Causes of Financial Crises - Article Example

Causes of financial crises The causes of financial crises have been attributed to a variety of factors, including volatile capital markets, an excessive budget deficit, and government deregulation. Allen and Gale (2007) have undertaken an exhaustive review of financial crises and argue that it is important not to take too narrow a view of crises. Financial crises have a sudden onset and they are as likely to occur in countries with sophisticated financial systems as they are to occur in countries where bank lending is dominant. Financial crises in countries such as Mexico and Brazil have been attributed to inconsistent macroeconomic policies. In the case of Argentina’s financial crisis of 2001, the blame for the country’s fourth crisis in two decades was heaped on the Government, for creating an unsustainable budget deficit. But as Hausmann and Velasco (2004) have pointed out, the lack of a sophisticated financial system in Argentina due to its being an emerging economy may not be the real issue at all; because just a few years earlier, its fiscal policies were being praised on Wall Street, for successfully privatizing, deregulating, linking its currency to the dollar and reducing inflation. Argentina’s crisis was precipitated by several events, including the crises in Brazil and Russia, which caused the economy to decline but with the large extent of debt, the fiscal stimulation that could be undertaken by the Government was limited.(Allen and Gale, 2007). The root cause of the financial crises in Argentina may have been both (a) debt intolerance and (b) faulty institutions (Hausmann and Velasco, 2004). These authors point out that foreign borrowing is essential for emerging economies to invest in infrastructure and development that would take them years to achieve otherwise and debt intolerance cannot be faulted for financial crises. Improving institutions can also go only so far, because even the best institutions will tumble if necessary pressure is applied. For instance, Hausmann and Velasco (2004) have cited the example of countries like France and Germany who violate the fiscal rules of the Maastricht Treaty, which they were responsible for writing, because those rules were potentially costly to follow. In a similar way, Argentina’s institutions also collapsed when sufficient pressure was applied. These authors have argued that building better institutions in any emerging country, if it must bear fruit, should be complemented with better development of international markets in emerging market currencies. In the case of the Asian financial crisis of 1997, the sudden fall in the value of Thai currency precipitated the crisis. Hwang et al (2007) have provided a strong argument to support their contention that collusions between lending institutions, borrowing chaebols and informed politicians who influence lending decisions may have been the root cause of the crisis, although the failure to form such collusions would not be in the best interests of a lending institution. When there is any deterioration in the economy, such as that which was precipitated by the fall in the Thai currency, the expectations about the failing of such collusions is likely to generate a financial crisis. These authors have concluded that corruption and collusion between lenders, chaebols and politicians can exist during times of economic stability but become subject to increased scrutiny during periods of deterioration in the economy, which may lead to more investor withdrawals and precipitate a crisis. On the basis of the above examples of Argentina and South Korea however, it cannot be concluded that financial crises may be caused by the inherent instability and lack of financial regulation within the emerging economies. It is interesting to note that not only were Argentina’s fiscal policies lauded in international circles before the crisis, the Korean economy was one among the South Asian “tigers” – economies that had demonstrated sustained economic growth and development. After the Asian crisis, it was argued that the reasons for it lay in the faulty institutions in those countries. The lack of transparency and the existence of corruption were seen to be causes of the crisis (Allen and Gale, 2007), yet ironically, these factors had also been present during the previous decade of economic growth, when the same Asian economies were being lauded for their fiscal policies. Financial failures are not necessarily restricted only to countries that are emerging economies. Banking sector failures leading to a financial crises are characteristic of both developing and developed countries. In a study of 125 countries over the time period from 1981 to 2000, Richards and Gellery (2007) explored the impact of banking crises on the risk of domestic agitation. Their findings support the conclusion that banking crises are systematically associated with greater levels of collective protest activities, such as riots and strikes. This suggests that domestic agitations may be a precursor for crises arising in financial institutions, suggesting that political instability may fuel financial crises in developing countries and emerging economies. The root causes of financial crises cannot however be dismissed as being typical of developing or emerging countries, because countries with sophisticated financial systems have also been the victim of financial turbulence. For example, Norway, Sweden and Finland had sophisticated economies and institutions, yet despite this, they all suffered from a severe crisis (Allen and Gale, 2007). During the period 1985-87, there was a boom cycle that inevitably led to the bust in the 1990s. In Norway, lending jumped by 45% in the 1980’s and consumption rose; similarly in Finland there was expansion in credit with a rise in housing prices. There was a similar property boom in Sweden due to increased availability of credit. But this was followed by the bust, when the collapse in oil prices was coupled with a decline in trade with Russia, leading to a situation where asset prices plunged, value of the currencies fell and banks collapsed, precipitating a financial crisis that led to a severe recession in all the three economies. This trend is also observable in Japan, where the 1980s were a period characterized by an expansion in credit arising out of the desire to support the U.S. dollar, with asset prices reaching very high levels. (Allen and Gale, 2007). But when a new Governor took over at the Bank of Japan who was more concerned about tackling inflation and less concerned about supporting the U.S. dollar, monetary policy was tightened, leading to a sharp rise in interest rates and a drop in real estate values, with banks failing and the value of assets tumbling. It may be noted that the economy of Japan is one characterized by sophisticated financial systems, yet it has been as vulnerable as any of the emerging economies or economies fraught with corruption, to financial crises. The examples of Sweden, Norway, Finland and Japan as provided above demonstrate that financial crises could cause downturns in the economy in any country, including those with sophisticated financial systems. In discussing the causes for the current global financial crisis which originated in the United States, Kaprowy (2008) points out that the root cause may have been the deregulation, which allowed customers with poor credit histories to secure housing loans. These customers were provided these sub prime housing loans, with no down payment and no information about applicant income but the interest rates provided on these loans were not fixed for a 30 year period. They were adjustable within as little as six months, generally upward, as a result of which many applicants were unable to make payments and foreclosures ensued. The problems was further exacerbated by the securitization of loans and packaging of subprime loans with other stable ones and investors were initially eager to snap up these mortgage backed securities because of the history of stability in the U.S. housing market. Investment banking firms like Shearson Lehman and Bear Sterns bought these securities in the belief that they could easily find investors for them, borrowing from other sources to do so. But the continuing trend of foreclosures in the sub prime mortgages made investors reluctant and when demand for these mortgaged backed securities fell, investment banks were so heavily leveraged that they were placed on the brink of bankruptcy (Kaprowy, 2008). The United States has a sophisticated financial system in place, yet it has also been subject to financial crisis. Banks may often be the worst hit in a financial crisis, because their investments in assets and securities often place them at risk for suffering the fallout when the prices of those assets and securities drop in the market. Banks are also vulnerable to fluctuations in exchange rates of other countries which can precipitate a crisis, as was the case in Argentina and the south Asian countries. But this is not necessarily grounds to conclude that countries where bank lending dominates are more likely to be afflicted by a financial crisis. As demonstrated above, in the discussion of the various financial crises, the onset of one is sudden and is often caused by the increased availability of unregulated credit. Allen and Gale (2007) have pointed out that the period from 1945 to 1971 known as the Bretton Woods era has been one of the most stable periods in financial history, because this was a time when there was very strict regulation of financial activities, hence there was no banking crisis at all. But in the present time, the extent of regulation is not that high and deregulation also carries attendant risks. The current global financial crisis that originated in the defaults on subprime mortgages have been caused by deregulation that increased availability of credit without attendant safeguards. But the current financial crisis in the United States is not restricted to the United States alone. It has spread to countries all over the globe, including countries in Europe and Asia, due to the interlinking of the global markets through securitization and mortgage backed securities. This financial crisis has also extended to China, which has a more tightly controlled and regulated economy, and countries with sophisticated financial systems such as Germany and Japan are also facing the impact of the current financial crisis. Banks all over these countries as well as banks in other countries have experienced the fall out from the current global crisis. Germany and UK have already reported that their economies have entered a recession, while Asian countries appear set to follow suit and more than a million jobs were lost in the United State sin the month of October alone. Hence, while there may be a number of factors that are responsible for triggering a financial crisis, what appears certain is that it is not restricted to any particular kind of economy. Rather it appears that strict regulation as exercised in the Bretton Woods era may prevent bank failures, but they still do not provide protection from the risks posed by other kinds of financial instruments that are generated through deregulation and lead to financial crises. For example, the current financial crisis may not affect the deposits of the average account holder because these are insured by the Government, but it is those who have engaged in large scale risk taking activity that may have to face the consequences of the lack of regulation. Every economy may be subject to boom and bust cycles and when risks are taken, there is often an adverse impact on the economy which must be redressed through a bust cycle when it goes through a recession. This is exactly what is happening currently in terms of the financial crisis in the United States, where the excesses that led to the sib prime crisis now need to be addressed through the restrictions that will be imposed through a recession. Bibliography * Allen, Franklin and Gale, Douglas, 2007. “The anatomy of financial crises: Understanding their causes and consequences”, Extract available at: http://knowledge.wharton.upenn.edu/article.cfm?articleid=1856; * Hausmann, Ricardo and Velasco, Andres, 2004. “The causes of financial crises: moral failure versus market failure”, Kennedy School of Government, Harvard University, Accessed from ProQuest. * Hwang, Jinyoung, Jiang, Neville and Wang, Ping, 2007. “Collusion and Overloading”, Economic Inquiry, 45 (4): 691-708 * Kaprowy, Tara, 2008. “Root causes of financial crisis complicated”, The Sentinel-Echo, September 30, 2008. http://www.sentinel-echo.com/local/local_story_274154552.html; * Richards, David L and Gellery, Ronald D, 2006. “Banking crises, collective protest and rebellion”, Caadian Journal of Political Science, 39(4):777-802 Read More