Introduction
The global economic recovery in the aftermath of the global credit crunch has been slow. In developed economies such as the United States, Japan, and European Union, new government policy measures have by far helped to stabilize the financial markets. However, weaknesses in these economies pose a risk to the recovery process of the world economy. In particular, the banking sectors in many developed economies are prone to multiple risks. The risks include a low rate of credit growth due to overall weaknesses in the global economy, financial distress in debt markets, slow growth in real estate markets, and continued de-leveraging from firms. In addition, the high levels of unemployment strains consumer demand, which further affects the financial system. Public finance is another financial sector affected by the global financial crisis. The widening fiscal deficits in public finance reflect declining government revenues. The fiscal stimulus measures, though beneficial in stimulating recovery, have contributed to an increase in public debt. Recently, some Euro zone countries such as Greece and Italy have requested bailout to meet budget deficits (Summers 2004, p. 121). Most governments are shifting from fiscal stimulus to fiscal austerity due to increasing budget deficits. However, this is likely to prolong the global recession. Additionally, the fiscal austerity proclaimed by governments of leading developed economies will adversely affect the gross domestic product (GDP) for 2011/2012 period.
The Scope of the Study
The 2007 financial crisis adversely affected the global economy. Currently, there are concerns over the high levels of unemployment, prolonged recession and a flawed financial system in the Euro-zone. Five main events define the global financial markets currently; increased fiscal austerity, debt de-leveraging characterized by limited spending and investments, declining prices of assets, reduced fiscal stimulus and deflationary pressures. This report explores these recent events in relation to the global financial crisis and the recovery process. In particular, this report will track the fiscal austerity in Euro-zone and the monetary stimulus measures in developed economies as primary approaches to promoting recovery.
Objectives of the Study
The objectives of this study will be:
- To investigate how the deflationary pressures affect a firm’s spending and investment
- To examine how fiscal austerity has affected investor confidence and job creation globally.
- To examine the connection between the limited fiscal stimulus and recession slowdown
Sources of Data/Methodology
The report will rely on primary and secondary research information. The primary data will consist of qualitative and quantitative data collected during the research process. It consists of information obtained from surveys and independent observers. The sources for this research will include the McKinsey Global Institute report, the World Bank development prospects and the IMF estimates.
Findings
Fiscal Austerity Measures
In response to the global financial crisis, most European countries undertook fiscal austerity plans and phased out the fiscal stimulus. According to the IMF (2007), the austerity measures are meant to keep the interest rates at a minimum, government securities are being sold out to banks, and other financial institutions (p. 96). However, the quick adoption of austerity policies raises many concerns with regard to slowing down the recovery, increasing the public debt as the GDP output decline and high unemployment rates. The austerity measures have led to associated sovereign debt risks, which have largely affected the global developed economies in many ways. The budget deficit in most developed economies has widened in the recent past, which points to a further increase in public debt in the future. Towards the end of 2010, the average budget deficits for developed economies rose to 10 % of the GDP raising the public debt to an average of more than 80% (Summers 2004, p. 119). However, the budget deficit is expected to decrease to less than 9% in 2011 following the reduced bailout spending to the financial sector in the US.
Exchange Rate Instability
The exchange rates involving the leading world currencies viz. the Japanese yen, the dollar and the Euro, experienced volatility in the 2010/2011 period. According to the UNCTAD (2010), volatility in the exchange rates of the leading world currencies arose from the sharp devaluation of the Euro and concerns about the sovereign debt in Euro-zone countries. Between January and June 2011, the Euro depreciated sharply against the US dollar and the Japanese yen by approximately 20%. However, the decline in the projected growth for the year 2011/2012 for the United States economy has reversed this foreign exchange trend. Aspects of exchange rate instability such as weakening exchange rates, global imbalances, and deflationary pressures are current issues facing the financial markets.
Important Financial Markets Events
Fiscal stimulus measures in the majority of the developed and developing economies were one of the approaches that governments undertook to combat the 2007 financial crisis. It arguably stabilized the world economy, prevented massive loss of jobs, and facilitated monetary expansion following the financial crisis in the United States. However, despite the global economy being largely fragile, the fiscal and monetary policies implemented became neglected. In 2010 and the first quarter of 2011, the global financial markets were in turmoil again. This arose due to distress in public indebtedness especially in Euro-zone. The rise in public indebtedness, in Southern European countries such as Greece, has led to concerns over a likely rise in debt-service burden, decline in investments, and rise interest rates.
Budget deficits and Public Indebtedness
In 2011, most developed economies continue to experience a rise in budget deficits. For 2011, the budget deficits indicate a decline by 1% of the GDP pegged on a projected growth of GDP, growth of the capital markets and adoption of the fiscal plans announced by governments. Secondly, from a conservative perspective, the average public debt especially in developed economies is projected to increase to an average of more than 100% of GDP in 2011-2013 (Kelter 2009, p.24). Although the increase in public debt and budget deficits are blamed on the fiscal stimulus measures, the crisis itself largely affected the public debt ratios. The greatest concern is whether the continued increase in public debt will create a debt distress, which will lead to a rise in interest rates of securities, and widen the public debt. The debt distress of this nature is currently experienced in many Euro-zone countries including Greece, Portugal, Spain, and Ireland because of the relatively limited tax capacity in these economies.
A debt distress occurs when agents, firms, individuals, or governments have a high level of indebtedness, which slows down investments and economic activity (Kelter 2009, p.22). It can also arise when the debt interest rates are high relative to the profits generated. Debt distress increases the cost of servicing the debt as firms become reluctant to spend or invest in the economy. Additionally, when debt interest is exceptionally high, firms or countries have a high likelihood to default servicing of the gross debt. The gross debt comprises of a combination of the private, government, and corporate debts in an economy. In Keynesian economics, deficit spending is justified because governments need to borrow from the public to reduce savings, and stimulate economic growth during recession. However, debt distress arises if the public debt is high and the private sector has debts.
Additionally, in the present crisis, the interest rates (both nominal and real interest rates) have remained low. At the same time, the public debt in the economies of United States, EU and Japan has kept on rising. Historically, no much evidence exists to support the events experienced in these economies except in Japan. In Japan, in the 1980s the public debt rose to 200% of the GDP characterized by deflation and low interest rates. However, in the United States, historically, the debt to GDP ratio bears no relationship with the interest rates. The IMF projections for of debt/GDP ratio indicate that the average cost of servicing the public debt lies below 2% of GDP except for countries such as Italy, Finland, and Greece (IMF 2007). For other developed countries, the cost of offsetting the public debt is projected to be nil or negative.
Weakening Currency Exchange Rates
A volatile currency exchange market is another problem facing the financial markets. According to Skidelsky (2003 p. 243), there are prospects of the dollar weakening relative to other leading world currencies such as the Euro. In Europe, this will negatively affect the recovery of economies of countries such as Greece, Ireland, and Spain, which are highly dependent on foreign income from exports. These countries have implemented fiscal austerity to stimulate domestic demand. Germany, whose economy is highly export-oriented, will also be affected by the instability of currency exchange rates. Emerging economies also feel the effects of the instability of the exchange rates of three main currencies: the Euro, the yen, and the US dollar.
The increase in investment and capital flows into emerging economies coupled by the weakening of the dollar has had a profound effect on emerging economies exchange rates. For instance, the value of the real of Brazil rose to about 10% in the last quarter of 2010 relative to the other currencies of the S. America trading bloc (Odell 2009, p. 165). The developing countries primarily employ two of strategies to intervene in the currency markets: adopting foreign capital controls and purchase of foreign exchange. These strategies help to manage the exchange rates, enhance the value of assets, and promote competitiveness in the domestic market. For instance, Thailand imposes a tax rate of 15% for foreign purchases of local public debt while this year Brazil tripled the tax rates on domestic debt purchases. This examples represent a trend of protectionist measures that will likely derail global economic recovery and affect the performance of the global financial markets.
Global Imbalances
Following the 2007 economic recession, each country implemented monetary and fiscal policies to protect its economy from external effects. The uncoordinated monetary policies have largely contributed to global imbalances, which has filtered into the financial markets. The external deficit of the US fell sharply from a pre-recession high of 6% to 2.7% in 2010 (Parsons 2009, p. 57). Other export-led economies such as Germany, Japan and China report a reduction in external surpluses. For instance, China reported a decline in surplus from a pre-recession high of 10% to 6% in 2010 (Minsky 2008, p. 106).
Additionally, these economies experienced a decline in savings and investments over the same period. In the US, the saving rate for households rose from 2% during recession to 5.9% in 2009 (Eichengreen, Hausmann, & Panizza, 2003, p. 11). However, the increase is largely attributed to the increase in the budget deficit. Additionally, the domestic demand in leading developed economies began rising to a high of 60-70%. In contrast, in China, the domestic consumption began rising steadily after the recession to about 40%. These differences highlight the global imbalances that arise from uncoordinated monetary and fiscal policies. Nevertheless, the global imbalances are fair compared to pre-recession global imbalances.
In general, currently, the international economy has many imbalances (Eichengreen, et al 2003, p. 13). These imbalances are caused by three factors; large deficits experienced by the US with high surpluses in emerging economies of China and Brazil; accumulation of US dollars in international financial markets of emerging economies such India, China and Brazil; and high expenditure and low saving rates in developed economies with the reverse trends in emerging economies. Additionally, because most economies use the US dollar, capital flow is from developed economies to emerging economies further increasing the global imbalances. The Keynes plan proposes coordination between the debtors and the creditors with regard to adjustment of the global imbalances (Gourinchas, & Rey 2005, p. 12). International balance is vital as it allows each economy to operate within the limits of its resources. Accordingly, these resources would be directed at projects that create employment opportunities and improve the standards of living of a country’s citizens (Gourinchas, & Rey 2005, p. 14).
Prolonged Low Inflation
In 2010-2011, inflation is projected to remain low overall (Rodrick 2006, p. 24). In developed economies, the price levels decreased (deflation) in the aftermath of the recession. However, the economic recovery has led to a low inflation in most developed economies. In other nations such as Japan, deflation is still high partly because of the low interest rates, increased government deficits and the high liquidity provided by central banks of developed nations. However, the liquidity provided by the central banks remains within the banking system, which affects credit growth. Most central banks plan to reduce liquidity to avoid inflation in developing and emerging economies. Inflationary pressures are influenced by supply and demand factors (Arestis, & Amlcom 2010, p. 331). Currently, the inflationary pressure has led to high fuel prices, rise in food prices, and the rise in demand for manufactured products, in most countries.
The Fiscal Stimulus Measures
The fiscal stimulus involves measures undertaken by governments as a stabilizing tool. The Euro zone, the US and Japan implemented a number of stimulus packages that contributed to the decline in fiscal balances for 2010-2011 period. According to Parsons (2009 p. 44), policy makers should consider two factors when implementing fiscal stimulus measures. Firstly, the impact of the fiscal policies on businesses and investments should be considered. Secondly, the effectiveness of the fiscal policies in stimulating economic growth should be the second consideration. In the aftermath of the recession, developed economies increased tax cuts and adopted restrictive monetary policies.
Indeed, uncertainty still exists regarding the effectiveness of the fiscal policies in stimulating economic growth during economic crises with various models proposed to explain the effectiveness of discretionary fiscal policies. The Neoclassical economic model favours flexible pricing to stimulate growth in output, a reduction in consumption and create employment opportunities (Arestis, & Amlcom 2010, p. 328). On the other hand, the Keynesian models indicate a rise in consumption, real wages, and expansion of net output. Additionally, the vector auto-regression (VAR) models seem to agree with the Keynesian model by proposing a rise in private consumption due to increased government spending. In general, the monetary reaction to fiscal stimulus is accommodative rather than negative.
Liquidity Actions by the Central Banks
In response to the financial turmoil, the Central banks of various countries implemented different strategies to increase liquidity of the financial markets. The diverse approaches undertaken reflect the variation of the impact of the turmoil in different regions. The approaches aimed at maintaining the money markets at a desirable level during the crisis. In the US, the central bank (Fed) increased the duration of discount borrowing from a single day, initially, to 90 days to ease pressure on the money markets (Minsky 2008, p. 116). The Swiss National Bank (SNB) adopted a six-month transaction period for purchases to discourage borrowing, while the Bank of England (BoE) extended the collateral requirement and increased the maturity period for auctioning of funds to three months.
Most central banks also extended the collateral required in regular market operations. Others adopted new credit facilities that required an expanded range of collateral targeting mortgage securities. The rationale was to increase liquidity in financial markets affected by the financial crisis. Another approach involved facilitation of collateral swaps between counterparties (Minsky 2008, p. 117). In the US and UK, the Term Securities Lending Facility (TSLF) and Special Liquid Scheme (SLS) facilitated the exchange of collateral for liquid government securities by counterparties respectively. Other central banks expanded the number of counterparties to allow for a wider use of collateral. Besides adopting new counterparties, the central banks undertook a coordinated rate reduction to enhance a sustained economic growth during the turmoil.
Conclusion
In the aftermath of the 2007 financial crisis, governments adopted various measures to protect the domestic economies from external influences. Among these approaches is stimulus package, which, however, resulted to an increase in budget deficits and public indebtedness, weaker exchange rates, global imbalances and prolonged low inflation encouraged fiscal austerity measures. Strengthened policy coordination between developed nations can achieve a sustained growth and eliminate the global imbalances in financial markets. Additionally, the a stronger fiscal policy that promotes government spending, provides incentives to investors and implements appropriate structural policies would reduce the budget deficits and public indebtedness. Maintaining a monetary policy that is accommodative is another approach through which the fiscal stimulus could prevent a rise in public indebtedness. However, for this to work, the fiscal stimulus should target sectors that can create jobs. Additionally, the stimulus should encourage structural change for a sustainable economic growth.
Another approach could be to reduce the exchange rate volatility. Euro areas, the US, Japan and emerging economies have experienced a damaging effect on their currencies. To avoid these effects, the Fed, the Bank of Japan, and the European Central Bank should reduce the high liquidity through fiscal and monetary policies. Hence, agreements or a coordinated timing and magnitude of liquidity easing policies are necessary to address the current global imbalances experienced. Additionally, this will help other emerging economies integrate well into the global financial system and prevent increased capital flows to emerging markets. Capital control is another approach developing countries can use to address their volatility. Additionally, effective capital controls can deter economies from accumulating large a mounts of foreign currency and help mitigate the global imbalances.
Reference List
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