The Circular Flow and the Economic Crisis

 
Title: The Circular Flow and the Economic Crisis
Subject: Economics
Type of Paper: Essay
Words: 818
The current economic crisis began with excessive lending (injections) (lending without
proper attention to risk) in the early part of the decade, especially on houses. Banks then
repackaged loans into complex derivative products (the risk rating of which was difficult to
assess) and sold them on to other bodies. These complex derivatives spread throughout the
financial system. At the same time, the low cost of money combined with aggressive selling by
banks, resulted in consumers in many ‘western’ economies becoming very indebted (spending
another injection and saving little – a withdrawal). Finally, the low cost of money also fuelled
asset price spirals that helped drive demand (sucking in exports from emerging economies an
injection into their economies but a withdrawal from the importing country economies) and
drove up the prices of commodities (again an injection into commodity producing economies but
a withdrawal from importing economies). There were also substantial foreign investment flows
into emerging economies (an injection into those economies).
As house prices began to fall (starting in the US) so the complex derivative products
began to lose value, such that their value could often not be quantified as no one was willing to
buy the products. These became known as toxic assets. Suddenly the financial system could not
value its assets. Credit ceased to flow. Asset prices then began to fall and thus the value of assets
in the financial system fell further and the credit squeeze tightened (banks can only lend against
the assets they have). Falling property prices led to dramatic cuts in the construction industry in
western countries, while tighter credit cut consumer demand and led to business collapses. The
circular flow was then weakened by a vicious circle of business failures, rising unemployment
and declining consumer demand. This spread to emerging economies through lower imports and
lower foreign investment flows to these economies (and in some cases disinvestments).
A critical requirement to halt the downward spiral of contracting economies was to fix
the problems in the banking system. Governments tried to do this through injecting money into
the banks (increasing their liquidity, recapitalising them and in some cases nationalising them)
and attempting to deal with their toxic assets. The objective was to get credit flowing again.
In an attempt to stimulate the economy governments are using a combination of monetary
and fiscal policy. Monetary policy should bear the main brunt of tackling booms and busts. It is
based on two principal measures: i) Reducing interest rates to reduce the cost of borrowing
money (which also reduces the payments being made by existing borrowers and thereby
increases their disposable income, some of this will be spent –an injection into the economy) and
ii) control over the money supply. By the spring of 2009 conventional policy based on interest
rate reductions had virtually been exhausted and governments were beginning to use the less
conventional quantitative easing (increasing the money supply, see Appendix 5). This is
designed to inject money into the economy, although some money may leak abroad). Fiscal
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policy concerns tax and spending measures. Many governments have introduced substantial
additional spending programmes (stimulus packages, for example based on public works
programmes, an injection). In addition, governments may reduce taxes (for example, in the UK
the government reduced the sales tax -VAT - from 17.5% to 15% in 2008). This again leaves
people with more disposable income (some of which will be spent, an injection into the
economy). Many of these measures involve a time-lag before their effects are felt and thus it is
always difficult to judge when to halt the process of economic stimulation.
In countries with welfare systems (notably in Europe) the so-called automatic stabilisers
also influence the circular flow of income, contributing to injections during downturns. For
example, as unemployment rises, people pay less tax and are paid unemployment and other
social security benefits (boosting their incomes but adding to government spending). At the same
time the government’s fiscal deficit rises.
The dangers of increased injections into an economy are that: i) more money chasing
fewer goods will push up prices (inflation) and ii) higher government borrowing (Ireland, the UK
and the USA are likely to have public sector deficits of over 10 per cent in the coming years and
much higher levels of debt) means that there is an increasing burden placed on the citizens to
repay debts in the future (through higher taxation or lower government spending). In addition, as
government debt rises in