The Global Financial Crisis

The global crisis that struck the world in 2008 starting with the USA and soon to the rest of the world is still in the air making both the developed and developing nations suffer a series of serious consequences. At a time when we were thinking all is going well and people are enjoying the fruits of policies laid down by their government a sudden destruction changed everything and proved what we perceived to be wrong. What exactly is the cause of this serious destruction? Why is it hammering the whole world? This is considered to be the greatest recession since the great depression of 1930. A simple failure of few major banks has turned the whole economy leading to recession followed by a serious financial crisis.

The financial crisis also known as the credit crisis is an outcome of the breakdown of the financial institutions of the USA. The financial market is generally a risky and fragile market that has a potential to destruct the whole economy not to mention the whole world as it is the market that deals with money and all its transactions. The entire economy with industrial sector, manufacturing sector and service sector depends upon the financial institutions like banks and insurance companies to run and maintain their business. Any business organization can get funds to run or expand their business by two sources.  One that is well known is from banks known to be an indirect source and the other by issuing bonds and stocks the direct source. Let us concentrate on the indirect source, banks as it is the central theme of our discussion here. By now we all know that the failure of big investment banks like Lehman Brothers and Merrill lynch caused the US financial market to break down leading to crisis. A few banks were already going bankrupt. So what is the reason for these big banks to lose control and go bankrupt?

One of the fascinating truths about the market is that it gives us all the clues and signals about the economy doing well or bad. But the sad part and hard fact here is we fail to notice and interpret those signals then and there. But this is simple said than done. As it is with our life the whole world and all the economies is faced with uncertainty and this factor cannot be ignored while making predictions. Anyone who does so is at his own peril. This is where some great economists and policy makers have failed. Economics is a field that is confronted with uncertainty, little speculation and huge risk. Hence running an economy is an uphill task and no single group can be rightly blamed as it is the role of the politicians, policymakers and economists together to drive the economy in line with their own objectives. So in such a place where there are groups of people involved in decision making and where lives of millions of people are at stake, conflicts among the different groups are inevitable. The government’s primary objective is to drive growth and that of policymakers is to control macroeconomic instability like inflation and unemployment and that of an economist is to observe the past data and accordingly suggest policies for future course of actions keeping in mind about the welfare of the people and economy as a whole. Economists call such conflicting behavior and interests among the different class of groups as “principal agent problem.”

If you had observed the past data of the USA you will know that there exists a pattern in all the key indicators like inflation rate and money growth. The US data way back from 1860s tell us that there is a strong relation between the rate of inflation, long run cycle of money growth and more importantly government regulation. If you had read the book the great depression of 1990 by Dr. Ravi Batra you will know all these facts. Since the three most important indicators in analyzing the performance of a country have been following a set pattern it is obvious to think that the recession and depression also tend to follow a similar pattern. If you again look in the data you will see that the US economy has followed recession and depression in a periodic cycle. The recession occurred every 30 years and depression every 60 decades. This cycle in economics is known as the business cycle with periods of boom, recession, depression and recovery. If you observe you will understand that most of these depressions are caused because of a bubble burst. A bubble is something that is created by the economic agents in the market thinking that it is good and will bring better prospects to the people. Hence with this kind of an intention the agents along with the government create more such bubbles by aggravating it. Eventually as in any case these bubbles tend to burst leading to crisis of varying degree.

One such bubble that caused the recent financial crisis in the late 2007 is the housing bubble in the USA. The very beginning of the 21^st century came with this financial crisis. The crisis that we are experiencing now started in 2001 from the attack of the world trade Centre. America, at that time was already suffering and was into a recession because of the dot com burst. Stock market had crashed and investors were losing a lot of money. Businesses were on the brink of shutting down. The Federal Reserve the central bank of the United States of America soon started reacting to the slowdown and save the economy from a severe crisis. But what they actually did was creating more trouble on the wake of a crisis. The Federal Reserve started with lowering the interest rates from 6.5% to as low as 1% in 2001. The Americans are known for their extravagant spending and leading a luxurious life. By lowering the interest rate to an all time low they encouraged people to spend more. But few economists already warned that keeping a very low interest rate for a very long time will create a bubble burst. The financial crisis triggered when people thought that owning a home is the best investment option on the long run. Hence the Bush administration believed in this “American Dream” of owning a home and announced policies on 17 June 2002. People believed that the house prices tend to increase and the low interest rate caused the housing bubble. The Federal Reserve with its low interest rate introduced cheap loan that made borrowers to buy big homes. The housing price increased by ten percent in a year. This urged rich Americans to buy second mortgage.  The banks introduced home equity loans. It started to give away loans to almost everyone who wished to buy a home.  Home loans or home mortgage were also given to borrowers who are not fit to repay the loans. But the banks and the government encouraged these sub -prime borrowers. The government also encouraged this by deduction, subsidy and insurance on home ownership. So they introduced two mortgage financing company namely Freddie Mac & Fannie Mac. The primary job of this government sponsored enterprise was to insure home for those who could not get one in the open market. They made sure that these mortgages were backed by the government and the transaction were carried away by the congress and thus providing the borrowers confidence.

The congress announced that there is no down payment on home loans. This encouraged the sub prime borrowers. This then posed a serious threat to the banks that were offering them.  The house prices tend to increase to higher levels because of the cheap money and thus people started to buy more homes and resell it at higher prices. This then caused an inflationary pressure in real estate sector. With the continuing increase in prices banks targeted for a better investment strategy. The big investment banks on Wall Street bought all these mortgages loans and rearranged it as securities. These mortgage backed securities were then sold to investors in different countries like china, Norway, Germany and others. This is when the essence of the crisis turned to become global. This move became viral as investors across the globe considered this to be the best investment strategy as all started to believe that the house price will only increase and never come down. The rating agencies also on their part encouraged all these investors by rating these securities with AAA rating. Investors knew that higher the rating higher the return thus they all started to enjoy by investing all their money in these securities. Soon everybody started to make money out of this boom.

It was not very long time for the government and the investors to realize that the spell is broken in 2006. The house price suddenly started to come down and the interest rates came to normal levels. This is when people found it difficult to repay their home loans and the sub prime borrowers were denied new loans to repay their old ones. The house price substantially became lower making those mortgage backed securities worthless. This is when big banks like Lehman Brothers couldn’t get loans to stay in the market. Now you can see how the bush administration inflated a new bubble to come out of the old one. With the gloomy situation prevailing and the economy slowing down because of the financial crisis in 2008 the government all over the world started inflating another bubble called the Bailout Bubble. The government across the globe started providing stimulas packages to get the economy up. Soon in 2008 companies like AIG and Lehman Brothers went bankrupt because of their monumental debt in real estate. But true to the politics the banks were guaranteed with huge stimulas by the government to stay in the business. In course of time the money was also given to companies like General Motors and Crisil from the bailout packages that were only meant to save the financial institutions of the USA. In 2008 the US economy was on the brink of a serious collapse. The Federal Reserve again in the late 2008 reduced its key interest rate to zero percent to increase investor confidence and boost consumer spending who were already facing huge debts. This is the grave mistake they did as the US economy was already in crisis. The Obama administration introduced another huge fiscal stimulas package in 2009 to get the economy going. Now, at this time the total stimulas package stood at $1 trillion. This money from the bailout package was used for all purposes to help the sick companies and development projects. But only a part of this package was actually stimulas the rest was just waste money that deepened the crisis. The unemployment rate was increasing, jobs were unsecured and stock markets felt the crisis.

This is how the financial crisis took place and the consequences are now serious and are threatening the whole world. One would even wonder how the world’s superpower economy landed on such a serious economic collapse. The rating agency was rating the US economy on a positive side when the country was actually facing a catastrophe.  This is where the market signal comes into play. The rating agency should have warned the US economy on the verge of downgrading if they don’t take necessary and effective steps. The basic problem behind this financial crisis is the lack of incisive criteria and defined objectives. The first is the very low interest rates implemented when the economy is already going towards a recession. Second, the government and banks gave money to all borrowers without any conditions. Third, there was no idea of how to spend this money and what to do with the cheap money and end up in creating the housing bubble. In the first place, we could have avoided this housing bubble if the home loans were offered by the private companies because they don’t inflate bubble and would have moved along with the market price. It is evident from the crisis that the government intervention by manipulating the interest rate has bought the US economy to face a serious crisis of all time. Now it is clear that in order to avoid a burst we should stop creating bubbles in the first place. A lesson learnt the hard way!