The Global Economy - Essay Example

Credit Crunch (Impact on Consumers) – Final Paper 01 April Introduction Much of the global economy is going south these days due to the housing mortgage crisis that started in the United States in late 2007. This resulted in the Deep Recession which had destroyed market confidence in the banking and financial sectors of major economies. In between the time the crisis started and today, credit markets had virtually become frozen. This simply means people are reluctant to extend credit or in layman’s terms, people who have the money to lend out are more hesitant to do so because of concerns about getting paid back. The net effect of this nervousness among lenders and creditors is to drive interest rates up in order to partly compensate for the higher risks involved (not getting repaid). Another consequence is people who have money would rather put or park their funds somewhere safe in super-safe Treasury Bills (or T-bills) guaranteed by the government instead of investing them. This lack of confidence in the economy and the future prospects of how well everyone will be doing are putting a squeeze on available credit. The credit crunch has worsened into a credit freeze in which it is now virtually impossible to borrow money. The net effect will be a continued slowing down of the economy and creates a vicious downward cycle in terms of the jobs lost, reduced tax revenues and so on. More ominously, a credit crunch affects everybody alike but the poor and working classes are adversely affected more than anybody. This results in a nation of people with reduced expectations about their standard of living. It means people will have to content themselves with less because a credit freeze leads to reduced economic activities which could have helped to spread and re-distribute wealth around. A credit crunch means negative consequences for almost everyone (Herbert, 2011:1). Table of Contents Introduction……………………………………………………………………….......1 Discussion......................................................................................................................3 A. Different ways on how a credit crunch impacts on individuals....……....................4 A.1. Jobs and Employment Prospects………………………………………………....4 A.2. Higher Interest rates for Everything...............................................………………4 A.3. Reduced Savings and Pensions...............................................................................5 A. 4. Increasing Number of Home Foreclosures....................................………………5 B. Brief Overview of the Asset Price Bubble Phenomenon……………………….......6 C. Failure of the Free Market Economy..........................................…………………...6 C. 1. Sudden Price Increases in an Asset Class......................................................……6 C. 2. Central Bank Approaches to Mitigate Asset Bubbles…………………………....7 D. Preparing for a Credit Crunch……………………………………………................7 D. 1. Gather Enough Savings..................................................…………………....……7 D.2. Augment your Regular Income...............................................................................8 D.3. Look for Profitable Investment Ventures................................................................8 D.4. Be Financially Conservative...................................................................................8 D.5. Be Financially Literate............................................................................................9 Conclusion………....……………………………....……………………………….......9 Bibliography..............................................................................................................10-12 Discussion Ordinary people may not know much what a credit crunch is about or what it entails. This research paper examines and discusses in greater detail how a credit crunch impacts on the consumer from jobs to savings and interest rates to credit cards and housing mortgages. It is crucial to know what is going on about the economy and how we can prepare ourselves for the negative effects of a credit crunch when credit markets freeze during downturns. As they say, knowledge is power and forewarned is forearmed. The graph below shows one net effect of a credit crunch which affects everybody, from big business firms to ordinary consumers. As can be seen from the graph above, the practical implications of a credit freeze are higher interest rates for everything from credit card purchases to housing mortgages to car amortisations. In other words, everything becomes more expensive these days without the corresponding increases in salaries because businesses themselves are having a hard time to stay in competition due to reduced demand. In worse scenarios, some of them may have to shed workers and this creates further unemployment that reduces demand for products. A. Different Ways on How a Credit Crunch Impacts on Individuals A tightening of credit affects individuals in different degrees and in different ways. A common negative effect is on employment prospects when a graduate enters the workforce or when an experienced worker tries to transfer to another job in a different firm or industry. The ways in which a credit freeze affects people in adverse ways are discussed below. A.1 Jobs and Employment Prospects The most personal and direct effects of a credit crunch is on jobs (Seager, 2008:1). A tight credit will mean business firms will have difficulty raising capital or borrowing money for its expansion plans and in turn severely limits their ability to hire more people or keep those who are already employed in their present jobs. Reductions in the demand for products result to shorter production runs and mean reduced work hours or even in layoffs. This depressed demand for products and services will put a restraint on job hiring and make employment prospects for job applicants less bright. It is actually a vicious cycle that is very difficult to reverse once it starts and can result into deflation where asset prices go down. This is why setting interest rates is a very delicate balancing act between stimulating a down economy and when to raise rates to avoid inflation (Milliken, 2011:1). What usually happens is unemployment holds steady during a credit contraction but rises significantly when a credit crunch occurs because of jobs losses from a weak economy (Claessens, et al., 2008:21). A.2 Higher Interest Rates for Everything Monetary authorities will try to stimulate the economy during a recession but on the part of lenders, the tendency is raise interest rates to compensate for higher risks. This means interest charged on anything bought on credit or instalment will rise such as those on credit cards, automobile loans and housing mortgages. Central banks usually lower the interest rate but people worried about the economy are not inclined to follow (Time.com, 2011:1). A.3 Reduced Savings and Pensions The worst effects of the credit crunch are on people who had saved their monies and on people who are already retired and rely on these savings and pensions to get by in life. It is the people who are no longer actively or gainfully employed who are the worst hit. Recession has wiped out most of their investments in bonds, stocks and other financial instruments. It is a consequence of their brokers who had invested in supposedly investment-grade assets which turned out toxic when the sub-prime crisis unfurled and the paper assets are now worthless. A.4 Increasing Number of Home Foreclosures The spike in home foreclosures after the housing bubble had burst is a human tragedy. It is a tragedy in the sense that people are deprived of their homes and the one place wherein they are supposed to feel very secure. Owning a home is a cherished American dream and also anywhere else in the world especially for the working middle-class people. The sharp rise in mortgage delinquency rates is now termed as a “foreclosure epidemic” in public discourse. A foreclosure results in a substantial loss in value for both the borrower and the lender. Selling a home at a substantial discount leads to other negative impacts, such as further reductions in home values of surrounding properties in immediate neighbourhoods by 5% to 9% (Kiff and Klyuev, 2009:5). The rise in foreclosures is due mostly to negative equity and job losses. B. Brief Overview of the Asset Price Bubble Phenomenon An asset price bubble is a modern economic phenomenon. The tech (dot.com) bubble during the 1990s is an example of a bubble in which prices deviate from their intrinsic values and kept on rising due to speculation. The latest bubble from which people are still suffering from is the United States housing bubble during the period years 2000 to middle of 2007. In this period, US housing prices doubled in value with no inherent demand in housing units. It means a rise in prices was fuelled purely by speculative activity and this bubble burst in late 2007 resulting in a prolonged recession which caused the current credit crunch or freeze. A bubble is characterised by a persistent rise in prices of any asset that has stored value in it and then followed by a very sudden decline in prices, creating a panic or hysteria. In behavioural economics, it is herd mentality that creates self-fulfilling prophecies (Litan, et al., 2003:508). C. Failure of the Free Market Economy An asset bubble is not supposed to happen in a free-market capitalist economy because several instruments will prevent asset prices from de-linking from their fundamental values. A key tool to avoid asset bubbles is arbitrage in which investors with market knowledge will bid up or down the price of an asset, depending on their perception of its true market value. But in a bubble, this arbitrage opportunity is not employed. This is more so in the housing market in which there are no mechanisms for a short sale to adjust the prices of homes, unlike in stocks. C.1 Sudden Price Increases in an Asset Class A bubble can start innocently enough as a perfectly legitimate economic expansion but economists are still perplexed how a boom can turn into a bubble. They know its effects but at a loss as to its exact causes. As mentioned earlier, bubbles start to form when there is no good reason for asset prices to rise based on fundamental demand for that asset. The tech bubble is a good example in which the prices of Internet technology-related stocks kept rising. C.2 Central Bank Approaches to Mitigate Asset Bubbles There is no agreement among academicians, central bankers and economists on right approaches to dealing with asset price bubbles. More specifically, they are in disagreement in identifying a bubble when it first surfaces because it is difficult to distinguish from a boom. A favourite tool by bankers is to just let a bubble form and deal with the aftermath later on. It is a costly approach as shown by the current amount of stimulus funds being used to revive the weakening economy. Asset bubbles are financially destabilizing and these surprisingly occur even during periods of low or no inflation. Bank of England policy makers have resisted the idea of “leaning against the wind” or LATW (prick bubbles early on by increasing the rates). Some central bankers attribute bubbles to excess credit growth (Baum, 2008:2). D. Preparing for a Credit Crunch People should prepare for a credit crunch whenever they could. It is the proverbial saw like what the Bible says about preparing for years of drought and famine. This was preceded by a period of plentiful harvests and the Egyptians forgot how to save and prepare for worse agricultural and economic conditions. Similarly, people today can take precautions for a credit crunch by taking adequate preparations when credit is hard to come by (Baldwin, 2009:111). D.1 Gather Enough Savings This is sometimes very hard to do, considering that salaries are barely enough to buy all the necessities in life, plus payments for recurring bills like the utilities. However, a good savings plan entails not only finding ways to save on unnecessary costs but cut out expenses which are not really needed to live a comfortable life. Finding ways to save is not really hard if one is really determined to implement changes in spending habits and follows strictly a new budget on a weekly or monthly basis (Goldwasser, 2004:82). Try to live a frugal life and save in a bank account for the proverbial rainy day. Individual people and small businesses are the ones most adversely affected in contrast to large corporations (Warren, 2010:12). D.2 Augment your Regular Income One way to do this is to find a second part-time job which is quite plentiful these days. Many firms are reluctant to hire full-time employees because of legacy costs but are willing to hire people on a temporary basis which should suit fine many people who already have jobs. It is just a way to earn extra income, expand your professional network and broaden the skills a person already has for future use in another job or industry whenever it is needed. Incomes from second jobs can go straight to a savings account for the proverbial rainy day. Reliance on a single pay check is not very sound advice these days when jobs are not that secure anymore. D.3 Look for Profitable Investment Ventures It may seem outlandish to suggest anything like this but sometimes, opportunities will present themselves without people knowing it and able to grab these rare opportunities which sometimes come out only once in a lifetime. Be alert and on a constant lookout for investment opportunities which can grow the saved money into more productive and fruitful endeavours. It may even suggest a new business venture which can grow big someday. An example is the one given by the famous author Robert Kiyosaki in his book Rich Dad, Poor Dad (2000:43) to buy distressed real estate assets without investing too much money in it and turn it around. He cited his experience in buying a house on a tax sale but selling it for a quick profit. D.4 Be Financially Conservative It pays to be financially prudent and it means spending and living only within your means. Additionally, it entails avoiding credit cards as much as possible and paying in cash only as credit involves paying interest rates which can be at usurious levels. Conservatism as it pertains to personal finances is not spending income that is not yet earned, as what happens when using a credit card or buying anything on instalment schemes. The credit crunch impact on households varies such as in the Midlands and North England (plus Scotland and Wales) so it is important to prepare when credit markets contract (Forrest & Yip, 2011:52). D.5 Be Financially Literate Nothing beats knowing the intricacies of personal finances better than having intimate knowledge of how finance works. This helps a person avoid risky investments, look for wiser and safer investment instruments, maximise the funds available and help to better preserve his or her capital or savings. A financially-literate person can avoid the pitfalls of investing and it prevents other people from foisting a scam as well as. Financial literacy involves knowing the power of compounding interest, the time value of money and risks in relation to rewards ratio. There are many financial literacy programmes for this purpose (Fischer, 2005:15). Conclusion A credit crunch has very far-reaching effects on the economy and on individual people as well. Persons who are financially literate can understand how a credit freeze affects them. There are three things a person needs to know if a credit crunch is over or not yet. These are the amount of bad debts being written off (toxic assets), the liquidity conditions and interest rates charged by banks to each other (in the graph earlier) and lastly, too much credit growth (liquidity) in the beginning of the asset price bubble (Fitz-Gerald, 2009:2). It is stuff that is crucial on a personal level and important enough not to just let anybody else handle it for us; the third element mentioned above takes a reverse cycle resulting into a credit freeze instead. The credit crunch has made obtaining loans harder and more costly. The best antidote to an impending credit freeze is to have an emergency fund so that one does not have to resort to borrowing in times of need. Already, the British government is concerned on its effects on the standard of living of its citizens such that it had conducted hearings in House of Commons on how to alleviate the situation (House of Commons, 2009:60). It looked into how the credit crunch is adversely affecting access to the housing market by its citizens. In a credit crunch, there are serious implications with regards to standards of living people are used to. It results to lower standards of living from reduced consumption (Anderton, 2006:192). References Anderton, A (2006) Economics. London, UK: Pearson Education Limited. Baldwin, R. (2000) The Great Trade Collapse: Causes, Consequences and Prospects. London, UK: Centre for Trade and Economic Integration. Baum, C. (2008) Central Banks can do better than Just Mopping Up. [On-line]. Bloomberg News, 11 December. Available at: Claessens, S., Kose, M. A. and Terrones, M. E. (2008) What Happens During Recessions, Crunches and Busts? Washington, D.C., USA: International Monetary Fund (IMF). Fischer, M. (2005) Saving and Investing: Financial Knowledge and Financial Literacy that Everyone Needs and Deserves to Have! Bloomington, IN, USA: Author House, Incorporated. Fitz-Gerald, K. (2009) Three Ways to Know When the Credit Crisis Hits Bottom. [On-line]. Money Morning. Available at: Forrest, R. and Yip, N. M. (2011) Housing Markets and the Global Financial Crisis: The Uneven Impact on Households. Cheltenham, UK: Edward Elgar Limited. Goldwasser, J. (Apr 2004) Your Money: Find Ways to Save. Washington, D.C., USA: Kiplinger’s Personal Finance. Herbert, B. (2011) Op-Ed: Losing Our Way. [On-line]. The New York Times, 26 Mar. p. A23. Also available at: [Accessed 28 Mar. 2011]. House of Commons (2009) Communities and Local Government Committee: Housing and the Credit Crunch. Parliament Square, London, UK: The Stationery Office. Kiff, J. and Klyuev, V. (2009) IMF Staff Position Note: Foreclosure Mitigation Efforts in the United States: Approaches and Challenges. 18 Feb. Washington, D.C., USA: International Monetary Fund (IMF). Kiyosaki, R. and Lechter, S. L. (2000) Rich Dad, Poor Dad: What the Rich Teach their Kids about Money that the Poor and Middle Class Do Not! New York, USA: Warner Books, Incorporated (a re-print). Litan, R. E., Pomerleano, M. and Sundararajan V. (2003) The Future of Domestic Capital Markets in Developing Countries. Washington, D.C., USA: The Brookings Institution. Milliken, D. (2011) Hoenig Urges Fed to Shrink Holdings & Raise Rates. 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