Current Financial Crisis: a review of some of the consequences, policy actions and recent trends1
By Sameer Khatiwada and Emily McGirr, International Institute for Labour Studies2
What is happening?
On the heels of the near bankruptcy of a major insurance company and the effective end of all major US investment banks, financial markets around the world sustained severe losses in the first two weeks of October, 2008, accelerating the downward trend that started at the beginning of the year.
As a consequence, from New York to Moscow, and London to Sao Paulo, equity prices have fallen sharply – with the major stock indices of the G7 and BRICs losing nearly half of their value since the beginning of the year. This has seriously damaged banks’ balance sheets and restricted their lending capacity.
With the cost of short-term credit rising dramatically and liquidity drying up, these events have been dubbed the worst financial meltdown since the Great Depression in
1930s. More importantly, the shock waves from the US financial market have spread throughout the globe, with many countries on the brink of recession (see Figure 1,
Appendix).
How did a “house fire” in America turn into a global banking crisis?
Sub-prime mortgages are a financial innovation designed to provide home ownership opportunities to borrowers in the U.S. with a higher risk profile (such as borrowers with low incomes, bad credit histories or limited disposable income). Most of the sub-prime mortgages were given out on a variable interest-rate basis, with the risk of potentially large adjustments to monthly payments if interest rates rose. Instruments of this nature increase the probability of foreclosure.
Institutions (lenders) were “easy” with credit regarding these mortgages under the assumption that housing prices would continue to appreciate in value. Even if some of the sub-prime borrowers would default, an ever expanding housing market would still improve the lender’s overall position. However, money market rates increased, inciting foreclosures, as expected, but occurred at the same time the housing market and valuations cooled. This left the lending institutions with assets of significantly reduced, and in some case worthless, value.
And why did it spread out globally? Many of these sub-prime mortgages actually never made it on the balance sheets of the lending institutions that originated them.
Increasingly, these products had been bundled together with prime mortgages and a variety of assets to be sold on the market (so-called mortgage-backed securities, MBS).
The problem was that assets with different risk profiles were bundled together and nevertheless received a high investment grading, making them attractive to international investors, including European banks with free cash to go asset-shopping.
However, when sub-prime borrowers failed to repay their mortgages, the originating institution needed to finance the foreclosure with their own money, bringing the asset back on its balance sheet. This left many banks in a financially unviable situation, in a rather short, unmanageable timeframe. And, the fact that nobody knew how much more of those MBS would return on their balance sheets, banks effectively stopped lending to each other, drying up liquidity substantially, both in the US and in Europe.
1 The views expressed in this paper are solely those of the authors and do not necessarily reflect those of the
ILO or its member countries.
2 The authors would like to thank Ekkehard Ernst, Steven Tobin, and Raymond Torres for their invaluable comments. 2
What is being done to put out the fire?
The U.S. government has spent (or committed) more than a trillion dollars in trying to prevent the collapse of U.S. financial markets. Following the bailout of Bear Sterns,
AIG, Freddie Mac, and Fannie Mae, the U.S. Congress approved the Emergency
Economic Stabilization Act to give authority to the U.S. Treasury to buy troubled mortgages and mortgage-related securities. However, the original package (US$ 700 billion) has been revised to include a recapitalization of banks, federal guarantees on new bank debt for three years and FDIC insurance for non-interest bearing accounts. If the troubled assets (MBS) bought by the Treasury are later sold at a fair market value, this could ultimately be a profitable transaction for the U.S. government. And, if the
Treasury finds the right buyers for the banks that it partially owns, then it could also end up making money.
In Europe, the Bank of England pledged US$ 87 billion in direct support to the country’s major financial institutions. British Prime Minister Gordon Brown’s rescue package which involves direct capitalization and guarantee of inter-bank lending has been adopted by other major European countries and the U.S. government (as mirrored by the new revisions adopted by the U.S. Treasury). Furthermore, central banks around the world (Fed, ECB, Canada, Sweden, Switzerland, and China) introduced coordinated interest rate cuts to lower the cost of borrowing, with the aim of restoring confidence in the global economy.
Different views over how to fix the meltdown
A crucial issue with respect to the purchase of troubled assets is determining a relevant price. If the government pays too much, taxpayers stand to lose, but if the government offers too little, the financial institutions that are holding these assets will not sell them.
In addition, a repurchasing plan of this nature is time consuming and fails to provide the immediate capital infusion needed to save financial institutions.
Another criticism of this plan is that it has to raise the market value of all mortgage backed securities in order to be effective - but this will give a leg up to both stable and floundering banks, at considerable cost to the taxpayer. The 2008 Nobel Laureate in
Economics Paul Krugman has strongly criticized the U.S. Treasury’s Plan to buy up troubled assets, stating that, “the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.”
An alternative approach is a direct infusion of capital (equity injection) into troubled firms. Buying up shares would give the firms much needed capital quickly, while permitting governments to have a financial stake in those companies (AIG was an example of direct capitalization). As of Oct. 10, 2008, there seems to be a consensus that direct capitalization (partial nationalization) is the key to unfreezing of credit markets. The British Prime Minister’s rescue plan, which has received favourable reviews from notable economists, is the first to clearly spell out liquidity injection as a policy objective. Mirroring the British plan, the U.S. government recently announced an additional US$ 250 billion rescue package, which allows the government to take an equity stake (preferred stock) in the country’s major financial institutions.
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What are the short and long term consequences of the financial meltdown?
I. Global Trends
Slower global growth: Global growth stood at 5 percent in 2007, but the IMF expects world growth to slow to 3 percent in 2009 - 0.9 percentage points lower than forecasted in July 2008.
Economic contraction in some countries: In G7 countries except for the United States and Canada, GDP growth was slower in Q2 of 2008 compared to Q1 (see Figure 1,
Appendix). Three major European economies (Italy, France and Germany) experienced negative GDP growth in Q2, and forecasts are for a continued decline in Q3. The IMF forecasts around 0 percent growth for advanced economies in 2009, and the Federal
Reserve Bank of San Francisco said that the US economy will face a sharp slowdown in the final quarter of 2008 and a small contraction in the first quarter of 2009.
Depth of slowdown: Evidence suggests that economic slowdowns preceded by financial stress tend to be more severe, so in this respect, the impact of the current crisis could be even more significant than that predicted by the IMF. But although employment has contracted in several countries in recent months, it is important to note that recent employment losses have generally not paralleled the levels of job-shedding during the recessionary context of 1990-91 and have partly been triggered by energy price hikes unrelated to financial turmoil. While the bulk of the negative employment effects may still lie ahead, this could indicate that the current downturn may not be as severe.
Financing challenges for governments: If the crisis lingers on, state and local governments may begin to feel the pinch as they try to shore up new financing arrangements for their operations (recently the state of Massachusetts failed to raise the full amount of its tender offer and California is in a similarly difficult situation). There is some risk that governments may not be able to guarantee the stability of the financial system, as it has become clear in the case of Iceland, where the banking sector has assets of around 300% of GDP, something no government could ever guarantee, at least not on a short-term basis.
Rising unemployment: The IMF also predicts that unemployment in the advanced economies will rise from 5.7 percent in 2008 to 6.5 percent in 2009. While most G7 countries have lower rates of unemployment now compared to the 1990s (Figure 2,
Appendix), since the start of 2008 unemployment has been rising in all G7 countries except Germany.
Large employment losses in some sectors: As economic growth slows, some sectors, including construction and real estate services, are likely to experience disproportionate employment declines. Significant job losses in the financial sector of the industrialized nations are also likely. Since its employment peak in Dec. 2006, the U.S. financial industry has lost 172,000 jobs. In September 2008 alone, the U.S. lost 17,000 financial jobs, representing 10.6% of total employment losses that month. The financial sector employment in Europe exhibits similar downward trends.
Reduced world trade volume: According to the IMF, the forecast for world trade volume growth (in terms of goods and services) has been revised downwards by 1.9 percentage points to reach 4.1% in 2009, with a likely impact on labour markets in developing and emerging economies. A drop in exports, as well as capital inflow, may trigger a falloff in investments. Deceleration of growth and deteriorating financing conditions may trigger further business failures and possibly more banking emergencies – the result being that some countries may slip toward a balance of payment crisis.
Rising income insecurity and disproportionate impact on low-income groups: As stock markets around the world have eroded trillions of dollars in wealth and rolled back some of the investment gains of the past 5 years, the investment and retirement savings of many individuals have lost significant value. There is a risk that low-income
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countries and lower-income groups within countries will bear the brunt of challenges, as
“the most poor are the most defenseless,” says World Bank President Robert Zoellick.
II. The financial crisis is hitting at a time when income inequalities are already widening
There is evidence that financial globalization has reinforced the downward trend in the wage share recorded in most countries. In combination with rising unemployment and job losses, the fallout from the financial crisis may have long lasting effects on vulnerable groups, and so existing income inequalities could intensify.
The gains from the expansionary period which ended in 2007 benefited high-income groups more than their medium- and low-income counterparts (at least in more advanced countries), however the costs of the financial rescue packages will be borne by all.
The World of Work Report 2008 demonstrates that, prior to the financial crisis, there were already signs that observed trends in income inequality might not be sustainable; the crisis has underlined the limits to this growth model. This suggests a role for policy action to ensure that income inequality does not rise excessively.
Policy Actions
I. Overhaul of the financial system and effective public intervention
There are cross-border externalities to the financial rescue packages – capital injections by the US authorities would help alleviate the European financial crisis and vice versa.
Coordinated action will also help to stabilize developing markets and mitigate the risks of a global recession.
The current financial system is not sustainable and there is a need to strengthen capital and liquidity rules and improve prudential regulation. This includes the introduction of better disclosure requirements with closer supervision of the measurement and management of firm-wide risks, steps to increase the transparency and resilience of the financial structure and improvements in the assessment of systemic risks. As the ILO’s
World of Work Report 2008 argues, governments need to take into account the social impact of financial globalization while allowing financial institutions to benefit from the global capital markets. Having institutions and structures in place to ensure that a country is not vulnerable to sudden capital outflows is key.
Nevertheless, governments need to have a cautious approach to regulation because regulation is not a panacea. The policy requirement is neither complete financial deregulation nor overly stringent regulations -- it is instead a “middle-of-the-road” approach. A cautious approach to financial globalization is especially important in countries where financial markets are not sufficiently developed and where supervision mechanisms are weak. But in all countries, it is crucial to reinforce prudential regulation so as to reduce irresponsible risk-taking on the part of certain financial actors.
The size and scope of financial institutions not only transcends national boundaries but also goes beyond traditionally defined business lines. The speed at which shocks
(contagions) are transmitted across boundaries and business lines is mind numbing and as we see now, the potential impact of a bank failure on other institutions, markets and payment systems is severe. Harmonization of banking supervision and regulation is an important step in forging a multilateral solution to the financial crisis. Basel II has addressed some of the concerns related to capital requirements and risk management, but there is a need to improve the capacity to better absorb financial shocks, and, to avoid them in the first place.
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II. Address the global structural imbalance: large U.S. current account deficits funded by foreign countries The issue of structural imbalance lies at the heart of the current financial crisis, i.e. a burgeoning current account deficit in the U.S. funded by emerging and developing economies. In the face of relatively strong wage moderation (as the World of Work 2008 shows), it appears that workers and their families have become increasingly indebted in order to fund their housing investment decisions and, in many cases, even consumption decisions. This, in turn, has sustained domestic aggregate demand and economic growth. Financial innovations like sub-prime mortgages have made it possible to keep aggregate demand afloat. But the current financial crisis has underscored the limits to this growth model.
Even though the U.S. provides relatively low returns relative to comparable assets, gross capital flows to the U.S. totaled US$ 7.8 trillion over the five years from 2003 through 2007. Empirical evidence shows that countries with less developed financial markets tend to invest more in the U.S., and the strength of this relationship is inversely related to a country’s income per capita.3 A highly liquid and efficient U.S. financial system is the main reason why foreigners invest in the U.S. However, as the current financial crisis undermines the perceived advantage the U.S. enjoys, there may be serious adjustments to capital inflows, global imbalances, and asset prices.
Especially for capital-exporting emerging markets it is crucial to start thinking about ways to channel savings to profitable investments outside the U.S. or the U.K. and inside their own economies. Part of the surplus could be absorbed by public works projects like social security and infrastructure. On the spending side, this could remove some of the current obstacles to a more balanced growth such as infrastructure bottlenecks and lack of basic social insurance systems in many emerging economies
(such as old-age pensions, unemployment benefits, health care). On the financing side, deeper markets for public debt are actually one way of developing domestic financial markets and providing safe assets to risk-averse households and entrepreneurs.
III. Restore the confidence in financial globalization
Economic and financial pains tend to lead countries to pull back from globalization and openness. But history has shown us that international economic integration generally expands economic opportunities and is good for society. The great alternatives to economic integration failed,4 thus the choice is not between capitalism and noncapitalism; it is between good capitalism and bad capitalism, between inclusive capitalism and non-inclusive capitalism. The international economic system has ushered in unprecedented growth and prosperity in this world. It has helped countries to develop, alleviate poverty, improve social conditions, lengthen life expectancy, and carry out social and political reforms.
Global capitalism cannot survive without the help and support from governments around the world. The domestic politics of a country represent the prevalent public opinion within that country, and when public opinion shifts against openness towards trade and investment, global capitalism suffers. This financial meltdown is a reminder that international economic integration brings risks with riches and problems with prosperity. But, the history of the world economy illustrates that “economies work best
3 Forbes, Kristin J. “Why do foreigners invest in the United States?”, National Bureau of Economic
Research, Working Paper 13908, April 2008.
4 Frieden, Jeffry A., “Global Capitalism, Its Fall and Rise In The Twentieth Century,” W.W. Norton &
Company, Inc., New York, 2006
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when they are open to the world,” and “open economies work best when their governments address the sources of dissatisfaction with global capitalism.”5
Looking forward, the current financial meltdown is not an American problem, it is a global problem and it needs a global solution. Emerging and developing economies have benefited from financial globalization so the solution to the current crisis is not to shut doors to foreign capital, especially not as regards long-term foreign direct investment. Such in-flow of capital leads to productivity growth and transfer of technology, which are imperative for better labour market outcomes and economic development. IV. Ensure social protection to those most affected by the crisis
Income inequality in countries like the U.S. and the U.K, which are already high compared to that of other advanced economies, is likely to worsen. Therefore, it is important to ramp up social programs to provide assistance to the innocent victims of the crisis and to repair the damage done to pensions, retirement accounts, and the housing market.
As the global economy goes through a slowdown or recession, there will be a negative impact on employment growth, redistribution, and inequality reduction. Simultaneously, given the sustained increase in commodity prices, inflation risks remain higher especially in emerging and developing economies. Governments should use policy tools
(fiscal, monetary, social) to ensure that low-income households do not disproportionately bear the costs of the economic slowdown.
Finally, negative effects of financial crises on the labour market and distribution tend to persist well into the period of economic recovery, therefore, it is important that governments put in place appropriate social safety nets to help lower income households through the recovery period. In the face of these challenges, we have to remain devoted to providing opportunities for women and men to obtain decent and productive work in conditions of freedom, equity, security and human dignity. This is the essence of the
Decent Work Agenda which remains highly relevant, now more than ever.
5 Ibid
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Appendix: Recent Trends
G7 Countries
Some of the world’s leading advanced economies are contracting…
In all G7 countries except for the United States and Canada, GDP growth was slower in Q2 of 2008 compared to Q1. o The major European economies of France, Germany and Italy experienced declines in Q2, as did Japan (Figure 1); o Forecasts for Q3 predict continuing declines in a number of countries as witnessed by recent forecasts by the Federal Reserve Bank of San Francisco that the US economy will face a sharp slowdown in the final quarter of 2008 and a small contraction in the first quarter of 2009. Similar patterns are expected in other G7 countries.
Figure 1. Percentage change in GDP from previous quarter for G7 countries
-0.2
0.3
0.5
0.7
0.1
-0.5
-0.7
0.2
0.4
1.3
0.7
0.0
-0.3 -0.3
-1.0
-0.5
0.0
0.5
1.0
1.5
US Canada UK Italy France Germany Japan
2008 Q1 2008 Q2
SOURCE: Bureau of Economic Analysis, Canada Economic Accounts Quarterly and Eurostat.
…employment growth has turned negative and unemployment rates are rising.
Most G7 countries continue to have lower rates of unemployment compared to the
1990s. However, since the start of 2008, unemployment has been rising in all G7 economies except Germany. For example: o In August 2008, unemployment rates in the G7 ranged from a high of 8.0 per cent in France to a low of 4.1per cent in Japan (Figure 2); o In September, losses in non-farm payroll employment in the U.S. reached their highest level in 2008, with nearly 159 thousand jobs lost; o In the three months ending in August, the UK shed 122 thousand jobs and recorded the largest quarterly increase (0.5 percentage points) in the unemployment rate since the early 1990s; o In Japan in June and July, employment losses totaled over 800 thousand, with over 450 thousand lost in July alone.
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Figure 2. Unemployment rates in G7 countries, 1991 and August 2008*
8.9%
4.2%
8.5% 8.6%
10.3%
8.6%
2.1%
4.1%
5.7%
6.1% 6.1%
6.8%
7.2%
8.0%
0.0%
4.0%
8.0%
12.0%
France Germany Italy US Canada UK Japan
1991
2008
SOURCE: National Statistics
*Figure for Italy refers to July.
As economic growth slows, some sectors may experience disproportionate job losses.... Construction represents between 5 and 10 per cent of employment in most G7 countries; this sector is one of the first to feel the effects of an economic slowdown. o For example, construction has accounted for 44% of job losses in the US since the beginning of 2008, compared to approximately 6% as a share of employment. Similarly, job losses in financial services may be disproportionately large in the months ahead due to upheaval in financial markets. o In September 2008, for example, job losses in the US financial services sector constituted 10.6 per cent of total employment losses (but around 5 per cent of employment), Figure 3. Finance and construction as a share of total employment in selected
G7 countries, August 2008*
17.4%
5.6%
6.3%
5.4%
20.9%
7.4%
5.2%
6.9%
0%
5%
10%
15%
20%
25%
UK Germany US Canada
Financial Construction
SOURCE: National Statistics
*Figures are not directly comparable due to different industry classifications used by each country.
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…yet, as the G7 economies brace for recession, current employment declines have not yet matched the recession of 1990-91.
Although employment has contracted in many G7 countries in recent months, the magnitude is not yet as severe as the job losses of the early 1990s. For example: o In Canada, the loss of 60 thousand jobs to date in 2008 pales in comparison to the 770 thousand jobs that were shed between August and December of 1990; o In the nine month period from January-September 2008, 760 thousand jobs were lost in the United States compared to 924 thousand jobs between just
January and May, 1991; o Despite the recent significant loss of employment in the United Kingdom (122 thousand in the three months ending in August 2008) between January and
May 1991, 422 thousand jobs were lost; o Countries like Italy and Germany, where employment growth has remained positive so far in 2008, experienced losses of around 150 thousand jobs in the
Q1 and Q3, respectively, in 1991.
To this end, the full impact of the financial crisis on the labour market is not yet known. 10
BRIC Countries
The BRIC countries are relatively well-positioned to weather the financial crisis… The BRIC countries have been experiencing rapid GDP growth in recent years and employment gains continue to be realized. As large economies with trade surpluses and sizable foreign exchange reserves, the BRIC countries are to some extent well positioned to withstand external shocks and display resilience in the context of an economic slowdown. o For instance, so far, the financial crisis has not had a significant negative impact on India. The growth of the Indian economy over the past three years has been more than 9 per cent per annum – and although there are signs of a modest slowdown (current estimates stand at 7.9 per cent) – this is largely due to higher commodity prices, especially oil. Employment in India continues to grow at around 1 ¾ per cent.
…but the impact of the financial turmoil in G7 countries has global impacts. The impacts on financial markets in emerging economies are already clear, with some stock markets registering the largest declines in decades (e.g. Russia,
Brazil).
Developing countries are facing reduced export demand and access to trade credit as a result of the financial crisis – and this will indeed have an impact on the growth trajectory of the BRIC countries. o Exports figure prominently in China’s economy. China’s real export growth has slowed in response to the US deceleration, and so the trade surplus is expected to decrease. However, China has a large domestic market which can to some extent compensate as a driver of demand for the Chinese economy.
In addition to the financial crisis, BRIC countries are already feeling the strain of high food and fuel prices, which have raised inflation and standard living costs. o For example, the World of Work Report 2008 notes that in India, the redistribution effort through employment guarantee schemes and subsidized food has not been able to keep pace with escalating costs.