A critical analysis of the 2007 - 2009 global financial and economic crisis and its implications for the travel industry and associated businesses

Table of Contents

1 Introduction

2 how the 2007-2009 Global Economic crisis evolved
2.1 Recent historical background
2.2 The problem of sub-prime lending
2.3 The end of an era
2.4 Effects of the financial crisis on the real economy

3 Research Methodology

4 Impacts of the crisis on the tourism industry
4.1 General aspects
4.2 Key negative impacts
4.2.1 Decreased public funding for tourism projects and infrastructure
4.2.2 Restricted access to capital
4.2.3 Excursus: Unemployment in the tourism industry
4.2.4 Changing patterns in leisure travel
4.2.5 Changing patterns in corporate travel
4.3 Selected possible opportunities
4.3.1 Shift in source markets
4.3.2 Intensification of the trend towards ‘Smart tourism’
4.3.3 New spirit of companionship
4.3.4 Other opportunities

5 Discussion And Conclusions

List of References

Bibliography

Appendix

Table of Figures

Figure 1: Effective Federal Funds Rate 07/1954-02/2009; Source: Federal
Reserve Bank of St. Louis

Figure 2: S&P/Case-Shiller Home Price Indices as of October 2008;
Source: Case-Shiller Housing Whitepaper 2008,

Figure 3: The New Model of Mortgage Lending. Source: BBC 2007

Figure 4: The New Model of Mortgage Lending - How it went wrong.
Source: BBC 2007

Figure 5: Dow Jones and S&P 500 Indices 1996-2008;
Source: Newyorkfed.com 2009

Figure 6: U.S. mortgage delinquency rates 1998-2008;
Source: Case-Shiller Housing Whitepaper 2008,

Figure 8: Phases of Crisis Management.
Source: Adopted from Glaesser, 2003,

Figure 9: World Travel and Tourism Economy GPD and World Travel and
Tourism Economy Employment Forecasts.
Source: WTTC, 2009,

Figure 10: Consumer Price Index for selected countries 01/2007-07/2008,
including forecast until July 2009. Source: Advito, 2009,

Figure 11: Growth in outbound travel from selected markets in the Americas,
2008. Source: IPK International, 2009,

Figure 12: Advito 2009 hotel rate forecast by world regions.
Source: Advito, 2009,

Figure 13: Consumer Segment's Changing Behavior.
Source: Quelch & Jocz, 2009,

List of abbreviations

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Abstract

There have been numerous incidents in one or more countries in the past that led to sudden and unexpected reductions in demand for tourism services and confronted travel businesses with an economic environment of high uncertainty. However, the current financial and economic crisis appears to be of a larger dimension than most other crises before, and numerous experts around the globe agree that the present economic slowdown has the potential to become one of the most challenging and transformational disturbances on a supranational level since the Great Depression. Predictions of future developments are vague and can only be educated speculation at best, yet for the tourism industry the initial effects of this first major crisis of the globalization era are already clearly perceptible.

Drawing on an extensive review of already existing literature, this paper explains the various milestones during the period that led to the 2007-2009 global financial and economic disorder, and subsequently considers a choice of selected key implications for the tourism industry and associated businesses. The aim of this paper is therefore to provide an academically substantiated reference guide for market participants and policy-makers alike, with the ultimate purpose of making a contribution to reduce the number of cases where wrong decisions lead to major difficulties or even the failure of a destination or an individual business.

Results of the research indicate that the identified impacts are likely to intensify throughout 2009 and 2010, and that the crisis will most likely also entail fundamental changes for the industry on a long-term basis. In particular, it was found that in the medium term decreased public funding for tourism projects and restricted access to capital are likely to force many travel businesses into serious liquidity problems. This may cause a series of reactions, including widespread workforce reductions and severe cuts in the quality of the provided services. Besides, the crisis is likely to have considerable effects on the way leisure and corporate travel is conducted, as for instance shorter and less frequent trips or a stronger tendency towards cost containment. However, the paper also points out that every crisis embodies a great number of opportunities and provides an analysis of a range of selected chances for destinations and tourism businesses.

1 Introduction

At present (spring 2009), the world experiences one of the most severe economic crises in post-WWII history, precipitated mainly by the U.S. sub-prime mortgage crisis which became apparent to the broad public in 2007. In 2008, the U.S. sub-prime crisis turned into a global financial crisis, and subsequently into a global economic downturn that forced numerous countries into recession. Stock markets have fallen, large financial institutions have collapsed, and governments had to come up with rescue packages to bail out their financial systems.

Although it can be argued that overall the tourism industry may not be as vulnerable as other commercial sectors when it comes to fluctuations in clients’ purchasing power, in the medium term tourism businesses are still likely to be at least as seriously affected by the upcoming new distribution of economic power as any other industry. A long-term trade and industry downturn may bring about a broad range of changes to the world, like altered roles of the United States, the European Union and the Asian block, insecurity and crime, a different understanding of handling energy resources, further polarization between rich and poor, or changing values and therefore consumer preferences in general – to name just a few. All these factors may potentially have adverse impacts on tourism businesses, and thus require adequate attention and timely academic research.

However, change can also mean positive development and can open up new chances and opportunities for the world economy. These opportunities need to be identified, assessed and exploited. With an estimated direct and indirect contribution of the travel and tourism sector of 9.4 percent to global GDP, 10.9 percent to world exports and 9.4 percent to world investment, the significance of the industry’s role in the struggle for economic recovery clearly must not be underestimated (cf. WTTC, 2009, p. 4). As the tourism industry is all about pleasant experiences and the positive things in life, it is sometimes hard to think about crisis management. When having to operate in an economically insecure environment of the current dimension, numerous managers therefore face the challenging situation of having to make decisions in fields they do have little or no knowledge about. However, in a fast-changing and highly volatile economic climate like the present, inaccurate decisions by executives of tourism businesses can have devastating consequences and can seriously jeopardize the existence of a company. The timely information and education of decision-makers on the implications of the crisis can therefore become a decisive factor for a company’s overall survival or failure in the months to come as well as the years after the crisis. As many policy-makers and executive managers encounter ambiguities when it comes to comprehending the origins, backgrounds and possible threats of the current economic turmoil, this paper provides a concise overview of the emergence of the crisis and a critical examination of selected issues that are fundamental for the effective operation of tourism businesses during these economically troubled times. The aim of this paper is, therefore, to consider the overall global context of the crisis from various angles in order to identify and assess specific threats for the tourism industry, as well as to advance the perspicuity of the question which of the erupting risks are the most relevant.

To arrive at this objective, the paper draws upon three main pillars. First, in the introductory section a profound description of the causes and the development of the crisis is provided, together with a short explanation on how the crisis touched upon the world’s real economies. Then the paper presents a detailed examination of a range of selected positive and negative short- and long-term effects that the crisis may potentially have on the tourism industry and associated destinations and businesses. Finally, in the discussion section of the paper conclusions and recommendations on how to mitigate the concomitant risks will be provided.

As indicated above, the main focus of this paper is not on providing information about a specific branch of the tourism industry or geographical region. The main spotlight is rather on the enhancement of the general knowledge of tourism managers and policy-makers on the current crisis and its implications, with the ultimate goal to make a contribution to increase the number of cases where adequate decisions have been made and destinations and businesses have successfully weathered the storm. Due to the inherent complexity of the financial crisis, a certain level of previous knowledge about finance and economics is expected from the reader in order to be able to follow the content of this paper.

2 how the 2007-2009 Global Economic crisis evolved

2.1 Recent historical background

Since the current global economic turmoil undoubtedly has its roots in the U.S. financial system, an analysis of the recent developments in the latter must be regarded as an integral part of every attempt to comprehend the present state of affairs. The appointment of Alan Greenspan as Chairman of the U.S. Federal Reserve System in 1987 serves as a reasonable starting point for this analysis. It is crucial to recall that when Greenspan took over office from his predecessor Paul Volcker, during the first years of his administration guaranteeing price stability was considered as one of the main goals of the U.S. central banking system, and was also more or less successfully implemented (Greenspan, 1989, cited following Orphanides, 2006, pp. 2-3).

However, with the fall of the Berlin Wall in 1989 and the dissolution of the Soviet Union in 1991 countries like Russia, China or India significantly liberalized their economies, and thus contributed to a fundamental reorganization of the world-economic order during the years that followed. The development clearly brought along great opportunities for capitalist economies like the United States, which profited from the sudden emergence of several hundred million potential new consumers on the global market. Nevertheless, the onset of modern globalization in the early 1990s also put strong pressure on the U.S. job market, mainly as a result of cheap mass production in Asian countries. With rising international competition and the 1990/1991 recession, the U.S. financial policies had to undergo major changes during this period in order to avoid the disastrous consequences a substantial decrease in consumer demand would have entailed.

As a result, the Fed’s attention gradually shifted from price stability towards economic growth in the course of the 1990s, and in response to the need for economic stimulus, Greenspan’s team started to focus on an exceptionally inflation-responsive interest rate policy (cf. Mankiw, 2001, pp. 36-40). This in turn led to the frequent occurrence of periods with comparably low federal funds rates, a situation that clearly created a favorable business environment for investment banks. At the time, traditional commercial banks were to a large extent dependent on savings deposits to fund their credit business, and were thus also limited in the amount of lending they could do. They were safe partners to place money with, but “[…] failed to direct capital to its most productive uses” (Krugman, 2009, p. 65). Investment banks on the contrary offered a broader spectrum of financial products and could almost entirely be financed by the capital market.

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Figure 1: Effective Federal Funds Rate 07/1954-02/2009; Source: Federal Reserve Bank of St. Louis

This facilitated access to capital, along with sustained periods of low federal funds rates, made it easier to fund financial institutions like investment banks or hedge funds and, among other things, led to a strong overall increase in the lending business. This trend towards easier access to credit for almost anyone can therefore be regarded as the beginning of the alleged ‘golden era’ of American investment banks on Wall Street, and thus also of the U.S. financial system as a whole.

Figure 1 shows the history of the effective federal funds rate, which is widely considered to be the Fed’s most important tool to implement short-run monetary policy changes (cf. Mankiw, 2003, pp. 290-91). As the chart depicts, the Fed sharply cut the federal funds rate in answer to the bear market that followed the dot-com bubble burst in 2000 and the destruction of the World Trade Center in 2001, mainly with the aim to halt the then harsh economic downturn and to boost investment. The Fed’s policy of low interest soon started to take effect, and cheaper loans and growing credit expansion in general made it easier to finance private homes, resulting in skyrocketing demand for real estate, both for speculative purposes and for private use.

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Figure 2: S&P/Case-Shiller Home Price Indices as of October 2008; Source: Case-Shiller Housing Whitepaper 2008, p. 3

While most experts agree that the low federal funds rate was one of the main preconditions for a U.S. housing bubble to develop (cf. Krugman, 2009, p. 148; Soros, 2008, p. 82; Stiglitz, 2008b), others claim that the heavy increase in U.S. housing prices cannot even be regarded as a classic bubble, but rather as the result of newly invented financial tools like Asset-backed securities (ABS), in conjunction with sustained U.S. productivity growth and the strong influx of funds from Asian countries and oil exporting nations (cf. Reinhart & Rogoff, 2008, pp. 3-4). In any case the artificially created demand constantly drove U.S. house prices up over the years, with its peak in 2007, as illustrated by the S&P/Case-Shiller Home Price Indices shown in figure 2.

The soaring U.S. house prices led to improved loss experience with previously problematic borrowers, and subsequently to increasingly relaxed assessment practices for collateralized mortgage obligations by the rating agencies (cf. Soros, 2008, p. 83). Together with other related factors like declining saving rates and seemingly endless investor enthusiasm, the loosened valuation standards brought lending institutions to gradually ease conditions when awarding loans in order to sustain the affordability of real estate acquisitions and to generate more business in general. Starting in 2005, a strong rise in the issuing of loans to borrowers with little or insufficient securities, poor credit histories or inadequate down payments could be observed (cf. Krinsman 2007, p. 3; Krugman, 2009, pp. 148-49; Soros 2008, p. 83; Zandi, 2009, p. 163), and soon an inescapable, self-feeding vicious circle started to evolve.

2.2 The problem of sub-prime lending

In the course of the 1990s the financial community ‘invented’ a number of new credit derivatives with the goal not only to enable commercial banks to access financing options apart from traditional methods, but also to mitigate the inherent risks of weakly rated loans by simply spreading them over the entire banking system. Soon a broad range of structured finance products like Credit Default Swaps (loan default insurances) appeared, and a certain lack of regulation allowed the emergence of a number of highly complex and nontransparent monetary tools that were difficult to control. Collateralized Debt Obligations (CDOs), which can be described as packages of loans of unequal security levels that bundle high-quality with low-quality (‘sub-prime’) assets in order to spread the risk of defaults, became one of the most prevalent instruments in this segment. It goes without saying that investment banks like Lehman Brothers played a key role in this business.

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Figure 3: The New Model of Mortgage Lending. Source: BBC 2007

Figure 3 compares the traditional model of mortgage lending with the sub-prime model. Since the traditional model puts natural restrictions on the degree to which banks can engage in mortgage lending by limiting the sources of capital that can be used for this purpose to the clients’ deposits, the sub-prime model soon became popular among conventional commercial banks. Sub-prime lending offered a highly attractive alternative for banks as the hypothecary credits were passed on to investors in the bond markets, thus enabling the banks to finance more lending business (cf. BBC News, 2007, para. 2). The model seemed safe, and besides banks earned a fee for each contract, consequently making sub-prime lending very profitable for both banks and investors, as supported by Hull, who in a paper on the Credit Crunch of 2007 describes the participants’ course of action as follows:

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