Paste your essay in here…Economic history unfolded before our eyes during the 2007/08 crisis. The Great Recession is the worst financial crisis, the deepest recession, and the weakest recovery since the 1930s to deliver the enormous economic impact on the global scale. Although uneven the economic shock experienced by major advanced economics ensured a worldwide consequence for the fallout.
The Great Recession experienced in the United Kingdom is the biggest financial crisis since the Second World War. In the decade following the crisis and the recession, it's not the only the initial scale but the persistence of its effects that has been most remarkable. While the economy has seen growth, its slow paced by historic standards. The UK economy has seen record lows in earnings growth, interest rates, productivity growth, public spending coupled with high public borrowing. This experience is common to many other economies around the world.
The extended turmoil has brought back old controversies to the forefront of how economies work, crisis behaviour and the path to inconsequential recovery from the crisis. The works of Keynes (later Keynesians) and Hayek were essential in much of the debate during and after the Great Depression. Their works(also later interpretations and developments) explained various causes and ways out of a crisis. For this reason, their theories are effective in understanding the not only the crisis but the contemporary global political economy.
Keynes, Keynesianism and the International Political Economy
John Maynard Keynes was the most prominent economist in the 1900s. His book “The General Theory of Employment, Interest, and Money” and his later publications were perhaps the most important economic breakthrough in the 20th century. His works shaped political thought and influenced policy to battle the Great Depression in the United States in the Roosevelt administration. However, the 1970s global economic condition, the unpredicted stagflation1 raised concerns on the Keynesian economic model. A retreat from Keynesianism began and continued into
1A situation in which the inflation rate is high, the economic growth rate is slow, and the unemployment remains steadily high.
It's a complex situation as policy to lower inflation may worsen unemployment, and the vice versa.
the 1980s. Eventually Keynesian fiscal policy, if not completely set aside and done with, was administered loosely at best. In the Bush and Obama administration the Keynesian school of economics saw its revival come decades later to counter the crisis of the 2008 housing bubble bust. Keynes theorised that during recessions, the public tendency is to refrain on spending(capital accumulation), resulting in more unemployment, which leads to lesser spending in the economy. Thus spiralling to economic decline. He contested the classical economic theory which proposed that free markets produce full employment. He argued that the demand determines the levels of economic activity. Therefore, reduced demand would lead to recession and high rates of unemployment. While liberal political systems emphasised on freedom of individual initiative in the economic arena, Keynes recognised the limits of the pure laissez-faire system. Hence recommended active intervention from the state in the market society, not only to manage the fairness but for the overall efficiency of the system.
Crisis behaviour is shaped by the willingness to maximise self-interest(narrowing competitive behaviour), take greater risks, circumventing the regulatory rationale, reasonless rationality and moral hazard. Profitability is congruent to Risk; an essential law governing the market societies desire to make ‘risky’ investments(as maybe rational and reasonable from the available information).
Keynes view on risk is better understood through his piece ‘Treatise on Money’ than the classic ‘General Theory’. It details the financial side of a business downturn. He assumes the initial status- quo is distorted due to expected future returns from present capital accumulation. He highlights ‘demand for money’ leads to decrease in the volume of inside money. Firms anticipate this and direct their revenue to the repayment of trade credit and of the bank loans. This prompts the banks to choose not to resend all these funds but instead improve their own coffers. In his theory, it's the decline of investment expectations and the resultant reduction of output prompts ‘deleveraging’. (Leijonhufvud 2009)
It's essential to note the distinction between Keynes and the Keynesians. Strange as it may be, even his contemporaries showed great difference from his own work. Much of the scholarship and understanding of this theories are actually interpretations and embellishments of what he theorised. We cannot know how Keynes’s thinking could have evolved in light of the modern world, although
the crux of ‘General Theory’2 in the 1930s was to utilise fiscal policy in the context of deep slip and deflation. He did not recommend that an easy monetary policy would be effective in sparking a healthy recovery those circumstances and advocated two key alterations in fiscal policy. First, government should not attempt to balance its budget as the revenue is falling; and the second, it should spend on large-scale public works programs.
Notions of Keynesianism continued to develop profoundly in the post war era. Bringing forth ideas such as the use of fiscal policy to fine tune the economy and influence the level of consumer spending. However, Keynes himself did not advocate such fine tuning. His context was reserved for deep slumps and not regular business cycles. His original version was a blunt instrument and not a precise tool for regulation. He is reported to have rejected the idea of using fiscal policy for boosting consumer spending through cash distribution or tax deductions for the population. Later interpretations further undermine the crux of Keynes own theory.
The Climb to Crisis
The US Senates Levin-Cobourn Report concluded the crisis to have been a result of “high risk, complex financial products; undisclosed conflict of interest(information asymmetry), the failure of regulators, the (lack of monitoring over) credit rating agencies and the market itself…”(Levin- Cobourn, 2011)
The process leading up to the American financial crisis has the dollar supported by foreign central banks exporting capitol to the USA. Federal Reserve policy of extremely low interest rates3 made credit easily available, furled by large inflows of foreign funds. This caused a boom in the real estate industry. Seizing the opportunity banks began to give our loans to potential home owners, increasing the demand, as a result the housing prices began to rise. The creation of financial instruments such as Mortgage Backed Securities(MBS) and Collateralised Debt Obligations(CDO) which derived their value from mortgage payments and housing prices, greatly increased. This
2 This work was developed in the background of the Great Depression, therefore not fully suitable for the 2008 crisis if following to the letter. He acknowledges that the economy is ‘a delicate machine, the workings of which we do not understand’. Therefore, he would perhaps have a different approach than the Keynesian School of Economics.
3 Lower interest rates encouraged borrowing. From 2000 to 2003, the Federal Reserve Lowered the federal funds rate rom 6.5% to 1%. Although this was done to soften the effects of the dot-com bubble of 2001, and to combat risk of delation. It became apparent that the credit was fuelling housing instead of business investments.
innovation enabled institutions and investors from around the world in invest in the United States housing market.
Leverage Dynamics; As the leverage increased all over the system, all parties acquiring credit also found themselves profiting. This further reinforced the process. While the risk increased the new instruments of securitisation and default swaps the risk was uncertain and unperceived by most. Even for those who predicted the risk did not anticipate its proximity. Further compelled by the profits and competition it was all but impossible to opt out of the process. It would only seem rational to join the wagon. Whoever does not will show subpar returns.
The American banks are thought to have risen their leverage significantly in the years leading up to the crash. Hedge funds and some European banks may have even more highly levered. The leverage ratios were in a range that would cause the bank to go insolvent with a loss of asset value by only a couple of percentage points.
In the face of profits, financial institutions, brokers and the public found themselves naturally driven to take greater risks. Banks further eased the access to credit to bring in sub-prime mortgages, this increased the demand and value for real estate prompting further investment in securitisation. As the reliable debtors assumed credit from banks for homeownership, the banks then turned to lend to more unreliable debtors, with the growing market value of the asset, the risk seemed low, as the demand meant the assets could be liquified. However, the rate defaulters were largely underestimated. As the subprime mortgages began to fail, the real-estate experienced a steep crash. Consequently the asset value was far lower than the mortgage of homeowners, prompting them to holdback from paying the creditors.
As a result of the new financial instruments the burden of the creditors had already been spread among hedge funds, investment bankers, foreign banks; into the shadow banking institutions. This was made possible due to the lack of regulation and supervision over credit rating agencies that promoted bundles of securitisation that carried high ratings but were packed with a large number of sub-prime mortgages. Credit rating agencies were compensated for rating debt securities by those issuing the security, who had an interest in displaying the most positive ratings. Observe the maximisation of self-interest in the sparsely regulated system. The credit rating agencies displayed hazardous morality in rating the bundles that were otherwise riskier than presented.
This financial turmoil induced herd mentality, an increase in money demand in anticipation or collapse. This increase in hoarding resulted in corresponding decline in commodity demand. (Stefan Homburg 2015) Many large institutions that indulged in the housing bubble did no t have a sufficient cushion to soak the losses they sustained in the aftermath of the bust. That is, these firms were highly leveraged4. They had insufficient capital to post as collateral for their borrowings to finance the investments.
‘Pump-Priming’ (?)
The $862 billion federal stimulus package enacted in the United States in 2009 marked the great comeback of Keynesian economic philosophy. As the financial quarter displayed historic lows in the global economies. The world quickly embraced Keynesian fiscal stimulus solutions as the economics went into a free fall. Policy makers showed renewed enthusiasm in the use of fiscal stimulus. (Roberts 2010)
Keynes viewed ‘Global Trade Imbalances’ and ‘Capital control’ in great importance. But in the years following the Keynesian retreat, the general perception in the West was that governments need not concern themselves about them. However, in 2010 the United States suggest possible plan to address global imbalances with target to current account surpluses as earlier proposed by Keynes. Similarly, the capital control which Keynes strongly advocated for which had taken the backseat during the 1970s and 1980s were revived. During 2009 and 2010 capitol controls once again came to be acceptable. Although with caution from institutions like IMF against overuse.
In the time following the crisis there were many prominent and vocal advocates of further fiscal stimulus. While most of the economies are under pressure to curb deficits and debts, questioning the efficacy. Does fiscal stimulus work? While the economic conditions on 2008-09 were similar to 1930s than any other time since then, was the world right to go back to Keynes? Moreover, the policymakers expectations from the fiscal stimulus in 2008-09 seemed greater than possible. In a rush to save the quickly failing economies around them, emergency stimulus was utilised. At best, it acted as a cushion to soften the downward economic spiral. 10 years since the outbreak of the crisis,
4 Having acquired high ratio of debt to equity.
it's evident that the few public work projects and consumer spending concentrate formula did not result in a sustained, robust recovery. Considering its lack strict of adherence to the Keynesian theory already meant it should not have been expected to put forth results otherwise.
Another pressing question is whether the countries experiencing weak recoveries or a relapse of the recession would be in the right to utilise further fiscal stimulus or delay deficit-cutting policy until the economies grow stronger. Not only have global economies experienced historic slow revival from the crash, these countries public debt burdens are a record high, almost equaling the GDP, as with the public debt of United States which in 2013 was 80% to 100% of GDP. Further, the long- term projections of growth rates are horrendous. Therefore, a prominent part of their problems is that not merely the current debt but further pressure to the same due to improper policy. While this deficit does not need to be eliminated immediately to sustain the economies, longterm credibly planing to bring public finances on to a sustainable track over the next several years. Perhaps backed with concrete actions, regulations, commitments and policy to negate the uncertainty and instils confidence among investors.
Hayek’s World View
Friedrich Hayek was an Austrian economist who was influential all through the 20th Century. His work was contemporary and critical of John Maynard Keynes. His work explored the role that prices playing in relevance to knowledge of the individuals, to illuminate the various decision about what to buy and what to produce in various economies. In the aftermath of the 2007-08 housing bubble bust, Hayek’s work has become necessary to understand the behaviour that resulted in the global catastrophe.
Probably his most significant idea was the notion of ‘Emergent Order’. He theorised that a natural order emerges in market societies trough the decision making of individual rather that being curated. How does our complex society work so smoothly? Why are the stores stalked full in healthy economies? It's the fact that prices send information to consumers and supplied about how to make things and how to buy things in the most effective way. This system creates an orderly structure that no one created or is in charge of, yet it works miraculously well.
‘The Road to Serfdom,' Hayek’s influential book finds virtue as people are starting to again wonder whether the Keynesian perspective is the right choice. He warned at the end of the World War II that
if governments got excessively involved in the economy, we were on the path to becoming fascists or communists.5 While he never published a critique of Keynes general theory, he had contrasting view of the world. Much like Keynes even Hayek has been attributed to proposals and ideas that they did not themselves put forward. He is in fact criticised for encouraged a global culture of greed and laissez-faire. Regardless, his work is much better at explaining how the Great Recession occurred even though it fails to propose a quick escape from it.6
Hayek, Causes of Crisis and The Great Recession
Hayek and the Austrian school of economics hold the supply side of the economy as key not the demand side as Keynes thought. To begin understanding how economies got into crisis in the first place, they held easy money policies, excessive credit growth and in current terms ‘bubbles’ or ‘mal-investments’ guilty (Carling, 2012). These are supply side interventions that would lead to a crisis and a slump of the worst order. A crisis based in the balance sheets of financial institutions, households, businesses or government. The slump post 2008 crisis and the weak recovery since can be attributed to balance sheet phenomena which is rooted in long series of easy money policy, rapid credit availability in major economies.
While the 1980s and 1990s are popularly attributed to liberal and new liberal market society and ideology. It's not entirely true. Many claim that they were and suggest the reason for the financial systems going off the track was due to the lack of regulation or trust in financial institutions to regulate themselves. This is untrue. As noted earlier, the policy leading up to the peaks of the housing bubble the financial industry is one of the most intruded industries in the world.
It's important to reemphasise the role of risk, perhaps Hayek would make a similar argument that economic freedom and a self-regulating market depends on profit and loss system. Profit encourages the willingness to take risk and the risk of loss encourages pragmatic investments. The global political economic trend from the 1980s consistently reduced most of the risk of loss for financial institutions, who proceeded to credit without caution. The banks were thought to be ‘too big to fail’. If a lender has little consequence of bad lending and is certain of returns, it's extremely
5 The essence of Hayek’s argument finds its foundation in freedom, he imagined ‘the state in which a man is not subject to coercion by the arbitrary will of another or others’(Hayek, 1960)
6 I wonder if there is ever an easy exit. Perhaps the price must be paid, the bitter pill swallowed.
likely they’ll make riskier moves. The knowledge that the government will swoop in to bail them out spared little incentive among large financial institutions to be selective and careful with their investments.
The banks behaved certainly exasperated the crisis and regulation was deficient. Hayek was not an anarchist, he didn’t believe in complete government absence in the business cycle or zero social welfare spending. He would have proposed the use of consistent and predictable regulations. But he would be critical of the emergency monetary policy utilised. He always argued the ideal government action s to promote freedom and prosperity by predictable framework of policy, stability, regulate under the rule of law and sustainable public finances. This is not to say the Hayek economies would be free of business cycle. Whatever the intention, he theorised that positive effects on the demand side would be upset by the harm done to the supple side. He saw that inevitable crashes as a small price paid for the free market. Therefore, he held policies would make the cycle worse.
Hayek’s conceptualisation of fundamentals are timeless. The insights he had during the mid 20th century are more relevant today as our economy becomes more complex. He would be in favour of austerity in the current environment, coupled with tax and expenditure reform and other policies to strengthen the growth potential of the economy. He and other scholars would not suggest a fast road out of trouble, considering the progress of the individual economies and the global economic scenario there is perhaps no fast road.
Conclusion
The essay outlines the economic school of thought of two prominent economists of the 20th century, John Maynard Keynes and Friedrich von Hayek, to understand the 2007-08 economic crisis, the response and the aftermath of the same. These economists hold contrasting positions at the core of their beliefs. While Keynesians theorised political intervention to manage the crisis and regulate the business cycle. Hayek and the Austrian school of economics center their work on the necessity of freedom. Freedom is not to be understood as merely a liberal democratic governance but that the government is limited in its policy towards the business cycle and works under pre- defined, predictable and unchangeable rules, whose role in the market society is to sustain the system in a predictable and secure manner.
In the past decade, it has become evident that although Keynesian fiscal stimulus garnered support and revival among many economies. It has not proven successful in resulting a strong and progressing economy. The essay discuses the nature of solutions, which much to the short sighted and urgent manner of policy enactment from the political leaders failed to fully understand the nature of the crisis and thus failed in providing a robust solution.
The essay discusses that the boom and the bust in a business cycle is natural. It's the market mechanism to weed away the system of the inefficient and obsolete actors. Although Keynesian thought may appear to have the solution, perhaps even Keynes would defer from that idea. The use of his fiscal stimulus has evidently been unsuitable. However, at the offset of the crisis and considering its sheer magnitude Keynes pump-priming was naturally always comes back but it's not a good growth promoter. While Keynesian and Hayek debate has been long standing. It's also clear that their original works are rather distorted over time. Perhaps, it would not be incorrect to think if present they would both demand a dispassionate analysis of the crisis and a solution thereof. It's highlighted throughout the essay that the regulation has a crucial role in ensuring the sellers of risk have the resource support their bets and further regulations should not be in the form of bailouts or instruments of monetary policy that negate the consequences of the free market society ensued on incompetent, morally disturbed actors as this further deepens the fall. It's not the polarity of either economic philosophies that we must depend on, rather a balanced solution from deeply questioning the current crisis through their fundamentals.