Gadget by The Blog Doctor.

Friday, July 30, 2010

The Global Financial Crisis

In the second week of the Our World in Crisis? course, we investigated the Global Financial Crisis. Here is my contribution:


Poor regulation of financial markets played a role in the development of the Global Financial Crisis, particularly in the investment decisions that were taken, but there were a range of other issues relating to investment decisions and the development of excessive liquidity that led to the market failure.

Excessive Liquidity

As Paul Krigman has noted, in the years before the global financial crisis the “ world [was] awash in cheap money, looking for somewhere to go. Most of that money went to the United States …” (Source here)

There are three main explanations for this huge amount of money in the US economy.

1. Excessively low interest rates

After the terrorist attacks on September 2001, the Federal Reserve, let by Allan Greenspan reduced interest rates fairly rapidly to historically low level of 1%. These low rates led to a housing bubble.

2. The increase in inequality in the US

Income inequality has been increasing in the US for the last thirty years. The incomes of the very wealthy have increased significantly while the wealth of the Middle and Working Classes has stagnated.

“Such enormous wealth could not be used for consumption only. There is a limit to the number of Dom PĂ©rignons and Armani suits one can drink or wear. … So, a huge pool of available financial capital—the product of increased income inequality—went in search of profitable opportunities into which to invest.” (Source here)

3. The imbalance between deficit countries and surplus countries

Some countries manage to run a trade surplus. The main examples of surplus countries are China (and a few other East Asian countries) and Germany. Many countries operate a trade deficit. The US, UK and some European countries are examples of deficit countries.

The problems of this imbalance were recognised before the financial crisis became obvious. The Chairman of the US Federal Reserve, Ben Bernanke, described it as “the Global Savings Glut” in 2005. (Source here)

Paul Keating traces this issue back to the Asian Financial Crisis of the late 1997-8. (Source here) The IMF stepped in to try to stabilise the currencies of some South-East Asian countries. According to Keating, the Chinese Government decided that it would not be subject to such heavy handed intervention, and set about to “build its own IMF”, by establishing large foreign currency reserves.

Investing the Savings Glut

The huge amount of money generated by the three processes described above needed to be invested somewhere. Usually such funding flows would travel from the developed countries to the developing ones, but in this instance the flow was in the other direction – from the developing countries to the developed ones. Effectively poorer countries were financing the lifestyles of the richer countries.

One reason for this unusual state of affairs was the increasing inequality in the US and other western countries discussed by Milanovic. Middle class incomes had stagnated. According to Milanovic: “A way to make it seem that the middle class was earning more than it did was to increase its purchasing power through broader and more accessible credit. People began to live by accumulating ever rising debts on their credit cards, taking on more car debts or higher mortgages.” (Source here)
New investment products, such as collateralized debt obligations (CDOs), made this situation more unstable. CDOs are investments that consist of a group of assets (for example, mortgages) that are bundled together into one product. The level of risk of the different underlying assets varied, and made it difficult to determine the overall value of the product. This type of investment was generally sold by the originating bank or financial institution to another institution, which “lessened the incentive to of banks to screen borrowers carefully. This opens the credit-markets doors to poor quality borrowers. “ (Source here) This led to many NINJA loans – No Income, No Jobs, No Assets.

Wall St. bankers were involved in such risky behaviour because there was no incentive to reduce risk and every incentive to increase it. Their rewards were short term, and they could receive their bonuses and stock options, move on and when the system collapsed after they had left it wasn’t their fault. This led to “rational / irrationality” according to John Cassidy of the New Yorker magazine (Source here) . It was rational for the Wall St. bankers to do things that turned out to be irrational. As “Chuck” Prince, CEO of Citibank, said “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Source here)

Poor regulation was a factor in the bad investment decisions. As John Mack, Chairman of Morgan Stanley has stated:

The financial crisis laid bare failures of risk management at individual firms across the industry and around the globe. But, more significantly from a policy perspective, it made clear that regulators simply didn’t have the tools or the authority to protect the stability of the financial system as a whole. That’s why we need a systemic risk regulator with the ability and responsibility to ensure that excessive risk-taking never again jeopardizes the entire financial system.

(Source here)

The lack of effective government regulation of the financial system (ie of a “systemic risk regulator” was an important element in the irrational investment decisions taken that led to the financial crisis, but there were a range of other reasons for the development of excessive liquidity in the financial system. It is unlikely that surplus / deficit imbalance in the world financial system will be solved by regulation. A more likely solution will be found by negotiation in international forums such as the G 20.

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