BUSINESS & FINANCIAL ENVIRONMENT
I.INTRODUCTION
The Global Financial Crisis: Causes and the credit crunch
The global financial system and the global economy are currently facing a crisis unique in its magnitude and the worst seen in 80 years. This crisis, which Alan Greenspan called it a “once-in-a-century credit tsunami,” born of a collapse deep inside the United States housing sector, quickly spread to financial markets all over the world, undermining the confidence of consumers and investors and showing that it is capable of impacting hard real economies everywhere.
Arguably, the starting point of this major world financial and economic turbulence, which led to the collapse of a number of venerable investment firms and banking giants on both sides of the Atlantic, was the collapse of the U.S subprime mortgage market; the underlying causes though, were the extended periods of substantially loose monetary policy mainly, but not only, in the US and the persistent global current account imbalances that interacted with the flaws in financial markets and instruments to generate the specific features of the crisis.
Throughout the crisis, governments and central banks all over the world have attempted to respond effectively in order to stabilize the financial system and provide a boost to their economies, by taking unprecedented steps in conducting monetary and fiscal policies. However, these efforts have born little progress so far and their outcomes have been contradictory.
Concentrating, firstly, on the role of monetary policy – and more generally central bank policies – this assignment will argue the effectiveness of the monetary policy instruments and the other “non-standard” measures taken by central banks, most notably the U.S Federal Reserve (Fed) and the European Central Bank (ECB), in order to mitigate the effects of the crisis on the economy. Secondly it will examine the key role that fiscal policy plays in stabilizing demand and output and then it will explain the reasons for the contradictory consequences of these policies. Finally
The crisis and the implementation of monetary policy
Monetary policy refers to a set of actions by which central banks determine the supply and availability of money, as well as the costs of borrowing (interest rates). The three main instruments of monetary policy are changing reserve requirements, changing the discount rate, and buying and selling government bonds (also called “open market operations”)[1].
In response to the financial crisis, key countries such as the United States, the United Kingdom and Switzerland initially pursued an expansionary monetary policy, cutting interest rates effectively to zero, while the euro area followed the same path, reducing interest rates to the level of just 1%, which is a historic low. However, with interest rates near zero, this traditional monetary policy has reached its limit. As a result, the United States, United Kingdom as well as Switzerland have resorted to some unconventional ways of conducting monetary policy, referred to as “quantitative easing”, to inject additional liquidity into their financial systems.
‘Quantitative easing’ refers to increasing the size of the central banks’ reserves by purchasing securities, traditionally longer-term, in large quantities. This puts upward pressure on their prices and downward pressure on their yield and attempts to stimulate investment in long-term securities. In addition, banks then have access to additional liquidity that can be used to extend new credit (Murray, 2009)[2]. These unprecedented policies have been mildly successful but by no means a complete success.
Meanwhile, to support financing conditions and credit flows above and beyond what could be achieved through interest rate cuts alone, non-standard measures were also adopted by ECB. These measures have ensured adequate provision of liquidity to the euro area banking system at favorable conditions, so as to support the provision of credit to households and firms and thereby contribute to the revival of the euro area economy[3].
The crisis and the implementation of fiscal policy
Fiscal policy has a major role to play in minimising the length and depth of the recession by reducing bankruptcies, foreclosures, and further asset-price drops and stabilizing demand and output. A large part of the debate on the fiscal policy response to the crisis has focused on discretionary fiscal policy action in the form of fiscal stimulus packages[4].
The International Monetary Fund (IMF) recommended that governments should adopt expansionary fiscal policies to curtail the crisis effects on output and employment and more precisely to pave the way for the recovery[5]. Based on lessons extracted from past crises, the IMF has explicitly argued in favour of a “timely, large, lasting, diversified, contingent, collective and sustainable” fiscal stimulus package (Spilimbergo et al., 2008) and has recommended a global stimulus package of 2% of world GDP (Lipsky, 2009).[6] The IMF recommended that measures of the fiscal package should include on the expenditure side investment spending and targeted transfer payments. On the revenue side, the recommended measures should include, among others temporary reductions in tax rates, tax rebates, reduction in unemployment insurance contributions and exemptions[7].
The fiscal packages vary significantly in terms of size and extent, composition, scope and timing of implementation. The United States have taken the lead in stressing the importance of fiscal stimulus in boosting aggregate demand, and have implemented one of the largest programs worldwide. A $787 billion package (about 6% of GDP) was agreed to in early 2009, and by comparison this was somewhat larger than Japan’s package of 4.5% of GDP but less than the Chinese plan. The US package included $507 billion of additional spending and $282 billion in tax cuts[8]. The extent to which the euro area fiscal response to the crisis has been shaped, one could argue that it was much more restrained. The European Commission proposed in November 2008 a European Economic Recovery Plan which called for EU members to contribute an amount of �200 billion or equal to 1.5% of their respective GDP in order to stimulate economic growth.
The outcomes and usefulness of the policies followed
Internationally, governments and central banks have responded to the financial crisis by introducing a number of substantive and inventive measures to deal with both liquidity and solvency problems. Central banks have aggressively cut interest rates to unprecedented levels to offset the increase in private sector risk premia and to strengthen aggregate demand, while governments have stimulated economic activity through fiscal policy. Despite the above efforts, credit conditions remained very tight, aggregate demand and employment in many countries remained weakened, adverse spillovers from the weakening economies to the economies that had appeared to be more robust have increased, and the debate about the effectiveness of the policy responses in addressing the impact of the crisis is rising[9].
The credit market dysfunction and lack of liquidity have prevented and severely limited monetary policy as a stabilizing tool. Key nations have had very little room to lower policy rates – the financial source of the crisis weakens the link between policy rates and banking lending, thus rending the traditional monetary transmission mechanism much less effective – and as a result they have implemented further “extraordinary” measures, such as quantitative or credit easing, to inject additional liquidity into their financial systems. However, even if the response to these “extraordinary” measures is rapid, their effectiveness to foster real growth remains unclear. Furthermore, they are often constrained by the availability of external assets or foreign-currency credit, the degree of monetization of the economy and the depth of the financial market[10].
Focusing in European Union, the strict Euro conditionalities and the asymmetric policy architecture � centralized monetary policy via the ECB and decentralized economic fiscal policy in the competence of the EU member states � are clearly coming in the way of the ability of the individual Euro nations to respond aggressively. Conventional responses out of such economic downturns like currency devaluations, slashing interest rates, increasing government expenditures etc., are all constrained by these restrictions. This has left them with ineffectual and crisis-exacerbating approaches like wage reductions and lay-offs to combat the downturn[11].
In regards to fiscal policy, fiscal stimulus has been an efficient measure to strengthen aggregate demand and ensure the stability of the financial system. However, overall, the fiscal packages have several shortcomings. In practice, the fiscal stimulus packages are of a small size and the modest size of their multiplier effect indicates that these are expected to have weak effects on output and employment in the majority of cases.[12]
For developing countries the effects of the fiscal stimulus packages are mixed across different geographical regions. Nonetheless, for the most part, their impact on the fiscal position of the governments and especially public debt levels are not above historical standards.
Effects on the Cyprus banking industry
The European emerging markets, like all emerging markets, have had far less policy space in terms of macroeconomic stimulus and little influence in discussions about financial market reforms. They have been essentially forced to tighten fiscal and monetary policy to demonstrate to world capital markets that there will be no defaults or inflation that would destroy asset value. The NMS have additional institutional constraints in that a number of the economies have committed to fixed exchange rates or currencies boards. Finally, a number of the emerging economies are under IMF programs, which have strict macroeconomic requirements to fulfill. The difference in the economic policy options available to advanced and emerging economies in the region has been stark.
Our analysis implies that if fiscal policy and monetary policy work together, they can make a significant contribution to preventing the economy from weakening further and falling into a vicious cycle of deep recession and deflation. However, in deciding whether to use fiscal policy, countries must also pay attention to the fiscal space available and to the credibility of the fiscal authorities. Some countries have financing constraints�either high borrowing costs or difficulties in financing deficits at any cost, while others are constrained by high levels of debt. In addition, it is important to emphasize that while fiscal and monetary policy can help support demand in the short run, these tools have limitations and should not be viewed as a substitute for dealing with financial sector issues.
The subprime mortgage financial crisis began in the US in 2006 and become a global financial crisis in July 2007. ….. which led to the collapse of a number of major banking corporations on both sides of the Atlantic, obliging the state to step in and foot colossal bills.
When considering what the repercussions of the present crisis will be on the real economy, economic history has shown that on the heels of every credit crisis comes a downturn in the real economy. Accordingly, under the current circumstances, we should expect a sharp slowdown and recession across the developed world as a whole. extended periods of excessively loose monetary policy in the US over the period 2002-04
During 2008 we have seen the collapse of venerable investment firms and banking giants, the dramatic decline in financial markets and a considerable reduction in profits in important industries, such as automobile and construction.
During 2009, banks will have to operate in an environment that presents significant challenges, such as a further slowdown in growth rates, the possibility of an increase in delayed payments on loans, and difficulties in the capital and money markets. The above have prompted, and certainly demand, that global organisations, governments and central banks take a coordinated series of actions to deal effectively with this crisis.
1.http://www.nbg.gr/wps/wcm/connect/9e7ffa004c159c529385b302ee3bed0a/Leading+Ahead+11_EN.pdf?MOD=
AJPERES&CACHEID=9e7ffa004c159c529385b302ee3bed0a
2.http://www.nbg.gr/wps/wcm/connect/60f9d8804d2a6fbaaaf4be7aabd1b76c/Leading+Ahead_12.pdf?MOD=
AJPERES&CACHEID=60f9d8804d2a6fbaaaf4be7aabd1b76c
I. INTRODUCTION
The Global Financial Crisis: Causes and the credit crunch
In an age of globalisation, the world financial system and economy are currently facing a crisis which can only be compared to the intensity of the Great Depression from 1929-1933. Alan Greenspan called it a “once-in-a-century credit tsunami,” born of a collapse deep inside the United States housing sector.[13]
The financial crisis began in the US in 2006 by the collapse of the subprime mortgage market and become a global financial crisis in July 2007. It has shaken the financial markets, undermined the confidence of consumers and investors. It has shown that it is capable of impacting hard real economies everywhere, as demonstrated by the recessions that are currently gaining a hold in the developed world.
On 16 September 2008, the Federal Reserve System (Fed) helped the largest U.S. insurance company (AIG) by injecting 85 billion US dollars in exchange for 79,9% of shareholders capital. An intervention on such a scale has never been attempted before.
In early October 2008, U.S. Congress approved a historic $700 billion financial-rescue package allowing the Treasury department to use its authority on five fronts:
- purchasing troubled mortgage-backed securities;
- buying mortgages, particularly from regional banks;
- insuring mortgage-backed securities and mortgages, ensuring banks and investors do not lose money if borrowers default;
- purchasing equity in a broad array of financial institutions; and
- helping delinquent borrowers stay in their homes.
According to some officials this was done with one simple goal in mind – to restore capital flows to the consumers and businesses that form the core of the U.S. economy.1
On 10 October 2008, Lehman Brothers, the fifth largest U.S. investment bank founded 158
years ago officially went bankrupt, while Merrill Lynch, founded 94 years ago, accepted the offer of the Bank of America and was bought for 50 billion USD which was almost a half of its 2007 market value.
MONETARY POLICY
Monetary policy can be defined broadly as any policy relating to the supply of money. Since the main agency concerned with the supply of money is the nation’s central bank, the Federal Reserve, monetary policy can also be defined in terms of the directives, policies, statements, and actions of the Federal Reserve, particularly those from its Board of Governors that have an effect on aggregate demand or national spending
http://fpc.state.gov/documents/organization/61469.pdf
The process by which the government, central bank, or monetary authority of a country controls
(i) the supply of money, (ii) availability of money, (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.
- expansionary policy
contractionary policy
Expansionary monetary policy is monetary policy that seeks to increase the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry. Neoclassical and Keynesian economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy affects real economic variables (aggregate output or income, employment). Both economic schools accept that monetary policy affects monetary variables (price levels, interest rates).
Monetary policy relies on a number of tools: monetary base, reserve requirements, discount window lending and interest rates.
FISCAL POLICY
� can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money
� The two main instruments of fiscal policy are government spending and taxation
Monetary policy refers to a set of actions by which central banks determine the supply and availability of money, as well as the costs of borrowing (interest rates). In the United States, the Federal Reserve is in charge of monetary policy. Central banks such as the Fed can use expansionary or contractionary policy tools to affect a nation’s money supply.
The three main instruments of monetary policy are changing reserve requirements, changing the discount rate, and buying and selling government bonds (also called “open market operations”). Reserve requirements refer to the minimum amount of customers’ deposits banks must hold in reserve instead of lending out. The discount rate is the interest rate that a central bank such as the Fed charges banks that must borrow reserves to meet the reserve requirements. Central banks can use these tools to expand or contract the money supply.
Expansionary policy increases the supply of money. If the Fed reduces reserve requirements, then banks can lend more of their deposits received. A reduction in the discount rate has similar effects, as a low rate spurs banks to hold fewer reserves because it costs less to borrow money to cover shortfalls.
Contractionary monetary policy reduces the supply of money. Central banks often take these actions to reduce inflation. Contractionary actions include increasing banks’ reserve requirements, which reduces the amount of money available for lending, and increasing the discount rate, which makes it more costly for banks to fall short of reserve requirements, leading them to engage in less lending. These actions raise interest rates, making borrowing more costly.
http://www.ehow.com/about_5118503_characteristics-expansionary-contractionary-monetary-policy.html
II. QUESTION 1
III. CONCLUSION – RECOMMENDATIONS
REFERENCES
[1] Reserve requirements refer to the minimum amount of customers’ deposits banks must hold in reserve instead of lending out. The discount rate is the interest rate that a central bank (such as the Fed and ECB) charges banks that must borrow reserves to meet the reserve requirements. Central banks can use these tools to expand or contract the money supply.
[2] http://www.rba.gov.au/econ-compet/2009/pdf/first-prize.pdf
[3]http://www.ecb.int/press/key/date/2010/html/sp100226.en.html
[4] http://ftp.iza.org/dp4310.pdf
[5] http://www.econ.utah.edu/activities/papers/2010_02.pdf
[6] http://www.econ.utah.edu/activities/papers/2010_02.pdf
[7] http://www.econ.utah.edu/activities/papers/2010_02.pdf
[8] http://www.unece.org/press/execsec/2009/jk_28April2009.htm