Communism, the United States was confident that economic liberalizing and the proliferation of computer and communications technologies would contribute to ever-increasing global economic growth and prosperity. Globalization contributed to the extraordinary accumulation of wealth by a relatively few individuals and created greater inequality. In an effort to reduce inequality in the United States, the government implemented policies that engendered the financial crisis. As we discussed in Chapter 1, finance is usually the leading force in the growth of globalization.
The rise of great powers is inextricably linked to access to investments ND their ability to function as leading financial centers, as we saw in Chapter 2. Their decline is also closely linked to financial problems. Finance enables entrepreneurs to start various enterprises and to become competitors of established companies. It is also essential to innovation and scientific discoveries. Finance also facilitates risk sharing and provides insurance for risk takers. Countries that have large financial sectors tend to grow faster, their inhabitants are generally richer, and there are more opportunities.
Financial globalization contributed to the unprecedented growth and prosperity around the world. China and India became gallants economic powers, Ana ten Institutionalizes countries grew even realer. L Closely integrated into the financial system are banks and investment firms. When the financial system is in crisis, banks reduce lending, companies often face bankruptcy, and unemployment rises. Ultimately, as we saw in the financial crisis of 2008-2009, many banks fail. The financial crisis triggered a global economic recession that resulted in more than $4. Trillion in losses, unemployment rates that climbed to more than 10 percent in the United States and higher elsewhere, and increased poverty. Stock markets around the world crashed. American investors lost roughly 40 percent of the value of their savings. Housing prices plummeted from their record highs in 2006. Consumers reduced their spending, manufacturing declined, global trade diminished, and countries adopted protectionist measures, many turning their attention inward to focus on problems caused by the financial crisis.
Given the central importance of finance to virtually all aspects of globalization, issues such as trade, the environment, crime, disease, inequality, migration, ethnic conflicts, human rights, and promoting democracy are affected. Furthermore, the financial crisis weakened some countries more than others, thereby engendering significant shifts of power among countries, especially between the United States and China. The European Union struggled over how much to shore up or bail out banks and nations using the Euro currency.
The financial, economic, social, and political fallout continue. Citizens took to the streets in a protest movement against financial finance J The major catalyst in the growth of globalization and national power MOM PAYPHONE 04 SE CO. Tend 139 140 inequality that began in New York City as "Occupy Wall Street" and spread around he world. This chapter examines the causes of the financial crisis, its impact, and responses to it. It concludes with a case study of the decline of the Celtic Tiger (Ireland).
Causes of the Global Flanagan Crawls The causes of financial crises are as complex as many of the crises themselves and the human beings responsible for them. There have been at least sixty recorded crises since the early seventeenth century. Human beings seem to have always been obsessed with money, and greed drives them to obtain increasing amounts of it. And humans generally spend more than they have, thereby creating huge debts that undermine the stability of the financial system. As early as 33 a. D. , Emperor Tuberous AT Rome Ana to Inject puddle Tunas Into ten Atlanta system to prevent It Trot collapsing. Euphoria and excessive optimism, which often accompany financial bubbles, are usually followed by fear and panic when crisis arrives. Generally, people claim to not know how the crisis happened or that they could not see it coming. The Asian Financial Crisis in 1997 was a precursor to the financial crisis of 2008-2009. It started in Indonesia and spread to Malaysia, South Korea, other parts of Asia, and the rest of the world. Once-prosperous economies were now in deep recession, with stock markets crashing and capital flowing out of the various countries at unprecedented rates.
The Asian crisis was largely caused by "hasty and imprudent financial liberalizing, almost always under foreign pressure, allowing free international flows of short-term capital without adequate attention to the potentially potent downside of such globalization. "3 But the Asian crisis was part of larger global developments, many of which were driven by the United States. The end of the Cold War left America standing as the world's sole superpower with unprecedented power ND unlimited options, or so it seemed.
Affected by hubris, and made overly confident by the exponential growth of computer and telecommunications technologies, the United States believed, in the words of Thomas Paine, that it could build a brand-new world characterized by unlimited success. However, terrorist attacks on September 1 1, 2001 , fundamentally altered America's sense of security and plunged the country into a recession. An integral component of the struggle against terrorism was the restoration of domestic and global confidence in America's economic system in general and its financial system in particular.
President George W. Bush launched a war against terrorism. To accomplish this, the U. S. Defense budget was rapidly increased, a department of Homeland Security was created, and two wars, one in Afghanistan and the other in Iraq, were launched. Furthermore, part of the new security strategy was a comprehensive globalization agenda, in which American companies operating in foreign countries would be free from restraints imposed by those countries. 4 This meant increasing government debt and encouraging consumers to spend even more to strengthen both the economy and national security.
With easy access to capital created by economic globalization, consumers and the U. S. Asian financial Crisis J Started in Indonesia, caused stock markets to crash, and reversed economic growth MOM PAYPHONE 04 SE CO. Tend 140 Causes of the Global Financial Crisis 141 government relied on other people's money. In addition to concentrating on fighting a perpetual war against onstage actors, an atmosphere was created in which sequestering was Electorates Ana taking excessive Atlanta rolls Ana getting roll quickly were lauded. From John C. Boggles perspective, at the root of the problem was a societal change.
America valued form over substance, prestige over virtue, money over achievement, charisma over character, and the ephemeral over the enduring. 5 While it is almost impossible to disentangle the causes of the global financial crisis, we will concentrate on those that are most often discussed. They include (1) deregulation of financial markets; (2) sophisticated financial innovations linked to rapid changes in computer technologies; (3) excessive executive compensation; (4) low interest rates; (5) supreme loans, especially for mortgages; and (6) speculation in general, with an emphasis on speculation in housing. Regulation of financial Markets Just as the current financial crisis has engendered demands for reforms, the Great Depression of the sass led to the implementation of financial regulations to stabilize the economy and to give American savers confidence in banks. Banks were widely perceived as boring but safe. Although interest rates were low, inflation was also low. Furthermore, deposits were protected by the Federal Deposit Insurance Corporation (FIDE).
An outgrowth of the Great Depression, rising inflation, which also occurred following rapid and dramatic increases in oil prices in 1973-1974, contributed to the rosin of confidence in regulations designed during the Great Depression. Rising inflation in the United States prompted foreigners to lose confidence in the U. S. Dollar as the leading currency and to seek security by purchasing gold. In response, President Richard Nixon unlinked the dollar from gold and adopted a regimen of floating interest rates. This created greater volatility in the financial system as well as increased opportunities to earn higher interest rates. Significant societal changes and developments in technology combined to serve as a catalyst to propel deregulation. Although large banks and financial institutions initiated efforts to eliminate or modify regulations that restrained them, individuals were also more assertive in gaining control over their savings pension funds and investments in the stock market. Between 1974 and 1980, many regulations were removed. For example, in 1980, commercial banks and savings and loans institutions were permitted to determine their own interest rates on deposits and loans, thereby spurring greater competition.
Many smaller banks were acquired by larger, more distant banks. The local bank was fast becoming an outdated institution. Just as financial globalization drives economic globalization, the rapid growth of trade was now facilitating global financial liberalizing. Globalization in general enabled American banks to argue that they were disadvantaged in competition with British, German, Japanese, and other foreign banks that were free of restrictions faced by American banks. Moreover, American banks adopted a global outlook that freed them from limiting their operations to the United States.
Many were moving their activities offshore to places such as the Cayman Islands, Bermuda, and the Bahamas. President Ronald Reagan, elected on a platform of limiting the role of government, pressured other countries to open their financial fiddle J Insures individual bank deposits for up to $250,000 deregulation Removed many government restrictions on Atlanta Institutions In the United States and other countries global financial liberalizing J Opening banks around the world to competition MOM PAYPHONE 04 SE CO. And 141 142 Glass-steal act of 1933 J Prohibited commercial banks from underwriting or marketing securities systems to American firms. Financial deregulation in the United States was now inseparable from the globalization of trade and financial services. However, impeding global competition in banking was the Glass-Steal Act of 1933, which prohibited commercial banks from underwriting or marketing securities. 8 The rapid growth of capital flows across national borders and the increasing power of investment bankers eventually led to the demise of the Glass-Steal Act in 1999.
The phenomenal proliferation of sophisticated computer technologies and an almost unquestioning faith in the wisdom of markets contributed to escalating demands for and acceptance of less regulation. In essence, federal agencies designed to regulate banking became less effective. There was a general loss of control at all levels, which led to exponential risk taking at many companies, largely hidden from public scrutiny. Violations of financial regulations went largely unpunished. 9 Simon Johnson argues that from the confluence of campaign finance, personal connections, and ideology flowed a river of deregulatory policies.
These included : 1. Insistence on free movement of capital across borders 2. The repeal of Depression-era regulations separating commercial and investment banking 3. Decreased regulatory enforcement y the Securities and Exchange Commission 4. Allowing banks to measure their own rockiness 5. Failure to update regulations to keep up with the tremendous pace of financial innovations financial Innovations As the global financial crisis unfolded, it was obvious that many of those in the banking and investment communities did not fully comprehend how the financial system they created functioned, or the scope and severity of the crisis.
The financial wizards, the best and the brightest from leading business schools, could not really explain what was happening on Wall Street and in global financial markets. Ironically, aka capital less expensive and more available, ultimately led to the global financial crisis. Financial innovations, with instantaneous global impacts due to technologies that made electronic transactions faster and less expensive, raced ahead of regulations. Complex financial products created in one financial center involved assets in another and were sold to investors in a third financial market.
As we saw in Chapter 1, governments are increasingly challenged to operate effectively in a globalizes world. Whereas governments are restrained by issues of sovereignty, global financial firms enjoy relatively greater flexibility. Furthermore, many different agencies in the United States have regulatory authority, a situation that creates confusion and ineffectiveness. 11 Among the numerous financial innovations that led to the global financial crisis were characterization and hedge funds.
Prior to the widespread use of characterization, banks, many of them local, provided loans to customers they often knew, and the banks were responsible for the risks involved in making loans. This meant that bankers gave loans only to financial I innovations J Sophisticated financial engineering, an outgrowth of revolutions in computer and telecommunications technologies MOM PAYPHONE 04 SE CO. Tend 142 143 individuals and companies they believed could repay the loans. With characterization, risks inherent in granting loans were passed from the bank giving the loans to others who had no direct interest in the customers' ability to repay the loans.
Supreme mortgages, student loans, car loans, and credit card debts were securities. Characterization is a sophisticated process of financial engineering that allows global investment to be spread out and separated into multiple income streams to reduce risk. 12 It involves bundling loans into securities and selling them to investors. In 009, an estimated $8. 7 trillion of assets globally were funded by characterization. 13 This innovation made vast sums of money available to borrowers. For example, characterization increased the amount of money available to individuals purchasing homes. This led to unprecedented growth in house prices.
It also resulted in high default rates and the housing crisis. As we will discuss, applicants for mortgages were not carefully examined and were encouraged to obtain supreme loans. Another financial innovation was credit derivatives, which were bets on the creditworthiness of a particular company, like insurance on a loan. There were two types of credit derivatives: credit default swaps and collateralized debt obligations. 14 Credit default swaps were widely used, especially by insurance companies such as the American International Group (GIG). Life insurance companies invested in credit adult swaps as assets .
Parties Involved In a cereal adult swap agree a Tanat one would pay the other if a particular borrower, a third party, could not repay its loans. Credit default swaps were used to transfer credit risks away from banks. A major problem with credit default swaps was the lack of transparency. They were also unregulated. Ultimately, credit default swaps created confusion and encouraged excessive risk taking. It was difficult to determine where the risk ended up. Designed to pass on risks, loans were packaged as securities. Collateralized debt obligations were linked to mortgage companies, which passed on the risk.
Mortgages, instead of being held by banks and mortgage companies, were sold to investors shortly after the loans closed, and investors packaged them as securities. Similar to characterization, hedge funds grew rapidly, accounting for more than $1. 3 trillion in assets globally before the financial crisis of 2008-2009. The name hedge funds implies investment funds with a particular sort of hedging strategy. Created by the Investment Company Act of 1940, hedge funds allowed wealthy investors to avoid many financial regulations, and hedge funds were early participants in financial globalization. 5 Essentially, hedge fund managers created portfolios reflecting an assessment of the performance of diverse global markets. As long as the number of participants was relatively small, hedge funds avoided great systemic risks. This changed with revolutions in computer technology that allowed split-second timing on huge illume of trades. An integral component of the hedge fund strategy is a technique known as arbitrage. This involves simultaneously buying at a lower price in one market and selling at a higher price in another market to make a profit on the spread between the two prices. 6 characterization J Financial engineering designed to reduce risk derivatives J Bets on the creditworthiness off particular company, like insurance on a loan credit default swaps J Financial innovation used to transfer credit risks away from banks collateralized debt obligations J Linked to mortgage companies edge funds J Enabled wealthy investors to avoid some financial regulations in global financial markets executive Compensation Excessive executive compensation is widely perceived as playing a pivotal role in creating the global financial crisis.
Wall Street became a magnet for the brightest arbitrage J Simultaneously buying ATA lower price in one market and selling at a higher price in another market to make a profit MOM PAYPHONE 04 SE CO. Tend 143 Americans who wanted to make a large amount of money very quickly. Most companies rewarded short-term performance without much regard for market monumental and long-term earnings. Executives were given stock options, which they could manipulate to earn more money. The more an executive could drive up his or her company's stock price or its earnings per share, the more money he or she would get.
Frank Partner argues that a mercenary culture developed among corporate executives. They merged with or acquired higher-growth companies and, in many cases, committed accounting fraud. 17 This fraud led to the bankruptcy of companies such as Enron, Global Crossing, and World. Many executives received long prison sentences. Low Interest rates A fundamental cause of the global financial crisis was the easy availability of too much money globally. An oversupply of money created unprecedented levels of liquidity and historically low interest rates.
As we mentioned earlier, the terrorist attacks on the United States on September 1 1, 2001, triggered a national embrace of increased government spending as well as consumer spending. To accomplish this, the U. S. Federal Reserve, led by Alan Greenshank, lowered interest rates to around 1 percent in late 2001. The European Central Bank and the Bank of Japan also reduced interest rates to record lows. The U. S. Government encouraged Americans to purchase homes and to refinance or borrow against the value of homes they owned.
As consumers and the government lived beyond their meaner, they were able to borrow from developing countries that were accumulating huge reserves from the phenomenal growth of global trade. Much of the surplus of money in the global system also came from declining investment in the Asian economies following the 1997 financial crisis. Rising oil prices in the Middle East, Russia, and elsewhere enabled many countries to earn more money than they could spend rationally. By the ND of 2008, central banks in emerging economies held $5 trillion in reserves. 18 The money supply increased rapidly in China, India, Russia, and the Persian Gulf states.
Whereas it was generally assumed that global monetary policies were set by central banks in the United States, Europe, and Japan, the reality was that three fifths of the world's money supply growth flowed from emerging economies. 19 Based on their experiences with financial problems, many developing countries decided to save for a rainy day, as it were. They believed that high oil prices or trade surpluses would not last forever. Many of these countries created sovereign wealth funds to recycle their financial surpluses. Alan Greenshank J Chairman of the U. S.
Federal Reserve who kept interest rates sovereign revenues supreme wealth loans funds J Created by countries to save and recycle surplus Another major cause of the financial crisis was the availability of supreme loans, which were directly an outgrowth of easy credit. Supreme loans generally refer to credit given to individuals who fail to meet rigorous standards usually expected by lending institutions. These individuals could not really afford their loans because of inadequate income and poor credit histories. In most cases, borrowers were not required to have a down payment. With excess liquidity globally, interest rates remained low.
People with weak financial histories are generally more vulnerable to supreme loans J High-risk credit given to individuals who fail to meet rigorous standards MOM PAYPHONE 04 SE CO. Tend 144 145 being charged higher interest rates. For example, poor people pay exorbitant rates for payday loans. A basic reality of finance is that yields on loans are inversely proportional to credit quality: the stronger the borrower, the lower the yield, and vice versa. 0 Driving the demand for supreme loans was the development of a culture of entitlement and a false egalitarianism that appealed to people's egos.
Home ownership was pushed by the U. S. Government as an inalienable right, despite borrowers' inability to repay loans. Fannies Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), both U. S. Government corporations, made more money available to lenders and borrowers by purchasing loans from the lenders and selling them to investors in the secondary markets. Huge amounts of money gravitated to supreme mortgages in the United States and Europe and, ultimately, to weak borrowers globally.
Given the complex interdependence that characterizes financial globalization, problems emanating from supreme loans in the United States rapidly spread around the world. Governments were largely unaware of the risks associated with new forms of financing and were unable to prevent the global financial crisis. 21 As the unprecedented sums of money flowed into commercial and residential real estate, housing prices escalated. For thirty years before the housing boom, the average American house appreciated at an average of 1. percent a year. This low return of prime loans discouraged homeowners from viewing their houses as cash machines.
Home equity lines of Creole were not available until recently. I nulls change aromatically rater 2 Appreciation rates climbed to 7. 6 percent between 2000 and 2006, reaching 1 1 percent before the market crashed between 2006 and 2007. Real estate prices in California, Arizona, Nevada, Florida, and other areas grew even faster. There was a wide variety of supreme mortgages. These included distributable mortgages, balloon mortgages, piggyback loans, and interest-only loans. An adjustable-rate mortgage is a long-term loan that does not have a fixed interest rate.
The interest can be changed, with low rates at the beginning and high rates at the end. It is also possible, but highly unlikely, that rates could decline. Adjustable-rate mortgages were attractive to homebuilders who moved frequently. They were less expensive, or so it seemed, than fixed-rate mortgages, which offered more protection. A variation of the adjustable-rate mortgage is a balloon mortgage. Under this arrangement, lower payments are made on a loan for five to ten years, with a final installment, or balloon moment, that is significantly larger than earlier payments.
Most borrowers could not afford to pay the balloon payment. The piggyback loan allows the homeowner to take out a second mortgage that is piggybacked onto the first mortgage. This is a high-risk loan because it clearly indicates that the borrower cannot afford the down payment to purchase real estate. 22 In an environment that encourages consumption over savings, easy credit fueled the housing crisis. Interestingly loans required borrowers to pay the interest on a loan without reducing the principal balance. This enabled eek borrowers to obtain larger loans. Annie Mae and Freddie Mac J U. S. Government corporations involved in real estate adjustable-rate mortgage J A long-term loan that has varying interest rates speculation.