Thesis on "Global Economic Crisis"

Thesis 6 pages (2267 words) Sources: 12 Style: MLA

[EXCERPT] . . . .

Global Financial Crisis

The current financial crisis may have unfolded over a period of months, but the causes of the crisis encapsulate years of government decision-making. Many of the ill-fated decisions were made in response to other crises, which makes the response of the Bush and Obama administrations to this crisis all the more interesting. One of the roles of government, even in the most free-wheeling capitalist countries is to guide the state of the economy (indeed, to be free-wheeling is a specific choice). What this paper will show is that the crisis was caused by governments that made short-term decisions without considering for or evaluation of the long-term consequences of those decisions.

The first major antecedent in terms of government policy came in response to the savings & loan crisis in the late 1980s. The federal government stepped in and bailed out the savings & loan industry. At the time, the arguments were much like what we hear from government today -- investors need to be protected and the integrity of the banking system must be maintained. There were opponents to this bailout. They felt that protecting the integrity of the industry should be done with more stringent regulations, not bailouts. The savings & loan businesses that had accumulated bad debt had done so of their own volition. While the structure of the industry facilitated risk taking, it did not advocate it. Those managers who had taken on too much risk should face the market solution, which is failure of their institutions. Government intervention in the savings & loan crisis, therefore, set the tone for government bailouts of banks to come. This is turn resulted in a culture of risk-taking as bank managers felt they did not need to fear taking on too much risk, since the government would just bail them out anyway (Knowledge @ Wharton, 2008).

The next antecedent of the crisis came in response to the bursting of the dot-com bubble. This lead to a decline in the stock markets, which was then exacerbated by the terrorist attacks of September 11, 2001. The response of the Federal Reserve to this was to lower interest rates to historic low levels (NYT, 2009). These levels were widely believed to be out of equilibrium (Boeri & Guiso, 2007). These interest rates injected substantial liquidity into the system. The banks, flush with capital, needed to invest it so they increased their mortgage lending activities. This lead to a growth in subprime mortgages, that is, mortgages to higher-risk customers. The subprime share of the mortgage market expanded rapidly, from 9% in 1996 to 20% in 2006 (Trehan, 2007). Worse, these largely came in the form of adjustable rate mortgages. These mortgages, a favorite of the subprime market, typically have a fixed rate for a couple of years and then the rate adjusts upward. The influx of capital that resulted from Alan Greenspan's ill-conceived interest rate policy had created a housing boom, and prices were escalating. However, this boom ended, housing prices stopped increasing and subprime borrowers were no longer able to refinance when their mortgages reset after the first couple of years. These buyers then defaulted, en masse, creating a liquidity crunch and bringing several financial institutions to the brink of failure.

As early as 2007, there were signs that the crisis was spreading beyond mortgage markets. As banks began to take on heavy losses on their mortgage business, they were increasingly unable to engage in other forms of lending. As a result, businesses were no longer able to acquire capital for expansion or even ongoing operations. The bust of the housing market had also dented consumer capacity for spending. The combination of these effects began to have a damper on the economy. When the effects of the crisis began to hit the stock market in September 2008, the impacts were set to filter through the entire economy.

The subprime crisis spread throughout the economy the way it did because the credit crunch spread beyond just the immediately lending institutions. Banks were able to sell the mortgage debt bundled in securities known as mortgage-backed securities (MBSs). These are complex instruments, with the risk of different mortgages spread over the all or some of the MBS. Each MBS was embedded with different levels of risk and then sold (SEC, 2007). The underlying principle was that there would be sufficient diversification to offset the default risk posed by any one mortgage. However, the problem in this case was systemic and widespread. As a result, MBS holders bore much of the risk attributed to subprime mortgages. This spread the damage of subprime defaults around the entire financial system. Bond rating agencies had rated most MBSs as AAA, the highest investment grade. This was due in part to the backing of the issuing banks and to the supposed diversification inherent in the securities.

It was through the MBS market that the subprime crisis became the global financial crisis. As with interest rates and the housing bubble, there is significant culpability on the part of government officials here as well. The U.S. has a large trade deficit with the rest of the world. This represents a transfer of wealth to other nations, which in turn then hold U.S. dollars. These countries wish to invest their U.S. dollars, and the typical medium was once Treasury securities. Over time, the supply of Treasury securities became constricted. As a consequence foreign investors, particularly those in Europe and Japan, turned to MBSs, which with their strong ratings were viewed as a safe alternative to treasuries. This brought the crisis to many other countries around the world, as foreign banks were left holding large quantities of worthless MBSs (Palley, 2008). The only reason the crisis is not even worse is because banks in some countries, either by virtue of conservatism (Australia, Canada) or by virtue of bureaucratic inertia (China) stayed largely out the MBS markets.

The government's response to the financial crisis has been with bailout funding and stimulus funding, the former to stabilize the banking industry and the latter to kickstart the economy. Both are intended to improve the financial system's liquidity. In September 2008, the Federal Reserve bailed out AIG to the tune of $85 billion (Karnitschnig et al., 2008). The Federal government orchestrated a $700 billion bailout bill for the financial services sector in October (Associated Press, 2008). The automakers received money in December (Labaton & Herszenhorn, 2008) and when President Obama took office he offered up an economic stimulus package worth another $819 billion (Weisman et al., 2009).

At first glance, the bank bailouts represent little change from the way that the first Bush administration dealt with the savings & loan crisis. In principle, both were bailouts of industries that had taken on more risk than they could handle. The underlying arguments were similar, too. The financial system was in crisis and could not be allowed to deteriorate any further. However, the current response of government to the crisis reflects a shift in policy. Where the S&L crisis resulted in the government backing obligations and guaranteeing deposits, the government became more directly involved in the crisis this time, particularly with respect to the financial services industry. The response was bolder, swifter and altogether unprecedented. The government seized control of AIG and orchestrated the takeover of Washington Mutual by JP Morgan Chase. This direct involvement in the market marked a new course for the White House with respect to business. Furthermore, subsequent adjustments to bailout policy have included stipulations regarding executive compensation, spending and other day-to-day operational aspects of private business.

Despite the unprecedented involvement in private industry by government, there is concern that the actions taken thus far will not be sufficient. Job losses have mounted in recent months and there are indications that the banking system is still not solvent (Andrews & Dash, 2009). The cost of the bank bailout in particular may escalate as high as $4 trillion (Barr, 2009). This will continue to inject liquidity in to the banking system. The result of this should be an end to the credit crunch. Flush with cash, the banks will be compelled to start lending again, which should in turn allow businesses to begin hiring. This should, in theory, lead to the return of economic growth. The stimulus package spending is beginning to take place around the country, which should provide for further economic growth as governments and companies are able to begin hiring again.

Another consequence of this crisis is likely to be increased regulation of the financial sector. This does not represent a change in policy per se -- there was increased regulation following the savings & loan debacle as well -- but the amount of regulation is expected to be unprecedented. The moves that the Bush administration made with respect to AIG and the rest of the financial sector last year hint at government forming a new relationship with the banking industry. The government increasingly recognizes that a healthy banking industry is essential… READ MORE

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