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Understanding Finance and the Current Crisis

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Abstract

The recent financial crisis has raised several different questions as to how the crisis emerged, in the first place, and whether there were any aspects of financial management that would have increased the extent of the crisis, or could be used to assist during the recovery period.

Although the two primary areas that have been explored in the existing literature, namely the housing bubble and the slack credit criteria, it would appear that the real value of the existing literature came from the analysis of how the two factors interact, in terms of mitigating the ongoing economic crisis. Further research is required in this area, in order to gain a greater understanding of normal business cycles and how policy decisions can be used to influence behaviours, rather than being entirely reactive to external changes.

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Introduction

The current financial crisis which has been seen to be at the heart of the economic difficulties began in 2007 and has produced multiple questions as to how the basic principles of finance interacted with the crisis and the way that this could be used as a means of identifying potential crises, before they happen, thus potentially offering a means of assisting in the economic recovery.

By looking at the way in which the recent financial crisis has spread across the globe, a great deal of insight can be gained as to how finance operates and how potential this can create a dramatic knock-on effect which will ultimately impact on the global economic position. The aim of the literature review is to analyse the various different research papers which have emerged as a result of the current crisis, with a view to gaining a much deeper understanding of the various financial issues. More specifically, behavioural finance will be explored, as a means of identifying any gaps in understanding, as well as potentially offering explanations as to the behaviours which either mitigate or exacerbate the depth of the current economic crisis.

The literature review will look at issues associated with asset fluctuations and financial behaviours associated with credit which are seen to be the two key factors before considering how both of these have impacted on the overall economic behaviours and the implications that this has for both the current economic crisis and future research in this area.

Asset Fluctuations

Although there have been several different factors which have links to the recent economic crisis, with much research looking at the way in which the financial market moves, when various different analytical information reaches the market (Keynes 1930), it is suggested, in this case, that where there has been a dramatic increase in asset prices which cannot necessarily be explained by financial fundamentals, there are likely to be situations that result in a boom followed by a bust (Garber, 2000). Research in this area has indicated that, where asset prices deviate from what would be expected, based on fundamental financial factors, there is some form of inefficiency within the market which, at some point, will need to be redressed.

Further research goes on to look at the situation where the price of the asset extends itself to such an extent that it goes outside of what would be considered to be normal boundaries and a bubble is formed. This is commonly referred to in the press as the housing price bubble, with reference to housing assets and the way in which they increased, at an unreasonable rate, over a relatively short period of time (Zheng, 2005).

A great deal of effort has been put into attempting to explain asset price bubbles and why these bubbles arise, with a variety of different explanations being put forward.

One particular theory which has emerged as to why an asset bubble may arise is that individuals behave in an irrational manner when making investment decisions. Despite this, some models have developed which allow for rational behaviour, but which also allow for an asset bubble to arise, for example, where investors may have expectations about how the assets are likely to change in value, in the future (Brunnermeier, 2001). This was put forward by Blanchard and Watson, back in 1982, where it was argued that there is no need for the asset price to always be equal to the fundamental underlying value of the assets and a bubble could be established based on rational expectation. This suggests that asset movements, such as that experienced in the housing market immediately prior to the financial crisis, would not necessarily be linked to irrationality and there may be other factors which ensure that these extreme bubbles will arise.

Analysis has also taken place in terms of what causes the bubbles ultimately to disappear and whether there are aspects of behavioural finance which can be used to explain this trigger point, which is seen to be fundamental to the economic crisis, during the last few years (Marazzi, 2010).

It is argued that the slightest shock can create a bust situation, for example, where there is a slight change in fundamental values or the beliefs of the investors. As investors change their approach, the slightest shift can ultimately create vision turmoil to establish a bust. Consider, for example, in the housing crisis where a slight change in how mortgage holders were able to repay the amount owed immediately created a liquidity problem within the lenders. It can be seen, therefore, that even a slight change in the circumstances of the borrowers can create an asset pricing situation where the fundamental value of these assets drop and the likelihood of repayment reduces (Gorton and Ordonez, 2012).

Credit Booms

The other area of relevance is seen to be the areas of credit and how the credit markets influenced the financial behaviours leading up to and during the financial crisis (Brusco and Castiglionesi 2007). To a large extent, it can be argued that the increase in the asset price of housing across the US and UK was due to relatively easily available credit conditions that allowed a wide variety of individuals to purchase properties that were stretching their financial position to such an extent that, when fundamental factors changed, such as employment, the asset price could no longer be maintained.

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Based on the research, it has been suggested that the recent economic crisis was, in fact, down to a credit situation within the financial markets and not necessarily the asset itself, namely houses.

Immediately prior to financial crises, there is indication that there was also a rapid increase in the amount of credit being made available, and during the recent financial crisis, the focus has been on credit availability for the purposes of purchasing property. However, similar issues have also emerged in short-term credit, such as personal loans and credit cards allowing individuals to gain access to credit streams that their income would not necessarily suggest should be available to the rational lender (Calomiris and Kahn, 1991).

Interestingly, research has indicated that a credit boom will often happen as a result of a prolonged period of positive economic shock or following from a particular, economic growth in a region or market. This will suggest that where there was a great deal of growth and buoyancy within the housing market, this was a precursor to the credit boom (Claessens et al., 2010). It is also argued that monetary policies are also seen to be linked to the credit crisis, and that an understanding of the financial decision-making within the financial market can have a detrimental effect on whether or not the credit boom takes place. For example, it is suggested that low interest rates encouraged the US housing market and that more people were able to borrow money, at this lower interest rate. This shows an indication that a monetary policy decision, namely to reduce interest rates can have a knock-on effect on asset prices and credit availability, all of which has been arguably fundamental when it came to the recent economic crisis (Lansing, 2008).

This type of activity has been referred to as financial liberalisation, whereby investors of every kind are more inclined to take financial risks and to pursue new financial opportunities, such as purchasing property. This type of liberalisation could also be seen as inherently linked to the willingness of banks to lend to customers and to have less stringent lending criteria which would appear to be linked to the volatility within the housing market, as having such financial flexibility within the banking sector allowed for the housing assets to boom, at an irrational level. This again suggests the notion that external factors and policies can ultimately change behaviours of agents within the financial markets and the decisions that they make, in terms of their own investments and their own decision-making (Dell’Ariccia, Igan and Laeven, 2012)

Combined Impact on Financial Markets

Having identified that there are the two factors in the unnaturally high price of assets, namely housing assets and the lenient credit conditions which were placed on the market through policy decisions such as low interest rates and low interference with banking regulations that have been deemed to be inherently linked to the recent credit crisis, it is unsurprising that a wide amount of research has been undertaken to look at how these factors came together to create the shift in the financial markets that have occurred, in recent years.

By looking at the combined movement within the credit markets and within the housing market, it was established that there were substantial differences between the movements experienced as a result of external factors during a period of economic crisis and the reactions of similar changes during periods of stability. This suggests that the financial markets behave differently during a crisis, something which may be very relevant to how policymakers should behave when looking to navigate their way out of the financial crisis period.

It has been identified that one of the key factors linked to a bust which is likely to result in a credit crisis can be seen in the volatility of the movement within the financial markets.

Having identified that the two issues of available credit and the increasing house prices are inherently linked and that both factors led to the credit crisis, the researchers largely moved on to identifying how these factors have created the behaviours seen within the economy, in the last few years.

Banking institutions have been perceived to be central to this, as these were the institution that lent the money and made credit available in the first place and also the first institution to suffer when the asset price dropped from the exceptionally high level and borrowers began to default. Research has looked at the way in which the banking institutions operate under these conditions, as it is perceived to be a particularly important means of determining the impact that the financial market is having on the credit crisis and the potential recovery. An argument has been presented which suggests that, where borrowing and lending is collateralised in some way and the market price of that collateral changes for the negative, the organisation simply cannot rely on this collateral, in order to continue its operations (Schleifer, 2000). In this case, collateral is deemed to be housing assets, although many of the financial institutions use complex arrangements in order to bundle the debts and sell them on to third parties, although fundamentally they were linked to the housing assets which were dropping as a result of changes in monetary policies and increasing concerns over the sustainability of house prices. Crucially, it is therefore argued according to rational behaviours where investors (in this case house buyers) opinions on the likely future for the assets and their own ability to sustain the assets change, so do the financial markets surrounding these assets, something which is particularly exacerbated when policy decisions result in an increase in interest rates and fears relating to employment levels, all of which creates a spiralling situation and potentially volatile reactions from investors.

Implications of the crisis

A large portion of the research and the literature in this area looks at the causes of the economic crisis and attempts to identify patterns that could offer explanatory value as to why the crisis happened in the way that it did. However, it is contended in this literature review that the real value comes from identifying the implications of the asset and credit crisis, in terms of the reactions of financial institutions and how this can potentially be used as a means of recovery for the future.

Specific research looking at the reasons for the financial bubble indicated that banking institutions were central to the crisis, in terms of encouraging excess lending and therefore also encouraging the unnaturally high house prices, which became unsustainable, in the long run.

Some of the literature has focused almost entirely on the economic crisis and the impact that this has had on longer-term economic activity (Claessens, Kose, and Terrones, 2012). Research has indicated that, whilst the economic crisis itself created problems in the housing market, it also ultimately led to greater widespread recession than would normally be expected in the typical cycle associated with the performance of the economy.

Various different research approaches have been taken in order to compute the precise impact that the recent economic crisis has had on financial markets and how this can ultimately be used to pave the way forwards. The approach taken by Claessens, Kose, and Terrones, 2012, used traditional methodology of analysis the business cycles, in order to identify whether or not a recessionary period is being entered into. This theoretical approach argued that recessionary periods, which are associated with a form of asset crisis, in this case a credit and housing would cost more to the economy overall than any drop associated simply with equity prices, e.g. as part of the traditional business cycle.

Of perhaps more interest regarding this topic, going forward, is the way in which the financial markets are likely to recover from the period of recession, with research suggesting that recovery will typically be low and weak in comparison with the volatility of the drop, in the first place (Kannan, Scott, and Terrones 2013). This body of research is deemed to be highly relevant, as it not only looks towards linking the concept of credit crisis with the way in which the financial markets are behaving, but also explores how these two factors can interact, in order to deal with the recovery, in the most appropriate way, something which is likely to be of interest to policymakers and those within financial markets, for the future.

Future possible research and conclusions

Despite the myriad of different research papers which focus on different aspects of the credit crisis and have looked at the interaction between credit and housing, as well as external monetary factors, the real value comes from understanding the reactions and behaviours of an economic crisis, as a means of improving recovery prospects. One particular area of research that would be beneficial in this regard is the way in which the financial markets fluctuate, even where there is no ultimate crisis. This is deemed to be important, as there is a cycle that emerges within the financial markets which must necessarily be understood, if the true measure of a crisis is to be established, in the future. Without understanding what is perceived to be ‘normal’, it is simply impractical to appreciate the cause and effect of abnormal periods within the economic cycle and how these can be reduced or mitigated, in the long run.

References

Blanchard, O. J., and M. W. Watson, (1982), “Bubbles, Rational Expectations and Speculative Markets,” in Crisis in Economic and Financial Structure: Bubbles, Bursts, and Shocks, P. Wachtel, ed. Lexington Books: Lexington

Brunnermeier, M. (2001). Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis and Herding, Oxford: Oxford University Press.

Brusco S. and F. Castiglionesi (2007). “Liquidity Coinsurance, Moral Hazard and Financial Contagion,” Journal of Finance 62, 2275-2302.

Calomiris, C. and C. Kahn (1991). “The Role of Demandable Debt in Structuring Optimal Banking Arrangements,” American Economic Review 81, 497-513.

Claessens, S., G. Dell’Ariccia, D. Igan, and L. Laeven, (2010), “Cross-Country Experience and Policy Implications from the Global Financial Crisis,” Economic Policy. A European Forum, April 2010, Vol. 62. PP. 269-93

Claessens, S., M. A. Kose, and M. Terrones, (2012), “How do Business and Financial Cycles Interact?” Journal of International Economics, Vol. 87, pp. 178-90.

Dell’Ariccia, G., D. Igan, and L. Laeven, 2012, “Credit Booms and Lending Standards: Evidence from the U.S. Subprime Mortgage Market,” Journal of Money, Credit and Banking, Vol. 44, pages 367-84.

Garber, P. M., (2000), Famous First Bubbles: The Fundamentals of Early Manias, Cambridge, MA: MIT Press

Gorton G. and G. Ordonez, (2012), “Collateral Crises,” NBER Working Papers, No. 17771, National Bureau of Economic Research, Inc.

Kannan, P., A. Scott, and M. E. Terrones, (2013), “From Recession to Recovery: How Soon and How Strong,” in S. Claessens, M. A. Kose, L. Laeven, and F. Valencia, eds., Financial Crises, Consequences, and Policy Responses, forthcoming.

Keynes, J. M., (1930) The Great Slump of 1930. London: The Nation & Athen?um.

Lansing, K. J., 2008, “Speculative Growth and Overreaction to Technology Shocks,”

Working Paper Series 2008-08, Federal Reserve Bank of San Francisco.

Marazzi, C. (2010) The Violence of Financial Capitalism, NY:

Schleifer, A., (2000), Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press, Oxford

Zheng, Z., (2005) From Rationality to Bounded Rationality, Australian Economic Papers, December, 455-474.

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