The Global Financial Crisis

Triggers, Responses and Aftermath

Tony Ciro

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317030249
• Edition: 1
• Topic: Business
• Subtopic: Business Law
• Index: Business

This book offers commentary and analysis on the catastrophic events which have recently confronted the international economy in the modern era and contrasts the current situation with other financial crises. It includes case studies on Lehman Brothers in the US, Babcock & Brown in Australia, and Northern Rock in the UK. Asking many pertinent questions about the causes of the crisis and its effects, the book explores fundamental themes such as: asset bubbles and speculation in the financial and non-financial markets, systemic risks and the role of regulation, and regulators. It also reviews the response of international institutions such as the IMF, the World Bank, the US Federal Reserve, the EU Central Bank and the G20. The book assesses the triggers of the crisis and evaluates rescue packages and policy responses as well as suggesting reform of regulatory and supervisory frameworks to maintain banking and modern financial systems in the future.

Chapter 1
Previous Crises

Introduction

The global financial crisis that struck during the first decade of the 21st century was not the first economic crisis that the world has ever encountered, nor will it be the last. For whatever reason economic crises continue to occur and have often been mistaken for the boom–bust economic cycle. The current crisis has been described as the worst financial and economic crisis the world has encountered since the Great Depression of the 1930s. The GFC has, like other economic and financial crises, caused real economic damage.

The aftermath of the GFC has been substantial by any measure. World GDP and industrial production for both developed and developing countries have fallen considerably. It was not uncommon for industrial production figures to record falls of over 20% on an annualized basis.1 Similar declines were recorded in the United States, the epicentre of the crisis. Global GDP growth rates were also adversely impacted. While much of the world recorded positive growth rates in the lead-up to the crisis, negative GDP recorded at the end of 2008 and during 2009 easily eclipsed positive growth rates recorded in the previous quarters. The crisis led to a significant and prolonged decline in industrial production and GDP output, which was described by the International Monetary Fund as the “Great Recession.”

The world had suffered considerably through the Great Depression of the 1930s, as well as during and after World War II. The recession that took hold after the war affected many nations and resulted in a significant and widespread downturn. However, during the 1950s and 1960s most countries, particularly developed economies, enjoyed a global economic boom. It was not until the 1970s OPEC oil crisis that the world entered into a period of economic downturn with rising inflation. The OPEC oil crisis preceded the Vietnam War and the two combined to produce a significant malaise for the world’s largest economy, the United States.

The malaise continued for much of the 1970s and early 1980s, until a new economic boom took hold, only to falter with the equity market crash of 1987. This stock market collapse was the most severe and pronounced equity market decline since the great crash of 1929. In a single day equity indices fell over 50%, with some individual companies almost having their entire market value wiped out. The 1987 crash, commonly called “Black Monday,” sparked fears that the world would be heading into another depression. Policymakers were acutely aware of the potential for the stock market crash to develop into a much larger contagion. However their ability to respond quickly was hampered by persistent high inflation.

The dot-com bubble of the late 1990s burst in 2000. In the lead-up to the new millennium, speculators, investment banks and pension funds had poured billions of dollars into new technological ventures. The NASDAQ Composite Index was viewed as the new engine and driver for US dominance and superiority in technology and wealth creation. Technological startups were no longer valued on fundamental terms. It was argued that with the creation of a new economy, all of the old rules relating to fundamental or inherent value were no longer relevant. Hence, conventional wisdom and valuation methods based upon profitability or discounted cash flows were not applied and instead, non-conventional valuations premised upon turnover or revenue were used. All of this proved to be illusory when the dot-com bubble burst in 2000.

The terrorist attacks on 11 September 2001 also sparked widespread fear in financial markets. Following steep declines in equity markets on Wall Street and other international indices, and fearing a significant downturn in the real economy, the US Federal Reserve aggressively cut interest rates. The move to increase private sector liquidity was designed to stave off any economic downturn and restore confidence to a now insecure US consumer. The US Federal Reserve also adopted a range of measures designed to increase liquidity in the US economy.

Some commentators have argued that the US Federal Reserve’s action to help restore confidence in the US economy following the terrorist strikes contributed to the great crash of 2008–2009.2 It has been suggested that a prolonged period of low interest rates led to the creation of a dangerous and unsustainable housing bubble in the United States. We know now that the spectacular unravelling of the housing bubble during 2007–2008, which had its genesis in sub-prime mortgage lending, had devastating consequences for the entire global economy.

The 1930s Great Depression

The Great Depression was appropriately named. The significant repercussions from the economic decline which followed were felt all over the world. Industrial production and GDP fell dramatically as factories, shipyards, retail stores, mining, construction and manufacturing all effectively collapsed. Recorded unemployment rose mercilessly to over 30% in key economies. The US and Europe, the great engines of economic growth, stopped growing and went into reverse at an alarming rate. The high levels of unemployment, the slump in industrial and factory output, the loss of income and wealth, the bankruptcies and foreclosures and widespread economic despair were evident everywhere. The catchcry now was that capitalism was dead and could not recover from the prolonged crisis. Social despair and crisis followed and alternatives to capitalism were born and embraced.

Popular belief laid the blame for the Great Depression with the Great Crash of Wall Street in 1929. It has been suggested that the collapse on Wall Street on Black Tuesday “caused” the Great Depression because the stock market crash led to significant investor losses and large financial collapses. The Great Crash of 1929 no doubt had a considerable negative impact on the US financial system and overall economy. And, yes, the Crash on Wall Street led to an almost complete, simultaneous panic on other international bourses and exchanges. What was not entirely clear, and was the subject of much ideological debate, was whether the Great Depression had other causes or triggers as well.

Two central theories emerged which attempted to explain the causes of the Great Depression. One explanation that was put forward was the demand-driven thesis, largely attributed to the prominent economist John Maynard Keynes.3 The demand-driven hypothesis suggested that declining consumer and investment demand were key triggers, which led to significant decline in industrial output and economic growth. Since the US economy during the 1920s was largely driven by manufacturing and construction, declining consumer demand would have a substantial adverse effect on industrial output. Consumer and investment demand had fallen because of rising unemployment. Hence, as consumer and investment demand fell, so did industrial output. As output and economic growth slowed, unemployment rose and a feedback loop was created. Unaddressed and left to market forces, the feedback loop would be self-perpetuating, causing further declines in consumer demand, production, employment and wealth.

The Keynesian supporters further argued that the key to addressing the Great Depression crisis was to stimulate consumer demand. By increasing consumer expenditure and creating the conditions for consumers to spend their income on output, economic growth would improve. As economic growth and industrial production increased, so too would employment. In the demand-driven world, the economic boom–bust cycle would require governments to intervene to smooth out the highs and lows to ensure economic stability.

The Keynesian theorists placed great emphasis on the Wall Street crash for generating the initial decline in US economic output. Black Tuesday, as it had been described, caused much panic and contributed to heavy financial losses for investors. The panic that began on Wall Street soon spread quickly through financial, credit, and commodity markets. The US government did not react initially to the Crash on Wall Street. Nor did policymakers attempt to address the uncertainty and market volatility on the New York Stock Exchange.

The delay from government and policymakers was later compounded by anti-speculation measures that were adopted by the US Federal Reserve. The famous monetarist and supply-side economist Milton Friedman stressed the importance of the policy failure and restrictive monetary policy stance of the US Federal Reserve during the Great Depression.4 The current Chairman of the US Federal Reserve, Ben Bernanke, writing in 1983, also commented on the apparent failures of governments to deal adequately with the Great Depression between 1930 and 1933.5 According to Bernanke, the Wall Street Crash in 1929 was simultaneously associated with large bank failures in the US financial sector.6 The simultaneous occurrence of these events led to another adverse condition, namely the deterioration in the macroeconomic environment in the US economy.

All of these compounding developments led to an alternative theory that was put forward to explain the causes of the Great Depression, commonly called monetary, or supply-side, economics. The monetarists believed that the significant decline in the money supply in the United States in the late 1920s and early 1930s contributed to the Depression crisis in the United States as well as elsewhere. The decline in the money supply was a direct consequence of the large bank failures in the US between 1930 and 1933. As banks went under, so did depositors, who lost all of their bank deposits, and bank shareholders, whose capital was worthless. This led, in turn, to a feedback loop, with lower liquidity and bank lending, which exacerbated the economic downturn at the height of the Great Depression. The failure of thousands of financial institutions and banks in the US during the 1930s was a unique feature of the Great Depression. According to Bernanke, the number of commercial banks that were left operating by 1933 was only about half of those operating in 1929.7 The banks that had survived the collapse continued to suffer heavy losses, with some barely remaining financially viable.8

The causes for the bank collapses in the US in the 1930s were not entirely clear. Some banks were marginally viable and so, with the macroeconomic environment deteriorating, it was inevitable they would collapse. Bank collapses had begun to occur with a number of smaller rural banks in the 1920s as the agricultural sector started to contract sharply.9 With the deterioration in the macroeconomic environment in the US, depositors with major commercial banks panicked and began to withdraw their deposits at an alarming rate, causing a run on the banks. According to Bernanke, the banking crisis in the early 1930s differed from previous banking crises both in “magnitude and in the degree of danger posed by the phenomenon of runs.”10

Bernanke provides a detailed chronology of the banking crisis that occurred between 1921 and 1936.11 The banking crisis in the interwar years had its origins in Eastern Europe and the Baltic states in the 1920s. Banks began to fail in Sweden, The Netherlands, Denmark and Norway.12 This was quickly followed by other bank failures in Austria, Spain, Poland, Japan and Germany between 1923 and 1930. The first large reported bank failure in the United States was the Bank of the United States in December 1930.13 Further bank runs were recorded for Italy, Argentina, Poland, Hungary and Germany.

Most damaging for the United States was a series of runs on regional banks, which culminated in over 1,800 banks failing across the Midwest and West Coast of the United States.14 The panic runs by depositors continued in the United States with a series of bank failures in Chicago in 1932, as well as other bank collapses along the East Coast of the United States.15 The damaging runs on banks and other financial institutions created an environment of insecurity and fear that continued to undermine the health and wellbeing of the US and global financial system.

The second key feature of the Great Depression was the high bankruptcy rates among farmers, small- to medium-sized businesses, and households.16 Households had large debts, driven largely by sizeable residential mortgages that were used to purchase the family home. Households had also become indebted with the growth of the consumer instalment debt that was another important feature of the financial and banking crisis of the 1930s.17 The rise of small business debt was also occurring during the lead-up to the Great Depression. The increase in leverage for households, farmers and small- to medium-sized businesses introduced a new dimension and level of vulnerability to the strength of the US and European economies.

With the deterioration in the macroeconomic environment that had begun in the US and Germany, consumers and businesses that had fuelled the debt-driven boom in the 1920s were now vulnerable to any large-scale economic downturn. With unemployment rising and economic growth and industrial production dramatically falling, consumers could not spend their way out of the crisis. Instead, consumption and business investment fell, which, as Keynes pointed out in his landmark thesis, was a key ingredient in prolonging the Great Depression.18

A third key element of the Great Depression was the simultaneous weakening of the US economy. The Wall Street Crash of 1929, along with the household and business debt crisis and the banking crisis, which...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Preface
• List of Acts and Cases
• List of Abbreviations
• About the Author
• Introduction: Timeline of the Crisis
• 1 Previous Crises
• 2 Triggers of the Crisis
• 3 The Crisis Goes Global
• 4 Financial Markets and the GFC
• 5 Rescue Packages and Policy Responses
• 6 Inquiries and Proposals for Reform
• 7 New Financial Markets Regulation
• 8 The Way Forward
• Bibliography
• Index