The Financial Crisis in the United States and the Solution to This Problem - Book Report/Review Example

CRITICAL BOOK REVIEW, ECONOMICS: PART I INTRODUCTION The book tries to explain to us the reasons that led to the financial meltdown in the United States and how to put an end to it. The United States plays an enormous part in the world’s economy. The nation accounts for nearly 25 % of the global GDP. It is not a surprise that there is a significant reason to be worried when there is a financial meltdown in the nation. Its fall would result to sharp economic downturns among other nations. According to the writer the financial crisis could not be contained as it had already begun to spread to other nations (Peter, 2008). PART 11 SPREAD, CAUSES AND EFFECTS OF THE FINANCIAL CRISIS According to the writers the recession would spill elsewhere in the world through trade. If the product output and the quantity demanded could fall there would be a decline in the private consumption, spending by companies. This will lead to a drop in the importation of consumer goods, capital goods and other raw materials from foreign countries. Majority of South East Asia rely heavily on their exports to the United States. China for example exports most of its products to the United States, its growth is attributed to these exports and if the Americans are reluctant to buy, they will have no market for their products. China also enjoys indirect trade links with the United States. Asian countries produce components such as computer chips, which are exported to China. China in turn takes these parts and assembles them into finished commodities such as computers. This are thus exported to the American consumers and if there is a fall in US imports, then the Chinese exports will also fall. This will also lead to a fall in Chinese demand for component parts from Asian countries resulting in a global economic downturn (Peter, 2008). Also other factors that led to the spread was the collateralized debt obligation, these obligations had actually been sold abroad and majority of them to the European banks. These banks ended up all over the world as they were looking for safes high yielding assets. Some of the banks bought United States subsidiaries which participated in household lending. British banks such as the HSBC bought one of the leading US mortgage lender and others bought securities. This was one of the reasons that this financial crisis became global. Some of the worst hit banks included the UBS, the Swiss bank was involved with a pro active American subsidiary which was involved in this and ended up being worst hit. This is one of the reasons as to why the Swiss government had to come to its rescue (Thomas, 2008). The United States had also been experiencing significant booms in their housing sector. More quick money and the low long term interest rates were available in other parts of Europe too. Countries such as Britain follow the United States closely only that the value of their flats falls. Countries in Asia such as Singapore have also experienced significant boost in their housing sector. Despite all this, credit crunch and the higher interest rates have caused economic downturn and even recession in other countries. Also the failure of the individuals to pay their mortgages can also lead to serious downfalls, which can lead to banks falling and governments being overthrown (Bulow, 1985). Also, the decades of the financial expansion and the ever growing credit and debt of the financial sector balance sheet and the total assets, at an alarming rate. (About 6 times faster than the United States Gross Domestic Product since the last decade.) Majority of the expansion was due to the fact that, there was high inflation era just after the 1970s. This cleared out debt the country owed since inflation generally clears debt (Bulow, 1985). The early 80s was characterized by an error of little inflation and stability. The public began to borrow more from the banks and this led to creation of more credit. Banks found more credit worthy borrowers who expanded more their banking balance sheets. The balance sheets expanded easily since they were solvent. Also in the late 1990s the issue of global imbalance came into play. Emerging economies in East Asia emerged as surplus savings countries. With their immense current account surpluses they needed a place to invest their surpluses. They but I think in the late 1990s and the early 2000s something changed and this is the second cause which I genuinely focus on: the global imbalances issue. For a number of reasons that are quite complicated, the emerging economies of the world, particularly in East Asia, emerged as vast surplus savings countries. They ran enormous current account surpluses, which means they had an excessive savings looking for a home. First that drove down the value of the real interest rates worldwide, which drastically fell down, secondly, the countries found the home they had been looking for, for their investments to be the US (Johnson, 2010). Us an underdog in this error, the United States emerged as the surpluses in these Asian countries and China exploded. This capital was invested solely in outstanding foreign currency reserves, these assets were highly liquid and they were invested majorly in the United States markets. During this era Fanny Mae and Freddie Mac provided the public with a significant liquidity base. The public bought a lot of liabilities as they were provided with low interest rates that were attractive to the public in general. Due to all these factors, such as low interest rates, the increase in the availability of money, there began to be increased housing bubbles all across the developed world. Since the housing prices were rising daily, it seemed safe to borrow against the house. People knew that if one never had enough money, it was still safe since the coming year the value of the house would have increased. Also if you had problems in maintaining your debts, you could sell the house. All across the world, it was pretty obvious that you could not lose your money when you borrow for a house. Due to this housing bubble fevers, complicated assets were prepared, this were the so called safe mortgages that everybody wanted. These mortgages were then sold worldwide. Majority of the United States assets that were closely related to this bubbles ended up across the globe (Lowenstein, 2010). These issues by 2006 had created a combination of disaster and doom, which happened when the house prices started to fall and people discovered they were actually holding worthless assets. Credit had accumulated considerably. There were increased household debts that doubled over the decade both in the United States and the United Kingdom. People thought that they never needed an expanded financial sector with large equity. They thought everything was excellent but most of it was pinned to these complicated securities that were solely held to the belief that housing prices could only rise and not fall. Majority of influential economists in the United States had also stated that housing prices could never fall since they had never done that before. Also late in the housing bubble phase, the lending standards were thoroughly lowered and as a result majority of the people purchased houses both in the United States and the United Kingdom. This people couldn’t afford the loans, and soon when the housing prices began to fall they became insolvent (Mihm, 2010). CAUSE OF THE BUBBLE According to the experts this bubbles were accelerated by the savings of the Asian countries. According to financial expert Wolf there were reasons to be concerned about the effect of the East Asian savings. His view was that the only way to counterpart the excess savings was to borrow and majorly by the household sector. During this period the United States had been running on a high level of financial deficit. The nation was spending more than its income by a great margin. This borrowed money they used to finance the assets they purchased. Countries such as, China played a vital role to. The Chinese have large trade surplus and whenever the United States housing sector was heading to debt, they turned to China. The Chinese ended the American increasing the United States credit. They also bought US treasuries which they were financing by their exports majority of which were headed to the United States (Mihm, 2010). Another effect of the financial crisis is the fall of commodity prices. With the ever increasing price of oil, commodity prices have also surged in the recent years. But with looming financial crisis in both The United States and the Chinese economies the engineers of global economic growth, it a cause a drastic drop in the demand of basic commodities such as oil, food and energy. This in turn will be disastrous to the Asian, Latin America and African countries that export their products to these countries. The growth rate of these nations will be profoundly affected. Wall Street is also suffering from a severe credit crunch and liquidity due to the fallout in the United States subprime. Majority of the defunct mortgage securities and the collateralized debt obligations in Las Vegas, Cleveland and Phoenix were sold to investors in the foreign countries. Major multinational factories decided to cut their spending on factories in the United States and also in other European nations hitting their economies even harder. This is due to the fact that they depend more on bank lending than how the American firms depend on them. This global credit crisis not only will it limit their ability to produce commodities, but also their hiring and investment opportunities (Lowenstein, 2010). By checking the reactions of the global stock market, one is able to determine how the financial virus spreads across the globe. Investors become more aware of the risks whenever their economies are in the down turn. In the United States when there is high unemployment rate or negative GDP growth there are fears that the economy will suffer. Investors will rush to sell of their stocks in New York. This will continue in Tokyo, London, Frankfurt and Paris. There is complete panic in the market and investors dump their risky assets from their portfolios. This type of financial nightmare was witnessed in January when the global equity markets fell (Research, 1991). It is not as secret that the people charged with making sure that the financial system is stable in the United States helped to cause the 2007-10 crises. The Financial Guardians in the US and Europe established policies that encouraged adverse credit allocation, and a lot of risk taking by their financial institutions. They still stood by the same policies even after learning of the impending financial problems. Financial Guardians in the United States have at many times chosen and maintained policies that have always led to crisis. This counter reacted to the crisis by adding other rules and establishing newer regulatory boards with more powers granted by the Congress. An example is given where the regulators never reacted to the extra ordinary increase in the financial institutions leverage. This never reacted to the movement of assets worth trillions of dollars from banks balance sheet. This shows how the regulators did not do their work (Research, 1991). Increasing the regulators power without checking the problem and trying to regulate it helps in solving nothing. Barth, Caprio and Levine studied that the governance of financial regulation the system that is supposed to design, implement and reform financial policies contributed highly to the crisis faced in the United States. The senior most officials are blamed for repeatedly designing implementing and maintaining policies that destabilized the financial markets. The Financial Guardians maintained the same policies even after learning that these policies were increasing the instability of the financial system in the country. Also, even after the authorities had discovered about what was happening, the regulators did not adjust their policies even when they had the time and power this came to one conclusion that the regulators never worked ii the interest of the public but their own (Roubini, 2007). The group indicated in their book that the failures of the respective governments in the governance of the financial regulations played a crucial role in crisis by being part of the destructive policies created and maintained by the regulatory agencies. The proposals laid out by the institutions have not addressed the weighty issues including their weaknesses with governing financial regulation. The public is also not involved in the process as there is no mechanism laid down through which people can obtain well laid informed assessment of the financial institution. Since the public are the ones affected by these policies, it is highly recommended they get involved with the process. It is hard for the public to be involved in policy creation, since the financial authorities have monopolized the information and expertise that is needed by the public to assess their performance. The financial institutions have kept valuable information about their financial system activities secret (Roubini, 2007). The group also argues that, on the matter of being independent, the financial regulators are not independent of influences of politics, private financial institutions or the combination of the two. The Federal Reserve is taken as the best example of an agency that has the best combination in terms of human capital skills and the most information available. Although it is made to be independent of politics, the Federal agency is not independent of the private sector. This is because the financial institutions participate in the appointment of the FEDS leadership, and a number of senior managers have worked in the private sector prior to joining the FEDS. These senior officials still maintain contact with the private financial institution as they supervise them. Though, the Feds maintain contact with these institutions, it is not implied that they are corrupt or using their positions to land generous offers from the private sector. It, however, just goes ahead to prove that with these close connections they are not independent (Stiglitz, 2009). According the writers view, globalization of the financial system was dangerous. An example is when a large financial institution gets in a total mess, for example, Lehman, which is the third largest investment bank in the world to ever get into trouble. Since it does its business globally with everyone, leading banking institutions that is, and with their financial muscle they had managed to amaze. When this company took a hit of the financial crisis the confidence it had built in people fell. There was no other national financial system since the United States did not have one neither did the British. Majority of the assets in the United States in the banking sector are foreign assets and liability. Once these assets began to plummet, these financial institutions become insolvent and their governments cannot come to their rescue. According to this, it is quite evident that once there are crisis that will in a way affect assets such as households, it is easier for it to become global since all other institutions have their investments in it and this institutions are also connected to others (Stiglitz, 2009). Also when the financial system is fragile, it cannot lend anymore to its borrowers. This is due to the fright of the crisis which was more than severe to them. Since the financial institutions can’t lend, everybody feels the pinch. Businesses can’t borrow, governments, multinational firms can’t also borrow. Credit borrowing is henceforth affected in the entire world. Developing countries will be affected; consumers won’t be able to spend their money. Big economies such as Japan were among the worst hit by this crisis. Its GDP in the last quarter had a negative growth at the yearly rate of 10%. China growth was zero (Wolf, 2009). PART 3 The book does not only display the causes and effects of the financial meltdown but it also tries to offer solutions to the impending dangers. In order to fix the financial system, the government has to recapitalize it to make it effective in some ways. Even though largely ineffective, this will help households come out of their enormous debts. The government should also try to reduce its current account deficit. According to Wolf the government in order to sustain demand, will have to run on a high fiscal deficit, say 10 %. Even though it is a risky measure since there will be piles of vast amounts of fiscal debt. It is either this or to improve the US external balance (Wolf, 2009). Conclusion In earnest conclusion, economics in the financial sector has really played an important role in this world. This book has thus served the best example. The book through my critical analysis did indeed show the reality of how various macro and micro economic factors does affect the current global finances of the various and numerous nations in this world that have in essence, embraced such principles in applying to balance their economic situations which they happen to experience. It is hence appropriate to acknowledge the magnificent work that the authors of this book, through their efforts, done. References Peter, D (2008). A Panoramic View of Eight Centuries of Financial Crisis. NBER. Thomas, W(2008). Dont blame the New Deal. New York: New York times. J. Bulow, J. G. (1985). Multimarket oligopoly: strategic substitutes and strategic complements. Journal of Political Economy 93 , 488-511. Johnson, S. (2010). 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Pantheon. Lowenstein, R. (2010). The End of Wall Street. Penguin Press; First Edition,. Mihm, N. R. (2010). Crisis Economics: A Crash Course in the Future of Finance. New York: Penguin Press. Research, N. b. (1991). Financial Market and Financial Crisis. Chicago: University of Chicago Press. Roubini, N. (2007). The Coming Financial Pandemic. New York: New york times. Stiglitz, J. (2009). Death Cometh forthe Green Back. Wolf, M. (2009, March). Fixing Global Finance. (N. Chanda, Interviewer) Read More