ECONOMIC CRISIS: WHAT NEXT?

By Vinay Narasimhan

Edited by Balakumar M

The global economy can interestingly be compared to a human body and countries to blood cells. When blood cells in one part of the body get affected, the infection rampantly spreads to other parts making the entire body frail. An antidote may not be strong enough to help the blood cells recover. A human body makes its own antibodies to fight such infections. It allows the weaker blood cells to die and forms new blood cells to fight the infection effectively.

In this paper, we would try to establish how this phenomenon applies to the global economy where, often the best possible way to revive an economy is to allow it to correct itself with least government intervention.

A downturn in the economies across the globe stems from a slowdown in GDP growth rate. Often inflation (or deflation) and liquidity shortage accompany the downturn as symptoms for bigger events. This leads to financial instability within the country which, in turn spreads to other economies due to globalization. This results in a financial crisis across the globe.

Since a banking system acts as the backbone to an economy, its stability greatly depends on the adopted banking practices. One of the many disguised threats to an economy is the use of fractional reserve banking system. In this system, when a person deposits a particular amount of money in the bank, it keeps a small portion as reserves and lends the rest. The money lent gets deposited in another bank and the cycle continues.

This cycle shows that only a small fraction of money is in the physical form as currency and the remaining is in the form of debts. Such low levels of liquidity become a critical factor for perpetual growth or collapse of an economy.

Some of the major events of economic downturn across the world for the past 25 years are as follows:

The Energy Crisis (2003 onwards)

In 2003, the oil prices had suddenly gone up from a historic price level of $25 to $30. By 2008, it touched $147, an increase of 390% in 5 years. This was majorly because of unrest in the middle-east, fall in the US dollar, the Israel- Lebanon conflict and hurricane Katrina. This shows how oil prices were impacted by events across various countries in the 2008 recession.

The Housing Bubble (2008)

The collapse of Lehman Brothers, a giant global financial services firm in September 2008 almost brought down the financial system of the entire world. The credit crunch that followed the fall of many such banks turned the already nasty downturn into the worst recession seen in the last 80 years. The crisis had multiple causes. The financiers, central bankers and regulators were to be blamed.

Some of the events and their impacts were:

  • The emergence of Government Sponsored Enterprise – Fannie Mae and Freddie Mac and the Community Reinvestment Act pressurized banks to provide risky loans.
  • Increased savings in Asia led to a fall in global interest rates.
  • European banks borrowed American money and invested in dodgy securities.
  • Due to low inflation and stable economy till mid 2000s risk appetite of American citizens had increased.
  • Huge loans were lent without proper credit checks.

Several of these mortgages were passed on to financial engineers who converted them into low-risk securities. Investors across the globe were attracted to these securities as they gave good returns. In 2008, the borrowers started to default on their payments which became a big threat to investors. This led to the burst of the housing bubble. This economic event had a huge impact on the global economy especially the emerging nations and the Euro-Zone, which are known to be highly correlated to the US economy.

The European Sovereign Debt Crisis (2009)

This is also referred to as the Eurozone crisis. In 1993, the European Union originated from The Maastricht treaty that brought together 27 European countries to reduce the trade barriers between them and boost economic growth across EU. European Central Bank was then formed a regulatory authority for all the banks in the Euro Zone. Banks from any country within EU could lend to each other. This led to an increase in fiscal spending. There was a rise in employment opportunities in this zone which in turn increased the cost of living and borrowings. This had a cyclic effect.

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Since the US and the Euro Zone are positively correlated to each other, crisis in the US had a huge impact on European countries. Greece, Ireland, Portugal, Iceland and Spain’s debt increased rapidly leading to huge fiscal deficits. There came a situation where banks from stable nations like Germany started implementing stringent policies. This led to a crisis across these nations which were interconnected to each other. As these countries had huge borrowings from each other, all the countries that lent the money were also affected by the crisis.

Fiscal prudence and spending cuts were imposed in these countries followingthe suit that Germany had started. There was a huge unexpected multiplier effect because of the fiscal cuts which led to fall in employment and prices across EU.

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The Arab Springs (2010)

The European financial crisis was contagious to economies beyond its geographic dimensions. The dissatisfaction amongst the people due to high inflation, unemployment and poor living conditions led to a revolt against the ruthless autocrats of the Arabian countries.

Europe is the major trade partner of the Arab countries. About 60-80% of the oil in this region is exported to Europe. Euro crisis also affected the tourism in the Arab region leading to a drop in money transfers. Flow of money through the banking sector also shrank drastically due to fall of the European Banking system.

The result of the Arab Spring had an impact on various countries due to huge rise in the oil prices from $91.58/barrel in December 2010 to $126/barrel in April 2011. This led to an increase in inflation across several developing and developed countries.

Russian Crisis (2014)

Crude oil exports constituted a major part of Russia’s economy. Although Russia benefitted from the surge in oil prices, it had to face a negative effect in 2014 when the economy crashed due to two major reasons:

  • Fall in the price of oil due to increase in production by the US
  • Sanctions against Russia due to its military intervention in Ukraine
    This shows a negative correlation between US and the Russian economy.Stability in one region leads to a slowdown in the other.

Chinese Economic Crisis (Present)

The global debt is expected to cross $200 trillion. Apart from countries like US, Japan and the Euro Zone nations, China has a major share in the global debt owing to its expansionary monetary policy. The total debt has increased to around 280% of its GDP. Real estate which contributed largely to the GDP has also slowed down, piling up the unsold properties to a record high. The bonds of Chinese corporates are nosediving and several huge real estate companies sought bailouts from the Central Bank. The Chinese Central Bank responded by cutting the Reserve Requirement Ratio and relaxing the monetary policy. This might have a catastrophic effect on the global economy as it involves huge investments and lending from banks across the world. There is a great possibility of China becoming the epicenter for the second global economic crisis.

From the above analysis, we can infer that a period of rapid economic growth is succeeded by a slowdown in the economy. This can be termed as a cyclical slowdown. An intervention with an unavoidable delay in implementation could aggravate the situation. In such a scenario, Milton Friedman’s free market economy with least intervention unarguably holds true. Hence, allowing the economies to correct themselves with least government intervention would be the best possible solution.

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