The Global Financial Crisis of 2008 was the worst crisis since Great Depression of 1930’s. It emerged on global of the earth after failure of financial giants like Lehman Brothers, Bears Stearns etc. Crisis was a result of series of problems including the subprime mortgage crisis. Economic Crisis propagated through different channels like financial integration, trade. Global Financial Crisis had serious repercussions. Crisis led to liquidity problems. Poor countries were further pushed into poverty trap. World’s total output decreased significantly as real GDP growth rate plunged down to -1.9 % in 2009. World’s capital markets witnessed decline in stock and bond prices. Policy initiatives were taken all across the globe to mitigate the effects of crisis. United States and European countries announced bail-out packages worth trillion of dollars. Pakistan also suffered from Financial Crisis as GDP growth rate came down and it further led to economic instability. Pakistan’s current account deficit and fiscal deficit touched the figures of 8% and & 7% of GDP respectively.
The paper takes into account GDP as a dependent variable and potential independent variables such as trade deficit, current account deficit, fiscal deficit and inflation. GDP has been taken as a measure of macroeconomic stability. The paper further highlights and analyzes the discretionary fiscal policy adopted by the government and tight monetary policy being pursued by the State Bank of Pakistan.
History and Background of the Global Financial Crisis
Global Financial Crisis emerged in 2008 as a result of bursting of US housing bubble. Global Financial Crisis is considered to be the worst crisis since the Great Depression of 1930’s. Crisis originated in United States and European countries with the failure of Banks like Lehman Brothers, Bear Stearns.
History of Global Financial Crisis reveals that Federal Reserve was pursuing an expansionary monetary policy well before the crisis. After burst of Dot Com Crisis and 9/11 attacks, advanced economies in an attempt to mitigate effects of the crises pursued an expansionary policies. Low interest rates accompanied by housing prices facilitated credit growth. US Banks started giving loans to the people with poor credit history. The interest rate in US Economy rose from 1 % 5.35 % which rate resulted in reversal of the housing boom. People already faced trouble while paying the mortgage payments and, further rise in interest rate created severe problems and many of them defaulted on their mortgages
Repercussions of the Crisis
Global Financial Crisis spread to the rest of the world through financial integration causing serious unrest across the whole world. Global Financial Crisis had serious repercussions as International Monetary Fund (IMF) reported that world’s economic growth is expected to be -1.3 % in 2009. International Labour Organization reports the rising unemployment and according to ILO 30 million people are supposed to loose employment. According to the World Bank, 40 % of the developing countries are highly exposed to the poverty effects due to Global Financial Crisis .Global Financial Crisis resulted in liquidity problems and financial institutions lost trillion of dollars.
Global Financial Crisis had a severe impact on economies of both developed and developing countries. Global Financial Crisis originated from sub-prime mortgage crisis in 2008 and consequently resulted in financial turmoil all around the world. Confidence in financial institutions eroded resulting in collapse of giant financial institutions and banks. Banks which escaped from bankruptcy were bought in a severe competition at very low prices. Financial Institutions lost billions of dollars due to Global Financial Crisis. According to the Bank of England financial institutions across the globe lost approximately $ 2.8 trillion.
Source: IMF World Economic Outlook, April 2011 (Graph developed by the Author)
Causes of the Crisis
Major causes of Global Financial Crisis which have been identified are increase in asset prices, credit booms and failure of the regulatory agencies.
Before the onset of Global Financial Crisis, housing prices increased drastically in United States. Increase in housing prices was also seen in other developed countries like UK and Ireland.
Credit Booms were also the result of different crises which took place before Economic Crisis of 2008. Longer duration and relatively large sizes of Credit Booms result in economic crises soon. Credit Booms accompanied by increased leverage of borrowers fuel such financial crises.
Failure of Regulatory Agencies
Crisis reveals that regulatory agencies were unable to predict financial turmoil. Regulatory agencies showed lack of interest. Agencies responsible for oversight underestimated the crisis.
Channels of Transmission
Sub-prime mortgage crisis spread to other developed economies of the world as advanced economies had direct exposure to sub prime assets and US financial markets. Few other channels of spread of the crisis are given below
Financial Interconnectedness has increased in past few years. Financial Reforms have been able to bring financial integration. Financial Integration has resulted in greater efficiency of Financial Sector, increased competition and risk sharing. All this is also associated with greater risk of transmitting financial shocks across the countries . Crisis spread to developed and developing countries through financial integration. Developing countries banks were affected as far as they were contaminated by the sub prime mortgages.
Trade was a major channel of spread of the crisis to both the developed and developing economies. Developing and Poor countries had direct trade relationships with advanced economies which were suffering from serious macroeconomic problems and as a result decline in exports of developing and emerging economies was witnessed.
Reduced Financial Flows
Financial Flows to developing countries which include portfolio investment, FDI and remittances came down as a result of Economic Crisis. Cali, Massa and Te Velde (2008) estimate the decline in financial resources to developing countries to be around US$300 billion.
One aspect which has been ignored by different researches pertaining to Global Financial Crisis is the inequality. Rich countries have diverted attention towards saving their financial system while developing countries are under hoards of poverty and macroeconomic instability.
Low Income Countries which were already in poverty trap further suffered in terms of rising unemployment, low economic growth, decline in exports and decrease in remittances. Some of the major factors which were common in both the developed countries and developing countries are contraction in exports, hike in commodity prices and decrease in FDI and the exports. Poor countries suffered at a large scale as investors pulled their capital out of poor economies which pushed these countries further into recession.
Global Financial Crisis also introduced social problems as high unemployment and increase in poverty would give rise to more crime. Poor countries are dependent upon richer nations for aid and as a result of economic crisis; rich economies cannot afford to pay money to poor nations as foreign aid.
Financial Crisis and Policy Responses
Policy initiatives were taken all across the developed as well as developing economies. Global Financial Crisis led the governments to intervene in the economy and financial sector. The US has announced a $700 billion bailout package. European Union bailout packages ran about $2.3 trillion. Macroeconomic policy measures were also adopted as advanced economies pursued an expansionary fiscal and monetary policy. European Union has taken some other measures as well. EU is trying to increase spending in order to increase consumers and investors confidence.
Impact on Pakistan
Pakistan also did not escape from the financial crisis. Pakistan was suffering from acute macro-economic imbalances before the onset of Global Financial Crisis. Economic Crisis hit Pakistan in a variety of ways. Pakistan’s GDP growth rate came down. Pakistan also witnessed high fiscal and current-account deficit. Inflation which was an international problem also affected Pakistan. Pakistan’s macroeconomic indicators showed very poor performance as GDP growth rate declined from 6.8 % in 2007 to 4.1 % in 2008. Fiscal and Current Account Deficit reached to the highest 7.4 % and 8.4 of GDP respectively.
Global Financial Crisis hampered Pakistan’s economic growth to a great extent. Deteriorating foreign exchange reserves position due to Balance of Payment crisis compelled Government of Pakistan to approach IMF for a bail out package. Foreign Direct Investment (FDI) carries a considerable importance in economic growth and as a result of Global Financial Crisis. FDI came down from $5410 million in 2008 to $3720 million in 2009. Global Financial Crisis has also widened the Trade Gap in Pakistan as Trade Deficit rose to 12.8 % of GDP in 2008.
Unfortunately, Pakistan was suffering from different problems and thus government was not in a condition to provide a bail-out package. Pakistani government had adopted tight monetary policy to curb the rising inflation and similarly it also went for an expansionary fiscal policy as there is no room for counter cyclical fiscal policy.
Pakistan faces a major challenge of achieving macroeconomic stability and putting economy back on track. Fiscal and Monetary Policy carry a relative importance and thus there is a need to study the effectiveness of both the Fiscal and Monetary Policy in stabilization of Global Financial Crisis.
Global Financial Crisis has brought attention towards many issues. Crisis has revealed that there is a need for reformation. International Monetary Fund needs reformation. Similarly, there is a lot of betterment required in financial system of the World.
Blankbenburg and Gabriel (2009) have explained the onset of global financial crisis and some reasons behind the crisis. The research show that global financial assets have increased substantially. They also state in the paper that outstanding debt of US financial sector has risen from 20 % of GDP in 1980 to 116 % of GDP in 2007 (FED, 2009). The increase in outstanding debt is also associated with writing off the debt at a large scale as US financial sector has already written down $ 1 trillion. According to the paper, IMF reports that world’s economy will slowdown further. It also says that International Labour Organization has reported that 30 million have lost their employment.
Crotty (2009) has discussed the causes behind the global economic crisis. As he explained in the article that recent financial crisis is one of the worst crises after the Great Depression of 1930’s. Furthermore, Crotty (2009) explains the financial deregulation started in 1970’s and the newly evolved financial markets. He puts blame on the financial markets and the government for these financial crises. According to the article government announces bail-out packages for financial institutions in order to curtail crises and subsequently bail-out packages result in growth of financial markets. Financial markets are becoming bigger and bigger and so on the bail-out packages. The article moreover discusses the structural loopholes in our financial systems which are considered to be the leading cause of financial and economic crisis. At the end, paper suggests that enormous growth of financial markets should be curtailed and reversed as value of financial assets is very large as compared to real economy and real economy cannot generate cash flows for such financial assets.
Taylor (2008) has put the entire blame of global financial crisis on the loose monetary policy of Federal Reserve prior to the crisis. Moreover, paper also blames the governments whose actions prolonged the global financial crisis. It also reveals support to certain financial institutions by the governments further worsened the global financial crisis. Paper proposes that international financial architecture should be rebuilt. Resaerch emphasizes that policy interest rates should be kept on track.
Carmassi, Gros and Micossi (2009) have identified the major causes of the global financial crisis. The paper describes the reasons behind global financial crisis and also discuses some initiatives to be taken for alleviation of the problem. The paper considers the loose monetary policy as major culprit for the crisis. The paper also explains the flaws in regulatory system. The prevailing regulatory system time and again allowed excessive leverage and maturity transformation by the banking sector of US and Europe. Moreover, paper says that monetary policy should consider the macro-prudential policies of financial stability
Allen and Carletti (2009) have also researched on the global financial crisis. They have identified the causes; ramifications associated with the crisis and have put forth some suggestions. Research carried out shows that there were numerous reasons other than the mortgage crisis. According to the research, there were real state bubbles developed in different countries including the United States. The real estate bubble busted resulting in financial crisis. Loose monetary policy of Federal Reserve was the leading cause of real estate bubble. The second reason of the crisis was the prevailing global imbalances.
The research depicts the effects of the crisis as evident from the bankruptcy of financial giants. The paper also heavily criticizes the policies of IMF and World Bank.
Claessens, Igan, Dell’ Riccia and Laeven (2010) have discussed the policy implications from the global financial crisis. The research carried out depicts the emergence of global financial crisis. Furthermore, it tries to explain the crisis with respect to international linkages. It shows that crisis proliferated through international linkages. It also shows that countries directly related to United States through trade and other means were the one which were highly affected. Research work also exhibits that crisis became severe due to new financial instruments and intermediaries and interconnections. As explained earlier in research, European banks had direct exposure to US assets and thus the problems faced by US banks further trickled down to European banks. Countries have been grouped according to the dates in which the countries entered into recession and timeline showing the events of crisis have been presented in the paper. Econometric and regressions models have been used in the research. Mean and standard deviations of performance indicators which are the severity of income losses and change in the average growth rate show that Group I countries (United States, Ireland, Iceland, Estonia and Latvia) suffered the most due to financial crisis. The research paper has also revealed the flaws with the traditional macroeconomic policy measures. The paper in conclusion emphasizes the need for coordination between macroeconomic and regulatory policies.
Lenza, Pill and Reichlin (2010) have discussed the role of three central banks and the policies undertaken by them for stabilization of global financial crisis. The paper analyses the policy responses to mitigate the impact of global financial crisis of European Central Bank, Bank of England and Federal Reserve of United States responses to mitigate the impact of global financial crisis. The paper had a special focus on the monetary policy enacted by Central Banks of these regions. The paper shows that quantitative measures as well as non-standard measures were taken to ease the pressure of the crisis. Non-standard measures actually changed the composition of balance sheet of the central banks. They also say that non-standard measures are very useful and can be of equal importance. Paper concludes that non-standard measures adopted by three central banks have been successful in stabilizing the economy and the financial sector.
Musleh-ud-Din (2009) has worked on the global financial crisis. Paper says that Pakistan was suffering from acute macroeconomic imbalances at the onset of global financial crisis. Global Financial Crisis further deteriorated the macroeconomic condition of the country. A sharp decline was witnessed in economic growth According to the research carried out, exports declined by 6.4 % in 2009, Foreign direct investment came down from $5410 million in 2008 to $3720 million in 2009. Fiscal and Current Account deficit reached to 7.4 & and 8.4 % of GDP respectively in 2008. Worker’s remittances also came down. Pakistan lost 3 million jobs in different sectors of the economy. Paper also explains the role of shock absorbers in stabilization of economic crises. The researcher has justified the stance of Pakistani government to adopt a concretionary fiscal policy as there is no room for counter-cyclical fiscal policy. Paper also talks about the high inflation and the tight monetary policy adopted by State Bank of Pakistan. The paper concludes suggesting that tax to GDP ratio should be increased and public sector investment be increased. Paper says that there is dire need for coordination between fiscal and monetary policies. Research also suggests that current account deficit should be maintained at a considerable level because high current account deficit hinders economic growth. Author also recommends that development policies such as technological advancement, human resource development and export diversification should be adopted for stabilizing the global financial crisis
Usman (2010) has also worked on the global financial crisis identifying its impact on Pakistan. The paper explains the repercussions of the global financial crisis. According to the research, global trends which led to the crisis are inflation, trade, high commodity prices and unemployment. Paper also quotes Bank of England report. Bank of England reported that world’s financial firms have lost $2.8 trillion due to global financial crisis. It is also reported that US passed a bail-out package of $700 billion while EU had a bail-out package of $2.3 trillion. Usman (2010) has also exposed global financial crisis impact on developing countries. Some of the similar effects on economies of developed countries include weaker export revenues, lower investment, unemployment and current account and balance of payment problems. Social effects identified are increase in poverty and more crime. Paper draws the conclusion that tight monetary policy should be pursued. It says that cuts should be made in expenditure and public sector development programmes be started. It also says that Government should intensify public private partnerships which would increase economic growth
The research which has been carried out by me is be a quantitative research as qualitative research is not feasible due to the nature of the topic. The objective of quantitative research is to develop and employ mathematical models or hypothesis pertaining to phenomenon.
Data Type and Research Period
The research has mainly used secondary data. The data type is time series data and it has been obtained from different databases. The reference period for the time series data is 20 years (i.e. from 1990-2010)
Sources of Data
The data for research was taken from various databases and websites. Major sources of data retrieval are Federal Bureau of Statistics, Ministry of Finance Pakistan, Economic Survey of Pakistan and IMF World Economic Outlook. Data for fiscal deficit, current-account deficit and trade deficit will be extracted from Economic Survey of Pakistan (For years 1990-2010). Inflation data has been taken from Economic Survey of Pakistan as well as State Bank of Pakistan’s website. Fiscal and Monetary Policy statements were also taken into account for data retrieval.
The technique carried out for research is Regression analysis. Regression analysis is a statistical technique which is used to determine the relationships between variables. It involves modeling and analyzing variables relationships between one dependent variable and several independent variables.
The statistical software’s employed for research purpose are Minitab, Statgraphics and EViews. Multiple Regression Analysis has been carried out. GDP was taken as dependent variable depicting macroeconomic stability. Potential independent variables which had an impact on total output (i.e. GDP) are fiscal deficit, current account deficit, trade deficit and inflation. The research has also used graphs and tables extensively for illustration.
Credit Crunch: when banks suddenly stop lending, or bond market liquidity evaporates, usually because creditors have become extremely risk averse
Fiscal Policy: One of the two instruments of macroeconomic policy; it comprises public spending and taxation, and any other government income or assistance to the private sector (such as tax breaks).
Tight Fiscal Policy: Fiscal policy which tends to restrict effective demand
Easy fiscal policy: A policy of cutting taxes, increasing government spending, and not worrying about the resulting budget deficits and increases in government likely to be advocated when the economy is depressed
Monetary Policy: The use by the government or central bank of interest rates or controls on the money supply to influence the economy. The target of monetary policy may be the achievement of a desired level or rate of growth in real activity, the price level, the exchange rate, or the balance of payments
Tight Monetary Policy: A restrictive monetary policy. This is intended to restrict the level of effective demand by making loans expensive and difficult to obtain
Easy Monetary Policy: A policy of having low interest rates and easy access to credit, to stimulate real economic activity likely to be adopted in times of depression
Current Account Deficit: An excess of expenditure over receipts on current account in a country’s balance of payments
Balance of Payments: An overall statement of a country’s economic transactions with the rest of the world over some period, often a year
Balance-of-Payments Crisis: An unsustainable balance of payments. This means that foreign exchange reserves are falling rapidly, or are being maintained only by a level of foreign borrowing leading to difficulties in obtaining further loans
RESULTS AND ANALYSIS
Multiple Regression Equation:
GDP = 5.42758E10 + 3.15626*Current Account Deficit – 2.08214*Fiscal Deficit – 5.69878E8*Inflation – 7.31908*Trade Deficit
Dependent Variable: Gross Domestic Product (GDP)
Current Account Balance
Current Account Balance
Analysis of Variance Table
Sum of Squares
R-squared = 90.3205 percent
R-squared (adjusted for d.f.) = 87.7394 percent
Standard Error of Est. = 1.34824E10
Mean absolute error = 9.61604E9
Durbin-Watson statistic = 0.855216
Multiple regression analysis was conducted to examine the relationship between Gross Domestic Product and four various potential predictors (independent variables) which are Fiscal Deficit, Trade Deficit, Inflation and Current Account Deficit.
Multiple Regression Equation is;
GDP = 5.42758E10 + 3.15626*Current Account Deficit – 2.08214*Fiscal Deficit – 5.69878E8*Inflation – 7.31908*Trade Deficit
Linear Multiple Regression Equation shows that Gross Domestic Product (GDP) will increase 3.15 times when Current Account Deficit increases by one. Similarly, it also shows that Gross Domestic Product (GDP) will decrease 2.08 times when the Fiscal Deficit increases by one. The multiple regression equation further more shows that Gross Domestic Product (GDP) will decrease 7.31 times when Trade Deficit increases by one. Coefficients of independent variables show that they are strongly associated with the dependent variable.
The R Squared value indicates that regression model describes and explains 90.3205 % variability in Gross Domestic Product (GDP). The adjusted R Square statistic which is a better measure for comparing models with different number of independent variables tells that the model accounts for 87.3% of variance in the Gross Domestic Product (GDP), thus it can be termed as a very good model.
ANOVA table which assesses the overall significance of the model. As p < 0.01 there is a statistically significant relationship between variables at 99% confidence interval.
The Durbin-Watson (DW) statistic tests the residuals to determine if there is any significant correlation based on the order in which they occur in data. Since the DW value is less than 1.4, there may be some indication of serial correlation. The highest P-Value in the model is of Fiscal Deficit i.e. 0.6755, since the P-value is greater or equal to 0.10, that term is not statistically significant at the 90% or higher confidence level.
Null Hypothesis: Gross Domestic Product declined due to high fiscal deficit
Alternative Hypothesis: Gross Domestic Product did not decline due to high fiscal deficit
As the P value for this hypothesis comes out to be 0.67 which is greater than 0.05 so the Null Hypothesis should be rejected
Null Hypothesis: Widening of trade deficit has caused decline in Gross Domestic Product
Alternative Hypothesis: Widening of trade deficit did not decline Gross Domestic Product
P Value for this hypothesis is 0.0063 which is less than 0.05, thus the null hypothesis that widening of trade deficit has caused decline in Gross Domestic Product should be accepted.
Null Hypothesis: Current Account Balance had an impact on Gross Domestic Product
Alternative Hypothesis: Current Account Balance had no impact on GDP Domestic
P Value by the regression results is 0.0498 and it is less than 0.05 so it can be concluded that Current Account Balance had an impact on Gross Domestic Product
Null Hypothesis: Inflation had an impact on Gross Domestic Product
Alternative Hypothesis: Inflation had no impact on GDP Domestic Product
P Value for this hypothesis is 0.3913. As it is greater than 0.05 so Null Hypothesis that Inflation had an impact on GDP should be rejected. Inflation has no impact on GDP as suggested by regression results.
Pakistan’s deteriorating macroeconomic conditions after the Global Financial Crisis had resulted in sharp downfall in GDP growth rate. Real GDP growth rate declined significantly in 2008 as it reached to 1.6 % and in 2009 it rose slightly to 3.4 %. Unfortunately, Pakistan was already suffering from macroeconomic instability before the Financial Crisis due to hike in oil prices and depleting foreign exchange reserves. Financial Crisis widened trade gap. Increase in budget and current account deficits and soaring inflation brought further problems for Pakistan’s economy.
Under IMF agreement Pakistan has to adopt tight fiscal and monetary policies. IMF progarmme is directed towards restoring macroeconomic stability in Pakistan. State Bank of Pakistan has increased discount rates to curb inflation but it has also hampered economic growth. Private investment is restricted due to increase in discount rates. Public finances remain in a precarious state. Pakistan has no fiscal space and there is less room for counter cyclical fiscal policy. In counter cyclical fiscal policy, taxes are cut and spending is increased during downturns to promote economic recovery and growth. Discretionary fiscal policy cannot be adopted in Pakistan as public debt is high and government is unable to finance the resulting fiscal deficit. Tax evasion is already on peak in Pakistan and as a result Pakistan’s tax to GDP ratio is very low.
It can easily be concluded that GDP is one of the measures of macroeconomic stability and regression results have made it clear that Current Account Balance, Trade Deficit and even Inflation had an impact on GDP. Multiple Regression Analysis has depicted that Null Hypothesis should be accepted. Global Financial Crisis had a severe impact on macroeconomic stability of Pakistan. Null Hypothesis that high fiscal deficit decreased GDP growth has not been justified by the regression analysis. Null Hypothesis that widening of trade deficit has caused decline in GDP needs to be accepted as shown by the regression results.
It has been established by research that GDP carries importance in assessing macroeconomic stability. Regression results have shown that potential impendent variables have an impact on GDP.
Global Financial Crisis has exposed loopholes in financial system of World. The crisis has revealed that there is a dire need for reformation of currently existing financial system. The crisis has further given a lesson to governments all across the World to improve regulatory authorities especially Central Banks. The global recession has worsened macroeconomic conditions of all countries. All countries need to develop collective action plan to deal with the Global Financial Crisis. Pakistan should reduce its fiscal, current account and trade deficit. Government of Pakistan needs to pay attention towards development policies. There is an urgent need to increase tax to GDP ratio and expenditures of the government should also be reduced.
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