Global Financial Crisis and Government Intervention: Surplus Generation, Gearing Ratio, Asymmetry of Financial Multipliers and Other Considerations

Global Financial Crisis and Government Intervention:
Surplus Generation, Gearing Ratio, Asymmetry of Financial Multipliers
and Other Considerations

Arun Kumar
CESP/SSS, JNU, N Delhi 110067.
arunkumar1000@hotmail.com.

Published: 'Accountancy Business and the Public Interest' Vol. 8, No. 1. February 3, 2009.
http://visar.csustan.edu/aaba/aabajourVol8-No1.html

I. INTRODUCTION: CRISIS NOT ANTICIPATED BY THE EXPERTS.

II. MONEY, RISKY FINANCIAL ASSETS AND UNREGULATED INVESTMENT BANKING

III. PROFITABILITY OF FINANCIAL INSTRUMENTS AND CONSEQUENCES.
III. a. Financial Assets and their profitability
III. b. Anatomy of the Financial Crisis

IV. BASE FOR FINANCIAL ASSETS CREATION: IMPACT OF LOW US SAVINGS PROPENSITY, WAR EFFORT AND TAX HAVENS

V. MONEY, MULTIPLIERS AND GOVERNMENT INTERVENTION IN A CRISIS
V. a. Non-Functionality of the Multipliers
V. b. Limits to Government Intervention in a Crisis: Asymmetric Multipliers

VI. CONCLUSION.

End Notes.

References.

Graphs


Completed: November 11, 2008

Abstract of the Paper:
The paper analyses the roots of the current global economic crisis and the reasons for the failure of the massive government interventions to control the crisis.
The paper tries to understand whether the crisis is a generalized crisis of capitalism or a specific crisis originating from the financial sector. If it is the latter, a reform of the financial system would have been enough to resolve the crisis but if it is the former then a more basic solution would be required.
The paper analyses the deregulated financial markets and the nature of their instability. The paper presents a simple model linking the returns on financial instruments to capital gains and the gearing ratio. As the gearing ratio rises, the instability increases. Further, the paper points to the inter locked balance sheets of the financial institutions so that as collapse sets in it spreads from one to the other. It points to the fact that when the asset values fall, liabilities do not decline in value to that the balance sheets have big holes in them and this is particularly the case due to the provision of mark to market.
It traces the trigger for the instability in the real economy to rising disparities, the growing challenge to the dollarization of the world economy, rising speculative activities, falling savings propensity of the US economy so that more and more of the assets of the US economy were being owned by foreigners and the surplus generated in the US economy was going out. This was being aggravated by the growing use of the tax havens and the rising war effort and the internal security expenditures. All this led both to the creation of the sub-prime assets in the US economy and their eventual collapse.
It is pointed out that in the current crisis, trust has disappeared amongst borrowers and lenders and credit has frozen. Entities wish to remain liquid. Consequently, the money multiplier is tending to one and the financial multiplier to zero. In the circumstances, the monetary authority’s steps to reflate the economy become ineffective even though under normal circumstances, they would have led to hyper inflation. The economy appears to be in a liquidity trap. Fiscal steps also do not yield the required results due to the downward adjustment of the private sector’s expectations about profits and investments.
The paper points out that an orderly reversal of the financial markets is not feasible because while there maybe micro reversibility there is macro irreversibility. It is like in a random walk where each step can be reversed but the probability of going back to the origin is low.
The paper discusses the need for global coordination of fiscal steps otherwise demand may leak out and leave the economy trying to inflate itself in deeper crisis. It points to the dangers of countries going in for protectionism and suggests that the architecture of the International financial institutions is likely to change because the US position has been severely dented. Further, it suggests that the free market paradigm is likely to undergo a rethink and there would be greater receptivity in the public to alternatives.