The recession and financial crisis

The current recession that has hit western economies and whose waves have hit developing countries deeper than anticipated; was caused by the global financial crisis which can be traced to some, but not all the extent to the sub-prime mortgage crisis that hit the USA in 2008. 

The current recession that has hit western economies and whose waves have hit developing countries deeper than anticipated; was caused by the global financial crisis which can be traced to some, but not all the extent to the sub-prime mortgage crisis that hit the USA in 2008. 

That financial crisis can hit world economies to the extent we are witnessing is not surprising given that, finance can indeed be regarded as the mainstay of modern economies, and its role in the process of economic development has been aptly put that: “Money as a unit of account and medium of exchange reduces the transaction and search costs involved in barter transactions thus facilitating and expediting economic transactions. Money as a store of value provides time for making purchase decisions, thus reducing the risk of ill-formed and hasty decisions.”

Thus, the development of financial sectors of an economy has both positive and direct impact on the overall development of the real sectors of the economy without which these sectors stagnate.

To appreciate the consequences of the financial crisis to real economies of nations, one needs to comprehend the role of finance in economic growth and thus development, which also justifies the huge stimulus packages (bank bailouts and nationalization of financial institutions) the western world is putting in their economies to kick start them.

Up to, and until the early 1970s, the issues of casual/effect of financial development in economic development seems to have been resolved and consensus had emerged among leading researchers in this area, practitioners and policy makers alike, that, financial development is important to, and leads to economic development.

This is done by financial institutions and markets which avail financial resources for the production of goods and services. A financial system would then perform such functions as the mobilization of savings, facilitation and intermediation of savings mobilized, mitigation of risk transfer, and as a result ensure an increase in the quality of, and quantity of investments.

The central argument for the development of financial systems as a pre-condition for economic growth and thus development lies in the inherent distinction between savers and investors, which remain remote unless and until an effective financial system is put in place.

According to this view, savers may not necessarily have the required innovativeness to invest, while investors with such innovations may not have the necessary savings.

By providing the required intermediation role, financial systems bring to harmony the otherwise diverse needs of savers and investors and, by so doing, facilitate not only the savings process, but also the investments of pooled savings, which then enhance growth, and as a consequence, development.

It is against this theory that, financial development has been espoused as a necessary condition for economic growth and thus economic development.

Finance is the life blood of a modern economy and there can never be meaningful and sustainable development without financial development. The size and depth of a financial system is a reflection of the size of the underlying economy of which it is a product.

However, many economies have put in place financial systems to spearhead their development with great success, while others have left it to the markets to evolve the necessary financial systems to respond to the development of the real sector.

The later model of financial development and thus economic development seems to have failed to spur real sector growth as it is too slow to respond to the polity’s  to grow economies at the rate at which the standards of living of people can be maximized.

Many countries have had to intervene and put in place measures, systems, and institutions that enhance the development of financial systems as a pre-requisite for economic development.

Thus, Patrick (1966) argues therefore that, “supply leading finance” would induce development by pooling resources from non-exchangeable form to exchangeable and investible form.

He concludes that , “… the creation of financial institutions and the supply of their assets, liabilities and related services in advance of demand for them… has two functions: to transfer resources from traditional (non-growth) growth sectors to modern sectors, and to promote and stimulate an entrepreneurial response in these sectors. Financial intermediaries which transfer resources from traditional sectors, whether by collecting wealth and savings from these sectors in exchange for its deposits and other financial liabilities, or by credit creation and forced savings, is a kin to the concept of innovative financing”.

The above hypothesis draws credibility from Japan’s development which was preceded by constitution of a string of banking (e.g The Main Banks typical of Japanese development paradigm) and financial intermediaries, strategically placed to provide long-term finance that would fund massive investment in industry.

This model of development was also used by Germany with success, where financial institutions were designed to spur her industrial development.

Therefore, challenges faced by decision makers both in the west and indeed in developing counties is to ensure that, financial markets (mainly banks) are functionary efficient during such period (when Trust in such institutions has been seriously eroded, and yet is one of the cardinal assets of any financial institution) to provide credit for growth and thus development. 

In case of developing countries in Africa whose financial systems are rudimentary, and not well designed to spur meaningful growth and thus development, financial crisis in the West will simply affect them by default.

This is so, given that they have relied heavily on credit and other financial services from the western financial markets (as they have not developed their own) that, failure in these markets has a direct effect on developing countries in Africa which can no longer access these financial services.

But, this serves as a call to these developing countries to develop their financial systems like they do for other sectors of the economy such as education, health and agriculture, for this a critical sector to all these other sectors as they depend on it for their financing.

Research done on many of Africa’s financial markets has found out that they are remains of colonial outfits which were designed to facilitate colonial trade and transfer of raw materials to western economies, and that no effort was made by post-colonial African governments to reform their financial systems to suit the demands of ‘new post-colonial economies’.

Nonetheless, the recession in the western economies is a result of financial crisis which works simply as follows: The mortgage bubble in USA led to the credit crunch that swept western financial markets as most of these mortgages were discounted and rediscounted in the so-called financial engineering mechanism that has seen the creation of many derivatives of the original financial instruments.

With the onset of the credit crunch, customers could no longer access credit from banks even for ordinary purchase of goods and services.

This then lead to reduction demand and thus a fall in output of many firms in the west, and such a reduction was so widely spread that, it virtually covered every sector of the economy, from car sales, to home appliance, travel to tourism.

This phenomenon eroded growth in these economies leading to negative growth (GDP) up to -3% GDP in some economies for a period of three quarters which gave rise to recession (defined as reduction in output (GDP) for at least six consecutive months.

This then lead to massive job cuts by many corporations which fed back into recession through reduced demand arising outfall in incomes. In the next series we will discuss impact of recession on African economies.

Ends

 

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