The Causes Of The Crises

Published Date: 02 Nov 2017

The sovereign debt crisis originated with the signing of the Masstricht Treaty that led to the formation of the European Union. The treaty included the Masstricht convergence criteria in which there would be a common set of goals which member countries would have to follow, thereby lowering national disparities and achieving greater economic stabilisation. The adoption of the Euro as the single currency for trade and transactions among member countries, together with the formation of the Economic Monetary Union and the European Central Bank, were steps to integrate member countries of the European Union, and were intended to facilitate economic integration, stabilisation and growth.

However, not all member countries experienced economic growth with a single currency and monetary system. GDP growth rates and real inflation rates differed within the European Union, which caused distortions in the trade balances among member countries. Countries that experienced higher inflation rates had declining exports due to currency appreciation rates not being able to keep up with inflation rates, thereby making exports more expensive and imports cheaper. This caused net exports to decrease and an overall increase in current account deficits. Furthermore, as interest rates were the same between countries, countries with higher inflation, such as Greece, experienced faster economic growth and relatively lower real interest rates compared to those where inflation was relatively well controlled, such as Germany. As such, a single interest rate had expansionary economic effects to some economies but was a hindrance to economic growth to others among the European Union.

Also, wage contraction policies and tax reduction policies implemented by countries with low inflation rates, in particular Germany, further exacerbated trade imbalances in the European Union by reducing the export competitiveness of other member nations. This resulted in member countries with high inflation rates to incur increasing trade deficits, while countries with low inflation rates were enjoying growing trade surpluses. The implementation of a single currency and interest rate, with differentials in inflation rates, and a lack of economic cooperation among member nations, further widened the economic disparities in the European Union. The result was that member nations, such as Greece, Italy, Ireland and Portugal, incurred growing external deficits, and these deficits had to be financed by government borrowing. People were willing to lend to these countries as they had confidence in the Euro and the European Union as a whole.

However, the growth in sovereign debt levels was an important factor in triggering the European sovereign debt crisis. The subprime crisis in the United States brought with it increased defaults on home mortgages, and banks that had operated heavily in the securitisation of mortgages suffered huge losses, with some that went bankrupt and many that went to the brink of collapse. The crisis carried on to the Euro zone, where financial institutions that invested heavily in United States mortgage-backed securities suffered great losses. Investors lost confidence in the markets and began to withdraw their capital. Assets depreciated in value, causing negative wealth effects. A credit crunch ensued and banks stopped lending to one another. With an overall sharp decrease in private aggregate spending, and recognising that the economy was entering a recession, governments in the European Union implemented fiscal and monetary policies to try and rescue their economies from spiralling deeper into a recession. However, given the large current account deficits and sovereign debt levels of certain member nations, including Greece, Ireland and Portugal, coupled with a decline in fiscal revenues of these countries due to decreased investments from pessimistic market sentiments, these countries had difficulties financing their own debts and therefore had to request for official funding from the International Monetary Fund, in return for austerity measures to keep its debt levels under control. Thus, structural weaknesses in the economies of European countries, coupled with the subprime mortgage crisis in the United States that affected markets in Europe, triggered the sovereign debt crisis.

Compare and contrast the initial policy responses of the United States and China to the outbreak of the global financial crisis. In your opinions, how effective were their policy responses? (20 points; Limit your answers to no more than 3 pages.)

The United States and China had similar fiscal and monetary policy responses. Given the reductions in economic growth brought about by the crisis, both the United States and China implemented fiscal policies by injecting capital into the economy to help spur economic growth. At the time of the outbreak of the financial crisis in the United States in 2008, the Chinese government introduced almost immediately a $586 billion fiscal stimulus package to help boost its economy through domestic consumption and internal investment, to provide for new jobs and maintain its economic growth rate. In the United States, the Troubled Asset Relief Program (TARP) was passed that aimed to increase liquidity in the markets and increase the capital of banks, helping to reassure investors and stabilise the economy. Both countries’ fiscal policies aimed to provide capital to the private sector such that there would be proper functioning of their economic systems which would help to spur economic growth in the long run.

Moreover, both China and the United States implemented similar monetary policies to cope with the decrease in aggregate spending in the economy. The Chinese government eliminated lending quotas and reduced interest rates so that financial institutions will be able to provide more loans to consumers and households. To maintain and improve its export competitiveness, some of these bank loans would be lent out at better rates to state-owned enterprises that export Chinese goods and services. In the United States, the central bank implemented initial monetary policies in the form of cutting the federal funds rate to an effective rate of zero, and conducting quantitative easing to make credit more readily available in the markets. Both China and the United States’ initial monetary policies targeted increased ease of borrowing from the central bank and lowered interest rates to increase liquidity, with the goal of raising domestic consumption and investment to reduce unemployment, increase GDP, and boost their respective economies.

However, the initial policy responses of both countries also have their differences. Given that China’s economy relies heavily on exports and foreign direct investments for economic growth, the fiscal policy of a $586 billion package includes spending on public infrastructure, healthcare and education to boost private aggregate spending and increase employment. The stimulus package was structured with a renewed focus on domestic consumption spending and investment, and decreased reliance on exports to reduce its vulnerabilities to future global economic shocks. Yet, in the United States, the initial policy responses by the government were mostly targeted at saving financial institutions, with the government directly purchasing private securities from banks in the United States markets, in particular mortgage-backed securities. As of September 2009, government spending under TARP was $360 billion, of which $200 billion was spent on purchasing shares of large banks. The government also implemented measures that reduced the interest premium that households and firms could borrow from banks, and increased the set of assets that financial institutions could use as collateral when borrowing from the Federal Reserve. These measures were done to increase liquidity to the markets, prevent bankruptcies, and help to restore confidence to the markets such that the financial economy could be recovered quickly. As such, the Chinese government’s initial policy was targeted at the economy as a whole whereas the United States’ government’s initial policy was targeted to rescue financial institutions such that the whole financial sector would not collapse.

On the other hand, I believe that the policy responses by the United States and China were ineffective to some extent.

In the United States, the initial monetary policies carried out by the government had little effect to help boost the economy. Cutting the federal funds rate to an effective rate of zero, and implementing quantitative easing measures were ineffective as interest rates were already close to zero. Hence, the United States economy was in a liquidity trap, and by injecting large amounts of liquidity into the markets, the Federal Reserve was unable to further spur the economy and the only way to stimulate economic growth was by introducing more fiscal policies. However, fiscal policies would not be sustainable as the federal deficit would continue to increase, thereby putting pressure on taxpayers and threatening the solvency of the United States government. This would cause harm to the long term growth of the United States economy. As a result, monetary policies implemented were ineffective and there was continued slow economic growth and growing unemployment during the onset of the crisis.

Also, quantitative easing by the United States government was ineffective because the policy was more beneficial to banks than to the whole economy. Banks would be able to keep the money provided by the government and improve their balance sheets instead of lending them out, leading to continued decreases in private aggregate spending in the economy.

Moreover, initial fiscal policies by the United States government were ineffective to help lower unemployment rates and improve consumer and investor confidence in the markets. Market sentiments were pessimistic, and people were unwilling to spend, which resulted in recessionary effects for the United States economy. Additionally, the American Recovery and Reinvestment Act passed in 2009 included extended unemployment benefits for citizens, which would not be sustainable in the long run. With a large federal deficit, increase in unemployment benefits would hamper the government’s goal of decreasing unemployment rates, and the recovery of the United States economy would be hindered. Hence, for sustainable recovery, the United States has to target private demand growth instead of continued large fiscal deficits.

For China, monetary policies that loosen control on banks were effective in helping to spur the economy. Unlike the United States, banks in China responded almost immediately and lent out to households and firms, helping to increase capital flows and private aggregate expenditure. However, fiscal policies implemented would not be sustainable as trade issues would occur between China and the rest of the world. Export subsidies given would cause unfair competition, and may therefore lead to trade restrictions that would hurt an export-oriented Chinese economy, resulting in slower GDP growth for China. Expansionary monetary policies implemented by the Chinese government would also cause concerns of inflating the real estate bubble that is happening in China, as can be seen with rising property prices in China’s major cities. This may potentially cause the real estate bubble to burst and cause China’s economic growth to decline, which may have negative repercussions to the global economy given China’s share in the world market.

Yet, it is in my opinion that the global financial system would indeed have been worse, and may have potentially collapsed without the intervention of respective governments to pumping capital into the markets to increase liquidity and cushion the negative impacts brought about by the crisis.

Read the article "2007-2008 Financial Crisis: Causes, Impacts and New Regulations" and answer the following THREE questions:

What were the causes of the crisis? (20 points, max length: 2 pages)

The causes of the crises were mainly due to mortgage-backed securities, cheap credit, and poor regulation and supervision of banks and hedge funds.

Mortgage-backed securities were new financial products created by banks to increase profits. Mortgage loans were given out to less credit-worthy home owners with little to no downpayment, as there was a widespread belief that property prices would be rigid downwards and would continue to rise. These loans were bundled together with other investment products through securitization. This led to the creation of Collateralised Debt Obligations (CDOs), Special Investment Vehicles (SIVs) and asset-backed commercial paper (ABC paper), which were then sold to investors at a profit. Insurance against the default of such investments were also sold as Credit Default Swaps (CDS) to improve their credit-worthiness. These CDSs were traded in the secondary market and involved many individuals, creating a complex network of counter-party obligations that were difficult to comprehend.

This network was far-reaching, as investors from all over the world were attracted to the profitability of such financial products in the United States. However, once home owners started defaulting on their loans, it created a domino effect that threatened the solvency of financial institutions that invested heavily on such financial products. The net worth of these institutions fell, and most of them had to find extra equity capital to meet regulatory requirements and repay their debts. In addition, as the mortgage-backed securities were complex, it was difficult to place a precise value on them, and therefore, it was difficult to place a market value on firms or financial institutions that held them. This caused banks to highly restrict lending to one another. Moreover, the risk positions of these banks were not publicized, which exacerbated the restrictions that banks had in lending to one another given the fragile economic situation. As a result, a credit crunch ensued. Financial institutions that operated on short-term funds could not carry out day-to-day business functions as they were cash strapped. Thus, as they were unable to honour their debts, this led to the bankruptcies of many financial institutions that include large banks and hedge funds.

In addition, banks and hedge funds were not regulated properly as they operated on high leverage. According to the article, famous banks such as Goldman Sachs were "using about $40 billion of equity as the foundation for $1.1 trillion of assets", while Merrill Lynch was using $1 trillion of assets with $970 billion in debt. Although operating on such high leverage ratios helps to boost the returns on assets when prices of these investments increase, the reverse is also true when prices of these investments decrease, as can be seen when the decrease in housing prices and therefore, prices of mortgage-backed securities, caused financial institutions to suffer huge losses almost overnight. This led to the insolvencies of banks, corporations and hedge funds that invested heavily in these assets, and a collapse of the financial sector that ultimately led to the credit crisis.

Many critics argue that new regulations and regulatory structures would now be required to pave the way forward for the global economy to recover from the current financial crisis. What would be the new regulations? In particular, what sectors of the economy should be regulated? Explain. (20 points, max length 2 pages)

The new regulations would involve policies that would require a change in capital structure of financial institutions to allow them to better weather losses in times of an economic downturn. According to the article, the framework posited by Martin Wolf on the "Seven Cs" would help to create a regulatory structure such that financial institutions would be more transparent in their reporting, be more responsible in their investments, and are more financially ready in an economic downturn with greater capital reserves.

Similarly, implementation of the Basel Accord would help to improve financial security of institutions and banks. The Basel Accord has the intention of increasing capital requirements of firms when they engage in lending to other parties both in the banking and non-banking sectors. These capital requirements are subdivided into different categories based on the level of risks associated with the particular type of loan, which ensures that banks would have sufficient reserves to cope with future crises; banks would have suitable risk-reserve ratios for the different credit ratings of its financial products. Moreover, the Basel Accord would require greater supervision of banks and financial institutions. This would help to improve the transparencies of financial transactions taking place in these corporations, and allow for greater understanding to access the level of risks that these financial institutions are undertaking as well as the degree of financial leverage that banks are using to finance their daily operations.

Greater regulations would also be placed on financial managers to ensure that they are responsible for their investment decisions. The current crisis was due in part to managers that made very risky investments and pocketing huge benefits and compensations at the expense of shareholders and taxpayers. Such excessive risk-taking gave rise to moral hazard that swept the financial sector. Hence, greater regulation towards executive compensation would help to reduce negligence and increase responsibility on the part of managers.

Other sectors of the financial industry that should be regulated should be the hedge fund industry, which also had a role to play in the sub-prime debacle. Before the crisis, hedge funds had no supervision and were often located in offshore markets where regulations are lax. Many of these hedge funds invested in United States mortgage backed securities, and the onset of the crisis thus caused many hedge funds to collapse, further leading to the bankruptcy of pension funds and other institutional investors that invested in these hedge funds. Thus, more regulation in the form of greater transparency towards hedge funds would not only help to protect investors but also mitigate the negative consequences to the financial industry brought about by the collapse of hedge funds should further crises occur, thereby serving to improve the stability of the financial system.

However, apart from regulating the financial sector, greater regulations should also be given to the housing sectors. Given that the cause of the credit crisis was due to a housing bubble, more supervision should be done on the real estate sectors such that recurrences of such crises could be averted. This may include monitoring the prices of property and land being bought and sold, and placing stringent lending criteria for certain housing loans such that future housing bubbles can be averted.

Also, given that the government implemented expansionary monetary policies in the form of quantitative easing, overestimating the amount required to recover the economy would cause asset prices to increase and thus cause inflation. If inflation rates are too high, this would hinder the recovery of the economy, and the higher prices as a result might even cause citizens to be worse off than before. Moreover, inflation causes exports to fall as it would lead to a depreciation of currency. This would hurt GDP growth and retard economic recovery from the current financial crisis. As such, the government should therefore also take note of the inflation rate to ensure that the economy could recover quickly from the credit crisis.

Has globalization created the inevitability of global contagion in financial crises? Explain (20 points, max length: 2 pages)

Globalisation has indeed created the inevitability of widespread financial crises to a large extent.

Globalisation has without a doubt caused greater interconnectedness between countries. The increase in technology brought about by globalisation has facilitated the ease of capital flows from one country to another. However, such integration does not always entail growth. The credit crisis in the United States has shown that the result of excessive risk-taking of managers on Wall Street did substantial damage to not only the United States economy, but also economies all over the world. This can be seen when the subprime mortgage crisis resulted in a loss of investor confidence in markets worldwide, and helped trigger the European sovereign debt crisis in which the current state of the European economy still appears fragile.

In times of financial crises, the reduction of capital flows will be exacerbated due to the effects of globalisation. As happened in the 2007-2008 United States financial crisis, the burst of the housing bubble caused investors all over the world who bought mortgage-backed securities to have drastic decreases in their wealth. As such, loss of investor confidence worldwide caused reductions in capital inflows into economies all over the world, leading to drastic decreases in private aggregate spending and causing recessionary effects in global markets. Moreover, financial institutions that faced economic difficulties were also unwilling to lend, causing huge liquidity problems which worsened economic conditions. As a result, globalisation would amplify the negative effects of a financial crisis by causing greater reductions in capital flows around the world.

In addition, globalisation would cause countries to face indirect negative consequences of a financial crisis. The recent financial crisis was due largely to mortgage-backed securities. However, countries in Asia that did not purchase many of these investments still faced risks of recession. An example would be China, where the country is the largest holder of United States Treasury securities. Given that China has an export oriented economy which relies heavily on foreign direct investments, crises in the United States and Europe would lead to a decrease in exports of Chinese goods and services, thus causing Chinese net exports to fall significantly. Given that China’s foreign direct investments largely come from the United States, the United States financial crisis would also cause China’s foreign direct investments to fall. These effects would have negative repercussions to China’s economic growth. Moreover, the example of China can be extended to other countries whose economies rely significantly on exports and foreign direct investments for economic growth. Given the interconnectedness of global economies, a decrease in private aggregate spending brought about by financial crises would hurt countries all over the world, thereby causing further decreasing wealth effects and a slowdown of economic growth in global markets.

Given the above arguments, global contagion is inevitable in our digital age. To lessen the impacts of the contagion, governments whose economies that rely heavily on foreign trade and external financing, and thus are vulnerable to sudden withdrawals of foreign capital, should implement policies that target rapid liquidity support to their financial sectors in cases of financial shocks from abroad.