Appraise the proposition that the bank failures and crisis of 2007-2008 could have been foreseen from academic work published prior to 2004?

Since the financial crisis had started in 2007 great number of people were “shouting out” that it was obvious and predictable that the banks would fail and crisis was forthcoming. This assignment is going to examine if it was actually predictable, if so did the government authority miss the main points or the predictions were not clear to hear. Or else maybe this crisis was done on purpose so that the US can payout the external debts from its balance of payments, as with the different exchange rate- dollar appreciated in comparison to other currencies, the debt owed by US became much cheaper. Furthermore, perhaps the predictions were obvious to hear and comprehensive but somehow ignored the purpose of high profits on derivatives.

The fact that the crisis was predicted, suggest that the crisis could have been predicted and prevented. Several lonely voices struggled to be heard amidst the financial communities’ celebrations of the latest day’s profits derived from fees and trading. Just as Greenspan warned of the dangers of “irrational exuberance” in the midst of the stock market boom years earlier, so alone Sage practiced the art of financial prophecy from his base in Omaha. An exceptionally wealthy investor, Warren Buffett repeatedly warned of derivatives being financial weapons of mass destruction.

According to The Economist article “Doors now closing” (2002) researchers were waiting for the crisis to come but were not expecting it to come so soon. There are further reasons for believing the crisis could have been foreseen. A look at economic history warns us that booms always end in busts (South Seas, Tulips et al). Housing booms suffer similar fates, Sorel, The Marshall Plan warns of the possible unsustainability of ever increasing balance of trade deficits. In common with “bubbles” such as the South Sea “bubble”, “Tulip mania”, the U.S stock market in the run up to 1929, and the “dot com bubble”, the housing “bubble” shared the same fate; it burst (Galbraith The Great Crash). In America this began in 2006, and precipitated, or was the primary cause of, the collapse of a decade (approx.) of global prosperity (“global prosperity” in this context should be taken to mean most parts of the world, not all parts of the world). This collapse is called the “credit crunch”, or more accurately and more specifically, the sub prime liquidity crisis.

“By 2009 economists widely considered the downturn to be the worst since the Great Depression and promised a full scale rethink of financial regulation, structures, a reconsideration of economic theory and talk of a “grand bargain” to re-order the global balance of financial power” (Council for Foreign Relations). The magnitude of the credit crunch is confirmed by Paul Tucker; Monetary Policy Committee, BoE, 2008); “policymakers are having both to make big picture judgments about the balance of forces buffeting the UK economy; and to apply areas of economic theory that stretch the frontiers of existing research.”

Another significant casualty of the sub prime liquidity crisis has been the Anglo American (“neo con”) laissez faire capitalist philosophy, enshrined in the light touch regulatory environment provided by the repeal of parts of Glass Steagal (1999) and the decision to let the derivatives markets regulate themselves (2003). As noted in the quotes above from Tucker and the CFR, questions were being asked as to whether this crisis could have been prevented, and how to prevent similar crises occurring in future.Commenting on Basel II, negotiated between 1999 and 2004, Tarello (Tarello D.K., Banking on Basel II; the Future of International Financial Regulation) states “The Basel Committee implicitly acknowledged in Spring 2008 that the revised framework would not have been adequate to contain the risks of the sub prime crisis and needed strengthening”. This therefore, gives a comprehensive indictment of such banking regulatory pillars as the Basel II’s “Revised Framework on International Convergence of Capital Measurement and Capital Standards”.

Looking back to 1990’s (The Economist, “Crunch time again?”, August,1999) when financial crisis hit the world, the Federal Reserve in order to inject liquidity into the economy had to cut the interest rates. Now again the crisis was blamed on low interest rates. Former Federal Reserve governor Alan Greenspan was accused for taking inefficient policy on keeping low interest rates fro prolonged time. He quoted that “Managers of financial institutions, along with regulators, including but not limited to the Federal Reserve, failed to comprehend the underlying size, length and potential impact”

We have already dealt with the issue of whether the crisis could have been prevented when discussing the role of regulators during the crisis, and prior to the crisis, and concluded that regulatory powers had purposefully been depleted by the neo con Government philosophy of Bush Jnr., to such an extent that they had little authority to intervene e.g. the derivatives markets were self regulating, and saw that Basel II, by it’s own Committee’s admission, was inadequate

The sign coming from, granting mortgages to those with least likelihood of maintaining payments suggests that the “bottom of the barrel” is being “scraped”, and a boom predicated upon such uncreditworthy creditors, surely suggested a weakness in the future sustainability of the boom.

We may therefore summarize the role of the Regulators as being that of being neglect; there was little apparent intervention to prevent the crisis. Further, if we take the reduced regulatory powers of the U.S. authorities -designed by amendments to Glass Steagal (1999) and allowing the derivatives markets to regulate themselves and the inadequacy of Basel II according to it’s own Committee, the existing bank regulation (of e.g. capital ratios) was inadequate. Such inadequacy of regulation on both sides of the Atlantic ensured that a state of Regulatory affairs existed such that the Regulators could not have prevented the crisis.

Reference list:

http://www.economist.com/business-finance/displaystory.cfm?story_id=E1_TNNSDVDJ

http://www.economist.com/business-finance/displaystory.cfm?story_id=E1_TQDPSNQ

http://www.economist.com/business-finance/displaystory.cfm?story_id=E1_NPDGQR

http://www.fitchdominicana.com/noticias/ofai2903.pdf

http://news.bbc.co.uk/1/hi/business/8607679.stm

http://www.cfr.org/publication/19710?gclid=CLWX3-T_pp4CFVqX2Aodpz9nvQ

Galbraith The Great Crash

Sorel E., The Marshall Plan; Lessons for the Twenty First Century, OECD Publishing, 2008

Soros G. The Alchemy of Finance

Tarello D.K., Banking on Basel II; the Future of International Financial Regulation, 2008, Peterson Institute, Washington DC