Financial Upheavals. Financial crisis - Essay Example

Financial Upheavals Financial crises are inevitable and seem to be a usual and reasonablyinvariant characteristic of such business cycle. The economic system of any country is subject to discrete business cycles that lie on the boom-depression continuum. The aftermaths of any such business cycle may vary from being modest to remorseless hinging upon its magnitude and continuance. History show that the American economy has moved through periods of boom, recession and recovery. The years 1837, 1893 and 1929 help retrace the occurrence of three major depressions in United States (Calomiris 2010). The downturns of 1857, 1873, and 1907 are also referred in the history books (Rothbard 2002). The America of 1819 and the financial crisis its people went through was only the first of speculative cacoethes which is America's true national interest (Maloney 2009). But then again, the Great Recession of 2008 is the latest financial turmoil in the United States, the twinges of which are still being sensed. Both these financial upheavals resemble one another with respect to their causes and consequences. For instance, they headed to extended bank failures, loan foreclosures, high unemployment rates and a depression in manufacturing sector. The causes of the panic of 1819 can be assigned to the economic system of the United States (Rothbard 2002). The panic of 1819 ended the tremendous economic expansion that occurred after the War of 1812. Rampant inflation, debtors’ relief which was constantly associated with monetary strategies and a protective tariff on imports worked as a pivotal point in creating the situation of panic in the US at that time. Whereas, the oncoming of the Recession of 2008 can be assigned to complicated and interconnected constituents. Sub-prime loans, lax financial regulation, loose monetary policy and global instabilities collectively induced the latest financial upheaval that caused entire world staggering. This suggests that there were more than one element that sparked off the two financial upheavals discussed above. Among those major causal elements, monetary policy played a key role to trigger the financial turmoils. The purpose of this paper is to compare and contrast these two historic financial upheavals; the earliest and the latest to have rocked the United States of America with special emphasis on the role of the monetary policy in each case. The Panic of 1819 The major causes of the panic of 1819 were delved within the US economy. Similar to so much of what is disastrous to civilized society, the Panic of 1819 had been produced in the violent agitation particularly of the War of 1812. The young American economy confronted many rapid breakdowns that were brought by the War of 1812 and its consequences. United States previously had been a big country with a thin population of around seven million which were mostly committed solely to agriculture. Many agricultural products such as wheat, cotton, and tobacco were exported across borders, although the residual of the agricultural products was mostly consumed by self-sustaining rural families. Public debt held by Americans during the war of 1812 induced the prices rise throughout the United States. At that time, the monetary system of the country was not advance or highly-developed. The American banks were restricted almost entirely to the cities and their tools and methods to run the economy inclined to be lax with insignificant Government control. The reality, that most banks and other institutions of that era had to acquire their position by exceptional legislative charter, tempted inquisitive and high-risk misuses through exerting force on the legislature. All this resulted in an inadequacy of uniformity in administering banks within and among states. The emergence of the First Bank of the United States had regulated the banks towards uniformity until the year 1811. Irresponsible and mismanaged banking system had played a crucial role in creating that panic. From 1811 to 1815, banks multiplied and underwent into sharp and rapid growth loaning out credit they did not have. Paper bank notes and deposits, all which laid claims on actual money had increased by 87.2%, the actual money in bank vaults had reduced by 9.4% during that period. With no central authority state banks had power to issue currency notes in that era leading them to lend money, more than their capacity of lending backed by specie, to assist economic expansion through establishing manufactures and producing employment. In the war of 1812, like in every war, the American government should have first struggled to biff the local currencies, which had been comprised of state bank notes that were redeemable in gold, or leastways promised to be. The war had been really expensive for US as wars are always deadly-ones and the state’s lacking of ability to print paper money as chosen or demanded had been an immense disadvantage to them. The same year of 1812, the US cohered to a gold standard which was essentially to be broken down, and by 1814 it failed (Rothbard 2002). In 1815, the jeopardy in terms of credit that the government injected into the system, through paper debt purchase and suspension of gold redemption, caused people to start out actively buying everything which was accessible and handed on to them. A great amount of loans was invested by the people to purchase land from the federal government and this over-indebtedness stimulated prices to go higher. In 1816, another central bank, the Second Bank of America instituted amid much backroom dealing, hypocrisy, bribery, threats, and displays of great oratorical skill. The new Bank of the United States was set up with a suggestion of more money and power and running with the apparent aim of bringing the state banks to curb the rampant inflation. The bank was formulated with an intention of running on the same policies as those of other state banks. The management of the new central bank assured not to demand redemption of any state bank paper notes until over one year later. Also they bailed out the bankrupt state banks with $6 million in taxpayer money. However, whatever was done to save the economy went failed (Dupre 2006, p. 271 cited in Maloney 2009). In 1818, the second bank of US changed its views of expanding economy to curb rearing inflation by switching from expansionary to deflationary stance, and contracted money supply by calling out all outstanding loans. The things became more dangerous and spoilt in 1819, when foreign debtors, specifically England and France, started to demand payments in specie from the Bank of the United States. The redemption of currency in specie was substantial to pay off the debt accumulated during the war. Prices hiked in attempt to raise money to pay back debt which in turn was a major cause of inflation. By the time, currency outstanding was devalued in relation to the specie reserves and the debts could not be paid off with inflated money. Land was devalued and investment in western lands collapsed as prices began to correct by selling of land to pay off loans. The measures to combat inflation resulted in failure of many banks, soaring unemployment, foreclosures of mortgages and fall in prices of agriculture (Rothbard 2002). The panic of 1819 was dreadful in its scope and impact and spanned across the country. Farmers suffered a lot as some lost everything to pay off the huge amount of loans. In New York State, property values were around $315 million in 1818 which fell to $256 million in 1820. In Pennsylvania, land values fell from $150 an acre in 1815 to $35 in 1819. Unemployment reached to a level of 75% and many people were committed to debtors’ prison. More than 1800 people were committed to debtors' prison in Philadelphia and approx 3500 in Boston. Many debtors fomented for stay laws for debtors’ reliefs and abolition of debtors’ prisons. To handle the problem of destitution, appeal for old clothes and shoes for the poor was made in newspapers, and churches and municipal governments set up kitchens to give food to the poor (Mintz 2007). The degradation of currency, speculation and the urging to gambling money organized likewise the folly of monetary handling, and the uncertainty caused to business because of such contrived injections was considerably noted (Rothbard 2002). Failure of expansionary monetary policy was not the only crusade of the panic of 1819 as other international events contributed partially to the panic during the financial crisis in US. European demand for American agricultural products especially wheat, cotton and tobacco declined after the war of 1812 as European crop yields swell and prices of American crops plunged. Domestic manufacturing suffered due to global competition, and European economy contraction stimulated banks credit reduction and coupled with crisis abroad, American banks called in their loans (Reynolds 2009). The panic was over by 1823, but it left an enduring depression and embossment on American politics. The panic conduced to requirements for the democratization of state constitutions that was about discontinuation of restrictions on voting and office holding, and enhanced ill will towards banks and other privileged corporations and monopolies. The panic also aggravated latent hostility within the Republican Party and exasperated sectional tensions. Manufacturing sector demanded increased trade protection from foreign imports, whereas many southerners blamed high protective tariffs to be the main source of their troubles as tariffs raised the cost of imported goods and trimmed the flow of international trade. Northerners agitated for higher tariffs while southerners desolated their support of nationalistic economic programs. Many people proclaimed insistently for a diminution in the cost of government and exhorted for precipitous decreases in federal and state budgets. Other Americans, especially from the South and West, attributed responsibility of the panic to the state banks and peculiarly the tight-money policies of the Bank of the United States (Mintz 2007). The Recession of 2008 The crisis occurred mostly as a storm to many policymakers, investors, multilateral agencies and academics. Hence, it is not storming that the severity of this universal downswing was underrated for much of 2008. Naturally, some shrilled voices of economists and other professional analysts tried to issue frightening monitions of a disastrous storm, but such sounds were not enough to alert other people who were calmed by a feel of self-satisfaction in the years that initiated the recession of 2008. After the crisis came along suddenly in terms of worldwide downturn, some policymakers confidently observed that no one could have anticipated the crisis. (Bezemer 2009 cited in Verick 2010) claims that 12 economists and professional analysts foreboded a potential recession. The financial sector recession began in January 2008 for major banks in the U.S. and Europe got into grievous worries by investing in forged mortgages. The financial upheaval spread globally because of the reality that many banks and other businesses worldwide had invested in these very mortgages. Simultaneously, it is recognized that government failure has wreaked the crisis by allowing banks and other financial institutions to take advantage out of loop-holes in the regulatory system to heighten leverage and returns, through most contributions to the ongoing post-mortem analysis of the crisis. According to Taylor (2009 cited in Verick 2010), the excessively loose US monetary policy, resulting in interest rates that were far lower than suggested by the Taylor rule, ignited the credit boom. In contrast, others such as Elmendorf (2007 cited in Verick 2010) reason out those interest rates being not too low and claims that the interest rates were only a bit too easy for too long, but the modifications that seem to be optimum in hindsight would not have essentially modified the housing cycle and associated developments. The combination of perverted incentives in the financial sector and goals of enhancing householder rates produced the setting for the emersion of alleged ‘sub-prime’ housing market in the US. Such sub-prime borrowers who would not be thought of being credit-worthy under normal prudential criteria were viewed to be profitable and worthy business targets by investors and yield-seeking lenders (Baily et al 2008 cited in Verick 2010). In course of explanation, US banks encouraged home loans by creating easy credit conditions with low interest rates and heavy inflows of foreign funds in early 2000s. Demand for property enhanced inducing hike in home prices. The widened loan disbursements and easy loan conditions facilitated find more potential borrowers and sub-prime mortgages were lent to as many people as available for home loans in order to take benefit of housing sector boom. For this reason, many prominent fund investors such as mutual funds and hedge funds considered subprime loan portfolios as winning investment opportunities as stock markets had been flourishing and the system outpouring with liquidity. Therefore, they purchased such portfolios from the original loaners and provided the lenders with new funds to disburse loans. This made subprime loan market to be a fast growing segment. Many large American and European investment banks and institutions, in a desire to diversify their investment portfolios, intemperately purchased these subprime loans which were known as Mortgage Backed Securities, MBS. To make loans, even the repaying capability check of borrowers was ignored. To get benefit of rising prices of houses, many borrowers opted for second mortgages on increased value of property for consumer spending. And this contribution to high prices of homes caused ultimately overall price level of economy to rise (Eklavya 2008). Overall, the primal components of this failure were insufficient capital requirements on products such as the collateral debt obligations, inadequate use of ratings and the way credit rating agencies themselves were regularized, and the incentives for risk-taking brought forth by integrated remuneration arrangements (Astley et al 2009; Baily et al 2008 cited in Verick 2010). This combination of a lax financial regulation, low returns on riskless assets and misperception of risk ignited the inordinate leverage and investment in risky assets such as the mortgage-backed securities. Sub-prime mortgages were the major cause of the crisis but were not by a blame sight the cause. Against this backdrop, the trigger for the crisis unsurprisingly was the United States housing market. After the Federal Reserve started increasing interest rates, the delinquency rate on home loans commenced to rise in 2006 before acquiring impulse in 2007 (Astley et al 2009 cited in Verick 2010). After events of year 2008, risk taker banks and investors around the world rapidly inverted from what they had considered previously. The complexity of the mortgage-backed securities did not let them be cognisant of the true magnitude of the liabilities associated finally to a rapidly devolving US housing sector which accordingly cause liquidity to dry up promptly, nearly causing the dropdown of the global financial system (Verick 2010). The financial crisis could not stay within the limits of US and spread into the global financial markets as many large American and European Banks had been heavily buying Mortgage Backed Securities of subprime loans. The Fed moved to contractionary monetary policy in order to curb inflation by raising interest rates and calling for loans. Housing sector left with surplus inventory of homes which caused decline in home prices and people found themselves unable to pay off loans as their home values declined more than their mortgage values. They began to default on loans and opted for selling or walking away from home rather than repaying their loans as their homes are worthless than their mortgages when money devalued because of rampant inflation. All this resulted in foreclosures of mortgages and failures of many large banks in US which had been backbone of many large corporations and industries in US for taking loans to invest in businesses. A chain reaction of panic initiated with huge losses and banks and hedge funds defaults, and ensued in vast unemployment up to 12.5% and economy slowdown. The recession remained till 2009 and the Fed tried every trick to stabilize the markets even by lowering interest rates and pumping hundreds of billions of dollars in the economy but the unemployment is still not controlled and consumer confidence worsened (Eklavya 2008). The financial turmoil that was initiated in the United States in the middle of year 2007 finally propagated globally to both developing and advanced economies leading to what was regarded as the worst recession since the Second World War. However, countries affected by the downswing in terms of both magnitude of economic condensation and consequent worsening of the labour market with much of diversity regardless of the asperity of the recession. Governments across the globe progressively realized the rigorousness of the recession and the need to promptly interpose in order to obviate a ruinous break down of the real economy and financial markets as the global financial turmoil unscrambled. The government actions in response to the crisis has comprised of three main interferences. First, it focused on keeping credit flowing through bailouts and injections of money into the financial system. Second response went about stimulating borrowing and investment through interest rates cuts. Third intervention focus included extra fiscal expenditure to prop up aggregate demand. Such steps have attempted to foreclose further economic worsening and ultimately helped reducing lay offs and creating new jobs to furnish opportunities for the unemployed people, and in overall avoiding a far more severe downswing (Verick 2010). Comparison between the Panic of 1819 and Recession of 2008 "Asset bubbles all have a few things in common. First and foremost, they end badly." (Caroline Baum 2005 qtd. in Maloney) The two financial crises share similarities in terms of bust after a boom cycle and others such as the massive soar up in housing and equity prices, the springing up current account deficit and rising level of private debt. Banks could not foresee the rampant inflation due to pumping more money in the economy and eased credit stipulations for expansion of the economy in both the cases of US crisis. The panic of 1819 was contributed by international factors whereas the recession of 2008 caused ripple effects in other countries as well. The first financial upheaval was seen destructive in magnitude in a way that the unemployed set up a city of tents in outlaying areas of Baltimore. The Recession of 2008 was corrosive in terms of huge bankruptcies associated with not only banks but eroded global banking system. However, in the case of the crisis of 2007-2009, there was no turnaround of capital flows to the United States and therefore the US dollar did not collapse as anticipated by some economists (Baily et al. 2008 cited in Verick 2010). The two financial tumults differ with respect to the banking system itself as the Fed system functioning today was established in 1913 to control banks through money supply or setting interest rates, whereas, in 1819 era state banks had authority to print notes according to their specie reserves. There was not central currency to make payments in home or abroad, rather payments abroad were made in terms of metal money. Banks redeemed at the expense of general public and even people could not have food to live. However, the recession of 2008 had ripple effects in other countries of which twinges are even felt today as unemployment has been of a great stature which is being struggled with. The crisis was largely unexpected and on account of its complex beginnings, it extended to flummox policymakers, economists and other commentators as it untangled and sopped up at first banks and companies, and then economies all around the globe. The recession of 2008 seemed to be a new phenomenon, but it is certainly something that had happened before in terms of wave of paper money and vacuous credit. An analysis of how the people responded to the panic of 1819 and, most especially, what the consequences of those responses and actions were, may give an idea to help solve the current crisis as both have similar causes (Maloney 2009). Works Cited Calomiris, Charles W. "Banking Crises Yesterday and Today." Financial History Review 17.1 (2010): 3, 3-12. ABI/INFORM Complete. Web. 12 Sep. 2011. Eklavya. “Reasons for Global Recession: In plain simple English.” (2008) Web 11 Nov 2011 Maloney, C.J. " 1819: America's First Housing Bubble." Mises.org. Ludwig von Mises Institute. 7April 2009. Web 18 Nov. 2011 < http://mises.org/daily/3395> Mintz, S. “The Growth of Political Factionalism and Sectionalism.” Digital History (2007). Web 11 Nov 2011 Reynolds, David S. “Waking Giant: America in the Age of Jackson.” New York: Harper, 2008. Web 11 Nov. 2011 Rothbard, Murray N. “The Panic of 1819: Reactions and Policies.” Mises.org. Ludwig von Mises Institute. (2002). Web 12 Sep. 2011 Verick, Sher., Iyanatul Islam. The Great Recession of 2008-2009: Causes, Consequences and Policy Responses, May 2010 Read More