Recent events have merely confirmed what economists have known for some time, namely, that the interconnectedness of global economic activity renders macro- management by single governments redundant. Their function is now to regulate markets to ensure economically efficient solutions. This essay will argue that the 2008 financial crisis has brought to the forefront of global political consideration what some economists have known for some time.
This is that 1) The global financial system is inherently flawed and cyclical recessions are a product of its nature 2) The interconnectedness of the global financial system means acre-management cannot fully buffer an economy against these cyclical recessions 3) Policy has reduced effectiveness In this Interconnected world 4) Globally co- ordinate regulation and co-operation In preventing and managing crises Is an imperative 5) Although less effective, macro-management can still have a role in terms of preventing, and managing future crises.
Minsk (1992) financial instability hypotheses took stance against the laissez fairer ideology that was politically rife throughout the 1 ass’s. He argues that flaws are inherent in the capitalist system, as roods of economic prosperity encourages risk-seeking behavior by both lenders and borrowers which Is fundamentally dangerous In the financial sector. He argues that private sector debt accumulation during periods of boom Is the mall contributing factor to economic busts.
This debt is contributed to by 3 kinds of borrowers, each associated with a different level of risk. These 3 borrowers -ranging from least risky to most risky- are: hedge borrowers, speculative borrowers and Opinion borrowers. During periods of prolonged good times, risk is not appropriately attended to and deregulation occurs in flannels markets. Resultantly, Opinion borrowers become more commonplace In an economy and their ability to pay their debts relies solely on the reliance of the rising price of the assets for which they borrowed money to buy.
Any fall in these asset values- the ‘bursting of the asset bubble’- means these borrowers inevitably default and a chain reaction begins; investors and banks alike begin to suffer from an inability to pay their debts and the cracks In the financial sector start to surface. This leads to a rush to hoard cash to liquids assets, resulting In what Is dubbed a ‘credit crunch’ as Inter-bank and
Minsk theory holds to the recent 2008 crisis is quite astonishing, with the American sub-prime mortgage popularity rocketing and the development of an ‘asset bubble’ in housing prices, the instability hypotheses has provided a framework for understanding what went wrong. It would seem then, that Minsk knew more than most about the faults of the system, so what did he suggest to counter-act them? Do these faults and the changes required to counter-act them mean macro- management is now rendered completely redundant? First, the potential redundancy of economic policy in today’s global economic climate shall be assessed.
The 1944 Breton Woods agreement was undertaken by governments under the prevailing assumption that monetary and fiscal policy was responsible for adjusting any unsanitary economic conditions such as inflation, unemployment and general economic welfare (Ferret, 2007, pop). Since then, the ever increasing presence of globalization has presented the world with a vast network of trade between nations on an unprecedented scale. Such trade has meant that what once was a world of individual economies is increasingly becoming a world of mutually dependent economies relying more and more on one another for trade, investment and production.
Needless to say, nations within such a complex and mutually dependent network of economies have inevitably experienced the consequence of the financial crisis that began in the USA. The global transmission of such a crisis, and its resulting negative impact on economies across the globe, has- for some countries more than others- undermined the ability of modern day governments to successfully use policy to meet their own macro-economic targets. Kumar (1996) compares trends/fluctuations in key macro-economic variables in India pre and post 1991, both before and after initiation of new Indian economic policy in 1 .
These reforms included, amongst other things, the opening up of the Indian economy for international trade (prior to this India was a socialist state not involved n these markets) plus investment and heavy De-regulation processes. These particular changes to this policy allow for great insight into the impact of De- regulated, international capital trade on previously effective macro-management. He Observes that this new economic policy increased economic instability which facilitates speculative activity, particularly resulting from financial sector liberation’s and the opening up of the economy.
He adds that the observed increased volatility in economic fluctuations is a result from state intervention under these new economic policies that have reduced policy effectiveness. To quote: “The NEAP not only lay greater stress on market forces but on opening up of the economy to foreign capital. This imposes constraints on policies since government cannot control the external environment which is governed by international finance capital- a force far more powerful than the Indian state hence able to dictate to it”.
He argues that since the interest of the finance market capital is not Just India alone, there will be no Interest in these markets in stabilizing any fluctuations in the Indian economy, but such fluctuations will be utilized to gain ‘concessions’ from governments, further diminishing the government’s role and ability to effectively manage their economies- process he coins the ‘strategic retreat of the state’. The evidence assessed in this Increases economic cycle volatility 2) reduces policy effectiveness and 3) reduces the influence and power of the government.
The effect of foreign capital on policy effectiveness as Kumar observed, can be significant. Alfalfa (2010) shown that as of 2007, FED represented 17. % of capital formation in developed nations. Looking at COED data for a developed nation such as Britain, we can see that in the 3 years prior to the cents (2005-07), it attracted EYE billion in 2005, EYE billion in 2006 and EYE billion in 2007 through foreign direct investment from Just the COED nations alone.
Any monetary policy hoping to slow down transactions within such an environment Mould have to contest with such huge capital influx having, as large government spending would, knock-on effects reverberating throughout the economy. Considering FED, trade and production inflows and speculative capital movement, here is an enormous amount of capital swilling round economies providing exogenous factors that reduce policy effectiveness and governments do not have the policy instruments available to effectively react with.
Minsk suggested a larger role of the government in capitalist systems. He particularly encouraged financial regulation in order to prevent these asset bubbles and thus reduce the negative impacts of ‘bust’ periods. Would then, as Minsk contended, the role of governments now be to regulate financial markets in order to ensure economically efficient solutions? The modern-day economic landscape, with the emergence of private authorities in global financial markets and the resulting damage that has ensued, has certainly increased the demand for more effective financial market regulation.
However, regulating financial institutions worth billions to an economy is not as easy as it may seem. Regulatory capture occurs when the regulated exercise excessive influence over the regulator (Hardy, 2010, up) and this issue has been cited as one of the leading causes of the 2008 crisis (Baker, 2010, IPPP). Moral hazard is a related issue; financial institutions using government bail-out intervention to insure against heir excessive risk-taking, operating under the assumption they are too big to fail’ (Morrison,2011).
It seems to be the case now that any political stance in countries reliant on the financial sector such as the US and UK towards reversing the regulatory capture issue, leads to the threat of ‘capital flight’ as large financial institutions threaten to move to countries less restrictive than the ones they flight from. Considering governments are operating under this threat, it seems somewhat understandable how this comes to fruition, given the sheer size and worth of such institutions to an economy.
Favoring the huge tax revenue streams from financial institutions over stringent and restrictive regulation, governments and their respective regulatory bodies in countries reliant upon the financial sector have tended to weaken their regulatory stance, almost to turn a blind-eye’ to extreme risk taking and low leveraging ratios (McKeon, 2013). Given that extreme risk-taking and high leverage presents a global threat, should there then, not then be a global solution?
The FSP Turner review (2009) was compiled after the Counselor of the Exchequer requested that the FSP chairman, Adair Turner, recommend reforms for UK and international banking regulations. The paper highlights the failure of the financial market to be self-regulatory, and calls for new outlooks on the two ultimately destructive views that 1) financial markets can be both efficient and rational, and 2) markets from being so. He explains that the 2008 crisis had revealed faults in global regulation, and had also highlighted the fact that global banks were not being appropriately attended to by global governance.
Prior to and during the crisis, primary responsibility for financial regulation was undertaken by the country of origin for these global banks, whose regulatory response was taken in consideration only for national, not global, economic efficiency. Such a circumstance, when a single government tries to tackle such a large industry by itself, can lead to the aforementioned issues of regulatory capture, and thus a more global alternative should be sought.
After all, there can be no hope to insulate individual economies from/deal with international crises, involving international institutions, when governments focus lies with national efficiency. Turner writes ‘at the core of the policy dilemmas… s the fact that the world has a global economy but not a global government’ (2009, polo). He suggests then that there should be an increase in International co-operation in financial regulation through the likes of ‘colleges of supervisors’, and also heightened international co-ordination and co-operation in terms of managing crises.
Ferret (2010) similarly agrees that the globally co-ordinate regulation of global finance is of ‘crucial importance’ for democracy. The MIFF already stands as an international regulatory board and so could assume such a role of providing this newly erected global regulatory framework. However, Michaels (2010) argues that the MIFF has shown to be ineffective as an international financial regulatory board, and therefore recommends it undergo drastic reform if it were to do so. The 620 Seoul summit in 2010 resulted in similar agreements to the abovementioned reforms.
Modernizing the MIFF, new regulatory frameworks and globally co-ordinate policy action are the commitments put forth to provide a stronger, more resilient global financial network (620, 2010) The most widely considered globally co-ordinate reaction to slow down the swilling of international insane capital, particularly the particularly harmful speculative capital, is the Dobbin tax. Nobel Laureate James Dobbin (1978) put forward a tax on all international transactions between currencies. This was with the aim to lessen the risk of large, damaging, short-term capital movements of foreign currencies to allow for more effective macro-management.
The proposal has since been developed to cover transactions of shares, currency and bonds. The revenue, he suggested, then be used for developing countries- though it has since been thought more appropriate it be used to deal with future financial crises. The revenue potential is huge, estimated at $850 billion per annum (Turner, 2010). Has (1996) presents a case for the Dobbin tax based upon the observation that foreign exchange markets lack efficiency in a laissez fairer system and the resulting economic costs are huge.
The benefits from such a tax could be substantial, yet the potential loss of tax revenue from slowing down economic transactions can only be speculated, and there is empirical evidence from Sweden to suggest its ineffectiveness (Webber, 2013) It has to be noted though, that the implication of reduced policy effectiveness does not mean that government acre-management is in effect, redundant. To be redundant, monetary or fiscal policy would have no impact whatsoever, before during or after a crisis- but this is far from the case.
Classless et al (2010) states the 2008 crisis has not shown policy to be steered from its conventional route and to be concerned with both asset price booms and heightened leverage in the financial institutes, alongside international regulation. He follows that it has also shown how the transmission to a global financial network has not been appropriately dealt with using Just national regulation. Shifting the instruments available for policy, he suggests, would have more of an effective impact upon the economic variables that should be focused on such as housing prices, liquidity ratios, stock price increases etc. Than improving Just regulation alone would. Monetary policy could, and should be used for inflation or aggregate demand targets, but as far as the more readily observed indicators of economic crises are concerned; there should be more available for the policy-maker to react to these with. He further suggests improvements in the timing and impact of automatic stabilizers used to react to economic downturns. Finally, closing the large fiscal gaps that many governments have become accustomed to budgeting towards and also lowering the debt to GAP ratio of these nations can help promote economic stability.
As Classless (2009) suggested, the fiscal position of a country can have great significance upon the effect of the crisis. A publication from the New Zealand treasury (2010) evaluated this, seeing what impact a strong or weak fiscal position had on economic performance once the crisis had struck. They conclude that a strong fiscal position helps limit the impact upon an economy from a crisis, and a Neck fiscal position leads to a more severe impact upon the economy. Another finding in this publication is that irrelevant of fiscal position, an economy heavily dependent upon the financial sector will experience strong economic downturn.
Nat this means for countries such as the UK and US, who both suffered weak pre- crisis fiscal positions alongside a strong reliance on the financial sector, is that their economies will fare far worse than an economy that had a stronger fiscal position upon impact of the crisis and did not rely so much on their financial sector, such as China. Cove et al (2010) shown that China’s 2009 fiscal package-a huge 12% of their SAD- effectively worked in stimulating aggregate demand and was successful in limiting the negative impact of the cyclical economic bust.
In contrast, the fiscal package of the I-J and US seems to have done more in the way of harming their fiscal position than actually reviving their economies (Taylor, 2009). China’s focus lied with stimulating aggregate demand through public spending and direct household transfers, whereas the US and the I-J focused on fiscal aid to stimulate credit availability from the financial sector. The results were limited for the US and I-J as confidence in the financial sector was still wavering, and banks took to increasing their liquidity further, rather than leveraging the fiscal aid to help stimulate the economy through credit provision.
It would seem then, that economies that maintain relatively strong fiscal positions, and do not heavily rely upon their financial sector, can still effectively use counter-cyclical fiscal policy in order to, at least to some degree, smooth out cyclical recessions. In conclusion, the 2008 financial crisis has aught the governments of the world what some economists have known for some time, that is; globalization and the resulting interconnectedness of trade has meant that single economies are now open to more exogenous shocks than they otherwise Nerve independently, and this has reduced policy effectiveness.
This does not mean successfully implement it, fiscal policy has proven to be an effective counter-cyclical measure in smoothing out economic fluctuations. Unfortunately this is not the case for many of the world’s economies, and therefore co-ordinate, global financial coagulation together with renewed policy instruments should be used in order to create a safer, more responsible banking system in order to lessen the ferocity and Laterality of economic cycle fluctuations and to hopefully avoid another crisis of the severe measure the world has recently seen.