Macroeconomic Origins of the World Financial Crisis

2012Cambridge Business & Economics ConferenceISBN : 9780974211428

Lepeshkina Ksenia

PhD Student (International Economics)

Finance University

under the Government of the Russian Federation

+7909 9357797

MACROECONOMIC ORIGINS OF THE WORLD FINANCIAL CRISIS

MACROECONOMIC ORIGINS OF THE WORLD FINANCIAL CRISIS

ABSTRACT

Recent financial crisis has witnessed a number of anomalies that stand out of the mainstream monetarist paradigm. It setsa need for a new paradigm in economic theory capable to explain all the failures of financial market. This paper argues that a basis of a new paradigm lies in understanding various interdependences between financial market and real economy with regard to systemic features of modern financial market. World financial crisis is not solely a result of financial market activity, its roots lie deeper - in distortions and imbalances of the world economy; it is also representative of a world economic crisis. Evidences for macroeconomic roots of the financial crisis include forestalling economic recession and falling capital investment rate; distortions acrossparts of global economy and imbalances between key economic processes within national economies. The paper introduces a few indicators characterizing these anomalies and presents a modification of R. Solow economic growth model showing that financial market activity contributes to a “contingency” of global economy.

INTRODUCTION

According to T. Kuhn’s “Structure of Scientific Revolutions” along with the accumulation of anomalies, i.e. failures of the current paradigm to take into account observed phenomena, scientific discipline experiences a crisis leading to a paradigm shift. The world financial crisis has revealed a number of anomalies that stand out of the common perception of financial market. Existing mainstream paradigm basing on “invisible market hand” and neo-liberalist concepts failed to explain financial market inefficiency in many aspects, major of which are:

-inefficiency of financial market in keeping balance between consumption and investment (in spite of the “savings glut” and financial market expansion the rate of capital investment which provides a base for creating new real value and repaying financial liabilities has gone down by 13% since 1980-s [Mckinsey, 2010])

-failure of financial market to provide adequate valuations of financial instruments;

-fail to manage the crisis by automatic market powers.

The situation calls for a paradigm shift in economic theory. Bringing into effectthe dialectics law of the negation of the negation we make a turnaround from perception of financial market as autonomous and self-sufficientstructure to realizationof its primaryaim of channeling capital to real economy stimulating its growth.But changes in financial market performance make impossible a simple relapse into Marxist and reproduction theory view of financial market asan auxiliary to real economy processes. It has become clear that we need a new paradigm basing on comprehensive understanding of interdependences between financial market and real economy with regard to systemic features of modern financial market. In terms of financial crisis this interdependence has shown in two ways –macroeconomic roots of financial market crisis, on the one hand, and financial crisis effect on the world economy, on the other hand.

RESULTS

Financial crisis unwounded in 2007 has origins in theproblems of the development of the world economic system, and it is as well global economic crisis. This hypothesis has three major evidences.

1. Forestallingeconomic recession and falling capital investment rate;

2. Distortions betweens the parts of a global economy;

3. Imbalances between key economic processes within national economies.

The real recession had started earlier than the financial crisis did, with a decrease in capital investment rate. Artificial growth forced by lowrates and mortgage policies resulted in a boom that was based not on creation of new real value but mostly on an unfounded rise in asset pricing and boosted private consumption. According to Catte et all [Catte et all, 2004] a rise in households net wealth tends to increase private consumption to a widely ranged degree – from 1% (Italy) to 7% of housing wealth growth (Japan). The major threat here is that the consumption increase is supported by cheap loans and mortgages rather than higher income. That creates a dependence of economic condition on future income and provokes a dangerous spiral when asset prices go down, resulting in loan defaults along with a consumption freeze.

Application of technical analysisto the curve of world GDP growth gives additional proofs for macroeconomic roots of financial crises. Economic development is subject to cycle movements, booms and slumps. Prolonged boom times are accompanied by a surplus of temporarily spare funds circulating in the world financial market that take forms of speculative investment and driveasset prices up. When world economy reaches its limit there occurs a slowdown in economic activity that triggers systemic risks in financial market and crisis. There are different theories of economic cycles aiming to explain their length and predict cycle movements. This problem is out of the scope of this paper, and we suggest a simple indicator to evaluate booms and busts in world GDP growth, i.e. stochastic oscillator. Stochastic oscillator was developed by G. Lane [Lane, 1984] and is now widely used for predicting movements of stock assets prices. Having replaced stock prices variable with world GDP growth rate we’ll get a formula for the world GDP stochastic oscillator.

%KGDP i = 100 * (TCi-TL)/(TH-TL),

TCi is world GDP growth rate for i-year,

TL is the lowest rate within the given time period

TH is the highest rate within the given time period

Empirical analysis of the latest 20-year world GDP data (1990-2010) shows that a value of stochastic oscillator higher than its mean value is an indicator of subsequent decrease in GDP growth rate. The graph below shows that during the last two decades this happened four times, and each time an outstripping stochastic oscillator was accompanied by a decline in GDP growth. In 1994 the oscillator reached 51,6% (versus its 20-year average of 50,2%) and in 1995 GDP growth rate fell by 3%. In 1996-1997 oscillator had exceeded its average for two years and was followed by a 38% annual decrease in GDP growth rate in 1998. Years 1997-2000 demonstrated a similar situation. Modern world financial crisis and economic recession were anticipated by a prolonged increase of world GDP stochastic oscillator. The indicator had excelledits long-term average for 5 years (2003-2007) and in 2007, just before the crisis burst, it totaled 100%.

Figure1: Stochastic oscillator of the world GDP

World GDP stochastic indicator reveals deviant acceleration of world GDP growth showing boom periods within a cyclical development of world economy. It may serve, in line with other indicators, a tool for forecasting world financial crisis.And at the same time it provides valuable evidence for macroeconomic roots of the world financial crisis that started in 2007. The crisis was preceded by an abnormal acceleration of world GDP growth.

It is necessary, hence, to examine carefully the growth itself, its basis and consequences. Regional composition of world GDP growth is indicative of warps and distortions in world economy development. World GDP growth in 2007 (5,25%) was driven mainly by emerging markets, namely BRIC countries, and to a much less extent by developed countries. We suggest using Herfindahl–HirschmanIndex for measuring the degree of regional concentration of the world GDP growth. It is usually calculated as the sum of the squares of themarket shares, in our case these are represented by countries’ contribution in world GDP growth weighted by corresponding shares in GDP. In 2007 HHI was 1064 whereas in 2000 it was slightly higher that 900. Historical growth of the concentration index by 16% indicates that the world economy is contingent on performance of a range of countries and thus vulnerable to any negative alterations in those.

Table1: Regional composition of world GDP growth

Country / GDP share of world total (by PPP) / GDP growth rate, % / Contribution to the world GDP growth (weighted by share), %
USA / 0,21 / 2,1 / 8%
Eurozone / 0,16 / 2,8 / 9%
UK / 0,03 / 2,6 / 2%
Japan / 0,06 / 2,4 / 3%
China / 0,11 / 13 / 28%
Russia / 0,03 / 8,1 / 5%
India / 0,05 / 9,4 / 9%
Brazil / 0,03 / 6,1 / 4%
World / 1 / 5,2 / 100%

Another good indicator of world economy distortions is given by international trade imbalances proportionate to the world GDP. The picture below illustrates current account deficits and surpluses of major world importers and exporters. According to the orthodox concept this is supposed to betoken international trade growth and advanced production specialization but as proved by modern financial crisis it may as well contribute to vulnerability of the world economy.

Figure 2: Current account imbalances

Source: World Economic Outlook, October 2009.

Presentrules of the global economy set by the activity of transnational companies and banksisolate reproduction phases from each other (production, distribution, trade and consumption) and alter the balance between key economic processes within national economic systems. One of the vital components of the reproduction process is savings that being transformed in investments build a base for fixed capital accumulation and industrial expansion. A balance between saving and consumption is established by demand and supply for capital, interest rates, prices and economic conditions. Financial globalization led to a rapture of this correlation within national economies. Low savings, current account and budget deficits in countries with mature financial markets are compensated by substantial capital inflows from emerging markets that entails an accumulation of economical imbalances.

Applying neoclassical macroeconomic models to analysis of saving and consumption processes reveals an interesting phenomenon. If we expand R. Solow economic growth model to an open economy by adding variables of capital outflows and inflows, assumed that capital outflows as well as savings rate are a function of output per worker while capital outflows is an exogenous constant, we can see that equilibrium consumption rate tends to increase to the detriment of a savings rate, even given the equality in outflows and inflows amounts.

Figure 3: Modification of R.Solow growth model

1. Assumptions of the classical R. Solow growth model:

1. Production function per worker y=f(k), где k=K/L – capital per worker, capital intensity.
2. i = sy = s f(k) , где s – savings rate per worker, i – investment function per worker.

с = f(k) – sf(k), гдес – consumption function per worker.

1. Equilibrium under growth terms is determined by an equality of savings rate to the required investment with regard to a population growth rate (n), depreciation (δ), technological progress(g).

ir = (n + δ + g) ke = sf(ke)

где ke – capital per worker in terms of effective labor - AL, where А represents multifactor productivity coefficient.

1. Modifications. Let’s extend R.Solow model to an open economy, adding capital outflows (Io) and inflows (Ii). Capital outflows are contingent on workers income thus representing a function of national output (Io = ∑io f(ke)), capital inflows are an exogenous constant Ii. Thentheequilibriumconditionis as follows:

(s-io) f(ke )= (n + δ + g)ke - Ii , where io – is capital outflows rate per worker (in terms of effective labor).

Let’s assume that Io = Ii, so that national capital outflows are compensated by foreign inflows and no surges in the production function y = f(k) occur.

i r1 = (n + δ + g)ke

i r2 = i r1 – Ii

With an increase of capital outflows required investments curve tends to go down (i r1 to i r2) as the amount requested from national workers diminishes by the value of Ii. A decrease of the savings rate (s) by an income share invested abroad (io) gives a portion of savings used in national economy shifting the savings curve down (the blue line). A new equilibrium is therefore set by an intersection of the required investment rate with a level of domestic savings left for the national economy. The graph shows that even given the equal values of capital outflows and inflows (Ii = Io), equilibrium levels of capital intensity and corresponding output per worker increase as well as consumption tend to go up.

So, we can conclude that a considerable capital inflow in a country may provoke an unfounded rise in consumption rate. In practice this phenomenon may be explained by high income expectations due to an output expansion, a propensity to consume exceeding propensity to save in terms of economic growth and low interest rates in a result of capital inflows. The recent practice supports the contention. A number of highly developed countries during pre-crisis years have experienced a prolonged downturn of gross domestic savings accompanied by a steep rise in consumption. In the year before crisis, according to OECD database, household savings rate in the USA was about 0,4% of the disposable income. The consumption per capita on the contrary soared by 230% since 2000, with consumption expenses accounting for 70% of GDP [Jagannathan, 2009]. At the same time the country was deepening its structural deficits covering them by an increase in public debt, foreign investments and dollar emission. Specific dollar’s position in the global financial market allows the USA to issue national currency to redeem international liabilities exporting inflation in foreign countries. The following figure based on the USA macroeconomic data for the last decade illustrates the correlation between direct foreign investments and savings/consumption ration of the future period (with a time lag of one year). Pearson correlation coefficient of 0, 85 proves the validity of the adjusted economic growth model for a country with high level of foreign investment and low savings rate.

Figure 4: Empirical proof: investment and consumption in the USA

Note: data taken from

CONCLUSION

Economic history shows that severe financial crises are always a result of a combination of macroeconomic, microeconomic and financial market related factors. The recent world financial crisis has been widely viewed as a crisis of derivatization, over-exposure, poor risk management and malpractice accompanied by lax regulation and excess cheap liquidity. Whereas all these factors had their place it is important to avoid underestimating deeper macroeconomic roots of the crisisas well as neglecting problems of the global economy.

Simple modifications of a neoclassical model show that equilibrium levels of savings and consumption in terms of an open economy with a large share of foreign investments eventually contribute to an increased financial fragility of the country. It is worth noting that these imbalances are sustainable in the long-term period and they are shaping a new state of the world economy- a state of contingency. The world economy is contingent on GDP growth concentrated in a range of countries, on future income and on the rise in capital investments necessary to finance creation of new real value.The current global economy is in an unstable condition that if triggered by certain events may provoke further financial crisis. It is the time to come with a new economic paradigm that will explain the basics of functioning of the global economy and its two-sided correlation with world financial market. Acknowledging the significance of liquidity support and capital injections at the early stage of the crisis it is the time to address global economy weakness and start stimulating real economic growth. Understanding interactions of various economic processes and the altered nature of reproduction under the global transnational economy will contribute to policy implications required to restore world economic growth and repay accumulated debtswithout further enhancing existing macroeconomic distortions and imbalances.

REFERENCES

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