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Old Wednesday, December 09, 2009
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Default part one

part.1
When Benjamin Franklin said, “There are only two certainties in life – death and taxes,” he might have added financial cycles.

Economic crises or bubbles are often of cyclic nature and keep revisiting the world every 10-15 or 50-60 years whenever there develops fault line in the system.

Financial Crisis defined:

* Business cycle defined with focus on recession and depression period
* Boom, Bust, and Recovery in the World Economy: A housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, and a hedge funds bubble.

History of economic bubbles and cycles:
As Winston Churchill said, “The farther backward you can look the farther forward you can see.”

* Tulip Mania>Ottomans (Turkey)
* Mississippi Bubble (value of metallic currency began fluctuating wildly bubble burst in May 1720)>France
* Great Depression>Wall Street: market turned bearish on October 24, 1929.
* The Japanese asset price bubble occurred during1986-1990 period (speculative real estate bubble) and burst in the early 1990s, leading to Japan’s “lost decade”.
* Argentinean crisis in the late 1990s.
* The dotcom bubble in the US, driven by technology, began developing in 1995 and burst in 2000.
* East Asian crisis (1997)

Root Causes of the Current Crisis / Mechanism of current financial crisis:
The principal causes of the recent turmoil in financial markets were a breakdown in underwriting standards, a significant erosion of market discipline, risk management weaknesses, and the failure of regulatory policy to offset them.
Two different views about American financial crisis:
1)

* American Financial crisis: PETRODOLLAR Scam
* Subprime fiasco and deregulation: Mortgage Business, Banking credit practices, loose rating mechanism of rating agencies, and loopholes in regulating bodies.

Chain reaction: The Crisis Took hold through following chain: 1) subprime market, toxic mortgages 2) rising number of foreclosures 3) engineering a sale to JPMorgan Chase 4) Sales, Failures and Seizures 5) stock prices of Fannie Mae and Freddie Mac, government-sponsored entities that were linchpins of the housing market, slid sharply. 6) bankruptcy for Lehman Brothers. 7) Lehman’s failure sent shock waves through the global banking system, as became increasingly clear in the following weeks. Merrill Lynch, which had not been previously thought to be in danger, sold itself to the Bank of America to avoid a similar fate. 8) American International Group, an insurance giant on the verge of failure because of its exposure to exotic securities known as credit default swaps, was bailed out by the Fed in an $85 billion deal. 9) Stocks dropped anyway, falling nearly 500 points.

* Week ending Friday, October 10 To will be remembered:

2. Alternate Cause of current crisis:

* “Savings glut” VS “monetary glut”

“In fact, Asian savings may have provided the rope; but America hanged itself.”
Alternate Cause of current crisis: The current economic crisis had begun well before the ongoing global economic meltdown. Over the past eight years, official policies had essentially focused on the services sector at the cost of agriculture and manufacturing sectors. The economy faced many challenges with worsening fundamentals, resulting in depletion of the foreign reserves and depreciation of the rupee.


Debate on fixing responsibility: Market vs State:
Transmission mechanism of global financial crisis in different economic systems: The psychology of fear plays a major part in all recessions. We may remember the quote of Franklin Delano Roosevelt. He said,
"The only thing we have to fear is fear itself."
“It is the nature of economics that you play today and pay tomorrow”.

* Arguments against Markets
* Arguments for Markets

Free economy / market economy / capitalism / liberal economy / laisez fair system
Controlled /managed / planned/ socialistic /communist system.
Thirty Years of Development Economics: After thirty Years of Development Economics there has been a great debate over fixing responsibility that whether states are responsible for global financial crisis or markets?
The late 80s to early 90s saw an intensive policy debate on “market failure” vs “government failure,” and on “neo-liberalism” vs “revisionist” approaches. (To put it simply, “neo-liberalism” is an approach which relies heavily on market mechanism, while “revisionist” is the one which emphasizes the role of state). However, this debate was over 15 years ago.
The World Bank in 1997 backed away from pure free market dogmatism by emphasizing the “role of state” in its World Development Report.
Policies recommended by international financial institutions as well as by leading development economists in this behalf emphasize an appropriate macro-economic framework, a realistic exchange rate which is competitive and stable, the right set of sectoral policies and investments, appropriate role of the state in the economy, integration of the domestic into the world economy, poverty alleviation, clear identification of priorities and peaceful resolution of conflicts.

Measures taken by the US administration such as nationalization of AIGs and bailout packages to rescue the failing financial institutions and commercial organizations, in fact do not fit in the free market regime that believes in survival of the fittest. Many analysts and economists have firm view that free market can’t do self-correction. It is being hyped at present that we are, “entering a new paradigm of tight money, tough regulation, less speculation and more government meddling in markets.” With the loss of credibility of the American model, it is being speculated that because of the shift in the base of capitalism and new centers emerging in Europe and Asia, they will take the initiative to modify the model in light of their experiences.

Linkages of current financial crisis:

* The demise of the Soviet Union and the end of the cold war,
* The rise of Reagan-Thatcher onslaught towards deregulation and unbridled laissez faire capitalism and finally
* WTO agreements and arrangements.
* The explosive growth of international capital movements as the principal driver of globalisation,
* Financial globalization: integration of national financial markets and its impact
* The finance revolution of the past 15 years or so has been rent-seeking rather than welfare-enhancing in character.
* Regional trade agreements

* Global economic imbalances: When a flow becomes a flood

The financial contagion now spreading worldwide: Implications for Developing Countries:

* Why are emerging economies affected? Emerging Economies More Dependant on Foreign Capital
* Liquidity crunch, dwindling reserves and falling rupee: Effect of current crisis on developing nations:

IMPACT On ASIA
-- some Asian institutions have exposure to subprime mortgage-backed assets and other CDOs;
-- re-pricing of corporate risks in the US probably caused some normalisation of risk premiums; and;
-- tighter liquidity conditions in the US and Europe may affect capital flows to and from Asia.



Linkages: Living in Free trade (Globalization) era. No isolation
Negative Impact

* Unemployment: Job losses
* Deterioration in purchasing power
* Slowdown in economic activity

Blessing in disguise: Opportunity

* Economic centers
* China, India, Brazil : Emerging economic superpowers of the future, China and India.

Deteriorating economic conditions of Pakistan: whether caused by exogenous shocks or by endogenous
October 6, both Standard $ Poor and Moody’s, two of the world’s largest rating agencies, downgraded Pakistani bonds.
Current Position of Pakistan Economy: Besides high balance of payments deficit, the country is at present facing a number of challenges, such as:

* low foreign exchange reserves;
* Impending huge debt servicing;
* Shortfall in power generation capacity, resultantly electricity load shedding;
* Poor physical infrastructure in terms of ports, railways and roads;
* Heavy dependence on imported industrial raw materials, consumer durables and plant and machinery; (f) fast rising population, urbanization, poverty and unemployment;
* Deplorable conditions in health and education sector;
* Severe supply gap in housing availability; and
* Lack of properly-funded and functional development financial institutions (DFIs).

Initial conditions due to internal factors:

* The credit and debit side of Pakistan’s economy
* Imbalances in the economy
* Oil for inflation,
* Twin deficit
* Monetary and fiscal policies poor coordination: One year of fiscal indiscipline was enough to cause severe macroeconomic imbalances
* Stock market: unfolding of the misery
* Reality of Pakistan’s Forex reserve management
* Currency devaluation and its impact on the economy
Devaluation in Pakistan in different periods not a good experience: First devaluation in 1955, Second Devaluation: On 11th May 1972, Pakistani Rupee was devalued by 56.7%, Third Devaluation: On 8th January 1982, April 2009 it stands to now Rs80

Just growth won’t work: rethinking development strategies

* Limitations of govt measures to check inflation
* War on terrorism
* Political instability
* Effectiveness of Vision 2030; a plan of socio-economic transformation of Pakistan has not been witnessed so far.

Fuel to fire by external factors due to current global financial crisis:

* Snowballing effect that will set in a recession.
* The buoyancy of the external sector
* Pakistan is poorly integrated with the global economy. This means that the shocks being felt in developed countries will not be felt to any great extent in Pakistan.
* As a developing country, one of the biggest problems that is likely to affect Pakistan because of the global credit crunch will be a sharp reduction in foreign aid flows and foreign direct investment. This, in turn, is likely to severely hamper Pakistan’s efforts to reduce poverty, raise income levels and get out of the morass of the poverty trap.

Negative impact on Pakistan:

* Stock Exchange
* Consumer spending declining in developed nations will cause Exports to developed countries have decline. Resultantly decreasing production level and ultimately employment
* Forex reserves depleting
* Dollarization Dilemma
* Decline in FDI
* The Stock market is affected because of withdrawal of portfolio investment.
* Flight of portfolio investment
* BOP adverse position
* Exchange rate in pressure
* Decline in exports: America as our major export country
* Decline in foreign remittances
* Rightsizing / downsizing /firing
* Debt and deflation Depressing times: Are rich economies heading merely for a bout of falling prices, or for a 1930s-style deflationary spiral?
-A deadly mix of falling prices and high leverage could foment a “debt-deflation” of the type first described by Irving Fisher, an American economist, in 1933. In this schema, debt-laden firms and consumers rush to repay loans as credit dries up. That hurts demand and leads to price cuts. The deflation in turn increases the real cost of debt. It also means that real interest rates can’t be negative, and so are undesirably high. That spurs yet more repayment so that, in Fisher’s words, the “liquidation defeats itself.”
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