Causes of the Current Economic Meltdown - Term Paper Example

? WHAT LED TO THE RECENT ECONOMIC MELT DOWN? SAIF HALABI The economy has never hit an all time low like when it did during the Great Depression however the recent economic melt down has come close. The Great Depression began in 1929 and ended in 1941 and the whole world was negatively impacted. Just before the Great Depression, the U.S economy experienced an unprecedented economic boom. There was mass production for most goods and services and infrastructure was being built to support all of these productions. It has been reported that due to the rapid supply of money, banks were opening up at the rate of 4 – 5 per day. Generally, economic recessions are a result of a decline in GDP growth, which is itself caused by a slowdown in manufacturing orders, falling housing prices and sales, and a drop-off in business investment. But the fundamental question is- what causes the slowdown in the first place? While few predicted the financial catastrophe, almost everyone has an explanation as to why it happened. Although it is important to note that recessions are a result of different factors as each has its own specific causes, all of them are usually preceded by a period of irrational exuberance. Before we look at the causes of the recent economic recession, it would be logical to first of all look at some of the reasons that led to the Great Depression, if for anything, see if some of the causes recur. Stock Market Crash In the 1920s, the economy was developing at a very high rate due to the birth of many businesses and companies. As a result, there was an increased supply of money and individuals invested their surplus in the stock market. On September 3, 1929 the stock market peaked, closing at a record of 381.17. Trading volume was 444,000 shares. At the end of the same month, the market closed at 343- a 10% decline. On Monday, October 29, 16.4% shares traded and the markets fell by an 11.5% margin. The markets closed at 230.17 by that time, down 40% from its all time high. Reports indicate that in a single day investors lost 14 billion dollars and by the end of 1929, 40 billion dollars was lost. This crash put a lot of pressure on banks and caused a lot of money to be taken out of the economy. The stock market bubble finally burst on October 24, 1929 as investors began dumping shares en masse. On a day referred to as “Black Thursday”, a record 12.9 million shares were traded that day and five days later, on "Black Tuesday" 16 million shares were traded. This was after another wave of panic swept Wall Street. Millions of shares were rendered worthless, and those investors who had borrowed money to buy stocks were wiped out completely. Federal Reserve’s Role during the Great Depression In most cases, recession is a result of inflation but in this case it was caused by deflation. Cycles of ups and downs in the economy are normal. One of the reasons strongly touted as being the cause of the Great Depression was the increase in interest rates by the government. The rates increased, from 3.5% in 1929 to 5%. Upon increasing the rates, the government failed to act to stabilize or increase the money supply. In fact, between 1929 and 1933, the supply of money fell by 30%. This led to deflation. Bank Failures At the time there was alot of fear that banks would collapse since, there were no guarantees on cash at the bank. As more and more people panicked, there was a massive run to the banks to pull money out and some banks were not able to fulfill the requests for withdrawal and closed their doors. As banks collapsed, very many people lost their money. More panic followed as people lost their money and banks collapsed. This rush to withdraw money created a domino effect. There was no confidence in the banks and people resorted to keeping their money under their matresses. Reports indicate that during that period, over 9,000 banks failed. Insurance policies were not as advanced as to cover deposits and thus as banks failed people simply lost their savings. For the few surviving banks, unsure of the economic situation and concerned for their own survival, they stopped being as willing to create new loans. This worsened the situation and expenditures were even further reduced. Reduction in Purchasing Across the Board Individuals from all classes stopped purchasing items and this was caused by the unemployment and opting to save for a rainy day like the ones they were experiencing. Giving further credence to the cause and effect rule, this resulted to a reduction in the number of items produced and inevitably a reduction in the workforce. The unemployment rate rose above 25% which meant even less spending and as people lost their jobs, they were unable to keep paying for items they had bought on credit and their items were repossessed. CAUSES OF THE CURRENT ECONOMIC MELT DOWN Failure to Nationalize finance A major cause of the economic crisis was the collapse of various financial capitalists. As was witnessed, the government was left with only two options in such cases; either bail out the financial capitalists in some way or suffer a more severe financial crisis. The latter will in turn cause an even more severe crisis in the economy as a whole, which will cause widespread misery and hardships. Such institutions whihc handle billions of dollars are poorly managed and their demise results in very many people losing their hard earned money. There has been an idea floated that the only way to avoid such a dilemma is to make the economy less dependent on financial capitalists. How can this be achieved? The only way to accomplish this independence is for the government itself to become the main provider of credit in the economy. Especially for consumer loans, home mortgages, and perhaps also for, business loans. In other words, finance should be nationalized and operated by the government in the interest of public policy objectives. At the moment, the economy is too dependent on the private financial capitalists who if on the verge of bankruptcy resort to borrow the government money. Would it not be logical for the governement to lend the money in the first place, instead of acting as a lender of last resort to this capitalists? The nationalization of these institutions would not be the elixir to the economic crisis but it would go a long way in reducing its impact. At this juncture it would be prudent to note that the nationalization of these institutions does not amount to socialism, but it could be an important step on the road to socialism. The use of government banks to implement important public policy objectives, would be a model for the rest of the economy. More people would realize that an economy run according to democratically decided policy objectives would be better for the majority of Americans than our current system, which is premised on profit maximization. The Housing Market Declined There was and still is an assumption that the value of real estate always increases. It should be noted that this is a mere assumption which most of the time turns out to be true, it could also be a false assumption. It is this assumption which gave most individuals the confidence to invest in real estate. The decline in the housing market has been flagged as one of the major reasons of economic turmoil. This housing slump set off a chain reaction in the economy. Thousands of people took out loans larger than what they could normally afford in the hope that they could either sell the house for profit or later refinance at a lower rate. Through these profits, they would then leverage to purchase another “investment” house. Very many people got rich quickly and in a short time people wanted more. The regulations that were there in place before in terms of acquiring a new house were ignored or loosened to meet the ever rising demand for houses. Soon, house buyers only needed to have a pulse and make a promise that they could afford the mortgage. Brokers had no reason not to sell you a home. As had been predicted by sound finanacial advisors, these mortgage backed assets were ticking time bombs. And before we knew it they just went off. One of the main culprits that is often pointed to as one of the main triggers of the global financial crisis are the mortgage derivative products, where risky mortgages were packaged with more traditionally secure mortgages and sold to corporate investors and other banks as secure investment products. This packaging of mortgages is generally accepted to have masked the real risks that were linked with such a product, which gradually grew as lending criteria were loosened in the first five or six years of the twenty first century. These products were created by one group of people who have been vilified more than any other industry over recent years, which are the bankers. The investigations that have been carried out by politicians and government in the aftermath are still proceeding, but there is no doubt that some of the blame for the crisis has to lie with them, and the way in which they packaged and sold the mortgage derivative products. Mortgages were sold to people who weren't really able to afford the repayments for the borrowing. Therefore, as a result of not being able to pay their mortgages, property prices slumped, and this caused an even bigger problem as the level of borrowing was above the value of the home, and more people started to default on their mortgages. The Credit Well Dried Up Credit in and of itself is not a bad thing. It promotes growth and jobs. Poor management of credit, however, can be disastrous. None of the great companies throughout history could have achieved success without credit. Credit began as an idea that was simply backed by the confidence that the said idea would pay off in time. If both the borrower and lender were correct in this assessment, both profited. However, when such an appraisal proved to be incorrect, they both lost. This is the game and its rules. Unfortunately economies are kept running by credit and this is how businesses thrive. However what happens when the sources of credit start to dry up? What we are experiencing now is the expected consequence of such actions. Curently, we are in a debt-bubble and without enough credit to feed the monster, the bubble is going to burst.  At this point, virtually the entire global economy runs on credit, but lending sources are balking at continuing to lend money to nations and financial institutions that are already knee-deep in debt. A perfect example here would be Greece. Investors don't trust the Greek government and they are demanding huge interest rates in order to lend them more money. They are therefore imposing high interest rates on them and it seems illogical to borrow in the first place. Massive losses have occurred as a result of individuals being unable to pay off their debts. It is these losses that have caused many banks to tighten their lending requirements. Nations and financial institutions would never get into debt trouble if they could always borrow as much money as they wanted at extremely low interest rates.  But what has happened is that lending sources are balking at continuing to lend cheap money to nations and financial institutions that are already up to their eyeballs in debt. A good example of such a situation is Greece. Investors don't trust the Greek government and they are demanding a huge interest rates in order to lend them more money. When credit sources are few, the economy slows down and more businesses fail.  This causes financial institutions to tighten up things even more in a bid to avoid the "bad credit risks". A slow economy means less tax revenue for governments. Less tax revenue means larger budget deficits and increased borrowing by governments. Securitization and the Subprime Crisis The subprime crisis came about where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others. This was known as securitization and at the time of its inception it was seen as perhaps the greatest financial innovation in the 20th century. How does it work? For banks, millions can be made in money-earning loans however the down-side is they are tied up for decades. In order to maximise on their profits, they were turned into securities. While the banker off loads the risk, the security buyer gets regular payments from the mortgages. This concept was started in Wall Street, and upon realising profits others followed quickly. For example; Banks even borrowed more money to lend out so they could create more securitization. Most banks stopped relying on members who save in order to acquire income. The focus had entirely shifted as long as they could borrow from other banks and in return sell those loans as securities. In the likely case of bad loans, that would be the problem of whoever bought the securities. Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on and on realising that they were running out of individuals to loan to, banks turned to the poor; the subprime or what was then termed as the riskier loans. The rising house prices led lenders to think these loans were not too risky and bad loans meant repossessing high-valued property. When there was the first sign of problems, panic ensued and confidencefell rapidly. As a result, lending slowed and in some cases ceased for a while. Some investment banks were left with the riskiest loans that other investors did not want. Since assets were plummeting in value lenders wanted their money back, however some investment banks had little in deposits, so some collapsed quickly and dramatically. In order to comprehend the magnitude of this issue, banks even with large capital reserves ran out, and were forced to turn to governments for bail out. At the time experts described it, it was said that banks had somehow taken what seemed to be a magic bullet of securitization and fired it on themselves. References Anup, S. (2010). The Global Financial Crisis: A crisis so severe, the world financial system is affected Brian, P. (2011). Creit Crisis: What Caused the Crisis? Evan, D. (2008). The City Uncovered: Banks and How to Break Them. Fred, M. (2009). The U.S Economic Crisis: Causes and Solutions Graham, T. (2010).b A Journal of Social Democracy: Causes of the Credit Crunch Ryan, G. (2009). The 2008-2009 Financial Crisis: Causes and Effect Sheldon, F. (2010). Global Economic Forecast 2010-2015: Recession into Depression Yale Global Online. (2012). A Publication of Yale Center for the Study of Globalization: The Global Economic Crisis Read More