PDF Ebook The Global Financial Crisis: Causes and Political Response
No one questions any longer the fact that we are facing the greatest international financial crisis since the Great Depression. Since September 2008, the world has seen unprecedented events that are re-shaping the international financial system and challenging liberal economic orthodoxy, which had gone practically unquestioned since the 1990s under US leadership. The sub-prime mortgage crisis that erupted in August 2007 has become a systemic financial crisis whose epicentre is no longer just in the US, but rather has spread to Europe and Japan and is having a powerful impact on the growth of the emerging economies.
Investment banks have vanished, and governments have redefined the role of lender of last resort, launching rescue packages on both sides of the Atlantic, first for specific financial institutions and then for the banking system as a whole. The G7 says it will use all means at its disposal to support financial institutions that need help, but the pledge lacks credibility because the group failed to present a coordinated plan. The US Congress, in its second attempt, approved a bail-out plan, called the ‘Troubled Asset Relief Program’ (TARP), a US$700 billion package that in the end will earmark US$250 billion for injecting funds to recapitalise the banking industry –and partially nationalise it–, something many Republicans do not approve of (the rest of the money will go towards buying up toxic assets). The UK, in a rare display of leadership, has nationalised part of its banking system and will back up inter-bank loans. The countries of the euro zone will follow the British model, although each country has set aside a different amount of money to buy preferential shares in undercapitalised banks or help them with their short-term financing problems (the funds made available for tackling the crisis in Europe exceed €2.5 trillion).
Furthermore, central banks have opened up new channels for increasing liquidity. In the US, the Federal Reserve has started making direct loans to the private sector by buying up commercial paper that is not guaranteed, which means the government is skirting bank intermediaries. In Europe, the European Central Bank has reduced auctions to zero, which means it will make available to the banking system all the liquidity that is necessary. And the Bank of England has decided to guarantee short- and mid-term debt issued by banks. Indeed, banking authorities in advanced countries have made it abundantly clear they are willing to provide as much liquidity as necessary, both to guarantee deposits and rescue institutions in jeopardy and to restore confidence in the inter-bank market and get money ploughing into companies again, nationalising banks if it is necessary. They will do this even if it means taking risks that could lead to the undercapitalisation of their own central banks. Finally, in an unprecedented action, on 9 October, the world’s main central bankers (including the one from China) carried out a coordinated, half-a-percentage-point reduction of their interest rates. This was tantamount to saying only a global response can halt the crisis.
Despite the battery of measures taken by governments and central banks –which have come late but shown that officials have learnt from earlier crises– for now the lack of liquidity and confidence remain. Furthermore, the process of contagion has been made easier by the high degree of integration in the international financial system and by the feeling that there was no clear leadership or transatlantic coordination. One factor that has shaken confidence even more is that the IMF has raised its estimate of bank losses stemming from the US sub-prime mortgage crisis. It now sees them at US$1.4 trillion (US$455 billion more than in April). What this means is that, so far, only half of the losses have been made public. In other words, more banks might fail. Furthermore, in its economic outlook for October, the IMF noted that the credit crunch has now hit the real economy, triggering recession in several developed countries and making it likely that there will be major increases in unemployment in 2009. In fact, the IMF forecasts that the world economy will slow down considerably and grow at a rate of 3.9% in 2008 and 3.0% in 2009 (1.9% if measured at market exchange rates), its slowest pace since 2002. This lower growth will help moderate inflation to a great extent (especially prices of foodstuffs, raw materials and energy). But the current context of the crisis and the ‘liquidity trap’ that many advanced economies appear to find themselves in indicates that over the mid-term deflation is a greater danger than inflation.
What initially appeared to be a liquidity problem is also turning out to be a solvency problem that requires a hefty recapitalisation of the banking system in advanced countries. And by definition this requires a government bailout (the question, mainly in the US, is to what extent the government should nationalise the banking industry). Also essential is a coordinated fiscal stimulus package in which the emerging countries, mainly China, should play a role. Raising spending and recapitalising banks will not avert recession, but they will reduce its duration and its impact on employment, so long as it is done in a coordinated fashion (unilateral solutions run the risk of being ineffective and serving only to increase the public debt of wealthy countries). Finally, it is necessary to improve regulation of the financial sector, strengthening the supervision of the credit derivatives market and raising financial institutions’ capital requirements so as to avoid leveraging and risk levels as high as the current ones.
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PDF Ebook The Global Financial Crisis: Causes and Political Response
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