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The Underlying Causes of the ‘Global Financial Crisis’


Dr. Gennadi Kazakevitch & Dr. Ratbek Dzhumashev

By

May 20th, 2017


This article first appeared in Short Supply 2017 – check out the full magazine via the Short Supply tab at the top of this page!


Common explanations put forth for the financial crisis of 2007-2008 have been rather simplistic, scratching the surface of issues caused by decades of structural changes in the global economic environment. One widely held understanding of the crisis nominates the vast sub-prime mortgage default in the USA as the primary catalyst. The other popular explanation places blame on the under-regulation of financial systems in Western countries, which fostered reckless and risky behaviour by major financial institutions.

Although generally correct, these two explanations tend to ignore another fundamental cause – emerging imbalances in the division of labour between ‘post-industrial’ and ‘industrialising’ countries. This has resulted in the rapid increase in debt of Western nations, with corresponding surpluses for developing countries with strong industrial capabilities. This increased debt and its resulting financial instability is one of the key causes of the Global Financial Crisis.

The conveniently used euphemism of ‘Global Financial Crisis’ conceals the fact that, in reality, not all countries experienced the recession. The impact of the crisis has varied significantly across the globe; industrialising countries free from significant debt escaped relatively unscathed. To understand how the impact of the GFC differs across countries, it is necessary to distinguish between two types of economies: post-industrial and industrialising economies.

 

The Division of Economies

 

Post-industrial economies

The ‘post-industrial’ label refers to economies which have, over the past few decades, experienced a decline in the proportion of manufacturing, and an increase in the proportion of post-industrial services such as science, education and R&D. This notably applies to OECD countries such as USA, Canada, Australia, Japan and members of the EU. Simultaneously, in these countries (excluding, perhaps, only Japan) the combined trade deficit, as well as public and private debt, have steadily increased. Unfortunately, these very countries have been the generators of the current economic downturn, which has resulted in the contraction of the world economy.

 

Industrialising economies

On the other hand, there exist rapidly developing nations that are considered to have ‘industrialising’ economies. These nations have been consistently increasing their manufacturing capabilities and absorbing outsourced manufacturing from industrialised nations. Notable examples include China, India and Mexico.

As a result, these economies typically have a combined trade surplus and have accumulated vast reserves in foreign monetary instruments, which lead them to become a primary source of borrowing for OECD nations. Despite substantial declines in exports of goods to straggling Western economies, many developing economies have sustained healthy economic growth rates throughout the past few decades.

The question, therefore, is whether the key underlying reason for the recent crisis can be attributed to the trade and current account imbalance that has persisted between post-industrial and industrialising economies.

Developing countries have been increasing their manufacturing and export capacity, contributing to a build-up of their current account surpluses. On the other hand, in post-industrialised countries, the opposite is occurring: the import of manufactured goods has contributed to decreasing current account balances. Surpluses generated by developing countries, with a growing manufacturing sector, are being absorbed by the post-industrialised countries in the form of debt. This condition cannot be sustainable, as in the long-run the increasing levels of debt may lead these countries to default, as seen recently in the case of Greece.

Investors from developing countries may, at some point in time, find themselves holding overvalued assets in highly indebted, post-industrialised countries. However, once information reveals the true value of these assets, there may be a drastic devaluation of currency in post-industrialised countries. This will decrease the burden of debt and make developed countries relatively poorer. Conversely, sharp appreciation of domestic exchange rates, and default of assets originated in post-industrial countries, will reduce the export levels of manufacturing countries. Then the post-industrialised countries may not gain much from their low exchange rates, as they would have little manufacturing capacity to trade with overseas.

Meanwhile, growing accumulated debt of most OECD countries ultimately means that they survive on “credit card” debt. The recent crisis, among other things, indicates that the credit limit has been reached and that the spending needs to stop.

That is why injecting struggling economies with huge stimulus packages, and consequently increasing debt levels, is about as effective as treating alcoholics by giving them vodka. Stimulus package polices assume that “throwing enough money at Wall Street will trickle down to the benefit of Main Street, helping ordinary workers and home owners…”. [1]
This is the reasoning of trickle-down economics, which has been shown to almost never work. Even if it ’works’ it is neither the most efficient nor fairest way of addressing the problem.

At the same time, successful industrialising nations have not only developed their export-based manufacturing but have also created a middle-class of their own that is eager to consume, yet has no culture of spending more than it earns.

These countries are also investing heavily in education and research, meaning it will not be long before they become largely self-sufficient. This is in terms of both creating domestic demand for their manufactured goods, and providing domestically produced “post-industrial” services.

 

The Future

Could the weakening of manufacturing capabilities, diminished competitive advantage in post-industrial services and the inability to pay for imported goods lead to the irrelevance of Western economies? If yes, does that mean that post-industrial economic development, as it is currently evolving, is a “no-through road” for Western nations?

The concept of a ‘post-industrial society’ was initially introduced by Bell, [2]
who observed its initial stages and predicted the further global diffusion of capital, imbalance of international trade, and decline in manufacturing. Subsequent developments and empirical analysis of this concept have emphasised knowledge and information powerhouses as the primary source of competitive advantage for post-industrial economies.

There is nothing wrong with a division of global economies based on ‘labour-intensive work’ and ‘skill-intensive work’. The burden of labour-intensive manufacturing falls on certain countries, leaving others to concentrate on innovation. This includes developing break-through, productivity-increasing and environment-preserving technologies, providing top-level education, and new methods of fighting dangerous diseases.

However, such a division of labour can be sustainable only if both groups of countries continue to master their competitive advantage, and live according to their means. Meanwhile the financial regulators, particularly in large developing nations, must not impose artificial restrictions on exchange rates. A breakdown of these conditions could well set the world on course for another financial crisis.

 

Dr Gennadi Kazakevitch is Deputy Head and Director of Education in the Department of Economics. His main research and teaching interests are in the area of economic policy and regulation. He is a regular contributor to the media on economic policy.

Dr Ratbek Dzhumashev is a Senior Lecturer in the Department of Economics. His research and teaching interests are in theoretical and applied macroeconomics.

 

[1] Stiglitz, J 2008, ‘We Aren’t Done Yet: Comments on the Financial Crisis and Bailout”, The Economists’ Voice, vol. 5, no. 5.
[2] Bell, D 1973, The Coming of Post-Industrial Society: A Venture in Social Forecasting, London: Heinemann.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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