales in October 2008 were down 33.8% from a year ago, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%. One in five car dealerships are expected to close in Fall of 2008.

2.2 Crisis in Europe

The economy of the United Kingdom has also been hit by rising oil prices and the credit crisis. Bank of England Governor Mervyn King said there might be "an odd quarter or two of negative growth," following the first quarter of 2009. In September 2008, British bank Bradford & Bingley's £20billion savings business was acquired by Spanish bank Grupo Santander.

Ireland in the first quarter of 2008 reported a contraction in GDP of 1.5 percent and 0.4 percent in 2009 due to a decline in multinationals hit by the global economic slowdown making Ireland the first member of the eurozone to enter a recession.

Spain's Martinsa-Fadesa, a construction companydeclared bankruptcy as it failed to refinance a debt of 5.1 billion euros. In the second quarter in Spain house prices reportedly fell 20 percent. Deutsche Bank said it expects a 35 percent fall in real house prices by 2011.

TheGerman economy contracted by as much as 1.5 percent in the second quarter of 2008 because of declining export orders. Industrial output in both Italy and Greece slumped 6.6 percent over the past year. Germany's industrial output was down 2.4 percent in May 2008, the fastest rate for a decade. The German Chamber of Industry and Commerce warned of up to 200,000 job losses in coming months.

In Italy, Fiat announced plant closures and temporary layoffs at factories in Turin, Melfi, Imola and Sicily. Car sales in Italy fell by almost 20 percent over each of the past two months following the global financial crisis. Analysts have predicted Italy to be in recession in the second quarter or would enter one by the end of the year 2008 with business confidence at its lowest levels since the 9-11 terrorist attacks.

The French economy declined by 0.3 percent, Finland's economy declined by 0.2%, and the Netherlands showed a zero growth in the second quarter of 2008.

2.3 Crisis in other Parts of the World

Housing prices in Australia fell in the second quarter of 2008 for the first time in about three years. Consumer confidence in Australia fell to a 16-year low in July and retail sales fell 1 percent in June 2008. High profile casualties of the credit crunch include Allco Finance, MFS, ABC Learning, Babcock & Brown and Centro.

In Japan exports in June 2008 declined for the first time in about five years falling by 1.7 percent. The decline in exports and increase in imports cut Japan's trade surplus $1.28 billion, a decline of 90 percent from the previous year. Taro Aso, secretary-general of Japan's ruling Liberal Democratic Party, said he believes Japan had entered a recession.

In South Korea Samsung Electronics has been reported to be posting a decrease in sales for the first time since the Asian financial crisis since home appliances saw a decrease in the domestic market of up to 20 percent since mid-June compared to the previous year. Domestic auto sales also saw a decrease in the second quarter.

Singapore's economy saw its biggest drop in five years in the second quarter, falling by 6.6 percent. Taiwan announced billions of dollars in spending and tax cuts due to declining growth and a 26 percent slump in the stock market in 2008. Finance Minister Tharman Shanmugaratnam said he could not rule out Singapore entering a recession.

2.4 The Financial Crisis and the Developing World

For the developing world, the rise in food prices as well as the knock-on effects from the financial instability and uncertainty in industrialized nations are having a compounding effect. Summarizing an UNCTAD report, the Third World Network notes the impacts the crisis could have around the world, especially on developing countries that are dependent on commodities for import or export.[16]

Commodity-dependent economies are exposed to considerable external shocks stemming from price booms and busts in international commodity markets.

Market liberalization and privatization in the commodity sector have not resulted in greater stability of international commodity prices. There is widespread dissatisfaction with the outcomes of unregulated financial and commodity markets, which fail to transmit reliable price signals for commodity producers.