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Impact of Global Financial Recession

Objectives of the Lecture

To explain the nature of current financial crisis or

recession.

To analyze the main reasons behind financial crisis.

What are the various implications of financial crisis

on developing countries? Especially challenges and

opportunities.

What can we do about this financial crisis? Policy

prescriptions.

What is the current status of this financial crisis?

What are the main theoretical ideas about this crisis.

Final policy messages.

Definition for Economic Recession Economic Recession: Negative Gross Domestic

Production (GDP) growth lasting two or more

quarters is called a recession. (Time your friend or

next door person lose job)

Economic Depression: Long lasting recession may be

called a depression. (Time you and your relatives start

to lose jobs)

Economic stagnation: Long period of slow GDP

growth but not necessarily negative growth. (Time

your partner complains that your monthly income is

not sufficient to run the household)

This shows the current financial crisis is more or less

economic stagnation led very low level of recession.

The Nature of Economic Recession

Potential output

Actual output

Recovery

Boom

Recession Slump

Financial recession

The Nature of Financial Recession

The term financial crisis is applied broadly to a

variety of situations

Some financial institutions or assets suddenly

lose a large part of their value.

banking panics.

Credit crunch.

Stock market crashes.

Bursting of other financial bubbles.

Currency crises.

Sovereign defaults.

Origin of the crisis: The housing and credit bubbles

A significant amounts of foreign money flowed into the U.S.

from fast-growing economies in Asia and oil-producing

countries due to very many reasons.

This inflow of funds made it easier for the US Fed to keep

interest rates in the United States too low from 2002–2006

which contributed to easy credit conditions: Loans of various

types (e.g., mortgage, credit card, and auto) were easy to obtain

and consumers assumed an unprecedented debt load.

Most of these money went to sub prime lending. Sub prime

lending: giving money to high risks areas, to the people with

imperfect credit history and lack of pay back ability without

collaterals.

Year 2007 on this sub prime market started to melt down with

a steep rise in the rate of subprime mortgage defaults and

foreclosures has caused more than 100 subprime mortgage

lenders to fail or file for bankruptcy .

The main reasons behind financial recession

Too much liquidity led real estate and credit bubbles.

Asset price inflation and lack of ethics and morals in B. schools curricula.

Investment banking sector size and the risks they took.

Problems in corporate governance.

Financial sector concentration.

Lack of regulatory compliance and framework on financial sector.

Demand pull inflation due to rising oil and food prices.

Cost push inflation affecting the transport, courier and airline industry due

to rising oil prices.

Sub-prime crisis led banking panics and the ensuing credit crunch.

Low interest rate and high trade deficit.

Low levels of consumer confidence.

Low level of investor confidence.

Predatory lending and high risk taking behavior.

Very many risky financial products innovations and wrong financial

modeling.

Inaccurate credit ratings.

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Implications on developing countries

Challenges

Export income including tourism decrease and its implications.

Employment losses and its implications.

Remittances decrease and its implications. Increase of informal sector.

Foreign aids, grants, loans and investments decrease and their implications.

Lower consumer and investor confidence and their implications.

Aggregate demand (Y = C+I+G+NX) falls which leads to many economic, political

and social disturbances and their implications.

Interest and exchange rate changes, BOP problems due to reserve drains and its

various implications.

Opportunities

Relocation of more business from the West and opportunity for entrepreneurs to

start new businesses.

To get corrected basics or fundamentals of business.

Improvement of governance.

Get focused the work of government, private and NGO sectors.

More regulatory and supervisory role for the economy.

Opportunities for some such as Universities and training schools.

Social Instability of Crisis

Anyone who doesn´t take seriously the danger of social

instability of this crisis is missing the point. There are very

real and genuine reasons for people to be angry about this

crisis. They fear, they feel, they know that they are the

innocent bystanders in a crisis they have done nothing to

create.

Number of Western governments have recently become

"bankers of last resort" rescuing large banks and

assuming their debts. Could not governments also take the

same approach to poor man’s employment, by becoming

"employers of last resort" and committing extensive public

funds to providing jobs?

Policy Prescriptions Policies to increase aggregate demand.

1. Fiscal expansion (bail outs to troubles companies and sectors, low tax and

government expenditure expansion programmes….etc).

2. Monetary expansion.

Improvement of good governance and regulatory and supervisory roles.

1. Regulatory and supervisory roles by the government and apex bodies.

2. Improvement of governance and getting basics fixed by the corporate

sector. Especially financial sector.

Foreign reserve re-building.

1. Measures including the promotion of investments in government securities

by the diasporas, arranging swap facilities and providing bonus interest on

Non-Resident Foreign Currency (NRFC) and Resident Foreign Currency

(RFC) accounts.

2. These will be further strengthened by the stand-by arrangements with the

IMF by many countries.

In July 2009, the U.S. announced the members of the Financial Crisis Inquiry

Commission to investigate the causes of the crisis. Its report is expected at

the end of 2010.

Current status of this financial crisis

Crisis is not fully over but the signs of recovery is shown.

Some economic sectors, some economies and the regions

showed more resilience for the crisis.

Countries which are more globalized and have more open

financial sectors have more impact from the crisis.

Most countries, international financial institutions and private

companies are getting fixed their houses to get basics correct.

Now companies start to recruit, expand and diversify with very

slow rates.

Macro economic struggle for government: inflation, economic

growth, fiscal and monetary expansion, deficit management in

external and external accounts, realistic management of

interest rate and exchange rate, etc.

Theoretical Explanation for the Crisis

Adam Smith’s explanation is that capitalism has this types of crisis time to

time but market itself overcome these crisis and get in to right track after

some time. Sympathy to others and self interest of economic agents will run

the system.

Karl Marx’s interpretation: Capitalism itself has its own germs for

destruction. The law of tendency of falling of the profits ratio is the norm of

capitalism and it is the basic behind the crisis of capitalism time to time.

Keynesian explanation is that for these crisis the government heavy

involvement is necessary by using fiscal policy. The current crisis should be

much worse if governmental bodies did not stepped up to intervene.

Monetarist explanation is that for these types of crisis monetary policy is the

most effective tool.

Schumpeter is the person who understand the real nature of the capitalist

economy (Fed Chairman Sept. 2009 Speech). Time to time creative

destruction (crisis) and innovation must to function capitalist economic

system effectively.

Final note Government led regulatory and supervisory roles are badly

needed for some sectors in the capitalist economy. Especially

for financial sector.

Corporate also have to have their own self-discipline and good

governance.

In capitalist economy, financial sector-driven crisis are quite

normal and it has many roots in sometime some of these are

inherent features of capitalism.

Without crisis capitalism never grow, especially in highly

globalised world many possibilities exist to emerge many more

crisis with intention for high greed for profits within very short

period.

The main Challenge - How do we design a financial system for

the future that is more robust to adverse shocks, self

disciplined and more socially responsible. But danger of

informalisation of the sector.

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Why Some Countries and Sectors have lesser Impact

Lesser globalization of the sectors and country.

Lesser out-ward orientation.

Highly regulated financial system

Country’s culture and consumer and investor

habits.

Right time intervention.

Safety nets.

Etc..

Who is Responsible

All of us and some nations are more than others:

Those who invest money in USA.

Nature of the capitalism.

Bad ethics and morals in business education.

Human nature.

Etc..

Sri Lanka has a bigger crisis ahead

Inequality based crisis (Income and non

income inequality) Violence and instability.

Governance and corruption related problems

in the system.

Therefore Sri Lanka has more room from these

fronts for crisis.