The Global Financial Crisis of 2008/09 was a result of policy mishap and corporate irresponsibility. Analysing the effectiveness of policy responses, this essay proposes reforms in a political context, focusing on the U.S and Europe.
December 19, 2011 Leave a comment
This paper will examine the effectiveness of policy responses to the Global Financial Crisis (GFC) of 2008/09 and propose various reforms that will mitigate, avert or significantly reduce the risk of a future financial crisis. I will also highlight the difficulties of implementing these reforms on the premise that the financial crisis of 2008/09 was in fact global. In recognition that this topic is vast, multifaceted and rapidly changing, this essay will focus almost exclusively on the United States (U.S) and Europe as case studies. There is some debate as to what constitutes a crisis. This essay will use the parameters of Jickling’s narrow definition; that a crisis is a major disruption in financial markets that stymies the flow of credit to households and businesses, and adversely affects the consumption of goods and services in the economy . In analysing policy effectiveness to the GFC, I will rely on indicators that demonstrate whether measures taken in responding to the crisis were successful in averting or limiting human costs including unemployment, investor and consumer confidence. This essay will be divided into three sections. Firstly, I will outline the causes of the GFC, particularly focusing on the origins of the sub-prime mortgage crisis in the U.S. Secondly, I will outline the effectiveness of policy responses to the crisis in the immediate aftermath, and financial re-regulation policies aimed at re-regulating the financial markets to prevent a future financial crisis. Thirdly, I will propose a series of reforms that could help avert a financial crisis of the magnitude we experienced in 2008/09. These include tougher regulation standards by governments, improvements in crisis management, and various other technical reforms that will reduce systemic risk of the financial system. I will also explore in significant detail, the likelihood of such comprehensive reforms coming into law and the political difficulties of achieving such meaningful reform. In particular, the essay will focus on the power of financial industry lobbyists, who have been successful in thwarting any significant financial overhaul in Washington.
The causes of the crisis can be attributed to a variety of factors: wreckless borrowing and spending by consumers, the provision of easy access to credit by banks , artificially loose interest rates by the Federal Reserve (according to the ‘Austrian School’) and the sharp reversal of this policy in 2006 , and most ostensibly, poor financial regulation. A combination of the three caused the bursting of the housing market that rippled through the rest of the financial sector . In its early days, it was simply referred to as the sub-prime mortgage crisis. The exponential rises in new financial products were expected to minimize, diversify and avert risk within the financial markets. Overwhelmed by the sheer number and complexities of new financial products, investors lacked due diligence and were complacent in recognising toxic assets that were often pooled together within complex financial products as Collateralized Debt Obligations. This led to poor underwriting standards . The knock-off effect from this was significant. As investors analysed the market, they became weary of the over-leveraged nature of the market . In addition, economists such as Hyman Minsky have stated that since the Great Depression, the global economy has been stuck in a perpetual cycle of crisis, and financial boom and busts are now a natural part of the business cycle, and therefore inevitable .
The crisis prompted a new era in international economic cooperation. The Group of 20 nations (G-20) was hailed as the new forum for international cooperation in the globalized world . The group of twenty-nations, largely an addition of a series of developing nations, the G8 allowed policy coordination to stimulate the global economy . However, the G-20 failed to address multiple issues adequately. The most prominent issues were the “too big to fail” concern which featured as a high priority issue for the reform agenda, and the failure to adopt an overarching enforcement agency that would regulate global financial markets . Instead, the G20 settled for watershed measures, such as strengthening the mandate for a new Financial Stability Board (FSB), as a successor to the previously weak Financial Stability Forum , and requesting that it work in partnership with the International Monetary Fund (IMF) in providing early warnings of macroeconomic and financial risks, and providing policy recommendations for national governments . If both the FSF and the IMF had failed to predict the sub-prime mortgage crisis and the ensuing financial crisis, what is the likelihood that they won’t fail again? It is clear that the G-20 had settled for stop gap measures, rather than solving the central issues surrounding hazardous business practices by financial institutions.
There was a broader recognition that though there had been 800 years of financial crises, globalization had increased economic interdependence and consequently, the magnitude of this financial crisis which threatened to bring capitalism to its knees . Susan Soederberg, a political economy development specialist at Queen’s University, argues that the GFC was actually a crisis in capitalism itself . Using Marxist theory, she critiques the current capitalist system as fostering a culture of over-accumulation of capital, which she argues, will inevitably lead to financial crises .
The United States injected US$3 trillion in spending, loan purchases, loans and loan guarantees through the Treasury, Federal Reserve system and the Federal Deposit Insurance Corporation (FDIC), including a $787 billion economic stimulus package that was aimed at kick-starting the economy . The economic stimulus packages have largely been perceived as a failure in the U.S and political support for the White House’s economic policies under the Obama Administration remain at an all time low . Unemployment rates remain stubbornly high at 9.1% in the U.S and as high as 20% in some European countries, with the U.S managing only to create a meagre 103,000 jobs in September .
Fiscal policies (largely following Keynesian economics) enacted by most economies have been unprecedented in nature, but have largely failed to spur economic growth in the developed world, though some economists argue that they managed to prevent a deeper recession . This has also prompted a revision in the existing regulations of the financial industry . In Europe, these reforms have been much more comprehensive than those adopted in the United States. The EU managed to cover all major areas of financial re-regulation including regulation of credit rating agencies, amendments to the capital requirements directive, regulation on short-selling and the creation of multiple regulatory authorities to deal with each of the following: identifying macro financial risks, coordinate banking regulation and supervision, securities markets regulation and supervision, and the adoption of crisis regulation procedures . In contrast, the U.S financial overhaul legislation; the Dodd-Frank bill, was far less comprehensive as the bill was watered down immensely as a direct result of powerful lobbyists from Wall Street .
Several proposals have been put forward by various actors, the most significant of them are those proposed by the Institute of International Finance, the US President’s Working Group on Financial Markets Actors and the recommendations of the Financial Stability Forum . All three identified five key areas: strengthening prudential oversight, increasing transparency and information sharing on risks independent of Credit Rating Agencies (CRAs), regulating the CRAs, improving risk mitigation procedures, and adopting new methods and practices to deal with systemic risks . Other proposals advocated for increasing the mandate of the Federal Reserve in the Monetary System to give it a larger range of tools without having to seek approval from Congress . However, due to current political circumstances, particularly the deep deficit levels of the U.S economy and the unpopularity of the Federal Reserve’s decision to bail out banks and other large financial institutions in 2008/09. This move is unlikely to gather much political support domestically .
Following the bail-out of major US and European financial institutions, there was deep scepticism for using tax-payer funded takeovers of large banks and financial institutions. This was and continues to be seen as rewarding the corporate greed that contributed to the unravelling of the Global Financial crisis. Governments are also aware of the risks associated with bailing out banks and financial institutions given their magnitude and importance to the global economy . To avoid such a moral hazard in the future, governments should make it clear that no bank is too big to fail by adopting orderly bankruptcy laws that would oversee the closure of failing banks and financial institutions. This would reduce incentives for excessive risk-taking within the business . However, this measure could be seen as economically costly and overly burdensome on free flowing capital and investment. It has also been argued that this could also hurt recovery of the fragile global economy .
The Dodd-Frank legislation in the U.S was aimed at overhauling the regulation over the financial sector, so that a future financial crisis could be averted . Yet, due to a highly politicised process in Congress, the resulting bill was watered-down and did little to address the systemic problems that caused the financial crisis in the first place . Wall Street and Corporate Chief Executive Officers (CEOs) in the financial industry are fundamentally opposed to stricter regulation in the financial industry . For instance, the U.S Chamber of Commerce spent more than US$6 million in efforts against the Dodd-Frank bill. In its final form, the bill did not even make reference to the accountability of credit rating agencies whose complacency was a primary contributor to the sub-prime mortgage crisis. The compromising nature of Congress, coupled with the power of financial lobbyists only serves to add huge layers of ineffective bureaucracy, unnecessary and costly legislation. Take the Volcker rule in the bill for example, which was aimed at restricting proprietary trading by large banks. When originally proposed by Paul Volcker in the aftermath of the financial crisis, it was only 3 pages long, but when finally adopted it was around 300 pages . The failures of the U.S political system are apparent, and in a recent interview with TIME magazine, Volcker himself admitted that the rule would probably do little and cost too much .
Few doubt the power of Wall Street and the disproportionate influence lobbyists from the financial industry have on Capitol Hill. One only needs to look at the track record of financial regulation in Congress to find patterns of deregulation legislation heavily lobbied for by the industry. Most notably, the American Home ownership and Economic Opportunity Act of 2000 and the American Dream Downpayment Act of 2003 . These two signature legislations promoted deregulation and lax lending practices in the mortgage market and were the result of intense pressure by the financial industry . According to a report by Deniz Igan and Prachi Mishra at the International Monetary Fund, during the period of 2000-06, legislation that disadvantaged the financial industry was three times less likely to pass through Congress than one promoting deregulation . The Center for Responsive Politics (CRP), which tracks and reports campaign contributions and lobbying expenditures, stated in its report that, “ the financial sector is far and away the biggest source of campaign contributions to candidates and parties, with insurance companies, investment firms, real estate agents and commercial banks providing the bulk of that money . There is a direct correlation between the amount of political donations made to members of Congress and the level of influence financial industry lobbyists have on policy makers on Capitol Hill.
The power of financial lobbyists’ aside, governing the financial industry can be extremely difficult on a technical level. Lawmakers are particularly aware of the trade-off between financial innovation and protection of the financial system. Given the fragile nature of the global economy, re-regulation of the financial industry is perceived to be harmful for economic recovery . In addition, heavy regulation is perceived as highly burdensome on the economy, and such measures are often associated with the failed central planning reforms of the Soviet era. Another major problem is that governments have a tendency to be reactionary rather than pre-emptive . This policy lag means that legislation to curb malpractice in the financial industry are back-ward looking, and may not address future threats. Moreover, the U.S experience is proof that even if authorities are aware of the structural defects in the existing system, little political capital is expended to reform these areas until a crisis has erupted or is imminent .
When governments do enact regulation, they tend to be rigid and fail to counter newly emerging threats to the markets. In contrast, markets tend to be much more fluid. This brings me to Stanton’s law, which predicts that as a result of market fluidity, financial institutions will create new ways to by-pass legislation in areas where governmental regulation is weak .This was evident in the market response to the restrictions on capital requirements under Basel I, which exempted Structure Investment Vehicles (SIVs), thereby diverting large amounts of investments into complex financial products with little or no government oversight . The most effective way to regulate the financial industry in light of Stanton’s law is to regulate the markets lightly with comprehensive crisis management policies . Other ambitious proposals to regulate the global financial markets have included establishing a World Financial Organisation (WFO) similar to the World Trade Organisation’s role in managing global trade . The organisation would establish minimum standards on capital and liquidity, increase supervision and regulation of global financial markets, and ensure adequate risk aversion mechanisms and internal controls are adopted by financial institutions through enforcement mechanisms . Introducing such a powerful, multi-lateral institution would discourage cheating and even the playing-field in an inter-nationalised financial system, though policy-makers are unlikely to adopt such a measure given the current global economic turmoil. Other proposals by World leaders have urged greater international financial cooperation by the setting up of new comprehensive international institutions, perhaps a Bretton Woods II, to address the inherent problems of a globalized financial system . Similarly, in the immediate aftermath of the GFC, there were some suggestions that the IMF take on a larger role to maintain the stability of international financial system, though no far-reaching measure was adopted with respect to increasing the role of the IMF .
Given that debt levels are exceedingly high both in the United States and in Europe, particularly in light of the problems facing the Euro-zone, if another financial crisis struck either continent in the next few years, the results would be dire for the global economy. This is mainly because governments have exhausted fiscal and monetary policies, and in the process have run up extremely high debt levels, leaving little room to manoeuvre if another crisis hit . In addition, whilst bail outs in both the U.S and the EU saved many institutions, they also illustrated poor fiscal and monetary management . They have forced investors and speculators to be cautious about Central Banks intervention . Poor quarterly growths in both continents are proof of exceedingly low consumer and investment confidence .
This essay has examined the causes of the Global financial crisis of 2008/09, policy responses that were adopted in response to the crisis and their effectiveness, both in terms of averting further economic downturn and the ability to protect the financial industry to avert a future crisis. I have argued that the reforms enacted have been inadequate as they have been limited in their nature, partly due to the power of financial lobbyists in Washington, but also due to technical factors that make financial regulation difficult. The political and economic (often intertwined) reforms proposed in this paper are far-reaching and could potentially stave off a future financial crisis. However, given the current sour political and economic climate, particularly in the United States, it is unlikely that such meaningful measures will be adopted by policy makers. As a result, the risk of financial collapse in the future, as witnessed in the Global Financial Crisis of 2008/09, remains virtually unchanged today. Some have suggested more realistic measures in the short-to-medium term to deal with this problem through light government regulation coupled with comprehensive crisis management policies, but if Minsky is right about the global economy being stuck in a perpetual cycle of crisis, and history is on his side, it is only a matter of time before the next financial crisis erupts. As the world becomes even more globalized, the costs of a future global financial crisis will be more severe than they were in 2008/09.