Financial Crises and What to Do About Them
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As far as natural disasters are concerned, prevention and mitigation policies against them require massive investment but help to reduce the exposure and to increase the adaptation of affected countries. Disruptive events still continue to occur. We can say their characteristics change over time. They can stem from unprecedented, poorly understood or ignored threats and hazards. The financial and fiscal crisis, although it demonstrates features that are similar to those in the past, has been much greater in its severeness and intensity.
In terms of falling output and rising unemployment, it has proved to be the most serious recession since the war. Without the creative monetary and fiscal policy tools applied in the European Union or in the US, China and Japan, the meltdown of the global financial system could hardly have been avoided. Global leaders have recognized that further systemic shocks could severely challenge even political stability. The recent global financial crisis demonstrated some new factors in terms of its roots: widespread implementation of complex and nontransparent financial instruments, the high level of national and cross-border interconnectedness of financial markets, banks and institutions, the high degree of leverage of financial institutions and the role of the household sector.
Owing to the interconnected nature of the global economy, crises can spread beyond national borders. Globalization has also resulted in an increased interdependence of production and delivery systems as well as a globalized financial system. It is a key responsibility for governments to manage new crises while building resilience to shocks at all levels.
This chapter discusses the different practices in dealing with the recent financial crisis of highlighting the way monetary policies can adapt to its changed nature and complexity. The new risk management, however, should focus on strategies that take place before an event occurs. The author used the literature review and analysis; therefore, the author collected data from diverse sources, including books, journals, newspapers, conference papers, reports from international organizations, government policy records and websites. It is not a simple presentation of such materials, rather the author integrated different arguments systematically and developed critical assessments of their meanings and value.
Hazards including industrial accidents, natural disasters, terrorist attacks, infection, refugee crises and financial threats have a cardinal feature in common: their socioeconomic impacts spread fast across borders, making modern societies vulnerable to a wide range of large-scale shocks.
Innovative crisis management responses became vital, which was the case in coping with the consequences of the global financial crisis of To design such plans, it is necessary to study past events and draw the conclusions and the lessons, which could function well for routine events. The term is based on an ancient saying which presumed black swans did not exist, though the observation of a single black swan was enough to disprove that belief in the seventeenth century.
The metaphor also sheds light on the fragility of any system.
Humans tend to find oversimplified explanations and later convince themselves that these events are explainable in hindsight. Analyzing black swan events, however, helps us to gain a better understanding why certain events are recurring in history and what consequences they have. The concept of resilience applied to societies, businesses, infrastructure, services and financial systems requires strong governmental or central bank commitment under fast-changing economic and social conditions which create higher probability for unexpected and uncommon crises.
The Great Recession was triggered by a bubble in housing and derivatives, which became entangled in the financial markets. Derivatives built on mortgages spread quickly and became the new, attractive thing that everybody wanted. Based on mortgages, there were so many of them available that when the prices were bid upward with supply lagging, a bubble was formed. When the real estate market collapsed in , large amounts of mortgage-backed securities and derivatives declined sharply in value, jeopardizing the solvency of over-leveraged banks and financial institutions.
Tulip bulbs became extremely valuable as the rich bid up their prices in the belief that there would always be a market for the exotic tulips, no matter how high their prices soared. A speculative bubble is usually triggered by the prospect of a greater profit and exaggerated expectations of future growth, rise in prices or other events that could result in an increase in asset values. This pushes up trading volumes, while supply remains at about the same level but demand increases. Value is what someone is willing to pay for.
The Greater Fool Theory of investment suggests that someone is sure to seek your appreciated item, no matter how high its price is at the moment, and willing to pay an even greater price for it later on. When the Greater Fool stops being the Greater Fool and prices are too high for the market to be sustainable, the bubble bursts. A crash is inevitable as the bubble must go down. Burst of financial bubbles that brought underlying economic problems to the surface developed into a financial and economic crisis at global level in The financial crisis turned into a debt crisis and a euro crisis.
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There were three main factors existing in the precrisis period that resulted in the escalation of the economic and financial crisis in the Eurozone. The economic situation within the euro area in — stemmed from its vulnerability and fragility owing to its architecture. The phenomenon that bank portfolios from the Northern part of the euro area were diverted toward the periphery of economies in Southern-Europe strengthened risk. Low nominal interest rates and easy access to credit-fostered demand and inflation reducing real interest rates, which had destabilizing effects such as housing booms accompanied with an increase in investment of nontradable construction or high government borrowing.
This process ended up in cumulating current account deficits and external liabilities. At the union level, the crisis has highlighted that institutional reforms are necessary to implement for two main reasons. One is that the euro area should develop effective mechanisms of fiscal supervision and policy coordination to prevent a crisis as severe as the recent one from occurring in the future.
The other is: should a recession occur in any EMU country, it is important to stop its escalation in the particular country and its contagion to other countries. The starting point of his analysis is stable equilibrium with the aim of identifying the economic factors arising from the economy itself that destroy the equilibrium and lead to evolution. Contrary to Keynes, Schumpeter presumed that in the circular flow, there is a constant tendency toward an equilibrium which, under competitive capitalism, tends to maintain the optimal allocation of available capital and labor.
It is basically entrepreneurial demand that determines the credit supplied by the banks; consequently, the money supply is an endogenous variable. Minsky regarded, however, financial innovations produced by financial institutions as the source of financial fragility, which lead to financial crisis and instability. Schumpeter contrarily stated that innovation was the main source of stability. Minsky concluded that Schumpeterian entrepreneurship, evolution and change are the most evident in banking and finance, where the drive for profits is the clearest factor to make a change [ 3 ].
Taylor [ 6 ] offered a framework for the analysis of historical policy and for the econometric evaluation of specific alternative strategies that a central bank can make.
The framework links interest rate decisions directly to inflation and economic performance abstracting from a detailed analysis of the demand and supply of money. These reactive rules facilitate the discussion of systematic monetary policy. The question arises if the recent business cycles in the US and Japan can be explained on the basis of the Austrian business cycle theory ABCT since they display some of its signs. ABCT suggests that an economic boom is sustainable if it is the result of an increase in investment funded by an increase in saving, while an economic boom which stems merely from credit expansion is not sustainable.
Financial crisis - Wikipedia
Excessive growth in bank credit is owing to the artificially low interest rates set by a central bank or through expansionary monetary policy. These interest rates are below the rate of the market for loanable funds that supply and demand clear. As a result, the information embedded in market prices or interest rates is distorted. Entrepreneurial decisions are affected, which causes a misallocation of capital across the economy and the credit-sourced boom results in a widespread malinvestment. Consequently, a sustained period of low interest rates and excessive credit creation leads to an unstable imbalance between saving and investment.
The boom fed by the credit expansion turns to recession when the money supply contracts and eventually resources are reallocated back toward their former uses [ 7 ]. Taylor [ 8 ] argued that between and , the US monetary policy was far more accommodate than an approach based on an interpretation of inflation and output data would have called for.
White and other Austrians predicted that a burst of an asset bubble, specifically, the real estate bubble would trigger a crisis while forecasts of some non-Austrian economists, such as Nouriel Roubini and Stephen Roach focused more on macroeconomic imbalances such as the current account deficit or the federal government debt [ 9 ].
Monetary policy is supposed to support the objectives of general economic policy for the purpose of achieving sustainable growth and a high level of employment. Inflation-targeting framework ITF sets two goals. While the ITF can greatly promote attaining the first goal, attaining the second provides more room to debates.
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It is widely agreed that central bank transparency can make the policy more effective. The only way for central banks to earn credibility is to demonstrate that they have the tools and the willingness to curb inflation and to keep it low for a period of time [ 11 ]. In addition, the element of discretion provides the central bank with the capacity to pursue other political objectives thought necessary in a certain case without compromising the attainment of the stated goal.
Public expectation from the central bank should be met, by suggesting that the bank has the power to expand or contract the money supply, to raise or to sink interest rates, to impose exchange controls, to alter the level of obligatory reserves, to alter the classes of assets and the conditions of granting access to discount facilities and to impose new bank regulations. Both critics and supporters of the ITF, including Kohn [ 12 ], Friedman [ 13 ] and Svensson [ 14 ] claimed, however, that the ITF does not constitute best-practice in resolving the question of other goals such as real and financial stability.
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Nevertheless, stabilizing inflation is the best way to achieve that goal. The conduct of economic and financial policies is strongly affected by the substantial implications of financial crises. A thorough analysis of the consequences of and best responses to crises has become an integral part of the policy debates.
Crises manifest the linkages between the financial sector and the real economy. Theories focusing on the sources of financial crises have recognized the importance of sharp movements in asset and credit markets. A financial crisis often occurs together with one or some of the following phenomena: a remarkable change in credit volume and asset prices, disruptive financial intermediation, immense balance sheet problems of firms, households, financial intermediaries and sovereigns or significant government support in the form of liquidity support and recapitalization.
The question may arise why neither financial market players nor policy makers anticipated the risks and tried to slow down the expansion of credit and increase in asset prices. Such phenomena have been around for centuries. Asset prices sometimes deviate from what fundamentals would suggest and move differently from the patterns of standard models. Information asymmetries exist among intermediaries and in financial markets. Safety deserves a premium, and perverse spirals can be created.
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When the demand for quality assets increases, some of the lower quality may experience a sharp decline in their prices.