The Current Financial Crisis in the US - Case Study Example

Introduction The current financial crisis in US is one of the most important chapters in its history as the country is facing one of the severe economic depressions in its history. Since the beginning of the crisis in 2007 there has been much discussion on the actual causes of the crisis and what actually went wrong. The initial debate on the cause of the current financial crisis was focused on the role of subprime mortgage and the toxic debt which banks have acquired. The subprime lending was done in order to derive more returns for the banks however; this was done by assuming more risk. What is however, significant to note that the crisis created a kind of contagion effect on other sectors of the economy also and started to take deeper roots in terms of creating recessionary pressures on the economy? During the last quarter of 2007, US officially went into the recession and official response from US government started to emerge. US took massive action in terms of supporting the failing institutions and government injected tax payers’ money in order to ensure that the whole financial system of the country should not collapse. This also included separate responses from the different actors of the State including The President, Congress, Treasury as well as the Fed Chairman while working in their official capacity. This paper will therefore focus on some of the academic work which has been published on this topic so far and what actions were taken by different actors of the State. Financial Crisis- a brief overview As discussed above that the original cause of financial crisis was the busting of asset bubble wherein the subprime mortgage portfolio of the banks started to get worse. Over the period of time, banks started the practice of lending to subprime borrowers- borrowers with impaired credit history- in order to earn higher returns. Most of the banks however, also securitized their mortgage portfolio and subsequently repackaged their loans and sold them in the form of mortgage based securities. (Cocheo. 2007). The real issue started to emerge when the subprime borrowers started to default and the banks have to divert their own funds to payoff their obligations on the mortgage based securities. This mismatching of the cash flows therefore created the credit crunch for other sectors of the economy and slowly started to engulf the whole economy. The apparent reason may be the subprime mortgages however, underlying this crisis, many critical weaknesses of the regulatory environment of the country. It is generally argued that the overall regulatory environment of the developed countries was so relaxed that the firms took undue advantage and started to adapt the business practices which were risky and put the entire survival of the whole organizations and resultantly the overall financial system of the country. The overall extent of the damage which has been done by the pundits in Wall Street therefore has made the economy crumbling on its knees and caused havoc in the international markets across the whole world. The Failure of Regulatory Authorities One of the most important reasons as to why the financial crisis occurred was the failure of the regulatory authorities in controlling and managing the economy and the financial markets. It has been argued that the financial system as a whole tend to embarrass the free market economics when times are really good however, when things start to get bad, the overall impact of free market economics may not be as effective as it should have been. Financial markets therefore require a regular intervention from the government in order to function properly and within some given rules.( McIlroy 2008). The current financial crisis is a direct result of the failure of the regulatory authorities because the overall regulatory infrastructure was so weak or rather it left so many loopholes that it could not deter the financial institutions from crossing their limits and finally culminated into the creation of the crisis of such magnitude. This also indicates the overall regulatory risk which the financial system of US was running through because regulatory authorities in US such as FED and SEC was not able to ensure that the financial system remain sound and work under the acceptable risk limits. It is important to note that the failure of the regulatory authorities have been due to their inability to understand and assess the risks which arose due to the overall process of financial innovation. IMF suggested in one of its reports that the regulatory authorities completely failed to anticipate as to what kind of risks new innovation can actually pose to the system as a whole. The mass scale development of financial derivatives as the main instruments of the financial transactions increased the overall level of exposure to the level where it was simply not manageable however, regulatory authorities went on to allow the firms to take extra exposure and risks. (Bonner and Wiggin,2006), Another important aspect of the regulatory failure is the fact that the regulatory authorities actually failed to regulate the whole sector properly. US went through a period of systematic de-regulation under the flagship of Alan Greenspan wherein a systematic de-regulatory approach was adapted to allow the free market policies to work on their own. This process of de-regulation however, remained unchecked and the financial services institutions went on to develop and market the products which were relatively more risky. Given the advancements in the technology and the speed with which money can flow easily, the overall magnitude of the risky assets increased manifolds thus putting adverse pressure on the soundness of the whole system as well as creating crisis for the economy.( Mishkin, 2007). It is also important to note that the BASEL accord was implemented much before the emergence of the financial crisis. It is however, now argued that the banks in US and UK did not paid much attention to the practices outlined in the new BAEL accord and failed to implement the practices within their own risk environment to ensure that they remain well guarded against the different risks. Fair Value Accounting The recent debate on the causes of the current financial crisis also points out towards the role which fair value accounting played. Fair value accounting principles suggest that the firms should record the values of their assets and liabilities at their market values rather than their historical costs. Normally, the financial statements are prepared in accordance with the historical cost concept however, the fair value accounting principles suggested that in order to better inform the investors regarding the true value of the assets and liabilities of the firm, it is important that the firm’s assets should be recorded at their fair values.( Kane & Marcus 2003), When crisis started to emerge the market value of the assets held on the balance sheets of the financial institutions started to decline and the firms were forced to record them at the lower values. Apart from this, the overall reduction in the values of the assets was supposed to be recorded as expense in the financial statements of the firm. Due to this reason, most of the firms went into the losses and a cumulative effect started to hurt the financial system as a whole because of the extent of the exposure of the banks in assets whose values were cyclical in nature. This reduction into the values of the firms’ assets and liabilities therefore was another major reason as to why the economic crisis started to emerge and engulfed the markets of the developed world and exposed the soundness of the financial system. Steps Taken by different Actors As discussed above that due to the current financial crisis, US government has to intervene into the economy and inject the tax payers’ money in order to ensure that the overall soundness of the financial system remain intact. The constitutional role of the Presidency, Congress and the Secretary of Treasury is always to ensure that the different organs of the State perform efficiently and that the overall welfare of the citizens of the State remains intact. The actions which were subsequently taken by the different actors of the State therefore was the direct result of their constitutional and moral responsibility to develop the appropriate regulatory environment which can ensure that the confidence of the citizen’s in the financial system remain high and the economy continue to operate without any significant hindrances. One of the strongest economic criticisms against G.W. Bush is deeply rooted into the argument that he pursued the policies of economic de-regulation during his eight years reign as the President of the country. One of the initial responses from the Congress and the President Bush was the promulgation of the Emergency Economic Stabilization Act 2008 which is commonly known as the Bailout plan for the country. Under this Law, government undertook to inject upto $700 Billion into the economy to purchase the distressed assets and allow a breathing space to the financial institutions. This amount in the bailout plan was subsequently increased also in order to better accommodate the failing institutions and the economy. This was probably the most important fiscal policy response from the US government in order to tackle the crisis and ensure that the aggregate demand in the economy remain stimulated during the crisis. (Calomiris, 2010) It is important to note that this act was proposed by then treasury Secretary Henry Paulson in the wake of the emerging financial crisis. Congress also subsequently approved a bailout plan which allowed the US government to take massive fiscal stimulus plan under the current government of President Obama. It is important to note that most important response towards the financial crisis came from the chairman of Fed who has the basic responsibility of ensuring the soundness of the financial system of the country. FED undertook important monetary policy initiatives such as systematic reduction of interest rates in order to ensure that the consumer spending remain at certain level. Apart from that, it also created an emergency fund in order to strengthen the equity base of the financial institutions and to provide them the required buffer against the losses. (Evanoff & Moeller, 2010) Quantitative easing was another important step taken by the FED wherein it attempted to ensure that the overall money supply in the economy remain at targeted level. Quantitative easing is a method of maintaining the money supply at a given level by artificially creating the debit and credit entries into the books of the banks when they transact with the FED. It is also important to note that the overall response from almost all the actors of the State remained reactionary in nature and all the subsequent legislation was reactive in nature. This therefore also lead to the conclusion that the regulatory environment before the emergence of financial crisis could not actually anticipate that the crisis of such magnitude can emerge as a result of the lax regulatory environment and attitude from the regulators specially. Effectiveness of the Steps The steps taken by US government, so far, seem to provide the results which are only ensuring a slow and gradual recovery of the economy. Since the emergence of the crisis, US economy has started to recover and there has been consistent and slow increase in the GPD of the country. Apart from this, the large scale manufacturing is also picking up as well as the unemployment level is coming down. (Investors Business Daily, 2010) However, the overall pace of the recovery is slow and suggests that the steps taken by the different State actors in the past may not have been entirely effective in ensuring the complete recovery of the economy. Only recently there were strong predictions for the double dip recession in the economy and as a result of this FED also increased the amount under the quantitative easing in order to ensure that the double dip recession does not occur into the economy. Double dip recession is particularly characterized by the decline in the general price level as well as in the GDP level- a sign which may push the economy towards depression. References 1. Bonner, William and Wiggin, Addison (2006), Empire of Debt: The Rise of an Epic Financial Crisis. New York: Wiley. 2. Calomiris, C. W. (2010). The political lessons of Depression-era banking reform. Oxford Review of Economic Policy; , 26 (3), 540-560. 3. Cocheo. Steve (2007). Can subprimes casualties be saved?. ABA BANKING JOURNAL. 0 (0), 28-35. 4. Evanoff, D. D., & Moeller, W. F. (2010). Financial regulation in the post-crisis environment. Chicago Fed Letter (pp. 1-4). Chicago: Fed. 5. Investors Business Daily. (2010, 09 27). Bernanke laments slow recovery. Investors Business Daily , p. A02. 6. Kane & Marcus (2003), Essentials of Investments. London: Irwin. 7. McIlroy,David H. (2008). Regulating risk: A measured response to the banking crisis. Journal of Banking Regulation. 9 (4), 284–292. 8. Mishkin,Frederic S.. (2007). Is Financial Globalization Beneficial? . Journal of Money, Credit and Banking. 39 (2/3), p.259-294. Read More