Economic Policy Review ISSN 1313 - 0544

The crisis and the economy

Author: Dimitar Chobanov / 08.05.2008
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Recently, the global financial crisis has been the subject of many comments since it is expected to affect to a greater degree the development of international markets. The expected slowdown of the growth of the major economies, such as the USA and the European Union, is spreading over the rest of the world through trade and capital movements. The increasing integration of the Bulgarian economy with the European economies, however, is making it more susceptible to unfavorable developments and is raising questions about the effects of the current situation.

An important issue, in this case, is how the financial crisis arose. The main factor is the monetary policy of the major central banks around the world, which for a long period since 2000, was directed towards maintaining low interest rates. In the USA the federal funds rate fell down to 1%, while in the Euro zone to 2%. Low interest rates practically mean faster growth of the money stock. In such case the money supply is greater than the demand, which leads to price increases. Something more - the prices of certain assets increase significantly by forming the so called "bubbles".

The growth of the economy is stable if it is due to increased savings. Under the current conditions, however, this is not always the case. The monetary system, dominated by the central banks, allows for printing money, when they are not covered by goods and services and they practically appear from thin air. The entrepreneurs receive wrong signals as a result from the higher prices in certain sectors, which are a result of additional liquidity in the economy. The initial effect is similar to that from the increased savings; however the long term effects are different.

The investments in the economy depend on the demand and supply of borrowing funds. The increase of the supply of borrowing money pushes the interest rates down and increases the supply of investment credits. When savings are growing that means the people are prepared to defer current consumption against the future one. In other words, at a later stage they would be looking for more goods and services, which could be met only by greater production. The main thing is that the higher savings lead to higher investments, which increases the production capacity and the economy grows.

The effect of the monetary and credit expansion is different. Injecting more money reduces the interest rates, investments increase, but savings actually fall due to the lower return. In such case the interest rate deviates from the so called natural level. For that reason its maintenance could be achieved only by further increase of the money supply. A disparity is created between the savings and investments and as a result temporarily growth is stimulated, but it is not sustainable and is followed by a downfall, since the investment must adjust to the level of savings.

The investments, however, represent a multi-stage process. The interest rate controls not only the level of investments but the distribution of resources in the investments. The different investment relate differently to the consumer goods. Research and development for example is more distant from the time of production of end-user consumer goods. The sensitivity to the interest rates increases with increased remoteness in time from the end use.

When the interest rates are reduced the investment in long term capital is stimulated, thus leading to changing the structure of production. If it is a result from money expansion however, it does not correspond to the expectations of the consumers. Hence, the received signal is wrong if there is no growth of savings. The misbalance between production and consumption leads to slowdown. The artificially maintained low interest rates are replaced with a high real interest rate, since the resources are reduced. The slowdown leads to liquidation and restructuring of the capital, through which the production activities are brought in line with the consumer preferences.

Identification of the misallocation of resources in time must be based on defining the flourishing and slowdown of the economy. Actually, the period when wrong decisions are taken must not be defined as growth and the subsequent restructuring and liquidation as a slowdown. The second period for all practical purposes represents corrections of distortions in the markets of labor and capital. During the artificial growth stage unemployment is low but when it is over workers are made redundant and the employment is reduced.

Such development could be expected in Bulgaria. Although the money supply in the country is to a greater extent orientated towards the preferences of consumers, the currency board is based on the policies of the European Central Bank (ECB). Hence, when the ECB maintains low basic interest rates this is transferred in Bulgaria as well. This contributes to the faster growth of the money supply and the credit activity, increases inflation, wages grow faster, and the current account deficit is greatly increased. These are symptoms that the money supply is greater than the demand for money, which leads to effects described above.

Hence, we could expect all negative consequences from the artificial growth. The economic growth would probably slowdown due to the liquidation of the malinvestments, which will lead to lower investment activity. Employment would be reduced and fewer new jobs would be created. It is possible that some of the commercial banks would have liquidity problems, which would effect their propensity to lend money. The interest rates would continue to increase which would lead to increase in the cost of servicing the credits.

The consequences for the state budget could also be negative. From one hand, the pressure for higher social spending would increase, while on the other hand it is possible that revenues would be reduced due to the lower economic activity. One of the factors for that is the slowdown of the rate of imports due to the lower demand.

As a whole, the future of the Eurozone does not look positive. This would have inevitably an effect on Bulgaria, which would lead to restructuring of the investments. The reduction of the prices of the financial assets must serve as a lesson to the investors, that they must use better judgment in their actions. In this case it is necessary they to bear the responsibility for their own actions and not to expect the government to compensate them for their mistakes. This applies for the commercial banks, which must be particularly careful with respect to managing the emerging risks.