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The term financial and economic crisis is widely used to refer to the awful situations, where some assets or financial institutions lose a huge part of their value. In both the 19th and the 20th century, many financial institutions were faced by terrible banking panics and other innumerable recessions that were consequently coincided with these panics. Other conditions also referred to as financial crisis include things such as stock market crashes, sovereign defaults and currency crisis. When financial crisis occurs, it directly results to loss of wealth and contributes to skyrocketing of the price of the common items in the market. This consequently leads to devastation of the entire populace, as many people cannot afford money to purchase those items. Since immemorial time, there is no single incidence in the human existence that the economic conditions have ever stabilized.
There have, instead, been economic instabilities that are unpredictable and that make the entire humans around the globe live in panic. Despite this fact, the 19th and the 20th century have been labeled the notorious centuries, when financial crisis derailed many nations by affecting the major emerging markets. Even after the policy recommendations by the International Monetary Fund that people thought would provide remedy for the world future crisis, Global financial crisis have still strike hard the global economy, hence, maiming development. This document provides various ways through which crises maybe prevented in the future, whilst maintaining world economic growth. This will be done by exploring areas that might provide feasible information on how to deal with this prickly issue.
The Theory of Financial Liberalization & Washington Consensus
Financial liberalization refers to minimizing of any kind of boundaries of the financial industry of any given nation. In other terms, it is lessening of restrictions on different types of lending institutions such as banks, nation’s treasury, money market funds, investment bank and hedge funds among many others (Philip 2005). One of the nations that has adopted money liberalization is the United States, which has used it for over three decades, hence, allowing many people to open up businesses in the U.S. Majority of the populace blame liberalization as being responsible for the current crisis, because it has allowed the setting up of so many risky financial institutions that are associated with problems of rating that have, consequently, led to the evident recession.
This was a term, coined by the economist John Williamson in 1989, to explain ten precise economic policy prescriptions, which he considered as those that contained the reform package that would promote developing nations, experiencing financial crisis. The policies were advocated by institutions such as the International Monetary Fund (IMF), US Treasury department and the World Bank. The recommendations were embodied by principles in such areas as stabilization of macroeconomic, development of market forces in the domestic economy and economic opening in relation to both investment and trade (Davidson 2003). Williamson had a strong conviction that these policies would redeem Latin America from the economic crisis that was facing it in the 1980s. He believed that the three Washington-based institutions, IMF, World Bank and the US Treasury Department would be of paramount importance in the recovery of the financial and economic crisis that had halted development in Latin America (Davidson 2003).
The first rule was the fiscal policy discipline, which emphasized that there should be an avoidance of huge cash deficits, when compared to the gross domestic product (GDP). This has the implication that a nation should not borrow excessive loan, especially, when its GDP is low (Philip 2005). It was in context of what many nations were undergoing since they had borrowed huge loans and interest had piled up so quickly due to inflation to the extent that they had been unable to repay the loans. The second rule is redirecting public expenditures from subsidies on the road to provision of major growth in sectors such as education, healthcare and infrastructural development (Philip 2005).
The third policy is the tax reform, which called for the government to combine broad tax base and moderate marginal tax rates that would not oppress the masses. The fourth policy is all about liberalizing interest rates, which involves making loose the restrictions of trade by allowing investors from outside the country to invest with less limitations. The fifth policy is the competitive exchange rate (Philip 2005). It was important to have a competitive exchange rate which has the implication that an instantaneous regime would be established.
The other policies include trade liberalization, liberalization of inward foreign direct investment, privatization of the state enterprises; deregulation, which includes abolition of rules that hinder market entry or impede competition, except for the few, allowed on safety, consumer protection and environmental bases as well as prudential supervision financial institutions; and authorized security for property rights (Davidson 2003). Despite the verity that the policies were brought forward to free Americans and other nations that would adopt it from financial and economic crisis, it cannot be completely inferred that Washington consensus has been a success. On the contrary, it has been faced by innumerable criticism from various economists who argue that the policies give way to financial crisis due to the heightened levels of liberalization.
Advantages of liberalization
There are a number of advantages, associated with liberalization. First and foremost, it will facilitate competitiveness of commercial markets, improve the efficiency of the world markets as well as promote the global banking sector (Demetriades & Andrianovas 2011). As such, liberalization has been reckoned as a tool that is necessary for the reduction of costs and the increment of profitability. A second advantage is that under conditions of financial liberalization, more openness and financial information can become more accurate, reflecting on the supply and levels of demand, hence, forms a more significant price signal. The third advantage is that it offers extra profitable opportunities through the provision of broader space for activities to take place. Finally, financial liberalization has facilitated financial integration, as nations are unceasingly giving way to the country’s capital flows, the pace is accelerating.
Limitations of Liberalization & Washington Consensus
Despite the various advantages earlier mentioned, liberalization is also associated with other negative effects. Firstly, it is associated with the improving the competence of financial markets, but in others, it takes the role of reducing their efficiency (FreePapers 2005). Secondly, the bank is devoted to the financial enticements to innovate. Under the influence of powerful financial controls, many financial institutions were required to continue introducing different new financial products in order to avoid financial constraints. Thirdly, financial liberalization increases the customer’s risk (FreePapers 2005). Through deregulation of exchange rates and interest rates, the market grew more and more volatile. Another disadvantage is that financial liberalization work together with other financial institutions like banks to heighten the risk of stabilizing of the financial system. Generally, liberalization should not be embraced as in the developed nations, as it can have very adverse effects on the developing nations (Wyplosz 2001).
The causes of the Asian Financial Crisis of 1997
The Asian financial crisis was a terrible financial crisis period that affected much of Asia as from July 1997, and aroused fears of a global economic crisis due to financial contagion. The crisis started in Thailand due to the financial collapse of the Thai baht, brought about by the Thailand administration to float the baht after tedious efforts to support it during the ruthless financial overextension that real estate driven. Unlike with the Debt crisis of Latin America, the debt crisis of Asia was a result of inappropriate borrowing of finances by the private sector (FRBSF Economic Letter 1998). Following the high economic growth in Asia as well as the booming economy, the private corporations engaged optimistically into finance speculative investment projects. Nevertheless, corporations overstretched themselves and an integration of factors contributed to depreciation in exchange rates as they strove to meet payments.
The first factor that contributed to the crises is the foreign debt-to-GDP ratio, which dramatically rose from 100% to 167% in the four major Association of Southeast Asian Nations (ASEAN) economies between 1993 and 1996 (Zhuang 2002). The second cause was that nations like Indonesia, Thailand an South Korea had huge current deficit. These nations were furnished by hot money flows and this caused a rapid accumulation due to the high interest rates, imposed in the East. A third cause is that financial deregulation led to borrowing of more loans and helped to develop asset bubbles (Zhuang 2002).
The fourth factor, which is considered to be the most colossal, is that due to the booming of property market and the booming economy, the Asian nations were encouraged to borrow more and more loans by firms. It was also noted that in the mid 1990s, the United States increased the interest rates of its debtors in order to cope with the inflationary pressures. This made the Asia less attractive to move hot money flows, something that discouraged investors from investing in this region (Zhuang 2002). As a result, hot money flows dried up in the east, currencies fell and the government struggled to keep pace with the exchange rates at their standard level against the ever rising US dollar. Another cause of Asian financial crisis is that Thailand became the first nation to have to float the Thai Baht, something that caused devaluation which, in turn, resulted to loss of confidence throughout Asian economies. Not long after this, other nations were obliged to devalue, as investors were determined to quit the Asian currencies.
Due to devaluation, the debt became even more difficult to repay to the extent that many nations started to default. It is at this stage that the IMF intervened to try to help stabilizing the crisis, but their efforts did not solve anything as many believe that their involvement only worsened matters. Despite many people’s arguments, the IMF insisted very much on fiscal restraint which included lower spending, privatization and higher taxes (Zhuang 2002). The major effects of this crisis are that it contributed to the global financial and economic crisis since the United States was affected and the dollar is the major controller of world economy.
Early Warning Systems
Prevention of economic crisis is the key role of sustaining financial stability. Consequently, use of early warning systems helps to echo the possibility of an economy to experience financial crisis over a given time. Financial crises that have shaken the global economy in the recent past have, majorly, been caused by loop holes in the economic systems in the structure of unexpected astonishment (Chari & Kehoe 2004). Such weaknesses make world economies vulnerable to effects of drooping currencies, depreciation in assets as well as steep increase in personal debts.
Economic crises are not only limited to developing countries, but also developed ones face the same predicament. Therefore, there is a need to understand and analyze factors that are likely to cause global financial imbalances. The International Monetary Fund (IMF) has been on the fore front to initiate and promote fortification of monetary and financial stability of individual economies through a number of strategies (Chari & Kehoe 2004). Besides having a strengthened financial stability, other strategies include regional integration, information exchange and enhancement of statistical clearness as well as appropriateness of information among others.
Early Warning Signs (EWS) models
There are two major approaches that are used in developing Early Warning Signs models, namely, the probit and signaling approaches. Probit, known as logit model, is used on multivariate situations that permit assessment of arithmetical importance of descriptive variables (Chari & Kehoe 2004). On the contrary, signaling approach is, normally, used in univariate systems that involve managing a set of high-frequency signs. Univariate systems work better with small samples.
Univariate EWS models
When constructing these types of models, the first and most important stage is to identify information on past crisis incidences and assessment of indicators of the crises. For example, in the banking sector, recessions, usually, come before a crisis. Financial crunch is also likely to occur, when a recession follows a time of extreme credit growth. Secondly, the leading symptoms are selected, based on the signs of crisis, emphasized in the first step. Most of the symptoms from past crises are grouped together into a set of indicators (IMF 2008). The indicators are calibrated to determine the distribution of every one of them and their respective thresholds. The signs should also hold for a specified period of time, after which they can become obsolete.
For example, in order to examine the financial conditions of countries, mostly hit by the Asian Crisis, EWS model was used. It helped to analyze the information that could likely have signaled occurrence of the crisis by focusing on data from 1970 to 1996. The analysis focused on getting the predictions of the economic crunch by aiming at economies of six countries that were worst hit by the problem (Vinay 2010). They included Indonesia, S.Korea, Malaysia, Philippines, Thailand and Singapore. Singapore was the only country that was exempted from the predicament and the rest were adversely affected by the crisis (Rosenberger 2010). Through the use of the EWS model, analysis was done to find out if there were warning signs in each of the six economies.
Knowledge from past crisis from worst hit countries indicates that banking and currency crises were related to excess borrowing phases. The reflective signs of the crisis include the relation between domestic credit and the level of Growth Domestic Product (GDP). Currency and banking crises are, most of the time, followed by bank runs. Most of the people rush to make immense deposits, thereby, increasing the possibility of bank default. Such an occurrence is a threat to the financial stability of economies and is, mainly, indicated by bank deposits.
Additionally, use of unsuitable monetary policies is a potential indicator of a looming economic crisis. They are, most likely, to instigate currency crisis, while depreciation of asset values aggravates the health of banking sector, thereby, generating banking crisis.
The ratio of liquid assets to the total assets in determining the liquidity level of the banking segment also plays an important role in measuring the vulnerability of an economy to possible crisis (Charles, Kindleberger & Aliber 2005). The ratio of loans to deposits indicates the amount of deposits that is held in loan facilities. This is a further indicator of the vulnerability of the banking and the entire financial system (Cheang n.d). Application of the above methods to predict the possibility of an economic crisis over a certain period would help to prepare policy makers in financial institutions and other responsible agencies for a potential havoc.
Causes of the 2008-2011 Economic Crisis
From one of the causes of the 2008-2011 financial crisis was the failure of proper regulation mechanisms and financial supervision. Financial players had operated in structures that led to an underestimation as well as imposition of excessive risks. Most of the financial institutions through their remuneration practices encouraged risk taking and led to the focus on short performance. Inadequate risk assessment through exposure to systematic shocks, lack of transparency, and overconfidence in credit rating agencies, inappropriate stress-tests and complexity of financial were major contributory factors (Paulo 2011). Regulatory practices such as the overestimation of banks capacity to manage risk, too much focus on micro-prudential regulation of financial institution and problems in the exchange of information are to blame for the predicament.
It is worth mentioning that the collapse of the real estate bubble in the United States contributed to the crisis. This was as a result of default in sub-prime mortgage. There was a considerable increase in the average rate of default at the beginning of 2006 to 2008.Securitisation of sub-prime mortgages facilitated the contagion within financial system. The spread of risk among many creditors made it hard for assets to be valued at their original price worth, even when the option of defaulting them and other debts was the only alternative. The uncertainty led to mutual mistrust between banks such that banks stopped lending each other. They had to sell their assets, leading to creation of short liquidity and depreciation of their capital.
The crisis also came as a result of macro-economic imbalances. Something that seemed favorable to the economic conditions, characterized by abundant liquidity and low interest rates further aggravated the crisis. Abundant liquidity and low interest rates were due to both expansive monetary policies in developing economies and global macro-economic imbalances. Tax monetary policies, especially in the United States led to credit growth, which stimulated investment and consumption.
Bankruptcy of Lehman Brothers was yet another factor that led to 2008 to 2011 financial crisis. This was due to the American authority’s act of not bailing out tthis investment bank. This caused its destabilization and being an important pillar in the country’s economy, there was an adverse effect in other important financial institutions.
World economic growth and liberalization
Most of the developing economies have embraced trade programs and financial liberalization without giving much thought on the possible consequences of making such a move. It has been established that countries that embarked on this approach were inclined to increase their imports more than the exports (Eichengreen & Hausmann 2005). However, this remains a debatable issue since contrasting information from some of the research show that the countries that embraced liberalization programmes experienced an improvement in their export performance. On the contrary, other researchers have found no correlation between trade liberalization and economic growth.
It has also been found out that highly protected countries and lowly protected ones experienced different effects of liberalization. The constructive impact of trade liberalization on development of imports was far greater in the industries that were well protected before liberalization. Therefore, a more liberalized trade translated to increased imports than exports (Eichengreen & Hausmann 2005). A research that was carried out in the nineties to determine the economic growth pattern of liberalized countries shed some light on the correlation between the two. There was a considerable increase in the real income for developing and globalizing countries with a remarkable 5 percent per capita income. On the other hand, developed countries recorded a 2.2 percent in per capita, while those that are developing but not globalizing had a 1.4 percent (Eichengreen & Hausmann 2005).
This implied that developing countries that had embraced globalization were faring better than those that were opposed to it. It is, therefore, apparent that trade liberalization leads to enhancement of real income and growth of per capita (Kahn 2008). Nevertheless, if trade is not incorporated with satisfactory policies to balance imports and exports, it would lead to discrepancies in the balance of trade and of payments (Shah 2010). Consequently, there is a decline in the growth of actual incomes.
The above graph shows how the comparative current account positions generally signify the contrasting balances between saving and investment in the respective countries.
The development of the current account position in countries that do not export petroleum products excluding China were influenced by growth of their trade. During the 1970s and 1990s, great discrepancies in trade contributed majorly to increased current account deficit. The ratio of trade account to GDP can show whether an increase in trade balance of any given economy was attained as a result of improved exports coupled with diminished imports or both (Cipriani & Guarino 2008). Also, it is worth mentioning that the effect of increased or decreased imports and exports is dependent on the individual country block. For instance, import compression in the early eighties inhibited economic growth in America. On the contrary, the same scenario of increased imports led to increase in economic growth in the Asian block.
A steady value of the ratio between the amount of world exports and GDP is observed in the late eighties to 2008. After 2008, there is a sharp decline in the above ratio, owing to the global economic crisis that affected world economies. Exports were affected as major world currencies, experienced instability.
Research findings have established that trade liberalization may result to faster economic development, if the countries were highly protected before liberalization (Avery & Zemsky 1998). However, increased amounts import than exports can have serious implications on the trade balances, thereby, limiting economic development in developing countries. Trade liberalization can enhance growth from the supply side due to efficient distribution of resources (Brunnermeier 2008). On the other hand, it may inhibit growth from the demand side, unless equilibrium between imports and exports is struck through employment of trade policies.
Appreciation of certain factors such as currency and asset values are possible causes of financial crisis. Currency appreciation is the rise in value of a foreign currency in relation to another foreign currency (Morris & Shin 1998). Instability of a stronger foreign currency such as the American dollar and the sterling pound has adverse effects on the weaker ones that are used by developing countries. This affects exports and as a result, developing countries are hurt since their economies majorly depend on exports (Obstfeld 1996). Furthermore, appreciation in real assets, such as home prices, can lead to economic crisis. For instance, the 2008 credit crisis in the United States was caused by increased mortgage and inflated house prices.
Prevention of Future Crisis
The world can prevent a repeat of the economic crisis by providing remedies to the problems, facing financial institutions. Reform on the global financial architecture is the first remedy. This reform should be steered by strong institutions like the group of twenty (G20) alliances, which should control other institutions like the International Monetary Fund (IMF) and Financial Stability Board (FSB). Political mobilization at the international level to prevent worsening of the crisis is crucial (Hamilton 2009).
The role of several specialized institutions in the field of regulation and financial supervision should be enhanced. Examples of these institutions are the Financial Stability Board (FSB) and International Monetary Fund (IMF). They help in shifting of powers in favor of the developing countries. Global financial and economic governance committee should also be stabilized such as the G20 alliance (Gilpin & Gilpin 2001). The alliance should coordinate measures to limit the effects of the crisis, taken at the national level, conduct a reform on international financial institutions to make them more effective and step up the lending capacity of the international financial institutions. IMF has helped countries, experiencing balance of payment problems through the G20 decisions to triple the amount of its financial allocation. IMF has also conducted bilateral and multilateral surveillance to stabilize its member states and provided analytical expertise and technical assistance in the strengthening of the world’s economy.
Institution of organizations in specific sectors of the global economy is another way of preventing the crisis. These are international cooperation forums that aim to improve supervision of the banking institutions. Example is the Basel Committee on Banking Supervision (BCBS). Other organizations include International Accounting Standards Board (IASB), International Organization of Securities Commissions (IOSCO) and International Association of Insurance Supervisors (IAIS). Adoption of minimum capital requirement principle, which aims to make banking sector more resilient, should be adopted (Goodhart 2011). This makes the bank to have buffer capital to absorb losses. Other remedies include credit rating agencies, and orderly resolution of bank failures and creation of deposit guarantee schemes.
The effectiveness of multilateral institutions
Multilateral institutions, mainly, include the major global financial institutions that have been assigned the role of leading towards the realization of the millennium development goals (MDG) (International Monetary Fund 2001). They include institutions such as The United Nations, The World Bank and the IMF, Regional Development Banks and the International Donor Community. Each of these institutions carries out specific role to achieve the preset goals. To start with, The United Nations takes the responsibility of monitoring the MDG targets and indicators. The efforts involve complementing research at the national and international levels. At the national level, it helps the developing nations in monitoring progress and in preparation of the MDG reports (Asian Development Bank 2011).
The World Bank and the IMF take the mandate to be involved in policy dialogue with the various member countries and later give a report to the respective executive boards (Upton 2000). The IMF has the responsibility, under its surveillance rule, to examine macroeconomic as well as the exchange rate principles in the developed and developing nations (Mingst & Karns 2004). Regional Development Banks also have their responsibility of carrying out policy dialogue with the members and later report their findings to the respective boards. They also have elaborate procedures for assessing various countries in the context of their performance-based allocation (PBA) policies. These provide updates on pointers of progress on changing the economy. Finally, the International Donor Community is expected to provide all the financing that would be required for the attainment of the MDG.