GROSS DOMESTIC PRODUCT

This article has been written by Anu Singh pursuing a Remote freelancing and profile building program from Skill Arbitrage.

This article has been edited and published by Shashwat Kaushik.

Introduction

This article aims to provide the readers with a simplistic explanation about what financial crises are and how they have affected the world globally. A lot of people do not know the difference between the different kinds of crises that haunt the world economies time and again and their implications worldwide. Is it even possible to stay unaffected even if it is happening in some other part of the world? Can these crises be predicted in advance? Is it possible to prepare ourselves for the future? All these topics are dealt with in this article for the readers to enhance their knowledge on the subject. 

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To assess the impact of financial crises on the global economies, we first need to understand their meaning, types, and causes. Only then will we be able to make sense of its implications on the world and the extent to which we have been able to learn from our past mistakes. Financial crises are an inherent feature of how modern capitalistic economies function. Where the business cycle fuels speculative growth during economic booms only to be met by contractions and recessions. Hence, it is imperative to gain proper and correct knowledge on the subject.

Definition of financial crisis

Financial crises, like earthquakes in the economic landscape, can cause sudden and severe disruptions in the financial markets, leaving behind a trail of devastation. These crises manifest as a steep decline in asset values, making it increasingly difficult for individuals and businesses to access capital and repay debts. The contagion spreads throughout the financial system, leading to liquidity shortages and a loss of confidence among investors. This loss of confidence is a critical element of a financial crisis, as it prompts investors to sell off their assets or withdraw money from savings accounts out of fear that the value of those assets will plummet if left within the financial institution.

The onset of a financial crisis can be triggered by various factors, such as a housing bubble bursting, a stock market crash, or a sudden loss of confidence in a major financial institution. These events can lead to a chain reaction, causing panic and uncertainty among investors and businesses. As asset values decline, lenders become more hesitant to extend credit, and borrowers find it more challenging to repay their debts. The liquidity crunch worsens, and the financial system becomes increasingly strained.

The consequences of a financial crisis can be far-reaching and long-lasting. Widespread unemployment, business failures, and economic contraction can ensue. Governments and central banks often intervene with emergency measures, such as stimulus packages and interest rate cuts, to mitigate the impact of the crisis. However, the recovery process can be slow and painful, as it requires rebuilding trust in the financial system and restoring economic growth.

Preventing financial crises is of paramount importance. This can be achieved through sound financial regulation, prudent risk management practices, and international cooperation to address systemic vulnerabilities. By learning from the mistakes of the past and implementing effective policies, we can strive to create a more resilient financial system that is better equipped to withstand shocks and mitigate the impact of future financial crises. They may be limited to a single country or one segment of financial services but are more likely to spread regionally or globally, requiring immediate policy responses like changes in monetary and fiscal policies in coordination with the global world. 

Types of financial crisis

Financial crises can be broadly divided into the following types:

  • Banking: When banks face a sudden wave of withdrawal, leading to insolvency and a loss of confidence in the banking system.
  • Currency: When a country’s currency rapidly depreciates, causing a loss of value and potentially triggering a broader economic crisis.
  • Debt: When a country or company is unable to repay its debts, it leads to default and potentially a cascade of financial problems.
  • Stock market crashes: According to Investopedia, a stock market crash is an abrupt drop in stock prices, which may trigger a prolonged bear market or signal economic trouble ahead. They are often driven by speculation and economic bubbles.
  • Credit crunches: These are situations where it becomes difficult for businesses to borrow money, hampering economic activities.
  • Sovereign defaults: As per Investopedia, this is a situation in which a nation is unable to pay its debt obligations, making it expensive or impossible for it to borrow in the future.

Causes of financial crisis

Financial crises are complex events with multiple causes. Some of the most common factors include:

  • Excessive risk-taking: Financial institutions, in the pursuit of higher profits, often take on excessive risks. This can lead to a buildup of bad loans and investments that can trigger a crisis.
  • Asset bubbles: This is when the price of an asset like real estate or stocks becomes inflated beyond its fundamental value. When the bubble bursts, it causes a sharp decline in the price of that asset, causing a loss of wealth.
  • Financial contagion: Financial crises can spread rapidly from one country or institution to another. This is due to the interconnectedness of global financial markets and the fact that many financial institutions hold similar assets.
  • Irrational behaviour: For example, a rapid string of selloffs can result in lower asset prices, prompting individuals to dump assets or make huge savings withdrawals when a bank failure is rumoured.
  • Policy mistakes: Governments and central banks can sometimes make policy mistakes that lead to financial crises, such as maintaining a loose monetary policy or failing to regulate financial institutions effectively.

Looking at these factors, the world has survived many financial crises since the inception of “Money” as a concept. Tulip Mania (1637), Credit Crises (1772), Stock Crash (1929), OPEC oil crisis (1973), Asian Crisis (1997-98), Global Financial Crisis (2007-8), Stock market crash-Covid-19 (2019-20) are a few examples. 

Global financial crisis of 2007-08

The global financial crisis of 2007–2008, often referred to as the “Great Recession,” was a severe worldwide economic crisis that began in the United States and had a significant impact on economies around the world. It is widely considered to be the most significant financial crisis since the Great Depression of the 1930s. The crisis originated in the United States housing market, particularly in the subprime mortgage sector. Subprime mortgages are loans made to borrowers with poor credit histories and low credit scores. These loans often come with higher interest rates and fees, making them riskier for both the borrower and the lender.

The crisis was triggered by a combination of factors, including reckless lending practices by banks, a lack of regulation in the financial industry, and a housing bubble fuelled by speculation and easy credit. Banks began offering subprime mortgages to borrowers who had little chance of repaying them. These loans were often bundled together and sold to investors as mortgage-backed securities (MBS). The value of these MBS was artificially inflated due to the high demand and lack of transparency in the market. As a result, many investors, including large financial institutions, were exposed to significant losses when the housing bubble burst and subprime borrowers defaulted on their loans.

The crisis quickly spread to the global financial system through interconnectedness and complex financial instruments. The failure of major financial institutions, such as Lehman Brothers and Bear Stearns, led to a loss of confidence in the financial system and a freeze in credit markets. This, in turn, caused a sharp decline in economic activity and a rise in unemployment rates worldwide. Governments and central banks responded to the crisis with a range of measures, including fiscal stimulus packages, interest rate cuts, and quantitative easing. These measures helped to stabilise the financial system and prevent a deeper recession, but the recovery from the crisis was slow and uneven.

The crisis had a profound impact on the global economy, leading to job losses, business failures, and a decline in living standards. It also raised questions about the stability of the financial system and the effectiveness of financial regulation. In the aftermath of the crisis, governments and regulators implemented a number of reforms aimed at preventing a similar crisis from occurring in the future, including stricter lending standards, increased capital requirements for banks, and the creation of new regulatory bodies. Rating agencies considered them extremely safe as they were backed by big banks, which caused the reckless investors to start to invest in them hugely. To fuel the situation, big insurance companies, who also got greedy, started to promise a reimbursement to the investors if anything went wrong. As more and more people who could not afford homes otherwise started buying homes with these below-average loans. Housing prices started to rise, creating a bubble. When this real estate bubble finally burst in 2007, it cascaded into other sources of debt as people now could not repay loans, leading to a general mistrust towards the financial system. All the large financial banks that had invested heavily in these loans were in trouble as the value of these securities plummeted, creating huge losses. The collapse of big banks and insurance companies like the Lawman Brothers and the American International Group led to a cash crunch among businesses. This cheap money and mortgage troubles in the U.S. caused a chain reaction, and a general mistrust in the markets converted a financial crisis originating primarily in the U.S. into a global economic crisis. 

Implications of the global financial crisis

It has had devastating consequences for economies and societies around the globe.

Recessions and depressions

Financial crises, in general, can trigger a sharp decline in economic activity, leading to a recession or even depression. The crisis of 2007–8 did the same.

Job losses

Businesses, in general, are forced to lay off workers or close down altogether, leading to widespread unemployment. Data shows that the global crisis of 2007-08 resulted in an estimated 9 million job losses in America alone. Unemployment peaked at 10 percent in late 2009. Even employment patterns changed; for instance, temporary jobs plummeted by 30% during 2007-09.

Poverty and inequality

Crises often hit the poor and vulnerable the hardest, increasing inequalities, as was the case in 2007-08, wherein there was an overall decrease in economic activity globally. 

Social and political unrest

Economic hardship can lead to social unrest and political instability due to a shift in power in some countries. General loss of trust of the public in the financial system and the government as a whole leads to more chaos and a call for greater regulations and oversight.

Trigger policy changes

Governments can be forced to adopt new policies in response to a financial crisis, such as austerity measures or financial reforms. In the case of America in 2008-09, the Federal Reserve took extra steps to support the economy and the financial markets in addition to implementing monetary policy. The Fed also designed special-purpose instruments for lending to various sectors of the market, creating a new standard for regular and emergency lending activities.

Regulations

As most of the crises take place because of excessive risk taking and irrational human behaviour, it is pertinent to make space for regulations in the financial systems. One of the first regulatory reactions was the formation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created agencies like the Financial Stability Oversight Council (FSOC) and the Consumer Financial Protection Board (CFPB) to serve as watchdogs on Wall Street. Dodd-Frank requires banks with assets over $50 billion to undergo stress tests and reduce speculative bets that could devastate balance sheets and hurt customers. In the United Kingdom, the Financial Services (Banking Reform) Act of 2013 required large banks to separate their retail and commercial banking from investment banking by 2019. In Europe, the Systemically Important Financial Institutions (SIFIs) started to attract a higher level of supervision. The regulatory response to 2008 may be open to criticism, but it did, in the end, help to avert a permanent or a long-term meltdown of the global financial system. 

Responses by various countries

The tremors of the financial crises were felt around the world, but each country was impacted differently. For example, the U.S., Europe and Japan were hit the hardest. At the same time, China, India, and Brazil, which had become increasingly integrated into the financial system by then, went through a rough phase of economic slowdown. Therefore, different countries responded differently.

Response by India

In India, the global slowdown cast a shadow over the economy, prompting the government to take decisive steps to counter its negative fallout. Recognising the need to stimulate demand and create employment opportunities, the government unveiled a series of targeted fiscal stimulus packages. These packages included tax relief measures aimed at boosting consumer spending and encouraging businesses to invest. Additionally, increased expenditure was allocated to public projects, fostering the creation of essential infrastructure and generating employment for millions of Indians.

To complement the fiscal measures, the Reserve Bank of India (RBI) implemented a range of monetary easing and liquidity-enhancing measures. These actions were designed to facilitate the flow of funds from the financial system to the productive sectors of the economy, ensuring that businesses had access to the capital needed to sustain operations, expand, and create jobs. One of the key measures undertaken by the RBI was the reduction of interest rates, making it more affordable for businesses and individuals to borrow and invest.

Recognising the importance of foreign investments in stimulating economic growth, the government eased restrictions on foreign investments, hoping to attract more capital into the market. These measures aimed to create a conducive environment for international investors, offering them greater access to Indian markets and opportunities for collaboration with domestic businesses. By attracting foreign capital, the government aimed to boost economic activity, create jobs, and enhance the country’s overall competitiveness.

These multi-pronged efforts by the government and the RBI helped mitigate the impact of the global slowdown on the Indian economy. By providing fiscal stimulus, easing monetary policies, and attracting foreign investments, India was able to navigate the challenging economic landscape and lay the foundation for sustained growth in the years to come. It also brought several economic reforms, policies, and packages to attract investments and revive the Indian economy. From all accounts, except for the agricultural sector initially, economic recovery seemed to be well underway. Economic growth stood at 8.6 percent during the fiscal year 2010-11, making India the fastest-growing major economy after China.

Response by Japan

In Japan, the government’s main focus was on increased investment and a gradual shift in the model of highly export-dependent economic growth. The crisis led to a sharp decline in their exports of automobiles and electronics; hence, a majorly manufacturing-driven economy had to stabilise its domestic demand and initialise structural changes. Japan’s government made an unprecedented stimulus effort with three stimulus packages, which, among other measures, contained a number of measures to curtail unemployment and emphasise creating a low-carbon society. In order to handle the negative consequences of having an ageing population, the government also brought in reforms in the field of social security through insurance and pension schemes.

Response by China

In China, the economy was registering double-digit growth prior to the outbreak of the financial crisis. Its strong dependence on foreign trade and foreign direct investment (FDI) made the country vulnerable to external shocks. With the onset of the financial crisis, the demand for goods and services from China’s major trading partners, especially the U.S. and the European Union, plunged, and the Chinese foreign trade growth collapsed, slowing down its economic growth. The Chinese government took immediate action by announcing a fiscal stimulus program of 4 trillion CNY in November 2008. The main focus of this package was on social welfare and investment in the restructuring of industrial enterprises and infrastructure. A lot of labour-intensive projects were undertaken to create new jobs, for example, the construction of affordable housing and airports. A major chunk of expenditure was spent on providing health insurance in rural areas so that the general public could spend more on consumption instead of saving for health care in the future. In addition to the fiscal stimulus package, the government also applied some monetary policy instruments, like lower interest rates for loans and savings. It ensured that no credit crunch occurred, and the banks provided easy access to loans for both companies and private households. These measures helped in improving China’s economic situation. By the end of May 2009, signs of recovery were visible as China’s exports stabilised.

Response by Brazil

In the 2000s, economic development was directly proportional to liberalisation and deregulation. Brazil, on the contrary, was characterised by a highly interventionist government levying heavy financial regulation up until the 2007-08 world financial crisis. This, however, worked in the favour of the Brazilian government, as these regulations helped the economy in dealing with the consequences of the 2007-08 financial meltdown. The most crucial factor in Brazil’s response to the financial crisis was the country’s international reserves. In 2005, the Brazilian government cleared its debt with the IMF. This helped the nation in increasing its international reserves. Hence, in 2007-08, when Brazil faced a sudden seizure in foreign funds and a drop in its exports, the government was able to use these international reserves to offset part of its liquidity constraints. Brazil had accumulated US$ 210 billion in international reserves before the crisis and, as the situation improved and foreign capital returned to the economy, all temporary foreign exchange operations were quickly reversed in the second half of 2009. The second crucial factor for Brazil’s successful response to 2007-08 was its high reserve requirements on banks. In their financial system, the governments were financed at lower interest rates than the market rates. Direct credit to agriculture and housing was also at lower interest rates than market rates. As a result, the Brazilian Central Bank had a huge pool of liquidity at its disposal to alleviate the banks’ liquidity constraint and improve the financial system.

A look at the above reforms and regulations clearly indicates that each country tried its level best to bring back its economy on the path to recovery. As a result, globally, the capital reserves of banks have increased so that they become more secure. Legislation requiring banks to apply more of their own resources and those of their owners in case of insolvency has eased the taxpayer’s burden in case of future crises. Greater coordination of supervision through the Single Supervisory Mechanism and common resolution mechanisms have made the systems more robust internationally. Financial Policy Committees tasked with identifying, monitoring, and mitigating risks to financial stability became a common phenomenon. Low interest rates, even negative in some countries and relatively low inflation have created a highly unusual financial and economic environment that has privileged borrowers over savers.

Can we predict the next financial crisis

Financial crises are a recurring feature of the global economy. While we can learn from our past mistakes and take steps to mitigate the risks. Can we predict when or where the next crisis will occur? Can we identify the bubble? Michel Girardin, in his explanation, has emphasised two major criteria to look out for when we want to identify or spot a bubble. According to him, excessive debt, be it in the government sector, the corporate sector, or the household sector, there will always be too much debt. We need to ask ourselves the question: is the debt sustainable? Can we afford the debt? Can we pay for it? This will be a better indicator than worrying about excessive debt. Another factor to identify the bubble, according to him, is global inflation. Governments and financial institutions around the world include the consumer goods basket as an indicator of inflation, but according to him, financial assets should be included in this basket rather than consumer goods. When the debt cost is 6% or more of GDP, this is a better indicator of global inflation. When the global inflation measure in terms of financial assets increases by 4%, soon after, we get a financial crisis. He talks about “The Dragon King Theory,” which can help in predicting crises to a great extent when studied and understood in detail. 

The Dragon King theory

According to Michel Girardin, the theory of complex systems provides us with hope and valuable insights into the behaviour of complex systems. Girardin emphasises that while complex systems may exhibit inherent unpredictability, they also contain pockets of predictability. This understanding challenges the traditional view that complex systems are inherently chaotic and uncontrollable.

The theory suggests that by studying and analysing complex systems, we can develop advanced diagnostics tools to identify potential crises and vulnerabilities. These tools can help us better understand the dynamics of complex systems and predict their behaviour with greater accuracy.

Girardin’s theory encourages us to take responsibility for our actions and decisions, recognising that we can influence the outcomes of complex systems. By understanding the pockets of predictability within complex systems, we can make informed choices and take proactive measures to mitigate the impact of crises.

The Great Recession and the Global Financial Crisis serve as powerful examples of how crises can have devastating consequences when we fail to anticipate and prepare for them. Girardin’s theory offers a framework for learning from these past events and developing strategies to prevent similar crises from occurring in the future.

By embracing the theory of complex systems, we can cultivate a mindset of resilience and preparedness. We can recognise that crises are not inevitable but rather potential outcomes that can be influenced by our actions. As a result, we can work together to build more robust and sustainable systems that are better equipped to withstand and overcome crises.

Conclusion

The crisis, worse since the great depression, has highlighted some key lessons for the world. Market discipline and supervision should complement each other; greater market transparency is crucial; countries need to contain their fiscal deficits so as to meet debt service obligations; strong financial regulations; improved risk management practices; crisis prevention mechanisms; and a need for enhanced global economic coordination between borders. Angela Merkel, Chancellor, Germany, has rightly put it, “We need financial markets in the modern world but not untamed ones, in which profit and greed are the only things that count. We need a market with rules.”  

References

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