History has witnessed many world crises. Some of them affect the entire world; others affect a narrow range of countries. Some of them are protracted; others are impermanent. As a rule, their causes are always different and the consequences are remarkably similar. The crisis phenomena leave their imprint not only on the economy of the countries but also on people’s lives, sometimes making them poor within a day, even the most wealthy ones.
The development of the world’s monetary and credit relations is accompanied by financial crises. Before the formation of the world economy, financial turmoil covered national systems of individual countries. They began to acquire an international character. A pronounced international character of the financial crises appeared in the 30s and 90s, and it finally reached a zenith in 2008.
The global financial crisis of 2008 is characterized by the considerable depth and scope. It spread around the world for the first time since the Great Depression. The problems in the U.S. mortgage market triggered the crisis mechanism. However, the heart of the crisis lies in much more fundamental reasons, including macroeconomic, microeconomic and institutional ones. A critical analysis of the crisis may reveal its root causes and help find the ways to prevent it in the future. The paper will discuss the course of the global financial crisis, underlying reasons for its occurrence and the ways to avoid it.
What the Global Financial Crisis Is and Its Course
The global financial crisis began in 2007. However, the crisis processes were limited that year. They were triggered by the U.S. mortgage crisis, which despite being very painful financially, did not produce a destructive effect on the rest of the world. These processes have become inclusive and very deep since the 4th quarter of 2008. They affected not only the stock markets but also began to spread to commercial banks and other financial institutions, jeopardizing proper functioning of the monetary sphere. The modern market economy cannot exist without it. Bankruptcy of important financial institutions, primarily in the US and the UK, has become a frequent phenomenon.
The unconditional epicenter of the crisis is the monetary sphere rather than the sphere of production and sale of goods and services. This fact distinguishes the current situation from the normal cyclical crises of overproduction. Cyclical crises could have started with a stock market crisis, which played the role of a trigger mechanism. However, the basic processes occurred in the production and sale of goods and services. Currently, the financial sphere has a dominant impact.
In turn, the center of events in the financial sphere is the domestic monetary relations rather than the world monetary system. The latter is the weakest link in the global economy due to the gradual weakening of the leading key global currency, namely the U.S. dollar, and accumulation of giant external and domestic debt by the United States.
The crisis quickly became global after originating in the U.S., affecting even those countries where the objective reasons for the crisis seemed to be absent. Many of the high-level politicians indicate the USA as a guilty party. In author’s opinion, this is an exaggeration. Of course, the United States is the originator but it is neither the single nor the chief one. If relevant processes in other countries had not prepared the crisis, it would not have taken such a universal and profound nature. It is hard to illustrate the effects of globalization in a more transparent manner than the global financial crisis did. The latter has created a crisis of the liberal-monetarist doctrine that was dominant in the economic views and economic policy of most governments for the last 20-25 years. The invisible hand of the market, which is so praised by advocates of economic liberalism, looks profoundly untenable in the current environment. Everyone rushed to the state as the main savior, and the state in most countries used the most active means of dirigiste policies, including strict control and nationalization of some of the key banks and companies. Some of the critics and supporters of the market system even announced the end of capitalism.
The global economic system has existed for decades and has been virtually a single currency system with one dominant component, namely the US dollar with the status of the main reserve currency. This fact caused almost limitless demand for its emissions, so the dollar was printed nonstop. As the demand increased, the printing press worked more actively. At the same time, the dominant dollar component in foreign reserves of the leading economic powers made these countries the prisoners of the ongoing processes in the US economy. It should be noted that the US government did not control the situation and dollar supply in circulation in the past two decades. The issue of global payment means alone cannot ensure its sustainability and be responsible for the consequences.
Today, one cannot give an accurate estimate of the value of dollar supply in circulation. Nevertheless, it is recognized that its value is several times higher than the value of real assets managed and redistributed in the framework of world trade and global economic cooperation. It is obvious that there was no way to continue this. Today, the financial market trades mostly with derivatives (options, futures and forwards) used for a speculative profit rather than with real values. There is a kind of bloating of financial liabilities, the value of which far exceeds the number of actual transactions. The global market for derivatives can truly be considered the center of the current financial crisis. The major US investment banks have acted almost without supervision and intervention of the Federal Reserve System over years. As a result, the point of no return was passed.
Moreover, the European and the US financial authorities and institutions perceived the crisis as rather superficial and underestimated its depth and possible consequences. Many major investment banks that were the reference point for investors and financial market participants either went bankrupt as Lehman Brothers or were resold or redeveloped as Merrill Lynch, Goldman Sachs and others.
All these events were a direct result of the incorrect assessment of the negative processes occurring in the global financial system. In recent years, there has been “dizziness with success,” a euphoria of the growth dynamics of the global financial market, which did not interfere with any fluctuations in the euro-dollar rate exchange or a sharp rise in energy prices. At the same time, the excess of financial capital fell not into the real economy but the financial sector given the cyclical development of the world economy, thus forming a bubble. Consequently, the bubble has burst just like it was supposed to. Certainly, such a huge number of negative events does not happen in a vacuum and suggest particular reasons for their development.
The Reasons for the Global Financial Crisis
The current global financial crisis is considered the most profound and dramatic in the last few decades of the development of the most countries’ economies. The main global and objective reason for the crisis is the features of the cyclical development of the world economy. Economically developed countries, primarily the United States and Western Europe entered a new period after the peak of technological and economic development in the late 20th century. This is a cycle of a slowdown in economic growth and recession. The mortgage crisis in the United States is generally recognized as immediate predecessor of the global financial crisis. Its first signs appeared in 2006 in the form of a reduction in the number of home sales. The mortgage crisis grew into a subprime mortgage crisis at the beginning of 2007, and later even reliable borrowers experienced credit problems. Gradually, the mortgage crisis transformed into the financial one and began to affect not only the United States but also other countries. By early 2008, the crisis became global, resulting in a widespread decline in output, lower demand and prices for raw materials and a rise in unemployment.
Today, there is a significant decline in growth rates of GDP, index of business activity, consumer confidence and others in many countries. The decline in the real sector of the economy leads to a decrease in the efficiency of the financial sector. Thus, the problem of cyclical development in the context of the current crisis can be described as a structural transformation of the global economy.
The reasons for the global financial crisis usually indicate typical errors in the policy of commercial and central banks, expressed, in particular, in the excessive expansion of the circle of borrowers in pursuit of profit and without proper control over their ability to pay. Also, one can see the reasons for the undue expansion of credit, which was not adjusted properly by central banks, and rampant exorbitant speculations in financial markets. It resulted in a large number of bad debts, which turned out to be disastrous burdens on the balance sheets of commercial banks. This fact became especially vivid during the subprime mortgage crisis in the United States, when the total outstanding loans exceeded the fantastic amount of $10 trillion. Attention is also drawn to a strong expansion of speculation in the stock market.
All these reasons are true but insufficient since they do not address the root cause of the crisis of the world monetary system. It is believed that an excessive gap between the financial sector and the needs of production and sale of goods and services that gradually developed after the World War II constitutes such a cause.
It is necessary to recollect the genesis of the monetary system of the market economy. The needs of circulation of money were automatically satisfied in the era of the gold standard when gold or silver in some countries was the basis for monetary circulation. In the case of expansion of the economy’s needs for money, it came from the reserves, where it was kept without the risk of impairment because the money had physically tangible value. Conversely, if the needs were reduced, money went into reserves and thus did not cause inflation.
However, the state had to pay the price for the stability of the monetary system. The needs of the economy were closely dependent on the reserves of precious metals, which limited the possibilities of economic policy and economic development, in general, increased the magnitude of the cyclical crises of overproduction. Gradually, the gold standard system collapsed. The process was long. It began at the World War I, continued during the Great Depression and finally ended in 1971 when the United States abandoned the commitment of the Federal Reserve to pay gold for the debts of the U.S. to central banks of other countries at their request. Thus, the system of pure paper money circulation with its indispensable companion – inflation – was created.
At the same time, financial institutions were able to expand the monetary superstructures in a very wide range. One should bear in mind that commercial banks by the very nature of their functions could create money, i.e. generate demand. In addition, there are opportunities arising from the rapid development of the securities market, i.e. a long-term capital market. Although, technically, public bonds are the only parts to be included in the money supply, all the securities have a high degree of liquidity in varying degrees, i.e. they can be easily converted into cash.
In the end, it looked like the acquisition of new capabilities to combat the broadest crises of overproduction and to stimulate economic development through increased financial superstructure. The crisis of overproduction on the surface means that there are many goods and services on the market, but there is not enough demand (money). Hence, the recipe is to create money. Of course, this was associated with threats to the stability of the currency and inflation risks, which often became very serious. However, it would be wrong to ignore the undoubted achievements of this policy. After the World War II, the crises of overproduction significantly weakened and, vice versa, the economic growth increased compared with the previous crises in the history of the development of capitalism.
These are very significant achievements. However, nothing is free of cost. Simultaneously, there was a huge expansion of the financial superstructures and an increase of the associated risks, including the ones of speculative nature. The whole structure has become very unstable. The volume of securities markets throughout the world has increased unimaginably. It is difficult to measure it accurately because prices change, and insecurities may include different elements. The market volume of the main classes of securities – bonds, shares and derivatives – is estimated in the tens of trillions of dollars. Gradually, a huge monetary financial bubble emerged.
Thus, one can definitely say that the global economy generated a strong and dangerous speculative gap between the monetary superstructures and the needs of production and sales of goods and services. So far, the economic science and practice has not established quantitative limits of these phenomena, but they objectively exist. An average loan must ultimately contribute to the expansion of production of goods and services. If it does not happen, then there is an imbalance between supply and demand. This expansion of the monetary sphere is speculative, and the bubble will be eventually blown away. These are the laws of the market economy. It may be argued that these processes are now taking place, causing turmoil throughout the system.
Another major source of instability in the financial system in the market economy is the increased role of the trust factor. No other area of the economy depends on it as a monetary sphere does. Commercial banks generally operate with borrowed funds, so investors usually have the right to withdraw their deposits on demand. Distrust, rumors, even the most unjustified ones may give rise to panic and mass withdrawal of deposits, capital flight, a flight from the national currency and so on and lead to a crisis of even strong credit institutions with consequences for a system as a whole.
Another factor that strongly influences the situation is the extent of speculation. Speculation is a natural element of the market economy. It can appear and destroy huge fortunes in the shortest terms. The rapid development of financial instruments, especially securities market, and an extraordinary expansion of the financial sector created a favorable environment for speculation, which contributed to an increase in the amplitude of the oscillations directly in the overall economic and financial fields.
These are the underlying factors that have paved the way for a financial bubble, which began to deflate. Other reasons, despite their great importance, are complementary. The global financial crisis could have begun sooner or later and been worse or less severe, but it was inevitable. Thus, one has to find a way to minimize the negative effects of economic recession and prevent a deeper depression and financial meltdown in the future.
The Ways to Avoid the Global Financial Crisis
The risks of further financial and economic crisis are very significant. That is why the development of the ways to avoid the crisis is of crucial importance. In my opinion, governments around the world should remove barriers to healthy financial globalization. Openness to foreign investment and capital flows carries certain risks but also gives a clear advantage. The degree of openness and the pace of progress towards it should depend on the size, the pace of development of the financial sector of a particular country and the power of its regulatory and supervisory mechanisms. The balance of risks and benefits can be enhanced by removing barriers for the most stable and long-term types of capital. Such barriers include the restriction of foreign investment and the right to acquire ownership in various sectors.
I think that the world government should create markets of equity and debt capital, especially in the developing economies. Capital markets are an important alternative to the bank lending as they allow foreign investors to operate in local markets. Most countries have the basic infrastructure and legislation for this purpose, but its implementation and control of the markets are too weak. Progress in this area would be advantageous for local borrowers as well.
I suppose that the European Union should quickly create a banking union in the eurozone in order to restore confidence and continue financial integration. This alliance, which includes mechanisms for monitoring, rehabilitation of banks and deposit insurance, could strengthen confidence in the future and promote healthy flow of capital. Other currency zones should create similar banking unions.
In addition, one should pursue a credit easing policy since the main problem of most economies is the excessive debt and bankruptcy of enterprises. If the European Central Bank revised its decision to increase interest rates, it would be an ideal situation as the practice has shown that such a decision only worsens the economic situation in many countries. This leads to a decline in business activity, which has a deflationary impact on the market of goods, labor, sales and real estate.
It is also recommended to organize state funding programs for the restoration of credit growth through strengthening banks and credit institutions with insufficient capitalization. Banks in turn have to set a short-term deferral of the requirements for liquidity and capital. Additionally, the government should organize financial support for small and medium-sized businesses that do not have sufficient liquid assets to obtain credit funds for their development.
The provision of liquidity to solvent states is the last measure that could prevent a crisis. It will prevent the loss of market access and the spike in spreads. The fact is that by taking the above measures and policies, the government of a particular country may temporarily lose its creditworthiness, so there is no need to organize a large-scale stabilization fund to support such countries.
Thus, the normal functioning of the world economy requires a stable, modern and predictable international monetary and financial system that is based on the maintenance of macroeconomic and financial discipline by leading world economies in the context of globalization.
The global financial crisis requires a global response. The objective requirements of the development make it necessary to create a new key global currency and new international financial centers that would have much greater regulatory functions than the IMF and the World Bank. The most likely option is the creation of new financial centers and key currencies on the basis of the euro and the dollar. Most countries are unwilling to depend upon the condition of the US dollar because its ‘health’ has deteriorated sharply in the past decade.
The current global economic crisis proves the need to abandon traditional approaches and requires collective internationally agreed decisions aimed at creating a system of governance of globalization. All countries need to act decisively to restore sustainable economic development, confidence and stability in financial markets.