Did Globalization Lead to the Current Economic Crisis - Essay Example

?Did Globalization lead to the current Economic Crisis? Introduction The recent financial crisis has affected the developed and developing countries greatly. Recession was reflected in economic growth, asset prices, interest rates and employment around the world. Probably the most alarming aspect was the assertion by prominent economists and analysts that the recession came out of the blue. The fundamentals of accounting and economics should have predicted this slump but analysts were blinded by the financial boom. Although many economists were predicting the crash, their predictions did not ignite any concern until it had happened. The recession has led to many assertions and analyses on the causes and events leading up to it. There has been a reevaluation of economic and financial models to ascertain the weaknesses in the system that were over looked. Similar to the stock bubble and dollar bubble, the financial bubble burst and took the global economy with it. The events that caused this financial bubble need to be analyzed. Many experts are of the view that globalization of financial and labor markets have led to the crash, while many argue that the lack of savings and investment in the real sector caught up with the financial market. This report will analyze all these views and aims to determine the effects of globalization on macroeconomic variables. The causes of the great recession The most common perception about the recession is that the financial crisis is responsible for it. Irresponsible banking, lack of regulation, displaced optimism and a high debt burden led to the collapse of the US financial markets resulting in ripples all over the world due to the US being the biggest economy in the world. However, these perceptions form a part of the picture but are not the underlying cause of the recession. Many economists including Alan Greenspan did not anticipate this meltdown and the fall in real estate prices was considered a minor bump in the road. Economists were focused on the integration of the financial market and the innovativeness and complexity of new financial instruments. They were excited with the increased investment and spending and the only issue of concern was the rising current account deficit. Households in the US were riding a consumption boom based entirely on credit; household spending was based entirely on credit cards. Due to the housing boom and rising asset prices, Americans felt rich, they consumed more Chinese imports and bought more houses on mortgage. Interest rates were low and banks had excess liquidity to lend to subprime borrowers through collateral debt obligations. For policy makers and analysts the recession was a shock; however an analysis of various factors leads to the conclusion that the recession was imminent. According to Bezemer (2009), the ignorance about the recession stems from the use of equilibrium models in macroeconomic policy making and forecasting. He advocates the use of accounting models to explain macroeconomic flows. The use of the flow of funds model, that takes into account debt, which equilibrium models ignore, is necessary to identify the effects of rising asset prices. The recession, according to him and many other experts, is the result of rising asset prices and thus greater investment in financial assets than in the real sector. The illusion of wealth that was created by the rising financial asset prices, that include real estate and insurance as well, caused the private sector to borrow more against their assets. This resulted in consumption driven by increased asset prices rather than wages and incomes. This is proven by the fact that the share of wages and salaries as a percentage of GDP dropped from 49% to 46% from the year 2001 to 2007. The resulting increase in debt and its effect was not perceived by prominent economists. The growth in debt relative to growth in GDP was unsustainable and thus resulted in the bursting of the financial bubble. According to the flow of funds view, any surplus of wealth that households own will be turned in assets in the financial market. This will result in greater funds available to be circulated in the financial market as well as in an increase in asset prices relevant to an increase in demand. The extra liquidity will, in turn, inflate prices more, thus increasing wealth and in turn increasing further investment in financial assets. The rising asset prices will make it a more attractive investment than the real economy; as a consequence, firms and households will borrow more against their rising asset wealth and consume more based on that rather than on returns from the real economy. This will eventually result in a larger part of credit and funds flowing to the finance sector for the servicing of debt than to the economy. Thus, consumption will be driven by the financial sector as will the resulting production to satisfy that consumption. However, the increasing dependence on financial assets to sustain the economy will increase the debt burden which will eventually be unsustainable as investment flows out of the real sector to the financial sector. Without the financial bubble, increases in debt corresponded to increases in real output. However, due to the financial bubble this is not the case and the bubble eventually bursts. A factor in worsening this recession was the complete ignorance of policy makers and regulators that focused on equilibrium models and ignored the effect of the increasing debt burden. Regulation in the sector would have helped limit the debt burden and shift the focus on the real sector; however the tax shields and low interest environment fueled the situation. The falling of real estate prices in 2005 did not open the eyes of the policy makers who did not predict the starting of the recession and no measures were taken to stabilize the market. (Bezemer 2009)(Jagannathan 2009) Another factor in this excessive investment in the US finance sector was the high inflow of foreign funds into the US real estate and financial markets. Since the 1990’s crash in Asia, emerging and developing countries opted for US assets as a more secure and profitable investment. Many developed countries also lack developed financial markets and this matter further increased asset prices in the US and fuelled the optimism of the market. Emerging countries with rising incomes and improving economic conditions invested in the US and this further worsened the debt situation in the country. This also resulted in global effects of the crash as countries around the world were affected by the financial crisis. Governor Bernanke (2005) addressed the issue of foreign capital inflows with regards to its effect on the US current account deficit. The US’s current account deficit in 2005 had reached to about 5.5% of GDP and is increasing further. Local savings were low and consumption was high. Although the popular perception is that it is the result of cheap imports inundating the market from China and other developing countries, the reality is different. Bernanke’s lecture provides the guide map into the recession and its causes. According to the lecture although some of the elements of the huge deficit may be local but the deficit is greatly a result of prevalent international economic and financial conditions. The crash in the capital market of East Asia in 1990’s, in Brazil and Argentina among other developing and emerging economies resulted in the countries changing their investment plans drastically. This, combined with the aging populations of developed countries such as Sweden and Japan, resulted in the direction of investment into the USA. The majority of investment flew into USA as dollar has been the most stable currency in the global economy and it is the most common reserve currency. Most international securities and most commodities are traded in dollars. The USA provided a mature financial framework and sound regulatory environment, as well a strong currency making it the ideal place to invest. Thus, it became the destination for excess liquidity and savings from around the world. The developing countries that suffered the stock market crash built up their reserves and developed higher rates of saving through encouragement of export led growth. This resulted in current account surpluses and more funds to invest abroad. Industrialized countries with low growth in working populations needed to invest savings in high return and secure instruments for their future aging populations. This resulted in a global saving glut which majorly affected the USA. As funds flew from around the world to the USA financial markets, the prices of assets increased and thus American households felt richer and decreased their savings further. Increased consumption resulted in more imports into the country. High foreign inflows resulted in greater demand and thus higher prices of dollar. The strong dollar, in turn, made US exports expensive and imports cheaper thus increasing consumption of imports and worsening the current account deficit. Although countries like Japan and Germany maintained current account surpluses, many industrialized countries such as UK and France also witnessed the same economic conditions with a burgeoning current account deficit and increased asset prices. Although in March 2000 the capital market weakened, global savings did not and, as a consequence, capital inflows continued even though at that time low real interest rates were the driver of low US savings rather than escalated asset prices. In this scenario, where the USA is importing large quantities of goods but is exporting less and there are high capital inflows into financial markets, the export industries suffered due to a lack of investment attractiveness and the non productive real estate sector flourished due to the capital inflows. Thus investment and capital inflows did not benefit the country in a productive manner; rather they inflated the asset prices furthermore inducing households to perceive themselves as wealthier. This combined with federal budget deficits and absence of credit regulation encouraged borrowing and investing in non-productive assets creating the financial bubble that led to the recession. According to Godley’s unsustainable trends, the USA faced low private saving, a rise in current account deficit, high net lending to private sector, a rise in asset prices higher than GDP, a rise in budget surplus and an increase in foreign debt. (Bezemer 2008) Capital inflows and investment in developing countries is a better alternative and a more natural flow of funds according to Bernanke (2005), as these countries have pools of labor and unused resources that can be put to productive use and help stabilize the world economy. Developing countries should be borrowers rather than lenders and industrialized countries should invest in these countries. The USA’s increased debt burden was a result of cheap exports and capital inflows into unproductive sectors. This increasing debt is unsustainable as it is not backed by real growth. The concept of international mobilization of funds and the integration of capital markets has brought up the issue of the imperfection of financial markets. Although there are still barriers to the integration of financial markets it can be argued the integration has taken place and this integration has caused the recession. As funds can now easily flow from country to country, according to economic theory, they should flow where marginal return is equal to marginal cost thus maximizing profit. However, this is not the case due to two factors. One is the imperfection of the financial markets. There is imperfect information, transaction costs, time lags and the problems of moral hazard and adverse selection. This results in investors not always opting for the best choice but the safer choice about which they feel they have sufficient information. The second factor is the speculative nature of financial markets. According to Keynes, uncertainty often results in skewed decision making and this is what speculation results in. Speculation in markets is not considered in economic theory and it is a major determinant of decisions due to information asymmetry. This is one of the factors why most funds flew into the USA, rather than developing countries as they were considered riskier and the dollar was a strong currency. An inflow of funds into developing countries would have resulted in an increase in the real world economy and higher returns rather than just inflating the bubble. The prevalent low interest rates since the 1980’s have also been an important factor in the bigger picture. Low interest rates affect the saving and investment behavior of the countries. As financial integration has taken place, it is easier for countries and companies to borrow and thus saving rates fall. The slower growth in the labor force and the increase in the ratio of the elderly in the industrialized nations also cause investment and saving to fall as less is required to sustain the economy and provide employment. Lower stock market returns also result in lower investment rates as was seen after the stock market crash of 2000. Increase in oil prices result in temporary shock causing disposable income and thus saving rates to fall temporarily. As the real interest rates fall due to lower saving and investment rates, global saving over all did not decrease due to the increased saving by emerging countries. The interest rates according to empirical evidence are greatly affected by slow labor force growth which is apparent in industrialized countries. However, this should be offset by greater increase in labor force in developing countries and their rising income. (Bank of Canada Review 2006) Thus it can be concluded that the financial crisis that caused the recession is the result of the saving and investment behaviors of the developing world. The fact that the developing countries saved more than the industrialized countries and proved to have learned from their stock market crash by investing in US capital markets, together with augmented local demand by developing exports, resulted in developing countries becoming lender nations, free of debt and able to put pressure on the US economy. However, the question that arises is: How did the developing economies come into this position? The advent of globalization has resulted in fewer barriers to communication, transport and business. The opening of economies and the ending of the Cold War resulted in economic growth as a fundamental objective of all economies. Advances in technology and their assimilation into everyday life have resulted in the ease of doing business globally. An important development has been the increased skilled labor available in developing countries at low wage rates. This large labor pool is a cheaper alternative for industries and multinational corporations as the issue of geographical immobility no longer exists. The developing labor pool has attracted jobs away from the industrialized world which has been made possible by technological developments and globalization. The manufacturing of branded goods in third world countries such as Bangladesh and Sri Lanka has now progressed to outsourcing many other services from developing countries such as India and China. As income increases in developing countries that have underdeveloped credit markets, savings are invested into the real economy instead of financial instruments or capital markets, or they are invested abroad in developed financial markets such as the USA. The emergence of labor from developed countries served to increase the labor supply of the world when labor was increasingly expensive in developed countries. This led to substitution of local labor for cheaper labor in developing countries and the massive relocation of services as well as factories to cheaper parts of the world. This decreased employment in industrialized countries such as the USA while increasing the income and employment in developing countries. These services and products that were then imported back to developed countries further worsened the current account of developed countries and were doubly beneficial to the developing countries. As it can be seen in the case of China, were there was a lack of consumer credit market, household saving was invested into the real sector. Foreign direct investment in the early years, from South Korea and Japan, targeted to exploit cheap labor resulted in factories being set up. The output was then exported to the USA thus resulting in trade surplus for China. The resulting increase in income and saving did not have local opportunities of investment and thus was invested abroad. The resulting unemployment in the developed countries takes time to diminish and labor needs to be reassigned, which results in falling income in the short run. This increase in the labor supply from developing countries should have resulted in a fall in consumption in developed countries due to higher unemployment and to a fall in income. However the increasing capital inflows from the emerging countries inflated asset prices making the households feel richer and optimistic about future financial gain even if they were losing their jobs. Thus, consumption remained constant. As it can be seen, when US salaries and wages fell as a percentage of GDP from 49% in 2000 to 46% in 2007, consumption remained at 70% of GDP. Thus real changes in the US economy were not felt until it was too late. The economists failed to see this recession coming as the economic equilibrium models do not consider wealth, debt and funds as an integral part of economic theory; instead they focus on individual decision making and the real economy. (Jagannathan 2009) Developing and emerging countries are always aiming to improve economic and regulatory environment in order to attract foreign investment. As a consequence the question that arises is: Why did not foreign investment in the USA benefit from the environment in developing countries by increasing output and promoting the economy? The reason why this did not occur is the direction of investment. Developing countries invested initially in government debt, capital market and technology. The technology and innovation resulting from the technological boom was beneficial to developing countries as it opened markets and decreased communication barriers. After the market crash of 2000, investors suffered due to their investment in overly priced shares which resulted in future inflows to be invested in safer fixed income securities rather than risky investments such as shares or industrial investment. Securitized mortgage pools were a major attraction for these investments. If investment in the US was directed towards the real sector, it would have been able to spur real growth of GDP instead of leading to the financial bubble and increased debt burden for the US. However, the focus of investments into safe securities and fixed return further led to the development of the credit market, decreased interest rates and easier borrowing terms due to the excessive liquidity. This excessive liquidity was ultimately invested in the housing market leading to the appreciation in real estate prices. This way the cycle of perceived wealth and excessive consumption based on a financial bubble continued. In the USA, although home prices increased, home owners did not increase their equity. Instead they started borrowing more against their holdings and the ratio of mortgage debt to wages increased from 0.6 to 1.2 from 1980 to 2007. The growth in house prices from 2000-2007 was triple the growth rate in 1980-2000. The households perceived this high appreciation in values to be permanent and instead of building further home equity were focused on borrowing against it. House prices have a greater effect on consumption due to the borrowing capability against housing. As funds from China and other developing countries entered the US market they first invested in government securities. After the saturation of the government security market, the housing market was the other option for these funds. Due to the rising house prices and the low returns on government securities, foreign funds entered the housing markets decreasing interest rates as well as relaxing borrowing terms. This resulted in investment in new mortgage types such as subprime mortgages. Financial intermediaries played a significant role in worsening the recession. The recession signals the failure of financial intermediaries in their role as credit facilitators and drivers of efficient fund flows. Financial engineering worsened the impact of the recession as it allowed the absorption of excess liquidity into the housing market through new products that catered to the subprime market. Subprime mortgages gained prominence and increased in the period 2001-2007 since they were based on easy credit terms and higher risk. This aggravated the situation and led to higher foreclosures and defaults. Another factor, which affected the scenario, was China’s accession to becoming the USA’s largest creditor. The trade surplus that China experienced should have resulted in the gradual appreciation of Yen as American importers begin to demand Yens to pay off their creditors. However, China’s intervention in the currency market and excessive buying of dollars to keep the Yen from appreciating kept the currency low and the exports competitive. This appreciation would have helped the US deficit by making its exports cheaper and Chinese imports expensive. Furthermore, instead of investing increased savings in the domestic market to promote industries and manufacturing, which would yield better returns financially and economically, China continued investing domestic savings in financial instruments in the USA to prevent rapid consumption growth in the country. Conclusion The world economy has undergone some drastic changes in recent years. The emerging economies have gained strength in key economic variables such as GDP growth and current account balances. BRIC countries Brazil, Russia, China and India have posted high GDP growth despite the recession and are developing their economies at a fast pace. They boast of large pools of skilled labor which has resulted in the outsourcing and relocation of various services and industries to these and other countries of the developing world. This accompanied with increasing exports to developed countries has resulted in high incomes and thus high savings in developing countries. This development results in lost jobs and falling incomes in developed countries till economic adjustments take place. The development of the cheaper pool of labor should result in higher standards of living around the world in the long run. However, the crash of the 1990’s that affected developing countries resulted in them being cautious about investing their savings in local financial markets. Developed markets especially the USA provided developed financial markets, a favorable regulatory environment and a strong economic environment for these savings. However, these savings were invested in safe fixed income securities and the housing market, which resulted in high asset prices in the USA. The declining job market in the USA was offset by rising asset prices which instilled a sense of increasing wealth and thus increased consumption instead of decreasing. The flow of funds to the USA also resulted in the dollar getting stronger, thus the imports getting cheaper and exports more expensive worsening the current account deficit and increasing the need for funds further. All these factors were followed by an increased debt burden as a ratio of GDP and a pattern of consumption and borrowing based on the financial bubble rather than on real economic growth. The declining saving rates in developed countries, rising house prices and increasing current account deficits are macroeconomic imbalances that contributed to the recession. The lack of developed financial systems and instruments available in developing countries has also caused this massive flow of funds and reversed the role of these countries from net borrowers to net lenders and contributed to the illusion of wealth in the USA by inflating asset prices. This financial bubble that was created had to burst when the limits were reached, which resulted in the financial meltdown having far reaching effects around the world. The underlying cause of the recession were the changing global economic conditions that occurred due to technological development, the integration of financial markets and the opening of markets as well as the easy and feasible access to labor in developing countries. Bibliography 1. Baclet A., Vidon E.(June 2008) ‘The world distribution of current account imbalances’, Banque de France Occasional Paper No.6 2. Bernanke, B. (2005) The Global Savings Glut and the U.S. Current Account Deficit. The Homer Jones Lecture, St. Louis, Missouri, 14 April. 3. Bezemer, D. (2009) ‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models’, 4. Caballero, R.J. Farhi, E, Gourinchas, P.O. (2008) ‘An Equilibrium Model of 'Global Imbalances' and Low Interest Rates’, American Economic Review. Vol. 98 (1): 358-93. 5. Caballero, R.J; Farhi, E.; Gourinchas, P.O. (2008) ‘Financial Crash, Commodity Prices, and Global Imbalances’, Brookings Papers on Economic Activity, No. 2 6. Caballero, R. J, and Krishnamurthy, A. (2009) ‘Global Imbalances and Financial Fragility’, American Economic Review. Vol. 99 (2): 584-88. Cambridge Journal of Economics, special issue July 2009. 7. Claessens, S., Dell'Ariccia, G., Igan, D. and Laeven, L. (2010) ‘Cross-country experiences and policy implications from the global financial crisis’, Economic Policy, No. 62 8. Desroches, B. and Francis, M. (2006/07) ‘Global savings, investment and world real interest rates’, Bank of Canada Review, Winter: 3-17. 9. European Commission. (2009) Economic Crisis in Europe: Causes, Consequences and Responses. European Economy 7. 10. Jagannathan R., Kapoor M. and Schaumburg E., ‘Why are we in a recession? The Financial Crisis is the Symptom not the Disease!’, NBER Working Paper, Read More