2012 Cambridge Business & Economics Conference
ISBN : 9780974211428
Lepeshkina Ksenia
PhD Student (International Economics)
Finance University
under the Government of the Russian Federation
ksenia.lepeshkina@gmail.com
+7 909 9357797
MACROECONOMIC ORIGINS OF THE WORLD
FINANCIAL CRISIS
June 27-28, 2012
Cambridge, UK
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2012 Cambridge Business & Economics Conference
ISBN : 9780974211428
MACROECONOMIC ORIGINS OF THE WORLD FINANCIAL CRISIS
ABSTRACT
Recent financial crisis has witnessed a number of anomalies that stand out of the
mainstream monetarist paradigm. It sets a need for a new paradigm in economic theory
capable to explain all the failures of financial market. This paper argues that a basis of a new
paradigm lies in understanding various interdependences between financial market and real
economy with regard to systemic features of modern financial market. World financial crisis
is not solely a result of financial market activity, its roots lie deeper - in distortions and
imbalances of the world economy; it is also representative of a world economic crisis.
Evidences for macroeconomic roots of the financial crisis include forestalling economic
recession and falling capital investment rate; distortions across parts of global economy and
imbalances between key economic processes within national economies. The paper
introduces a few indicators characterizing these anomalies and presents a modification of R.
Solow economic growth model showing that financial market activity contributes to a
“contingency” of global economy.
INTRODUCTION
According to T. Kuhn’s “Structure of Scientific Revolutions” along with the
accumulation of anomalies, i.e. failures of the current paradigm to take into account observed
phenomena, scientific discipline experiences a crisis leading to a paradigm shift. The world
financial crisis has revealed a number of anomalies that stand out of the common perception
of financial market. Existing mainstream paradigm basing on “invisible market hand” and
neo-liberalist concepts failed to explain financial market inefficiency in many aspects, major
of which are:
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ISBN : 9780974211428
inefficiency of financial market in keeping balance between consumption and
investment (in spite of the “savings glut” and financial market expansion the rate
of capital investment which provides a base for creating new real value and
repaying financial liabilities has gone down by 13% since 1980-s [Mckinsey,
2010])
-
failure of financial market to provide adequate valuations of financial instruments;
-
fail to manage the crisis by automatic market powers.
The situation calls for a paradigm shift in economic theory. Bringing into effect the
dialectics law of the negation of the negation we make a turnaround from perception of
financial market as autonomous and self-sufficient structure to realization of its primary aim
of channeling capital to real economy stimulating its growth. But changes in financial market
performance make impossible a simple relapse into Marxist and reproduction theory view of
financial market as an auxiliary to real economy processes. It has become clear that we need
a new paradigm basing on comprehensive understanding of interdependences between
financial market and real economy with regard to systemic features of modern financial
market. In terms of financial crisis this interdependence has shown in two ways –
macroeconomic roots of financial market crisis, on the one hand, and financial crisis effect on
the world economy, on the other hand.
RESULTS
Financial crisis unwounded in 2007 has origins in the problems of the development of
the world economic system, and it is as well global economic crisis. This hypothesis has three
major evidences.
1. Forestalling economic recession and falling capital investment rate;
2. Distortions betweens the parts of a global economy;
3. Imbalances between key economic processes within national economies.
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The real recession had started earlier than the financial crisis did, with a decrease in
capital investment rate. Artificial growth forced by low rates and mortgage policies resulted
in a boom that was based not on creation of new real value but mostly on an unfounded rise
in asset pricing and boosted private consumption. According to Catte et all [Catte et all,
2004] a rise in households net wealth tends to increase private consumption to a widely
ranged degree – from 1% (Italy) to 7% of housing wealth growth (Japan). The major threat
here is that the consumption increase is supported by cheap loans and mortgages rather than
higher income. That creates a dependence of economic condition on future income and
provokes a dangerous spiral when asset prices go down, resulting in loan defaults along with
a consumption freeze.
Application of technical analysis to the curve of world GDP growth gives additional
proofs for macroeconomic roots of financial crises. Economic development is subject to cycle
movements, booms and slumps. Prolonged boom times are accompanied by a surplus of
temporarily spare funds circulating in the world financial market that take forms of
speculative investment and drive asset prices up. When world economy reaches its limit there
occurs a slowdown in economic activity that triggers systemic risks in financial market and
crisis. There are different theories of economic cycles aiming to explain their length and
predict cycle movements. This problem is out of the scope of this paper, and we suggest a
simple indicator to evaluate booms and busts in world GDP growth, i.e. stochastic oscillator.
Stochastic oscillator was developed by G. Lane [Lane, 1984] and is now widely used for
predicting movements of stock assets prices. Having replaced stock prices variable with
world GDP growth rate we’ll get a formula for the world GDP stochastic oscillator.
%KGDP i = 100 * (TCi-TL)/(TH-TL),
TCi is world GDP growth rate for i-year,
TL is the lowest rate within the given time period
TH is the highest rate within the given time period
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Empirical analysis of the latest 20-year world GDP data (1990-2010) shows that a
value of stochastic oscillator higher than its mean value is an indicator of subsequent decrease
in GDP growth rate. The graph below shows that during the last two decades this happened
four times, and each time an outstripping stochastic oscillator was accompanied by a decline
in GDP growth. In 1994 the oscillator reached 51,6% (versus its 20-year average of 50,2%)
and in 1995 GDP growth rate fell by 3%. In 1996-1997 oscillator had exceeded its average
for two years and was followed by a 38% annual decrease in GDP growth rate in 1998. Years
1997-2000 demonstrated a similar situation. Modern world financial crisis and economic
recession were anticipated by a prolonged increase of world GDP stochastic oscillator. The
indicator had excelled its long-term average for 5 years (2003-2007) and in 2007, just before
the crisis burst, it totaled 100%.
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Figure 1: Stochastic oscillator of the world GDP
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World GDP stochastic indicator reveals deviant acceleration of world GDP growth
showing boom periods within a cyclical development of world economy. It may serve, in line
with other indicators, a tool for forecasting world financial crisis. And at the same time it
provides valuable evidence for macroeconomic roots of the world financial crisis that started
in 2007. The crisis was preceded by an abnormal acceleration of world GDP growth.
It is necessary, hence, to examine carefully the growth itself, its basis and
consequences. Regional composition of world GDP growth is indicative of warps and
distortions in world economy development. World GDP growth in 2007 (5,25%) was driven
mainly by emerging markets, namely BRIC countries, and to a much less extent by developed
countries. We suggest using Herfindahl–Hirschman Index for measuring the degree of
regional concentration of the world GDP growth. It is usually calculated as the sum of the
squares of the market shares, in our case these are represented by countries’ contribution in
world GDP growth weighted by corresponding shares in GDP. In 2007 HHI was 1064
whereas in 2000 it was slightly higher that 900. Historical growth of the concentration index
by 16% indicates that the world economy is contingent on performance of a range of
countries and thus vulnerable to any negative alterations in those.
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Table1: Regional composition of world GDP growth
Country
USA
Eurozone
UK
Japan
China
Russia
India
Brazil
World
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GDP
share of
world
total (by
PPP)
0,21
0,16
0,03
0,06
0,11
0,03
0,05
0,03
1
Contribution
GDP
to the world
growth GDP growth
rate,
(weighted by
%
share), %
2,1
8%
2,8
9%
2,6
2%
2,4
3%
13
28%
8,1
5%
9,4
9%
6,1
4%
5,2
100%
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Another good indicator of world economy distortions is given by international trade
imbalances proportionate to the world GDP. The picture below illustrates current account
deficits and surpluses of major world importers and exporters. According to the orthodox
concept this is supposed to betoken international trade growth and advanced production
specialization but as proved by modern financial crisis it may as well contribute to
vulnerability of the world economy.
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Figure 2: Current account imbalances
Source: World Economic Outlook, October 2009.
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Present rules of the global economy set by the activity of transnational companies and
banks isolate reproduction phases from each other (production, distribution, trade and
consumption) and alter the balance between key economic processes within national
economic systems. One of the vital components of the reproduction process is savings that
being transformed in investments build a base for fixed capital accumulation and industrial
expansion. A balance between saving and consumption is established by demand and supply
for capital, interest rates, prices and economic conditions. Financial globalization led to a
rapture of this correlation within national economies. Low savings, current account and
budget deficits in countries with mature financial markets are compensated by substantial
capital inflows from emerging markets that entails an accumulation of economical
imbalances.
Applying neoclassical macroeconomic models to analysis of saving and consumption
processes reveals an interesting phenomenon. If we expand R. Solow economic growth
model to an open economy by adding variables of capital outflows and inflows, assumed that
capital outflows as well as savings rate are a function of output per worker while capital
outflows is an exogenous constant, we can see that equilibrium consumption rate tends to
increase to the detriment of a savings rate, even given the equality in outflows and inflows
amounts.
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Figure 3: Modification of R. Solow growth model
ye
Output
per
worker
in
terms
of
effective labor
y=f(ke)
ye2
ye1
c1
Ii
c2
ir1
ir2
sf(ke)
Io
(s-io)f(ke)
0
ke
Capital per worker in
terms of effective labor
I.
Assumptions of the classical R. Solow growth model:
1. Production function per worker y=f(k), где k=K/L – capital per worker, capital
intensity.
2. i = sy = s f(k) , где s – savings rate per worker, i – investment function per worker.
с = f(k) – sf(k), где с – consumption function per worker.
3. Equilibrium under growth terms is determined by an equality of savings rate to the
required investment with regard to a population growth rate (n), depreciation (δ),
technological progress(g).
ir = (n + δ + g) ke = sf(ke)
где ke – capital per worker in terms of effective labor - AL, where А represents multifactor
productivity coefficient.
II. Modifications. Let’s extend R.Solow model to an open economy, adding capital outflows
(Io)
and inflows (Ii). Capital outflows are contingent on workers income thus
representing a function of national output (Io = ∑io f(ke)), capital inflows are an
exogenous constant Ii. Then the equilibrium condition is as follows:
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(s-io) f(ke )= (n + δ + g)ke - Ii , where io – is capital outflows rate per worker (in terms
of effective labor).
Let’s assume that Io = Ii, so that national capital outflows are compensated by foreign
inflows and no surges in the production function y = f(k) occur.
i r1 = (n + δ + g)ke
i r2 = i r1 – Ii
With an increase of capital outflows required investments curve tends to go down (i
r1
to i r2)
as the amount requested from national workers diminishes by the value of Ii. A decrease of
the savings rate (s) by an income share invested abroad (io) gives a portion of savings used in
national economy shifting the savings curve down (the blue line). A new equilibrium is
therefore set by an intersection of the required investment rate with a level of domestic
savings left for the national economy. The graph shows that even given the equal values of
capital outflows and inflows (Ii = Io), equilibrium levels of capital intensity and
corresponding output per worker increase as well as consumption tend to go up.
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So, we can conclude that a considerable capital inflow in a country may provoke an
unfounded rise in consumption rate. In practice this phenomenon may be explained by high
income expectations due to an output expansion, a propensity to consume exceeding
propensity to save in terms of economic growth and low interest rates in a result of capital
inflows. The recent practice supports the contention. A number of highly developed countries
during pre-crisis years have experienced a prolonged downturn of gross domestic savings
accompanied by a steep rise in consumption. In the year before crisis, according to OECD
database, household savings rate in the USA was about 0,4% of the disposable income. The
consumption per capita on the contrary soared by 230% since 2000, with consumption
expenses accounting for 70% of GDP [Jagannathan, 2009]. At the same time the country was
deepening its structural deficits covering them by an increase in public debt, foreign
investments and dollar emission. Specific dollar’s position in the global financial market
allows the USA to issue national currency to redeem international liabilities exporting
inflation in foreign countries. The following figure based on the USA macroeconomic data
for the last decade illustrates the correlation between direct foreign investments and
savings/consumption ration of the future period (with a time lag of one year). Pearson
correlation coefficient of 0, 85 proves the validity of the adjusted economic growth model for
a country with high level of foreign investment and low savings rate.
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Figure 4: Empirical proof: investment and consumption in the USA
Note: data taken from http://www.bea.gov.
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CONCLUSION
Economic history shows that severe financial crises are always a result of a
combination of macroeconomic, microeconomic and financial market related factors. The
recent world financial crisis has been widely viewed as a crisis of derivatization, overexposure, poor risk management and malpractice accompanied by lax regulation and excess
cheap liquidity. Whereas all these factors had their place it is important to avoid
underestimating deeper macroeconomic roots of the crisis as well as neglecting problems of
the global economy.
Simple modifications of a neoclassical model show that equilibrium levels of savings
and consumption in terms of an open economy with a large share of foreign investments
eventually contribute to an increased financial fragility of the country. It is worth noting that
these imbalances are sustainable in the long-term period and they are shaping a new state of
the world economy- a state of contingency. The world economy is contingent on GDP growth
concentrated in a range of countries, on future income and on the rise in capital investments
necessary to finance creation of new real value. The current global economy is in an unstable
condition that if triggered by certain events may provoke further financial crisis. It is the time
to come with a new economic paradigm that will explain the basics of functioning of the
global economy and its two-sided correlation with world financial market. Acknowledging
the significance of liquidity support and capital injections at the early stage of the crisis it is
the time to address global economy weakness and start stimulating real economic growth.
Understanding interactions of various economic processes and the altered nature of
reproduction under the global transnational economy will contribute to policy implications
required to restore world economic growth and repay accumulated debts without further
enhancing existing macroeconomic distortions and imbalances.
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REFERENCES
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Blanchard O., Milesi-Ferretti G.M. (2009). Global imbalances: in midstream? IMF
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Mckinsey Global Institute. (2010). Farewell to cheap capital? The implications of
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shifts
in
global
investment
and
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[available
at
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l]
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Lorenzo Bini-Smaghi. (2008). The financial crises and global imbalances – two sides
of the same coin. [available at http://www.bis.org/review/r081212d.pdf]
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Whelan K. (2010). Global Imbalances and the Financial Crisis. WP 10/13. UCD
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