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Unit-5-Economic-and-financial-crisis.pdf
Global Society

1º Global Society

Grado en Global Studies

Facultad de Derecho
Universidad de Salamanca

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UNIT 5 – Economic and Financial Crisis.

The making of a crisis – Stiglitz.

 The only surprise about the economic crisis is that it came as a surprise to so many.
o A deregulated market with high level of liquidity and low interest rate.
o A global real state bubble
o A skyrocketing subprime lending
 Financial bubble  when it broke people realized they owed more of their mortgages than
the value of their houses. They lost their home, live saving and retirement, college
savings…
 America had been living a dream: the richest country in the world was living beyond its

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means and the strength of US economy and the world’s depended on it.
 Global economy needed an ever-increasing consumption to grow  but how to do that
when salaries are frozen for a long time? If workers don’t have money to buy,
consumption can’t grown
 The solution found  debt. Borrow money and consume as if their incomes were bigger.
 Average saving rates fell to zero  rich people had savings, poor people had debts.
 How did this mechanism introduce?
o Low interest rate and lax regulations
o Housing bubble through mortgage equity withdrawals  people borrowed money
to sustain their consume, and they could not pay the mortgage because the price
of their house got higher.
o 2/3 to ¾ of the GDP was housing related: this was unsustainable
 The bubble popped:
o Because banks had created complex financial products on top of the mortgages.
This complexity, combined with the rapidity with which the situation was
deteriorating and the bank’s high leverage. (difference between real money the
bank has and money lent by the banks).
o The trust and confidence that underlie the banking system evaporated Banks
refused to lend money to each other.
o Global credit markets began to melt down.
 Impossibility to replace the consumption that sustained the system before: no more
credits, low wages, unemployment.
 How to sustain the inevitable restructuring of the system because of technology
revolution? A Great part of workforce needed to be re-ubicated
 How did the crisis begin: Technological bubble in 2000 created a recession in the US. Bush
administration decided to push an agenda of tax cuts for the rich  this was supposed to
bring investments and jobs to the US. The administration let the responsibility to monetary
policy  they transferred the job of economic growth stimulation to finance. Greenspan
lowered interest rate to make easier to borrow  used to replace the technological
bubble of the 2000 by a housing bubble. People didn’t invest in industry or technology,
they invested in housing and consume.

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 In this years of liquidity movement Wall Street did not come up with a good mortgage
product: low transaction costs, low interest rates and that would have helped people
manage the risk of home ownership (guarantees, etc). Wall Street was focusing on
maximum returns in a short time (high risk investments).
o Rating agencies were guaranteeing this products were save, distorting the market.
 Core functions of banking systems:
o Providing an efficient payments mechanism

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o Assessing and managing risk and making loans.
 Easy profit from transaction costs distracted many big banks from their functions:
o The banking system did not focus to lend to small and medium sized businesses
o They concentrated on promoting securitization (transforming mortgages into
financial products), tried to transform risky subprime mortgages unto AAA-rated
products
o They got directly involved in gambling.

Market failures.
 2 Main reasons for failures
 AGENCY: people handling money and making decisions on behalf of others. In companies
there is a separation between ownership and control  management for self-profit.
 There are agency problems in the process of investment (Banks):
o Pension funds  you give all your saving to banks expecting to recover it in your
retirement. This money was invested by the banks in risky products  not a choice
of the client.
 Along the agency chain there is concern about performance  focus on short-term
returns.
 No effective quality control: markets are supposed to control the investments of a
country. If a firm creates excessively risky products it would lose their reputation. During
the crisis this discipline fell down. Banks created toxic products and sold them as save
products  no control. This was the case of securitization.
 THE INCREASED IMPORTANCE OF EXTERNALITIES: externalities are situations when a
market exchange imposes costs or benefits on others who aren’t party of the exchange.
 The financial system was connected and central to the economy, the failure of big
institutions brought down the whole system  lost jobs, lost houses, lost money…
 Regulatory agency aka the government did not regulate. Failed to adopt new processes
and policies in the middle of the crisis  the Glass-Steagall Act allowed to create even
larger banks that were too big to be allowed to fail.

The Global Crisis

 About a quarter of US mortgages had gone abroad. The US economy is still the largest.
Financial markets were interlinked globally because of information technology.
 European countries had also bought toxic financial products and besides were facing their
own problems (public debt) Spain, Italy, etc.
 Iceland is an example of the consequences of deregulation:
o 300.000 inhabitants and three banks that took an investment worth 176 billion
dollars (11 times GDP)
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o The banks borrowed from European UK, Holland… banks but this was a temporary
solution.
o Icelandic system went down, depositors wanted their money back. GB and Holland
asked their money back but Iceland people refused to pay the bank’s debt  cycle
of protests, new constitution voted for Iceland, negotiation about the debt.
o Iceland paid a really lower debt and was rescued by the International Monetary
Fund.

Summary. Stiglizt’s conclusion:

 Underlying all this symptoms of dysfunction is a larger truth: the world economy is
undergoing seismic shifts:
o The Great Depression (1929) coincided with the decline of US agriculture  shit to
industrial economy. Economy resumed with the growth of industrial production

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after World War II and the inject of public money.
o Now there is a shift from an industrial system to a service system  it takes time
to reallocate the workforce  weakness of economy

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