Inside the Markets: Financial Crisis - Article Example

INSIDE THE MARKETS The current financial crisis is only the beginning By James Saft Reuters Published: October 9, 2008 CHARLESTON, South Carolina: Yes, Virginia, the banking crisis will one day end, but what comes after promises to be even more arduous. With the solvency of the Western banking system seriously in question, there is a temptation to hope that if only the latest bold, last-ditch rescue plan will work, we can go back to the good old days of 2006. One could argue that the banking crisis is just the cold sweat, not the flu that follows it. The problem is not just that the banking system has been broken by an orgy of foolish lending but moreover that huge swaths of the global economy are predicated on that foolish lending and the consumption it allowed. The bubble wasnt just in real estate, leaving the financial system holding the bag; the bubble was in consumption. That is not to say that the current scrambling to save the system is pointless. There is a very big difference in the damage that would be done by a disorderly deleveraging compared with a slightly slower, more controlled one. The banking crisis will have very serious negative effects on the real economy, and the cost will grow. This is true even if ATM machines continue working, our deposits stay safe, and gold, bullets, canned goods and bottled water dont become the best asset allocation choices for 2008. The core of the issue isnt even solvency. Its the way in which the debt causing the banking insolvency distorted, distended and hollowed out economies around the world. It caused a huge misallocation in the English-speaking economies into real estate, and into consumption that could only seem to make sense to people drunk on the appreciation of property prices. It caused a less huge but still significant misallocation elsewhere; I think we will see that a lot of what was being produced by Europe and Asias vibrant export industries were products that the United States and Britain will find they can do without, or with much less of. Dont get me wrong: The banking crisis is extraordinarily dangerous. But the changes in the global economy that are needed are even more profound. Savings rates are going to need to rise in the developed economies of the English-speaking world, and consumption fall. Those economies are also going to have to place a higher priority on producing goods and services they can sell abroad. There are lots of parts of the "service economy" that very likely wont exist in two years time, or only in a very feeble way. Take for example the U.S. and British phenomenon of late-middle-aged people setting up small service businesses after they have been laid off from their jobs. Very often they use a combination of their severance package plus equity extracted from their houses to provide themselves with working capital, and often to supplement their earnings. So, someone who - for the purposes of argument - used to work for IBM in the Hudson Valley in New York State starts a business installing marble countertops. For four of the last six years that has been a good business, but the people paying for it were only able and willing to do it so long as the illusion that consumption-is-investment could be maintained. That is over, and significant parts of the U.S. economy will need to be repurposed, and will need to do so at a time when we are suffering from asset-price deflation and may well get deflation. The recession will be long and probably ugly. Just think about your own lives and the people you know: How many of them do jobs that didnt exist 15 years ago but have nothing, really, to do with new technology? Many of those jobs are enjoyable and worthwhile offshoots of a credit bubble and will have a very difficult time surviving its demise. Similarly, it will be tough for those English-speaking economies global enablers. China will need to find somewhere else to sell many of its goods. The grand bargain of China buying U.S. Treasury bonds to finance consumption in the United States will come under enormous and dangerous strain. Europe, too, as well as other exporters, will hit difficulties - not just in their banking systems, which helped finance the binge, but also in their auto and consumer electronic industries, just to name two. There is no doubt that the needed changes can happen and that these innovative and creative economies can re-balance. But it is going to be very painful. International Herald Tribune http://www.iht.com/articles/2008/10/09/business/col10.php Economic Crisis 1 Samson Varghese Economic Crisis 08 The above article discusses the current financial crisis in U.S. banks specifically and the world economy in general. The author argues that current banking crisis will be solved one day, but the situation following that may be even worse. The current crisis is only a beginning. The reasons for the current crisis may not be due to the policies alone. The economy is seriously affected by the banking crisis. The current problem is enlarged not because of the solvency capacity of the banks. But their debts are distorted and distended and hollowed and that made the problem even bigger. In his opinion, even though the banking crisis is dangerous, the condition of global economy is more dangerous than the banking crisis. The existence of service economy is also under question. The author predicts that the current recession may continue longer than anticipated. The author has made use of microeconomic theories in this article. Microeconomics is a branch of economics that studies how individuals, firms or states make decisions to allocate limited resources, in markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviors affect the supply and demand for goods and services, which determines prices; and how prices, in turn, determine the supply and demand of goods and services. Economic Crisis 2 Now consider the fundamentals of microeconomic theory with respect to the above article. The article deals with the activities of a firm, in this case U.S. banks in particular and states and global economy in general. Allocation of resources by such firms or states is another consideration of the microeconomic theory. The author argues that the current problem is mainly because of the foolish lending activities of the banks. The banks miscalculated the global economy as a renewable source or in other words they consider it as an ocean of wealth which will never be exhausted. As per the microeconomic theory the allocation of resources are very important. The allocation of resources in the case of a bank is mainly the loans of different forms to the customers. This allocation has not been done properly by the bank. They have allotted loans to all the people irrespective of the financial strengths of the customers. They have not conducted any reviews to assess the financial setups of the customer at present and also they failed to forecast the future. The greedy customers accepted the offers (loans) from the banks with both hands. They have approached the banks for everything and the banks were ready to fulfill their dreams. As per the author, the banks thought that the global economy will never exhaust and whatever the goods and services sold in the market will bring profit. Such irresponsible allocation of resources by the banks in the market is the main cause of the current problem. The banks forget the basic principle of microeconomics which clearly states that the market is a place where the goods or services being bought or sold. In the above Economic Crisis 3 case the banks were more focused on the goods or services sold rather than the goods or services bought. They were more interested in selling of their services. They never though too much about the returns against the services they provided. As per the microeconomic theory there should be a balance between both the services and goods sold and bought. Once this balance is lost then either the seller or the buyer will be in great problem. As per the author this fundamental principle of microeconomics has been neglected by the banks and the current problem is mostly because of that. Again, microeconomics examines how the decisions and behaviors affect the supply and demand for goods and services, which determines prices; and how prices, in turn, determine the supply and demand of goods and services. The bank’s decision and behaviors with respect to lending was not based on the study of supply and demand theory. The supply must not be provided to all those who are in demand. It should be regulated to those who are capable of providing the return in time. The demand should be properly assessed before providing the supply or in other words the banks should ensure that the customer (Demand) is eligible for the loan (Supply). Supply and demand for goods and services determine the prices. If there is more supply than the demand then the prices will come down automatically. On the other hand if the supply is less than the demand the prices will go up. The supply and demand should be balanced in order to stabilize the price as per the classical theory of economics. “Reacting to the severity of the worldwide depression, John Maynard Keynes in 1936 broke from the Classical tradition with the publication of the General Economic Crisis 4 Theory of Employment, Interest, and Money. The Classical view assumed that in a recession, wages and prices would decline to restore full employment. Keynes held that the opposite was true. Falling prices and wages, by depressing peoples incomes, would prevent a revival of spending” (Major Schools of Economic Theory) The author also argues that the savings nature of the U.S. people should be increased which will reduce the consumption of the goods or services. The goods and services produced in the U.S. should be marketed in other external markets in his opinion. He also predicts that lot of service economies will not exist after two years. He also argued that the U.S. economy should be restructured to counter the asset price deflation. He also argues that the China will need to find somewhere else to sell many of its goods. These cheaper goods from China actually prevented the expensive goods produced in the U.S. from even the domestic market and it is not comfortable for the U.S. economy. The demand for cheaper goods from China is another reason for the asset deflation. There is more supply than the demand in U.S. markets and this is not well and good for the U.S. economy. The main problem is that this excess supply is not because of the excess production in U.S. but it is the end product of Globalization This article is well written and well structured. It discusses the U.S. economy in specific and the world economy in general. This article tries to find out the exact reasons for the financial crisis faced mainly by the banks. The author ridicules the actions of the banks with respect to lending. He also points towards the interventions Economic Crisis 5 and dangers of the entries of products from other countries into the U.S. market without any regulation. He also foresee the current recession will extended more than anticipated and also predicts about even more drastic situations in future. Economic Crisis 6 Sources 1. James Saft INSIDE THE MARKETS The current financial crisis is only the beginning International Herald Tribune Retrieved on 08/12/08 http://www.iht.com/articles/2008/10/09/business/col10.php 2. Major Schools of Economic Theory Retrieved on 08/12/08 http://www.frbsf.org/publications/education/greateconomists/grtschls.html#A1 Read More