Economists have already noticed long ago that the economic crises occur in relatively regular time intervals. Their incalculableness is rooted in the fact that we can never know which economic sector and national economy is going to be involved. With the help of descriptive statistics I would like to reveal and present the methods and processes enforced by and in the crises and constraints of the last hundred years, which, after all, have found their justification. With help of the mentioned methods of crisis handling we can prevent or reduce the effect of the following economic recession.
crises, Smart Money Index, WIR, recession
The economic and financial crises appear from time to time, they can be said to be the natural attributes and inseparable from the capitalist market economy. Their incalculableness is rooted in the fact that we can never know which economic sector and national economy is going to be involved. This course of thinking gave the very actual topic of this paper. In the course of the major economic crises documented to date we could observe some positive returns. We believe that on the basis of these results the prevention and management of crises could be elaborated on international scale. With the help of descriptive statistics I would like to reveal and present the methods and processes enforced by and in the crises and constraints of the last hundred years, which, after all, have found their justification.
Upheavals and crises have always accompanied the economic pursuits of man and they will remain an organic part of the circulation and cyclicality of economy. A crisis means the economic troubles arising from the difficulties of production, turnover and consumption, which occur when these difficulties rooted in these activities become commonplace. The various activities of the economic life must be in the right proportion with each other, namely, production must suit the extent and direction of consumption and turnover must serve production and consumption. If any of the economic activities perform at a higher rate than required by the other spheres or the other way round, if it cannot meet the demand of the others the disproportion will result in financial loss, which is the crisis.
The causes of the formation of crises have been investigated by numerous authors. Canova (1994) summed them up in four fields. One of them is the theory based on seasonality according to which the cause of the crises before the first world war was the seasonality of agriculture and the lack of the FED. This view was represented by Piatt (1907), Kemmerer (1909) and Sipos (1986). Another one is the credit-business cycle (Mitchell – 1913, Fischer – 1933) stating that the financial crises are the direct consequences of the final expansive phases of the business cycles. The third thesis is the monetary theory (Cagan – 1965, Friedmann-Schwartz – 1983), putting emphasis on the shrinking of the monetary stock and the enforced turning of the instruments of the commercial banks into money. The world crisis of 2007 also started with similar phenomena. The fourth thesis is the ‘bubble theory’ according to which the collapse of the share markets precedes and triggers the bank panic and recession. Its representatives are Wilson (1990) and Schwert (1990). We could state that one of the four theories could be observed when studying any of the documented recessions.
Among the preventive tools we should mention the Smart Money Flow Index, which is one of the most popular indicators of technical analysis. Its elaborator was Don Hays, who studied the investments carried out and the positions taken at the stock market by the less experienced private investors and experienced institutional investors in various market situations. He observed that the retail investors usually react to the events of the previous day early morning as soon as the stock exchange opens while the more experienced investors bide their time and get more active before closing. As it is widely known, inexperience is coupled with impulse impetuous decisions, which are rarely profitable. Hays measured the volume of trade in the first half and in the last hour of business and he added their difference (be it positive or negative) to the similar figure of the previous day to get his index. If the figure had positive correlation with the underlying share market index, further rise could be expected but if divergence could be observed a change in the trend was ahead on the share market. The collapse of the market took place within one or two years in all cases. The below diagram presents it clearly.
2.1 Economic crisis in 1929 and the WIR
The world economy sustained two great global crises in the 20th century. The first was the great economic crisis (1929) after the end of the First World War when the exhaustion of economy became global the human and material resources perished, insecure money was issued and commercial ties disintegrated. Crisis became inevitable. The rate of inflation and unemployment rose to incredible proportions, people were hungry and basic commodities got scarce. The peace treaties made recovery more difficult and the world market shrank as well. Germany and its allies had to compensate for the damage caused by the war (in 1921 the reparations was 33 trillion USD). True, reconstruction started after the war but it brought about a short uplift only. The United States became the leader of the world economic, which resulted in the movement of capital to the US while the base interest rates rose in the other countries giving birth to deflation. A real chase for riches started as a great number of people inexperience in money matters invested their money in the stock exchange. At the start of the crisis these investments almost all went bankrupt and the money went in the pockets of speculators and top dog businessmen.
Overproduction was experienced worldwide, all branches produced products over their capacity but production was financed from credit. Since markets did not expand what is more most of the money was channelled in the loans invested in production the purchasing power diminished and the heaps of products could not be sold anywhere. There was no money available either for purchasing or production or expansion, in addition, the third wave of industrial revolution was launched. After all this on 24 October 1929, on the black Thursday recession hit the stock market; many people see it as the start of the crisis.
Reading the above a justified question arises: what could have been done to avoid the return of the crisis in the future or what method could have mitigated the impact of the crisis. Unfortunately, the answer is far from simple because as I have already mentioned, the difficulties of operation affect differing economic activity in all cases. Then they expand and make the operation of the whole economy impossible. In the course of my research work I came across an interesting article, which focuses on an alternative possibility, which has already been applied. Although it does not ensure whole scale remedy of the crisis but it is able to decrease the problems caused by the crisis.
At the time of the world economic crisis of 1929 Switzerland faced similar problems as its neighbours, Germany and Austria. In 1934 nearly 16 companies were affected by the wind of the crisis that is their credit line was decreased or eliminated in full. Bankruptcy was only a matter of time. Since they could not find support from the banking sector due to the meagre economic situation they had to find a solution of the impossible puzzle. As the result of it the solution was found in Zurich in 1934 under the leadership of Werner Zimmermann. The heads of the 16 Swiss companies established a credit system inviting their partners to join. Despite the earlier attempts this initiative evolved into a successfully operating system of our time. The system was named WIR, which is the abbreviation of the Swiss term Wirtschaftsring-Genossenschaft meaning the circle of mutual economic support. Its headquarters are in Basle and comprises more than ninety thousand members.
Benefits of the system
Cost efficiency (low transaction cost: 0.006%)
this form of loan is cheaper and easy to reach
access to a large number of pre-selected clients as the pre-requisite of joining is reliability and creditworthiness
uninterrupted business is established that is it had a stabilizing effect on economy
supplementary services (expansion of customer base, PR and publication possibilities)
In parallel with the above listed features the operation of the system is surprisingly simple. The accounting unit of the system is the WIR which is at a 1:1 rate with Swiss Franc (1 CHF = 1 WIR). This currency serves as the medium of exchange among the members of the system, facilitating economic transactions. To put it simply: firm A buys a product from firm B. The account of firm A is debited with a credit while the sum amounting to its counter value is transferred to the account of firm B. When we compare them it is interesting to see that loan of Hungarian banks are between 10-20% while it is as little as 2% in Switzerland. The credit granted by the WIR use an interest around 1%. The father and developers of the WIR system saw to it that the WIR accounts do not yield interest and do not store value thus prevent lucre and the gaining of profit. What is more: since the system must not go abroad it functions as local currency and exclusively strengthens the local economy. It was one of the reasons why the economy of Switzerland weathered the economic crisis of 2008 relatively stable and sound while the banking system sustained heavy losses. On top of it all the competitiveness Switzerland even increased due to the economic difficulties of the European countries.
The below table clearly shows the fact that despite the deep economic downturn Switzerland was able to maintain its economic stability in 2010 in the second year of the economic crisis. The main strength of the country is its ability to innovate. This is what ensures its competitiveness and efficiency. With respect to these aspects Switzerland performs better than almost any of the EU member states.
2.2 World recession of 2008 and its results
Although the roots of the world economic crisis of 2008 were quite different from those of the crisis of 1929, still the two crises play decisive roles in our economic decisions and the development of the economy. The seeds of the economic slump were sown as early as 1992 when the affordable housing program was announced. According to the instructions of the Congress the major mortgage creditors of the market (Fannie Mae and Freddie Mac) were to support mostly the loans of the borrowers with low and medium income. It meant a 30% rate of the given year while it rose to 42% in 1996, 50% in 2000 and as much as 56% in 2008. In order to maintain this rising trend the eligibility requirements had to be slackened. In 2000 it resulted in loan placements without any down payment by the borrowers. The loans deteriorated to such an extent that the mortgage loans busted when the markets collapsed, which brought about the crash of the securities market as well.
The United States paid about 930 billion dollars to help out the banks and financial institutions in trouble. But it was in vain as the financial institutions went bankrupt one by one. And the process did not end here. The crisis went worse in the developed markets despite the fact that the central banks continuously pumped money in the banking system.
“At the end of 2008 the world economic and financial crisis that shook the whole world was followed by the crisis of the labour market. As the result of the economic throw-back the number of the unemployed rose by 5 million in the EU member states and 20 million in the OECD countries. It was qualified by some analysts the largest labour market crisis of the post-world-war period.”
In order to eliminate such moral problems a plan was prepared to develop a comprehensive integrated regulatory reform to cover all fields of the economic and financial activities on the level of the European Union in contrast with the earlier national level regulations.
The regulation is based on four pillars:
prevention and management of crises
The lack of transparency was explained for a long time with the complexity, far reaching many-foldedness of financial activities. However, the crisis showed that all financial actors must be subject to the appropriate regulation and supervision.
The adaptation or confirmation of the earlier regulations became necessary. Several objectives were launched to achieve it. According to the directive on alternative investment fund managers the commission ensured that potential risks threatening financial stability were monitored on the basis of uniform rules. The investment fund managers were able to enter the EU market only in compliance with the comprehensive system of requirements.
With respect to the derivative and short selling transactions the European Commission proposed the introduction of standard contracts on derivatives with clearing via a central counter party thus mitigating the possible risk of insolvency. In addition information relating to European transactions must be reported to trade repositories thus ensuring transparency.
According to the directive on markets in financial instruments (MiFID) the Commission proposed an even more transparent trade in the area of financial instrument thus ensuring the trade of various instrument within Europe.
In order to maintain the trust of consumers and investors in the financial system the responsibility of financial service providers were tightened. On the one hand to prevent corrupt practices on the markets and on the other hand, to develop the culture of risk taking on the level company management. The filling of the gaps of the legal regulations was another important step just like making the applied directives effective with respect to the over the counter derivative instruments and those used in multilateral trade.
On company management level the long term financial interests of the enterprise were to given priority. It ensured a larger scope of competence and independence for the risk managers. The emphasis on the role of shareholders, auditors and financial supervisors were also important steps towards new responsible operation.
The world crisis threw light on the shortcomings in coordination between the national supervisory bodies. In order to get rid of them a proposal was prepared on the development of a supervisory system on the level of the union.
The European Supervisory Framework entering into force at the beginning of 2011 comprised the European System Risk Body, which ensured that macro-economic risks were recognized in time and properly handled. EBA (European Banking Authority), EIOPA (European Insurance and Occupational Pensions Authority) and ESMA (European Securities and Markets Authority along with the European supervisory authorities of the sectors developed the ’Single Rulebook’.
The Commission wishes to raise the supervision of the operation of the credit rating agencies to European level too and foresees their registration in the framework of ESMA. It granted exclusive supervisory competence for the authority over the rating agencies. Issuers of structured financial instruments must ensure access to information to all interested credit rating agencies.
But the most important aim was to prevent another collapse of the economy like it happened in 2008. It required the appropriate early warning method in the financial system. Its most significant measure was the development of a more effective liquidity system in accordance with the Capital Requirements Directive (CRD).
The purpose of the accounting standards is to help bring decisions by the users and better reflect the aimed objectives.
The establishment of liquidation funds provides help in avoiding burdening the tax payers with the costs of liquidation. These funds dispose of the sufficient capital to grant cover in case an average size bank fails. Thus insolvency cannot affect the stability of the financial system.
In the aftermath of the crisis MiFID II (2014/65/EU) was adopted on 15 May 2014. The new directive dealt with the markets of financial instruments. It appropriately regulates the trade on markets in financial instruments, ensures new legal framework and puts more emphasis on the protection of investors.
The main objective of the directive is to ensure the regulated trade of financial products on international level. It also supports and ensures greater transparency mainly relating to the prices of the financial instruments, controls and restricts the speculative possibilities of the commodity exchange. It also foresees to give timely responses to the challenges staged by new technologies and the protection of the investors.
The governments were obliged to harmonize the Union’s decisions and directives adopted in 2014 with their national legislation. The implementation of the regulations on the markets in financial instruments, the malpractices of the markets and the protection of investors was carried out by 3 July 2016 and they took effect as of 3 January 2017.
As we could see the greatest achievements are produced in crisis situations. They urge mankind to solve the problem. Without the crisis of 1929 Switzerland would not have established WIR and most probably it would have become one of the most decisive and most stable economies of Europe. It is hard to understand why other nations did not adapt the supplementary currency system elaborated by Switzerland, which proved its grounds for the past almost 80 years.
Having studied the cycles of economic recession one can justly ask when the next crisis is expected and how big it is going to be. Since 2017 a new divergence can be observed between the Smart Money Index and the SP500 index and the difference is increasing. The below diagram vividly shows that.
As I have already mentioned earlier it has always meant the collapse of the financial market within one or two years. Thus we justly fear of another upcoming crisis in the near future. True, the rearrangement and the regulation of the market caused by the economic crisis may soften the bottom but I believe more preventional measures and preparation would have been necessary. I do not think we have enough time to prepare our national economies for the bottom. That is why it is important to call attention to the crisis management solutions elaborated on national and regional level which could stand the test globally considering the peculiarities of the financial markets.
Economists agree that tuned to this various national characteristics it would be a viable system in other national economies as well. The crisis of 2008 brought about numerous useful innovations and increased severity thus preventing the return of a crisis on similar basis. What distortion of an economic process will expand the next slump into global crisis is yet to be seen.
It pointed at, that the self-regulation ability of the market is limited without an equivalent prudential regulation beside the modern financial systems and it is not efficient to prevent of evolution of financial imbalance. The regulation should be transformed to consider the economic temperament of financial instability. Accordingly, the configuration of monetary policy strategy need to reconsider, that beside the aspects of real economic and financial processes the risk of financial stability need to get a bigger role. First and last, all of the economic policies need to help the recovery of real economic, but it cannot cause an extraordinary financial instability.
According to my opinion, the primal problem is that the reason of formation, market involvement, effect, depth of any economic recessions are always disparate. It means that we need experiences of many years and its proper evaluation. Otherwise, it can be that because of distinct and continuously changing economic and market factors cannot be work out an effective, solid international crisis management.
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BAMOSZ hivatalos honlapja, www.bamosz.hu
MABISZ hivatalos honlapja, www.mabisz.hu
MNB hivatalos honlapja, www.mnb.hu
Bogáth Emese Melinda
Szent István University, Gödöllô, Hungary
Bogáth Andrea Gabriella
Szent István University, Gödöllô, Hungary
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