CDOs were now filled with high-risk mortgages, regardless of their ratings. When homeowners began defaulting on their payments (an estimated $1.3trn in subprime mortgages were left outstanding in 2007) (Msnbc, 2007), it created a domino effect. Housing prices tanked (RealtyTrac reported 2,203,295 foreclosure filings by end-2007, up 75% from 2006) (RealtyTrac, 2008), sending the already fragile financial system into a free fall. Banks were stuck with mortgages and CDOs that institutions began shunning. Mortgage lenders could not sell mortgages to banks, institutions worldwide held CDOs that were junk and they in turn started defaulting on their dues payable to the general public’s investments (Jarvis, 2009). This led to a credit crunch that eventually took several reputed institutions into bankruptcy, with it came job losses and unemployment throwing the global economy into recession.
Discussion: Growing Capital mobility as a possible threat for crisis
The process of individual savings collectively leads to the process of Capital creation. This Capital is the reflective indicator of the financial health for the Nation. In order to overcome inflation and to earn interest on gathered capital it is better to use it as a source for investing. Investment of capital varies on many aspects such as preference of the investor, availability of investment opportunities, but more importantly on the risk weighted returns on the investment (Frankel, 1992). Some of the commonly used Investment strategies are based on the principle of diversification in different financial assets, markets and geographical locations. Lately in the new emerging global capitalistic world, investors use a wide variety of investment opportunities in different nations to diversify their risk and to average their return. This has led to high volumes in International investment and foreign currency denominated opportunities have become highly liquid. As a result, the desire for investors to procure more foreign assets reduced formal restrictions on international capital mobility over the decade before the crisis and was more noticeable in advanced markets than in developing economies. The growth in global financial linkages was followed with a rise in dispersal of current account balances and the magnitude of creditor and debtor’s position (Milesi-Ferreti, 2007). This led to the rapid rise of baking sectors in advanced economies and the banking integration was formed through cross border lending and operations by foreign affiliates, giving rise to regulatory arbitrage purpose and more complex portfolio models.
The global financial crisis which began in 2007 halted the constant growth in international financial integration over the previous decade. The retrenchment in international capital flows during the financial crisis in 2007 is greatly a heterogeneous occurrence: first across time, due to the Lehman Brothers’ collapse, second across types of flows,as banking flows were hit the hardest because of their sensitivity to risk perception, and third across globalized world, where emerging economies experienced a shorter span of retrenchment in compared to developed economies. Milesi-Ferreti (2007) forays that “The magnitude of the retrenchment in capital flows across countries is linked to the extent of international financial integration”
Growing International capital mobility has led to enhanced practise of Investment throughout the globe. It helps hedging for risk, optimize returns and also create economic liquidity. But this also have some serious limitations which supports economic crisis. Some of the limitations are discussed as below:
Spread of economic meltdown: When there is an economic crunch in any of the markets the international funds tends to move away from them creating a multipliers effect i.e. every possible down turn causes much more negative impact to the market. This implies the very factor that makes the capital market liquid affects adversely in the time of crisis. Essential feature of diminishing flows throughout the current financial crisis has been due to the shock of risk aversion, as confidence of investors reduced due to concerns in regard to the quality of financial assets and the solvency of major banks. Thus in a globalized world an impact of risk aversion for a specific country is subjected to the magnitude and nature of its transnational financial links, its macroeconomic environment, and its reliance on world trade (Milesi-Ferreti, 2007).
Concentration of economic power and arbitrage: Due to the a large amount of capital creation and foreign exchange reserves in some parts of the world, there exists a privilege to control the capital flow around the world and concentrate the process of wealth creation. Significant feature of globalization in relation to capital flows resulting in financial crisis is illustrated in developed economies value of both external assets and liabilities, as they rose considerably at a faster pace than the emerging markets (Lane and Milesi-Ferretti, 2007). This tendency was also supplemented with the growth in flows for regulatory arbitrage purposes through international financial centres large and small, by transacting substantial shares in cross border capital movements (Milesi-Ferreti, 2007). In adverse it had also led to regulators creating strict Foreign Direct Investment regulations as preventative measure to crisis.
Reckless Lending and Volatility: As discussed above capital if kept unutilised leading to a deprecated in value. This creates a pressure to invest surplus capital in order to achieve required returns on the capital. Now, the flow of international funds makes this very volatile as the money is pumped in different markets in times of growth and pulled back in times of crisis. Global capital flows progressively grew from 7% of world GDP in 1998 to over 20% in 2007, led significantly due to immense expansion of capital flows to and from advanced economies (Chinn and Hiro Ito, 2008). These flows simply faded away during the crisis period, showcasing huge repatriation in various economies across the globe. This was witnessed in the present crisis (2007) where property devaluation in US triggered a global crisis, which has been noted as one of the most expensive crisis in history.
The internet and websites can be considered as one of the most enthusiastic technological innovation in later 90’s and in the 21st century. Therefore this innovation can be considered as one of the major roots of financial crisis after seeing the effects of bursting of the Dot com bubble in 2001.
Dotcom bubble (2001)
With the internet boom in mid-90’s and the commercial entry and the growth of WWW (World Wide Web) and different kinds of web browsers a new transition or a trend has begun. With these technological innovations many internet based firms were developed with various kinds of business strategies with a policy of having growth over net profit and these companies had assumptions where they thought that having a large customer database will eventually will provide the profit’s they desire just like how it did for Amazon and Google. This enthuastic and excited stage in 90’s led to a stock market bubble where investors access their venture capital funds to start up .com’s to gain money through, big earnings in stock options. People started to imagine internet as the new global market place it was a new technology then and the fear of them being left behind made investors to spend even more. This process and the business model went on until they burned through their venture capital. Bubble started to burst in March 2000 when investors pulled out and businesses started to disappear overnight. At the same time this was happening coincidently major technology giants such as Cisco, IBM also made large multimillion sell orders which eventually bought NASDAQ index to its knees and to have their largest lost which they are yet to recover. The total amount of the crash caused a lost over 5 trillion dollars from 2000 to 2002 all because of a new information technology innovation. (, 2007)
Technological acceleration
As it is when the free market policy is aligned with technological innovation it almost seems like the two things cannot work along each other. A free market economy would require a viable labour market with enough jobs and proper incomes in order for them to have the necessary purchasing power to consume everything that the economy produces.
Today’s world as we can see the technological innovations are not just developing its accelerating at a rate where a large fraction of work done is completely replaced, performed by the use of machines. It is very ironic that people in western part of the world seems to think that they lose most of the jobs because it is being outsourced to China or India but the worse fact is that even people in Asian countries loose a vast amount of jobs due to automation at a very high rate. Another point is that even offshoring is done when the automation is impossible and on the other hand it is possible due to the technology innovations in communication and information. If it wasn’t for the technology it would not be possible to move and connect all the tech-support around the world to low wage countries such as India.
Effects of unemployment
Due to the reasons that were mentioned above we do have understanding that lot of jobs have being automated and the effects of it was well shown after the financial crisis in 2007 followed by the recession from 2008 to now ( Refer figure above). The higher unemployment rates eventually lead to a massive credit freeze up due to low income of people and the higher rates of demand for living. Health care prices have increase and in order for people to keep up with the standard of living they use up their credit cards and home equity loans thus contribute to the fall of credit lines. (Martin ford, 2009)
Impact of communication technologies
Electronic media can be considered as one of the major development of the innovation in communication technology. The electronic media itself could be categorized as one of the things which deepened the financial crisis. As we all know during the time of the crisis everyone was glued to the computers, TV’s and within seconds we were able to witness the sad faces of stock brokers on wall street and showing various other facts and figures showing how bad it is. Now this can be considered as one of the major difference between other centuries and the 21st century. Previous time’s if there was any sort of crisis it will take some time for the general public to actually hear the news and it may even take days and months before anybody can react to it. The time take to reach the people even if it is a bad news is very critical. This allows leaders and finance expertise more breathing space to analyse the problem thoroughly and create possible solutions. During the past finance crisis people knew it at that instance. People were able to watch how financial plans are made after debates between the political leaders. Due to this instant access to the information people are mentally always expecting instant gratification but unfortunately it is spread all around the internet from financial pundits that the recovery is going to be slow and long. (Susan Wilson, 2008)
Index trading technology
Index trading technology is an algorithmic trading system where they make use of computers to take the necessary decisions according to the information that they observe without any kind of human intervention. The current trading system in London stock exchange is capable of processing more the 1500 orders a second compared to the last system that which was capable processing 600 orders. From this fact we can understand that the technology innovation, replacement and involvement are accelerating at a very high pace. One of the problems which suspected for financial crisis is that it creates one way feedback loops which concentrates market momentum only in one direction which eventually causes a lot of trouble because no one else is willing to take the other side. Although there is major dark in the technology regulators keep maximizing trade with it due to transactional speed efficiency rather than looking at the true market efficiency. Therefore here the technology being efficient and productive ignores fact that it could be very destructive and it did contribute for the both financial crisis and “flash crash”. Flash crash can be considered as the spark that exploded the tinderbox of automated indexed markets which rapidly executed a 4.1$bn sale of stock index by the automated traders. This event caused $1000bn off the values of us shares for a period of several minutes. (Michael Mackenzie and Aline, 2010).
Conclusion: The intrusion of shadowy banking system clouding over traditional practices creating a massive surpluses of wealth being traded unnoticed or benefiting a certain few questions the ethical values of business. Free mobility of capital in the International markets in a more complex globalized world has astounded liberal thinkers, causing a reversal flow of money from the rich in developing economies to the safe havens of developed economies for security. Complex automated algorithmic functions being run by computers has been left unchecked, resulting in chaos and delaying the time interval for a human solution to the problem. These practices need to be changed since the global economy has not recovered completely from the ongoing financial crisis and steps have to be taken to prevent the ongoing recession. Market based banking needs to be strictly regulated by the government and new technologies need to be tested and monitored for a much extended period of time before putting into the real time scenario is our suggestion.
References
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