Financial Crisis

Public and private sector. Role of government (public money) in saving economies. Cases of selected countries.

Table of content:

1. What is a crisis?

2. Briefly about causes of financial crisis 2008

3. Public sector

4. Private sector

5. Government’s role

6. Selected countries cases

7. Sum up

8. Credits

what is crisis?

The term financial crisis is a situation in which the supply of money is outpaced by the demand for money. This means that liquidity is quickly evaporated because available money is withdrawn from banks, forcing banks either to sell other investments to make up for the shortfall or to collapse.¹

Types of financial crisis according to Asian Journal of Business and Management Sciences.

1. SPECULATIVE BUBBLES AND MARKET FAILURES

Valuation of assets in terms of true value has been an old concern in economics. Many individuals that have an interest in this issue wonder if there is a rational foundation for the current prices of : gold, land, shares, house or the value of money before an investment decision is made. Basic theory of finance based on the underlying market assumes that price of an asset is equal to the present value of its future cash flows. In principle, in an economy with a certain number of traders, assets must be valued on the basis of the fundamental values of the market.

Such conclusion cannot be sustained given that traders do not have the same information about real situation of companies, whose shares they trade. This refers to the short and long term plans of firms. Consequently, situation of this nature allows individuals that have insider information to speculate the stock prices. Therefore, the difference between market price and the basic money market of an asset is called bubble. In other words, bubbles refers to the prices movements that are based on unexplained fundamentals.

Speculative bubbles allude to a situation in which the price of securities or stocks rises above its real value. Such trend continues until potential investors believe that the prices are not linked with the market value. Until then, they usually buy shares because they believe the share prices will continue to rise to the extent that they execute profit when you decide to sell them out (Stiglitz, 1990). The presence of speculative bubbles increases the opportunity of the market failure given the investors commitment to buy shares while share prices rises consistently. If at some point, most trades decide to sell their shares at the same time, there will be no buyers in the market. As a result assumed market prices will fail, and the value of stocks and shares will go down drastically.

Some of the historical cases of speculative bubbles and market failures are : Dutch Tulip Bubble (1637), Mississippi Bubble (1719-17200), South Sea Bubble (1720), Bull Market (1924-1929), Japanese Economic Bubble (1984-1989) and The explosion of the internet bubble (2003).²

^{1 http://www.investopedia.com/terms/f/financial-crisis.asp}

^{2 http://www.ajbms.org/articlepdf/3ajbms20132122751.pdf}

2. BROAD ECONOMIC CRISES

Many times throughout history, economic crises with wider dimensions have sent a shock wave through different countries of the world. This has caused many large businesses, even those with international and transatlantic activity to suffer severe blow and failures as a result of the economic crisis with broader connotation (Rao the Naikwadi, 2009).

Crises with such proportions that affect individual countries or in block if they are under the single umbrella of economic union are called recession and depression by economists. Negative economic growth of the GDP for more than two consecutive quarters usually within a single economy is defined as recession. If economic growth continues with such negative rates for longer period is called depression. also experience increased unemployment rate in all of its economic sectors. On the other hand, economic stagnation is defined by economists as the situation when the pace of economic development slows down compared to the previous quarters although they are still positive. Some of the world know crisis with larger dimensions are the great depression of 1930s and the mortgage crisis (2008-2009) in the U.S.

3. BANKING CRISIS

Banking crisis is a financial crisis that affects the activity of banks in how they manage assets, liabilities and the equity in their possession. During crises, banks are exposed in so called phenomenon ''bank run'', which means that bank depositors suddenly rush to withdraw their savings and capital. The action comes due to the panic caused in the financial market because depositors believe that banks will soon go bankrupt, and as a result they may lose their capital accumulated over the years. Some of the examples of the runs are the case of the Bank of America in 1931 and of British bank Northern Rock in 2007.³

Financial Crisis 2008

In 2008 the world economy faced its most dangerous crisis since the Great Depression of the 1930s. The contagion, which began in 2007 when sky-high home prices in the United States finally turned decisively downward, spread quickly, first to the entire U.S. financial sector and then to financial markets overseas.

^{3 http://www.ajbms.org/articlepdf/3ajbms20132122751.pdf}

The casualties in the United States included a) the entire investment banking industry, b) the biggest insurance company, c) the two enterprises chartered by the government to facilitate mortgage lending, d) the largest mortgage lender, e) the largest savings and loan, and f) two of the largest commercial banks.

In 2001, the U.S. economy experienced a mild, short-lived recession. Although the economy nicely withstood terrorist attacks, the bust of the dotcom bubble, and accounting scandals, the fear of recession really preoccupied everybody's minds

To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy. Cheap money, once out of the bottle, always looks to be taken for a ride. It found easy prey in restless bankers - and even more restless borrowers who had no income, no job and no assets.

The Fed continued slashing interest rates, emboldened, perhaps, by continued low inflation despite lower interest rates. In June 2003, the Fed lowered interest rates to 1%, the lowest rate in 45 years. The whole financial market started resembling a candy shop where everything was selling at a huge discount and without any down payment.

But the bankers thought that it just wasn't enough to lend the candies lying on their shelves. They decided to repackage candy loans into collateralized debt obligations (CDOs) and pass on the debt to another candy shop. Hurrah! Soon a big secondary market for originating and distributing subprime loans developed. To make things merrier, in October 2004, the Securities Exchange Commission (SEC) relaxed the net capital requirement for five investment banks. which freed them to leverage up to 30-times or even 40-times their initial investment. Everybody was on a sugar high, feeling as if the cavities were never going to come.

The trouble started when the interest rates started rising and home ownership reached a saturation point. From June 30, 2004, onward, the Fed started raising rates. by 2004, U.S. homeownership had peaked at 70%; no one was interested in buying or eating more candy. new homes being affected, but many subprime borrowers now could not withstand the higher interest rates and they started defaulting on their loans.

This caused 2007 to start with bad news from multiple sources.⁴

^{4 http://www.britannica.com/EBchecked/topic/1484264/The-Financial-Crisis-of-2008-Year-In-Review-2008}

Every month, one subprime lender or another was filing for bankruptcy. Financial firms and hedge funds owned more than $1 trillion in securities backed by these now-failing subprime mortgages - enough to start a global financial tsunami if more subprime borrowers started defaulting.

It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the United States borders. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity problem. By that time, central banks and governments around the world had started coming together to prevent further financial catastrophe.

Central banks of several countries resorted to coordinated action to provide liquidity support to financial institutions. The idea was to put the interbank market back on its feet. The Fed started slashing the discount rate as well as the funds rate, but bad news continued to pour in from all sides.

Public Sector

On 15 October 2008 in The Guardian was printed interview with Andrew Simms- Policy director of New Economics Foundation. In the beginning of Financial Crisis he used such words to describe situation of public sector:

"Too many of us ended up believing in the reality of economic Narnia. Now it is left to the real economy of households, communities, natural resources and productive work to pick up the pieces.¹ "

Unfortunately he was right but let's start from the beginning.

INFLATION

The consequence of crisis which all of us could experience firsthand is inflation. The effects of the crisis on inflation expectations were largely temporary in the United States, but longer-lasting in the United Kingdom. That is surprising because the United Kingdom had a formal inflation target during this period. Expectations may have been affected more because inflation stayed above the central bank’s target for extended periods following the crisis.

HEALTH SERVICE

One of the most important to citizen part of public sector is health service. How we can suppose it also had problems during crisis. State didn't have enough funds to keep finance them. Because of inflation - prices of health services was going up, because of expanding public debt - a state stopped to finance this services. Citizens had to pay for more services that earlier.

TAXES

Tax is a key issue at any time, but during a financial crisis, when public finances suffer due to shrinking tax receipts caused by higher unemployment and lower company profits, it becomes even more important. The current financial crisis has seen tax issues climb higher and higher up the political agenda, from ‘tax havens’ to tax cuts and increases. In Poland VAT increased from 22% to 23%.

UNEMPLOYMENT²

It's not hard to believe that unemployment goes up very quickly and rapidly. 2,6 billions of people lost their job only in USA in 2008. From our point of view USA wasn't in so strange situation because unemployment went up to 7% but it was a record in USA. The White House is optimistic right now. In 5th anniversary of crisis government of USA published information that during last 3,5 years they created 7,5 million new workplaces but we know that it's still to less.

Very interesting situation was in European Union. In the large majority of countries, employment in the public sector grew up from 1999 to 2008 and total employment increased in the majority of EU countries between 2008 and mid-2010. ³This situation has two reasons. First, employment cuts in the public sector that were planned in a number of EU countries were not yet visible in data recorded by the national and European statistical authorities.

Secondly, and most importantly, job losses have so far been lower in the public than in the private sectors. feel affected by crisis is 53% of "private workers" and "only" 45% of people working in public sector

Private Sector

UNEMPLOYMENT

The labor market situation in private sector was destroyed by financial crisis. A lot of private companies went bankrupt. This firms which remained on the market had to fire a lot of employees. Citizens started to save money and demand decreased. People was poor and afraid od spending money. Private companies was most affected. Public institutions had some public money which they used to safe establishments. Private companies without customers had to collapsed. ⁴

SALARIES

The second possibility to save company was reduction of wages. Employees started to work longer for less money.

NEW BUSINESS AND SMALL COMPANIES⁵

Starting a new business in this period was also a big challenge. Everybody knows that at the very beginning companies need a big incomes. During crisis nobody can count on it. Because of the same reason big problems had small companies like housing estate shops. They need higher income from one shop than chain because of synergy effect. Their incomes was to small so they bankrupt.

LUXURY GOODS

It was the hardest time to companies which produced luxury goods. It's obvious that people start to save money from such stuff to have enough money for proverbial bread. We learn about it on economy classes- when incomes of people goes down - the demand on luxury goods decrease much faster in compare with necessary goods.

EDUCATION

Crisis wasn't forgiving even for students. A lot of private schools and universities stopped teaching, because they didn't have target which want to pay for education.

Governments role

There are five separate initiatives the authorities need to follow to contain the crisis, reverse some of its effects, and prevent it from happening again. National authorities are best positioned to respond quickly to contain the crisis, international initiatives are required to avoid repetition, and some combination of the two is best suited to reversing its effects.

National authorities can best contain the crisis through two measures.

First they must revive inter-bank markets by providing a temporary guarantee for short-term unsecured lending between regulated institutions. Central bank disintermediation of inter-bank markets is more costly and less sustainable.

Second, national authorities should also inject preference share capital to institutions that need it on condition of a partial swap of “old” debt for equity. Such involvement by government is best carried out at arm’s length – in Europe’s case, the European Investment Bank may be a good vehicle.

The third thing the authorities should do is to support a more immediate reversal of this process by facilitating the creation of long-term liquidity pools to purchase assets – rather like John Pierpont Morgan’s 1907 money trusts.

The result of this was the Dodd-Frank Wall Street Reform Act signed on March 15, 2010 and passed by the Senate on May 20.

Dodd-Frank proposed eight areas of regulation. Here are the major parts of the Act.

Regulate Credit Cards, Loans and Mortgages

The CFPB regulates credit fees, including credit, debit, mortgage underwriting and bank fees. It protects homeowners in real estate transactions by requiring they understand risky mortgage loans. It also requires banks to verify borrower's income, credit history and job status

Oversee Wall Street

The Financial Stability Oversight Council looks out for risks that affect the entire financial industry. It also oversees non-bank financial firms like hedge funds. If any of these companies get too big, it can recommend they be regulated by the Federal Reserve, which can ask it to increase its reserve requirement.

Stop Banks from Gambling with Depositors' Money

Banks were given seven years to divest the funds. They can keep any funds if that are less than 3% of revenue. Banks have lobbied hard against the rule, delaying its implementation until at least 2013.

Regulate Risky Derivatives

Dodd-Frank required that the riskiest derivatives, like credit default swaps, be regulated by the Securities Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC). In this way, excessive risk-taking can be identified and brought to policy-makers' attention before a major crisis occurs.

Bring Hedge Funds Trades Into the Light

One of the causes of the 2008 financial crisis was that, since hedge funds and other financial advisers weren't regulated, no one knew what they were investing in or how much was at stake. To correct for that, Dodd-Frank says that hedge funds must register with the SEC and provide date about their trades and portfolios so the SEC can assess overall market risk. States are given more power to regulate investment advisers, since Dodd-Frank raises the asset threshold limit from $30 million to $100 mln.

Reform the Federal Reserve

The Government Accountability Office(GAO) was allowed to audit the Fed's emergency loans during the financial crisis. It can review future emergency loans, when needed. The Fed cannot make an emergency loan to a single entity.⁶

^{6 http://useconomy.about.com/od/criticalssues/p/Dodd-Frank-Wall-Street-Reform-Act.htm}

Selected countries cases

Iceland

Iceland truly is one of the most interesting cases among the countries that got seriously hit by financial crisis in 2008. Although as much as their beginnings could be compared to the others, the overall approach to the crisis was completely opposite of Europe and US strategy.

Starting from the very beginning, Iceland had three biggest banks: Kaupthing, Glitnir i Landsbankinn, which in 2008 had debt of 85 billion dollars with GDP 12 billion USD dollars. Unemployment increased three times up to approximately 9% and inflation during the crisis was 20%.

They didn’t save their banks: the theory was totally different. Iceland let their banks collapse and focused on finding out who abused his power and is responsible for all that. They went into bankruptcy soon after that pretty dramatically.

By August 2011, Iceland had graduated from its International Monetary Fund bailout programme with flying colors. The economy – having shrunk more than 10% in two years – bounced in 2011 and 2012, and will grow by about 1.9% this year. But that is not the whole story. Throughout the crisis, the Icelandic population has maintained the lowest risk of poverty or social exclusion in Europe. Unemployment, which briefly rose to 9.2%, has dropped back to 5.1%. Inflation is falling back to its target range, and house prices in Reykjavik are on the rise.

Greece

Reasons of crisis in Greece⁶:

1. Greece joined the euro zone too hastily. They should have control over their public finances, but how we'll see, they didn't. They published false statistics of debt.

2. After 2001 (year when Greece joined the euro zone) investors started to treat them like Germany- Greece could borrow as cheap as Germany. When the financial crisis began, investors was scared that Greece will not be solvent anymore and they increased interest costs. After that Greece was in the even worst position.

3. Greece has been spending beyond its means for 15 years. It owed in the beginning of 2011- 150% of its GDP, which in real terms means it owes one and a half times its country total output per annum.

4. Greece tolerated too high expenditures, e.g. state railway. Someone told that it would be cheaper for Greece to pay for taxi to everyone than for railway.

5. Finally - social advantages. Government has to pay too much for early retirement in some professions. In Greece teachers and public workers work are one of the least working in Europe.

As the effect of this situation Budget gap increased to 150% of GDP and Inflation went up to 10,3%. When we look at this rates together we’ll see that it was big recession.

Help for Greece

Greece had only two options to solve its financial problems.

First of all they needed economy to grow. However, the Greek economy was becoming less productive compared to other Eurozone countries.

The second option was introducing an austerity program by Greek government. They should spend less money while increasing taxes. This would reduce the size of the government deficit, meaning the government would have to borrow less.

To decrease the size of the Greek government budget, the government was forced to make many unpopular decisions. For instance, the retirement age was increased. They increased taxes to help pay its debt, but this solution did not work very well . In fact, the economy went into sharp decline producing even less revenue and higher costs.

This program did not solve the Greek government’s financial problems and caused Greek people protest in the streets. Greece still needed to borrow more money, but they could no longer afford these loans.

In May 2010, Greece was forced to accept a founding worth €110 billion ($145 billion) from the EU, the European Central Bank, and the International Monetary Fund (IMF). This money would help them to continue paying its bills for three years. In return for the money Greece was supposed to keep on its austerity program, make its economy more competitive and privatize many of the companies owned by the Greek government.

Unfortunately it did not help as much as expected. EU agreed to extend the repayment period, decrease the interest rates of loans and even commercial banks decided to decreased liabilities of Greece.

They are 3 possibilities to deal with situation of Greece:⁷

1. Exclude Greece from the Euro Zone

2. Avoid bankruptcy of Greece

3. Implement the assistance and reforms in the same time - but it has to be controlled by EU and IMF

The last option is continuing right now. As we can see on the graph below this policy works and Greek economy started to be out of the woods.

Greek Real GDP

Sum up

Financial crisis is the result of overvaluing an asset. Crisis from 2008 called Credit Crisis was partially caused by extremely risky investments made by quite a lot of people. This crisis has affected both the public and private sectors and effects was terrible. Citizens lost their jobs, opportunities and confidence in financial sector.

The approach to the crisis was different in Europe, US and Iceland. The island decided to let their banks go bankrupt in order to rebuilt their economy from the scratch when meanwhile the other countries focused on rescuing theirs. Greece went bankrupt as they consumed the borrowed money and not invest it what caused really difficult situation. For now Greece is a crucial country for Eurozone as their bankruptcy might cause failure of many other countries involved.

Right at the moment we are not done with financial crisis yet but as statistics shows we are doing much better and there is a light at the end of the tunnel. As for Eurozone, because America is facing now the biggest public debt in history that still has to be dealt with.

Credits

• Investopedia.com

• Youtube.com

• Wallstreetoasis.com

• Imf.org

• Hdr.undp.org

• Economist.com

• OECD publishing - OECD Economics Department Working Papers

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1. ^{http://www.theguardian.com/society/2008/oct/15/banking-crisis-public-services}↩

2. ^{http://blogs.telegraph.co.uk/finance/ianmcowie/100012147/public-sector-pensions-must-share-the-pain-of-this-global-financial-crisis/}↩

3. ^{http://library.fes.de/pdf-files/gurn/00389.pdf}↩

4. ^{http://www.tradeforum.org/The-Impact-of-the-Global-Financial-Crisis-on-Public-Private-Partnerships/}↩

5. ^{http://www.imf.org/external/np/exr/facts/privsec.htm}↩

6. ^{Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison Carmen M. Reinhart, Kenneth S. Rogoff, January 2008}↩

7. ^{http://www.economist.com/blogs/prospero/2013/10/quick-study-athanasia-chalari-sociology-greek-economic-crisis}↩