Government's Role in an Interconnected Global Financial Market

Topics: Economics, Macroeconomics, Recession Pages: 9 (3025 words) Published: February 25, 2014

Recent events have merely confirmed what economists have known for some time, namely, that the interconnectedness of global economic activity renders macro-management by single governments redundant. Their function is now to regulate markets to ensure economically efficient solutions.

This essay will argue that the 2008 financial crisis has brought to the forefront of global political consideration what some economists have known for some time. This is that 1) The global financial system is inherently flawed and cyclical recessions are a product of its nature 2) The interconnectedness of the global financial system means macro-management cannot fully buffer an economy against these cyclical recessions 3) Policy has reduced effectiveness in this interconnected world 4) Globally co-ordinated regulation and co-operation in preventing and managing crises is an imperative 5) Although less effective, macro-management can still have a role in terms of preventing, and managing future crises. Minsky’s (1992) financial instability hypotheses took a stance against the laissez faire ideology that was politically rife throughout the 1980’s. He argues that flaws are inherent in the capitalist system, as periods of economic prosperity encourages risk-seeking behaviour by both lenders and borrowers which is fundamentally dangerous in the financial sector. He argues that private sector debt accumulation during periods of boom is the main contributing factor to economic busts. This debt is contributed to by 3 kinds of borrowers, each associated with a different level of risk. These 3 borrowers -ranging from least risky to most risky- are: hedge borrowers, speculative borrowers and Ponzi borrowers. During periods of prolonged good times, risk is not appropriately attended to and de-regulation occurs in financial markets. Resultantly, Ponzi borrowers become more commonplace in an economy and their ability to pay their debts relies solely on the reliance of the rising price of the assets for which they borrowed money to buy. Any fall in these asset values- the ‘bursting of the asset bubble’- means these borrowers inevitably default and a chain reaction begins; investors and banks alike begin to suffer from an inability to pay their debts and the cracks in the financial sector start to surface. This leads to a rush to hoard cash to liquidise assets, resulting in what is dubbed a ‘credit crunch’ as inter-bank and commercial lending dries up and economic downturn is inevitable. The parallels Minsky’s theory holds to the recent 2008 crisis is quite astonishing, with the American sub-prime mortgage popularity rocketing and the development of an ‘asset bubble’ in housing prices, the instability hypotheses has provided a framework for understanding what went wrong. It would seem then, that Minsky knew more than most about the faults of the system, so what did he suggest to counter-act them? Do these faults and the changes required to counter-act them mean macro-management is now rendered completely redundant?

First, the potential redundancy of economic policy in today’s global economic climate shall be assessed. The 1944 Bretton Woods agreement was undertaken by governments under the prevailing assumption that monetary and fiscal policy was responsible for adjusting any unsavoury economic conditions such as inflation, unemployment and general economic welfare (Perret, 2007, p69). Since then, the ever increasing presence of globalization has presented the world with a vast network of trade between nations on an unprecedented scale. Such trade has meant that what once was a world of individual economies is increasingly becoming a world of mutually dependent economies relying more and more on one another for trade, investment and production. Needless to say, nations within such a complex and mutually dependent network of economies have inevitably experienced the consequence of the financial crisis that began in the USA. The...
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