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Global financial crisis has been experienced for a while, but it started to show its effects in the mid 2007 into the year 2008. It is often referred to as the Global Financial Crisis, Great Recession, or the Credit Crunch and is considered by economists as the worst financial crisis since the Great Depression in the 1930s. The crisis has resulted in stock markets falling around the world, many financial institutions have collapsed and/or have been bought out and even the world’s wealthy governments had to bail out their financial systems (Diya 2). The housing market has also been affected in many areas, thus resulting in many evictions, foreclosures and lack of employment. As those responsible for the global financial crisis are being bailed out, the effects are felt by everyone. The crisis has contributed to failure of many important businesses, falls in consumer wealth and a significant reduction in economic activity resulting in the severe global recession in 2008 (Gordon 1).
As the housing disintegration progressed, credit tightened and international trade declined, thereby slowing many economies worldwide. This has seen many governments responding with fiscal stimulus, bail outs and monetary policy expansion (Diya 2). Arguments put forward suggest that credit rating agencies and investors were unable to accurately evaluate the risk associated with mortgage related financial markets, and policy makers were unable to identify the role of financial institutions, such as investments and hedge funds (Diya 5). Therefore, this paper will critically evaluate the global financial crises around the globe.
The global crisis was triggered by the global housing bubble disintegration, which hit its highest level in 2006, after the U.S. lowered security values connected to the real estate and as a result, damaging financial institutions globally. Speculation led to more home owners seeking loans from banks, as housing prices began to rise. The price of a typical American house had increased by 124% on average between 1997 and 2006 (Justin 4). The appreciating prices and lower interest rates triggered an increase in mortgage, though income generating projects were not able to grow at the same rate. Banks encouraged home owners to take on loans persuading that they would be able to pay them back quickly without overlooking the interest rates. The interest rates began to rise in the mid 2007, leading to a decline in the housing prices significantly. The speculative bubble was difficult to sustain by 2003 and 2008, the decline in the average U.S. housing prices was over 20% (Justin 5).
Refinancing became increasingly hard, thus resulting to a rise in the number of foreclosed homes. Lowering of interest rates, backed by the U.S. Federal Reserve from 2000 to 2003 from 6.5 % to 1 % provided simple credit conditions which led to increased borrowing. These easy credit conditions prior to the crisis fuelled the housing construction boom and encouraged debt financed consumption. The U.S. was experiencing high and rising current account deficit, which pressurized lowering of interest rates as the U.S. required borrowing money from the outside countries (Justin 6). The situation created a demand of different financial assets, rising of their prices and reduced interest rates.
In addition, the easy credit conditions allowed borrowers with low credit histories and higher chances of defaulting to increase. This sub-prime lending has been viewed as one of the causes of the debt crisis. Mortgage frauds have been confirmed and predatory lending has also been viewed as the cause of this financial crisis (New York Times 1). Further, it has been argued that the regulatory framework was not able to keep up with the pace of financial advancements. Some laws were bypassed and their enforcement weakened in parts of the financial system.
As the housing bubble expanded, the U.S. households and financial institutions became increasingly indebted as a result of over-leverage contributing to its collapse. The use of adjustable rate mortgage, mortgage backed securities, credit default swaps, collateralized debt obligations and other complicated, modern financial innovations were expanding, thus becoming leading causes of the debt crisis (Simkovic 4). Financial agreements called mortgage-backed securities and collateralized debt obligations, which passed on their value from the payments of mortgage and prices of housing that increased rapidly. These financial innovations enabled investors and institutions around the world to invest in the U.S. housing market.
However, the market participants failed to precisely evaluate the risks associated with such financial innovations. They were not able to assess its impacts to the economy and the overall financial system (Gordon 6). Decline in the housing prices left the major global financial institutions that had borrowed to invest in the subprime MBS counting significant losses. These great losses left many banks with very little funds to continue with their operations. The declining prices also resulted in houses valued going low compared with the mortgage, thus giving a financial incentive to enter foreclosure. This foreclosure has been ongoing and it continues to drain wealth from consumers and the strength of banking institutions continues to be eroded (Justin 2). Other parts of the economy have also been affected by defaults and losses of loans have significantly rose with the expansion of the crisis from the housing market. Below is a table reflecting the financial performance from 2006 to 2009.
The TED spread (in red) stimulated rapidly during the financial crisis, thus reflecting a rise in perceived credit risk. Other than housing and credit bubbles growth, various factors contributed to the increased financial inflation. These caused the financial system to expand and become increasingly fragile, a process called financialization. The regulatory framework was not able to keep up with the pace of financial developments (Briggo, Pallavicinni and Torresetti 3). Deregulation had been emphasized by the U.S. Government policy to encourage business, and this resulted in less disclosure of information concerning new businesses, as the banks were involved in. Less oversight of the financial institutions was also observed. Laws were bypassed, and their enforcement weakened in parts of the financial system.
Policy makers were unable to identify the role of financial institutions such as investments and hedge funds also referred to as the shadow banking system. Even though, these institutions were a source of credit to the U.S., as they were not subject to the same laws governing commercial banks. They assumed large debt burdens by providing loans, but they lacked a financial support to deal with the large loan defaults and losses (Gordon 7). Economic activity was slowed and the lending ability of financial institutions was greatly impacted by these losses. Central banks had to provide funds to restore faith in stock markets and encourage lending, which were integral in funding business operations. The government had to rescue the situation by implementing economic stimulus programs resulting to added financial commitments (Diya 5).
Subprime refers to the credit quality of certain borrowers who have weak credit histories and higher risk of default than the prime borrowers. High competition between lenders for market share and revenue and the short supply of creditworthy borrowers caused mortgage lender to provide risky mortgages to less credit worthy borrowers (Gordon 8). Easy credit conditions allowed borrowers with weak credit histories and greater risk of defaulting to increase. As well as easy credit conditions, these competitive pressures contributed to the increase of subprime lending during the years prior to the crisis. Government Sponsored Enterprises (GSEs) relaxed their regulations in order to keep up the competition with the private banks and together with the major U.S. banks played an important role in the expansion of lending. This sub-prime lending has been viewed as one of the causes of the debt crisis (Gordon 4). Further, it has been argued that the regulatory framework was not able to keep up with the pace of these financial advancements. Some laws were bypassed and their enforcement weakened in parts of the financial system.
Expansion of the Housing Bubble
The global housing bubble disintegration peaked in 2006 in the U.S., thus lowering the values of securities tied to real estate, and as a result, damaging the financial institutions globally. The price of a typical American house had increased by 124% on average between 1997 and 2006. The appreciating prices and lower interest rates triggered an increase in mortgage though income generating projects, which were not able to grow at the same rate. The speculative bubble was difficult to sustain by 2003 and 2008, the decline in the average U.S. housing prices was over 20% (Justin 7). This decline in the housing prices led to great losses being reported by the major financial institutions that and invested heavily in the U.S. Investors’ confidence was damaged, thus impacting stock markets greatly (Briggo, Pallavicinni and Torresetti 9). The strength of the banking institutions was eroded, credits tightened and international trade declined. Large losses in securities were reported in the late 2008 and early 2009 (Gordon 5).
Easy Credit Conditions
Lowering of interest rates in the U.S. from 2000 to 2003 from 6.5 % to 1 % provided simple credit conditions, thus leading to increased borrowing. The situation created a demand of different financial assets, rising of their prices and reduced interest rates. The U.S. was experiencing high and rising current account deficit which pressurized, thus lowering the interest rates as the U.S. required borrowing money from the outside countries (Simkovic 8). An inflow of foreign funds was needed to allow it to balance its current and capital account. Foreign investors were ready to lend either because of high interest rates (as high as 40% in China) or because of high oil prices. Foreign governments provided funds by buying the U.S.A Treasury bonds, and thereby, avoiding much of the impact of the crisis.
The practice of lenders enticing borrowers to get into unsecure loans for inappropriate purposes has been seen as a contributing factor to the financial crisis. The most common method used was the advertising of loans at low interest and later charging borrowers higher (Gordon 4). The consumers would be put into an Adjustable Rate Mortgage (ARMs), where the interests charged would be higher than the interests paid, though the advertisement might state that the interest charged would be 1% or 1.5%. This resulted to negative amortization which borrowers might not realize until after completion of the transactions.
Regulatory framework was not able to keep up with the pace of financial advancements, such as the importance of shadow banking. Some laws and regulations were bypassed or changed and oversight in enforcement was absent in parts of the financial system (Gordon 10). Restrictions on bank financial activities were not emphasized, thus allowing banks to rush into real estate lending and other activities even when the economy soared.
In the period preceding the crisis, the financial institutions became highly leveraged, thus increasing their risky investments and reducing their abilities to deal with losses. Financial instruments like off balance sheet securitization and derivatives were used to make it hard for creditors and regulators to oversee and reduce the levels of financial risks (Simkovic 6). This contributed to the need for the government bail outs, as the institutions were not properly organized in bankruptcy. As the housing bubble expanded, the U.S. households and financial institutions became increasingly indebted as a result of over-leverage. Their vulnerability to the collapse of the housing bubble was increased and worsened after the economic downturn.
This refers to the ongoing development of financial products to meet specific clients’ objectives such as assisting to obtain financing. The use of adjustable rate mortgage, mortgage backed securities, credit default swaps, collateralized debt obligations and other complicated modern financial innovations were expanding, thus becoming leading causes of the debt crisis (Briggo, Pallavicinni and Torresetti 5). The market participants failed to precisely evaluate the risks associated with the financial innovations like MBS and CDOs that were being used expansively in the years preceding the crisis. These innovations like the shadow banking system and the off balance-sheet derivatives were a way of evading regulation. The market participants were not able to assess its impacts to the economy and overall financial system. This resulted into great losses with many banks left with very little funds to continue with their operations (Briggo, Pallavicinni and Torresetti 6).
Incorrect Pricing of Risk
The pricing of risk refers to the amount of money for compensation obligated by investors for taking on additional risk. This may be measured in rates or interests. It has been argued that banks were not transparent in exposing their risks before the crisis, thus preventing markets from correctly pricing risks (Briggo, Pallavicinni and Torresetti 10). This enabled the mortgage market to grow as it was necessary and aggravated the severity of the crisis. Market participants did not measure accurately the risks associated with innovations such as CDOs and MBS for a variety of reasons. They also failed to understand its impact on the overall stability of the financial system (Briggo, Pallavicinni and Torresetti 4). As the complexity of the financial assets increased and became more difficult to value, investors were reassured by the fact that international bank regulators and bond rating agencies were convinced by the complex mathematical models, which theoretically showed risks to be smaller than their actual value.
Rise and Fall of The Shadow Banking System
It has been discovered that mortgages with the highest level of risk were financed by the shadow banking system, and competition of this system may have put pressure on some otherwise conservative institutions to lower their own underwriting standards and originate their riskier loans (Gordon 4).
Rise of Commodities
The prices of a number of commodities increased following the collapse of the housing bubble. This has been attributed mainly to the speculative flow of funds from housing and other investments to other commodities and economic policy. The price of oil has gone up over the past few years. This increase in oil prices tends to force consumers to spend a larger share on gasoline (Simkovic 5). This has placed downward pressure on the economies of importing countries as wealth increased in oil producing countries. The prices of oil over the last decade have not been stable and the destabilizing effects of this price have been identified as a contributory factor in the financial crisis.
Another explanation of the crisis is that the crisis is only a symptom of the deeper crisis caused by capitalism. There has been a decrease in the GDP rates in the Western countries since the 1970s, thus creating an increasing surplus of capital that lacks sufficient and profitable investments in the economy (Simkovic 8). Placing this surplus into financial market became the alternative, since it became more profitable when compared with the capital investment, especially with subsequent deregulation. This situation has caused recurrent financial bubbles. According to Ravi Batra’s theory, speculative bubbles that disintegrate and result in depression and major political changes can also be produced by the growing inequality of the financial capitalism. He has also proposed that a demand for gap deficit and debt dynamics important to stock market growth can be explained by differing revenues and productivity growth. Analysts have also suggested that the recent technological innovations such as computer based trading coupled with the interconnected nature of markets have magnified the effects of the crisis (Diya 2). This has created unstable conditions in the financial sector. Another explanation suggested by economists is that the current credit conditions in the U.S. can be attributed to stagnation of wages among casual laborers who comprise the bulk of the workforce forcing them to borrow in order to meet the cost of living (Diya 6).
Impact on Financial Markets
The U.S. Stock market
The U.S. stock was at its peak in October 2007, but it entered a pronounced decline which increased in October 2008. The stock market has, however, recovered much of the decline markedly in the first half of 2011.
Suggested by the International Monetary Fund (IMF), loss estimates of large U.S. and European banks are more than $1 trillion spent on toxic assets and bad loans from January 2007 to September 2009. These banks are still not through with their losses with the IMF estimating that the U.S. banks are 60% through their losses and those in the euro zone are only 40% (Arthur 6). At the beginning of the crisis, only institutions directly involved in house construction and mortgage lending were affected, as they could no longer access financing through credit markets. Many of these mortgage lenders went bankrupt between 2007 and 2008 (Arthur 7). The peak of the financial institutions crisis came in September and October 2008, when several major institutions failed, having been taken over by the governments or acquired under difficult financial situations.
Credit Markets and Shadow Banking System
The credit crisis is also explained by economists via the entry of the shadow banking system into the financial system. Shadow banking system became extremely popular and was nearly as valuable as traditional commercial banking sector. Investment banks and other institutions in the shadow banking system lacked the capacity to provide funds to the institutions and mortgage lenders (Briggo, Pallavicinni and Torresetti 8). Therefore, they had to obtain investor funds in exchange for asset backed commercial paper or mortgage backed securities. The collapse of the shadow banking was responsible for the reduction in funds available for borrowing, since traditional banks raised their lending standards.
There exists a direct relationship between declines in wealth and declines in investment and consumption which together with government spending represent a position of the economy. Loss estimation of the Americans is more than a quarter of their total net worth between June 2007 and November 2008. Decline in the average U.S. housing prices was over 20%, and the total home ownership which had been estimated at $13 trillion in 2006 dropped to $8 trillion by mid 2008, and decline continued as the year progressed (Diya 9). The second largest American house hold asset, total retirement assets, dropped by 22%. Savings and investment assets lost $1.2 trillion, while pension assets lost $1.3 trillion. The total losses are large and the household wealth is down by $14 trillion. In the years preceding the crisis, the U.S. home owners had extracted significant equity from their homes, which they could no longer do once the housing boom collapsed. As the housing bubble grew, the amount of free cash used by consumers from home equity extraction also increased. Home mortgage debt in the U.S. relative to GDP rose from 46% during the 1990s to 73% during 2008 (Justin 7).
The debt crisis developed rapidly and turned into a global economic shock. The crisis started from 2007-2008 among some European countries, and the situation became tense in early 2010. This resulted in failure of a number of European banks, declines in some stock indexes and great reductions in the value of equities and commodities. These countries included Euro zone members, such as Greece, Ireland, Italy, Spain and Portugal and some European Union countries outside the zone. The sovereign debt crisis has been most pronounced in some EU countries, but the effects of the problem have been perceived being spread thoughout area (Simkovic 5). MBS and CDOs were purchased by corporate and institutional investors from around the world. The deleveraging of financial institutions as assets were sold to pay off obligations accelerated the solvency crisis further and caused international trade decline (Briggo, Pallavicinni and Torresetti 4).
The largest crisis in 2008 was experienced by Iceland when its entire international banking system collapsed. However, the country has emerged to be less affected by the debt crisis because its citizens disagreed to the idea of bailing out foreign banks in a referendum. The banks owed the government over 10 times of Iceland GDP before the crash (Briggo, Pallavicinni and Torresetti 6).
From the year 2000 to 2007, the Greek economy was one of the fastest growing in the Eurozone with foreign capital flooding the country. During that time, the country’s economy grew at a rate of 4% annually. The government has been spending more money on future of the country. With the expectations that investment in infrastructure would yield better returns, the government borrowed money for purposes of infrastructure investment. Unfortunately, the borrowed money continued to exceed the country’s revenues, thus causing a structural deficit (Arthur 4). Decreasing bond yields and weak economy made the country run on huge structural deficits. The ratio of debt to the county’s GDP has remained over 100% since 1993.
At the beginning, currency devaluation assisted in finance borrowing. Due to the low interest rates, the government bonds could command, thus Greece was able to borrow after the introduction of the euro in January 2001 (Diya 5). The financial crisis that began in 2007 had a great effect on Greece. Tourism and shipping, the country’s largest industries, were badly affected by revenues falling with 15% in 2009. Greece hid the actual deficit figure to the E.U. to keep within the union’s monetary guidelines. Greek Government in 2010 was estimated to be 120% relative to GDP with its deficit being one of the highest in the world. In 2010, there were hints of default by the government with analysts question being the country’s ability to finance its debts (Diya 8). In such an event, investors would have lost 30-50% of their money. In response to this announcement, there was a decline in the world’s stock markets. Despite the fact that it was Greece that feared to default its debts, the other Eurozone countries were greatly affected. Portugal, Ireland and Italy also have large debts although the Italy’s budget position is better than the European average one.
Ireland’s sovereign debt crisis resulted from the government guaranteeing the six top Irish based banks which had financed an estate bubble. The banks were unable to raise finances and the state renewed the bank guarantee by September 2010. Irish Government bonds were impacted negatively and the government assisted the banks to rise 32% of the GDP. The government entered into negotiations with the ECB and IMF, which resulted into €85 billion bailout agreement in November 2010 (Diya 9).
Portugal’s debt crisis resulted mainly from bad policing and poor management of state finances. The country’s continuous recruitment of workers increased the number of redundant public servants. Inefficiency, mismanagement and over-expenditure in public works have allowed significant slippage in the government managed public works and inflated wages and dues for the top management officers (Simkovic 3). This kind of mismanagement of funds has been present for over four decades. The government was unable to prevent or forecast this in 2005, and the country was on the verge of bankruptcy by 2011. Portugal’s bailout has been termed unnecessary, since the country became a victim of speculation
Spain is one of the largest economies in the European Union and the condition of its economy is a source of concern to international observers. The country faced pressure from the United States, the IMF, the European commission and other European counties to cut its deficit more aggressively. The state was able to reduce its debt from 11.2% of GDP in 2009 to 9.2% in 2010, and its public debt stood at 60.1% of GDP in 2010, which is lower than that of the other countries in Eurozone (Diya 5).
Belgium’s public debt was 100% of GDP in 2010. It was the third highest debt in the Eurozone after Greece and Italy. However, the country’s deficit was 5% which was considered relatively modest and its bond yield of 3.7% was below those of Ireland, Portugal and Spain. Moreover, the country is less prone to international credit markets fluctuations, since it finances its deficit through domestic savings (Diya 6).
Fears of the global economic collapse have been prompted by the continuing development of the crisis. The world has started to take the necessary actions to fix the crisis by cutting interest rates, capital input by governments and systemic injection. Major Banks have collapsed around the world with Iceland’s banking collapse being the largest one in economic history. The U.S., Euro zone and the U.K. experienced negative growth in 2009 and very little growth in 2011 though not as bad as the Great Depression (Diya 7). Reports show that consumption in the U.S. accounted for more than a third of growth in the global consumption during 2000 and 2007. The economy has been consuming too much and borrowing too high, thus leading to the rest of the world depending on consumer as a source of global demand. With increased savings rate of the U.S. consumers and recession in the U.S, growth elsewhere has been declining dramatically (Simkovic 7).
Africa and Financial Crisis
The initial suggestion was that African countries might not have been affected by the crisis due to its weak integration with the rest of the global economy. However, those with some exposure to the rest of the world might face some problems. The IMF issued a warning in May 2009 that Africa’s economy might plummet because of the troubled world economy (Simkovic 9). Africa’s largest economy has entered into recession for the first time since independence due to the decline in its manufacturing and mining sectors. In addition, African countries may face pressure for debt repayment. With Western banks and financial institutions that have lent money to Africa facing crises, there are fears they could demand debt repayment. Social services like health and education have suffered before due to policies and crises in previous eras and still face further cuts.
The recession has caused some developing countries with strong economic to slow down. For example, Cambodia’s growth was forecast to fall from 10% in 2007 to almost zero in 2009 and Kenya was forecast to achieve the growth of only 3%-4% in 2009 down from 7% in 2007. This decline of growth was attributed to falls in trade, prices of commodities, investments and money sent from migrant workers (Diya 10). The effects of the crisis have led to a dramatic increase in the number of people living below the poverty line. The effects of the financial instability and uncertainty in food prices are having compounding effects on the developing world. Developing country analysts are also concerned about the global recession and the high costs of fuel and commodity prices.
Latin America and the Financial Crisis
Latin America will feel the effects of the United States economic crisis. Many countries in Latin America depend on trade with the U.S.; therefore, slow growth is expected to take place in the region. The economies of Mexico and Brazil continue feeling the effects of this financial crisis.
The Arab World
Reports by the World Bank have shown that the Arab world is in the best position to deal with the economic shocks (Simkovic 7). The countries were able to avoid going to the market for the larger part of 2008, since they had a relatively good balanced of payment positions getting into the crisis or having alternative sources of finances. The countries were in exceptionally strong economic positions as they entered the crisis, and hence, they were better cushioned against the global economic downturn. However, lower oil prices will have the greatest impacts on the global economic crisis, as oil remains the single most important determinant of economic performance. They would be forced to draw from their reserves and reduce their investments if oil prices decline steadily. Economic performance would be reversed in the event that oil prices would be significantly low (Arthur 10). In this increasingly interconnected world, the crisis has also exposed Asian countries to problems stemming from the West.
Stock markets of many Asian countries have suffered and the value of their currency has been going on a downward trend. The slowdown in the West also means a slowdown in the Asian countries, since their products and services are global. This also increases the risk of other problems, such as social unrest and job losses. India and China are among the world’s fastest growing economies after Japan. They are also the largest economies in Asia. Their growth is fueled largely by domestic market, but that does not help shield them from the effects of the crisis. Though, the growth figures of India are impressive even in good times, the speed in which they have dropped is concerning (Simkovic 9). China has also been experiencing a growing crisis of social unrests over job losses. India and China have both directed billions in recovery packages. Japanese banks seem to be more secure than their Western counterparts, but the country has suffered greatly from the crisis, since its economy depends highly on exports (Arthur 10). The country has also experienced a high level of unemployment, reduction in industrial production and the general lacks confidence have dampened optimism for recovery.
Effects of the Crisis on the U.S Economy
The output of goods and services produced in the U.S. reduced at an annual rate of 6% between 2008 and 2009. Unemployment remains high even as the economy struggles to add jobs with unemployment rates increasing to 10.1 % by October 2009 (Justin 6). This is almost twice the pre-crisis unemployment rates. The average working hours reduced to 33 in a week, the lowest level since data collection was started by the government in 1964. Support from the economic stimulus and the change in the inventory cycle are reducing leading to slow growth.
The poor lost relatively more than the rich in the population, widening the wealth gap of the economic class between those at the top of the demographic pyramid and those beneath it. The top 1% who owned 34.1% of the nation’s wealth increased their share of wealth to over 37.1% by 2009. The wealth of typical American families suffered a decline with the total wealth of 63% of all Americans being affected (Simkovic 4). The GDP growth was extremely weak in 2009 in the Eurozone and even negative in the UK, Ireland and Spain. A world wide recession of -0.3% was predicted for 2009 by the IMF averaged over the developed economies. As a consequence, several countries were forced to launch large bailout packages for their economies from November 2008.
Responses by Governments
Central banks around the world and the U.S. Federal Reserve have taken steps towards recovery from the great recession. The steps are aimed at expanding financial supplies to protect the economies from the risk of a deflationary spiral (Diya 6). In such a case, a self-reinforcing global consumption can result from lower wages and higher unemployment. The crisis caused a reduction in the private sector demand and this has stimulated governments to enact large fiscal stimulus packages. They are doing this by borrowing and spending to offset this reduction. Central banks purchased government debt and private assets from banks worth US$2.5 trillion during the last quarter of 2008 (Diya 10).
Most economic regions are either facing recession or are already in it. Standard macroeconomic policy has been recommended for governments attempts to stimulate the economy and includes policies to:
Though borrowing seems risky in times of recession, governments are advised to compliment it with paying back at better growth times. Reduced interest rates are incentive for encouraging people to take part in the economy. Tax reduction lifts the burden off people’s shoulders. Though it leads to reduced government revenues, this can be offset by increased borrowing in times of hardship for government spending (Arthur 5). Improving infrastructure will provide employment and this will lead to development and the much required progress. A reversal of these policies is required during economic good times. Interest rates need to be raised, borrowing should be reduced and debts repaid and taxes may need to be increased.
Developing World Saving
The world economy is now largely being driven by developing countries and they now account for half of economic growth. The developing countries are now leading in the world trade recovery. According to World Bank estimates, the growth trends in developing country economies may surpass that of developed country economies by 2015 (Arthur 10). This could be because developing countries are investing in technological learning and maintain a healthy balance sheet that will allow borrowing to infrastructure investment.
Reforming the International Financial System
Fundamental reforms for financial systems internationally have been called for. These include reforms in international banking and finance and international institutions like the World Bank and the IMF (Arthur 8). Economists argue that poorly designed incentive structures, inadequate competition and lack of transparency have caused failures in financial markets.
Fiscal Austerity Policy
Countries undergoing hard times around the world are following this prescription, though it may take a long time for them to grow out of debt. Many countries have been weak in productivity and growth trends over the past one decade and investing in their sovereign bonds will take a lot of will (Diya 9). The IMF programs are based on monetary and financial indicators like fiscal balances, price stability and inflation, low interest rates and high international reserves. The IMF believes that improving domestic demand depends on how nations balance privatization and public works. This focus shows that the ability to service external debts will take priority over the need for debt relief and public spending. It also means that the IMF believes in private sector being superior over the public sector in driving domestic economic recovery. This restricts the countries to apply policies that seek to create jobs, invest in the public sector encourage broader social policies and support growth and development schemes that expand the economy and improve the countries’ ability to deal with external shocks (Arthur 10).
Analysts observe that the IMF is discouraging the stimulus programs that developed countries have employed in the public sector, trade policies like tariffs and quantitative restrictions on imports, subsidies for domestic industries and management of exchange rate. The IMF insists that these should be reduced with price liberalization and exchange rate flexibility being encouraged. The IMF reports indicate that the measures taken in dealing with the crisis have helped lessen the severity of global recession and stabilize financial markets allowing many countries to return to normal life. The Fund recommends that rich states maintain their stimulus policies and for advanced economies with high rates of unemployment loose monetary policy is strategic. Monetary policy may need to be tightened for countries whose inflation seems to be rising (Diya 11).
Other international organizations, however, are of different views. There are social and economic dangers of imposing fiscal consolidation especially with global recession. The IMF insists on governments prioritizing poverty reduction and social policies when reducing public spending but the UNICEF review questions possibility of adequately addressing this parallel with fiscal adjustments. The main rationale behind the IMF return to austerity policies is the worry about fiscal and debt sustainability. The IMF is optimistic that the crisis will not result in long term debt problems across the countries with low economies with debt to GDP ratios on a downward trend by 2011-2012. However, the countries may not follow IMF’s advice to cut on fiscal deficits, and debt forecasts are likely to get worse for some of these countries. The recovery may also fail to happen fast enough if the assumption of a fast recovery is wrong (Lahart 5).
The global crisis was triggered by interplay of liquidity and valuation problems in the U.S. banking institution in 2008. The collapse of the U.S. housing bubble and the reversal of the mortgage boom in other developed countries have had quite a great effect around the world. The values of securities tied to the U.S. real estate pricing declined, thus damaging financial systems globally (Justin). Other problems have also surfaced in the course of this collapse with weaknesses in many financial systems being discovered. This decline in housing prices led to great losses being reported by the major financial institutions that had borrowed and invested heavily in the U.S. Investors’ confidence was damaged, thus impacting stock markets greatly (Briggo, Pallavicinni and Torresetti 3). The strength of banking institutions was eroded, credits tightened and international trade declined. Large losses in securities were reported in the late 2008 and early 2009. However, to overcome the situation, there’s need to improve the standards of living, elevated levels of investments and technological advancements are required. The world needs to invest in innovative technology, education and job training to achieve long-run sustainable economic growth.