Handling Economic Crisis in Housing Market - Essay Example

A review of the of the US economy for the last 2 years, what are the factors that have caused the housing market to face current problems, a review of the key fiscal and monetary measure undertaken by various government agencies to provide support for housing market, measures undertaken by this industry itself to turn its fortune around, analyze the effectiveness of those measures, analyze the outlook for the economy and housing market in 2009 and beyond. The severe decline in the state of world economy in the last two years is a culmination of several factors. But the bursting of the housing bubble in the United States alongside a precarious credit crunch situation have played major roles in precipitating the latest episode of economic recession in many countries. While the advanced nations in North America and Western Europe have borne the brunt of the recession, lesser developed economies and several emerging markets are simultaneously experiencing a slowdown in economic activity. Financial analysts and political commentators point out that the unregulated financial markets of Western democracies make such crises inevitable. The proponents of free market capitalism, on the other hand, do not concede this point. This essay will foray into the conditions that led to the present crisis in the housing market and try to assess the merits of remedial policy measures in this regard. The evaluation of the stimulus and bailout packages is followed by an inquiry into policy directions for the coming years. It will also place the prospects of the housing market in the broader context of revival of the economy both in the United States and abroad. The Federal Reserve, which has the power to decide the course of the economy, has been criticized for its lack of foresight. Although the actions of the Federal Reserve in the initial years of the Bush Administration are to be credited for the housing boom, exercising fiscal prudence could have mitigated the present crisis. According to John Gnuschke, “Daily evidence of the continuing erosion of the housing market, the associated disruption of financial and credit markets, and the spill-over impacts to other segments of the real estate industry are taking their toll on the broader economy. While the real estate industry continues to be a major component of the economy, the dramatic and overly-aggressive increases in interest rates promoted by the Federal Reserve Bank (between 2001 and 2007) have caused a major disruption in national and international markets”. (Gnuschke, 2007, p.4) Another reason for the decline of the housing market is the unmitigated expanse of mortgage lending across income groups. In spite of being warned by the former chief of Federal Reserve, Alan Greenspan, the financiers continued to ignore unpleasant realities. The transition of Chairmanship from Alan Greenspan to Ben Bernanke has so far not brought a change in the policy direction. When the markets are booming and there is plenty of credit available due to reduced interest rates, it is tempting to ignore warning of impending doom. This is precisely what precipitated the collapse of the housing market in particular and the economy in general. For example, lenders such as HSBC, who own the American company Household International, thought of mortgage lending as a lucrative opportunity to make profits. Such willing lenders catered to low-income individuals, who were keen to take advantage of the apparent rise in house values. At the same time, new financial market instruments such as ‘sub-prime mortgages’ were introduced. In other words, “the mortgage debts, offering better-than-usual returns (because of the low quality of the borrowers) would be packaged up into neat parcels--known technically as "collateralized mortgage/loan obligations"--and parked with banks and investment funds around the world” (Alex Brummer, 2007, p.17). It is easy for unsuspecting low income investors to succumb to the lure of these complex derivative products. But in reality, their real value is significantly lower than what is quoted in the financial markets, the latter being the result of speculation. But the high risk contained in these sub-prime mortgages was not nominal but very real. This precarious balance was sustainable only as long as the housing prices remain affordable and interest rates remained low. And it did not take long for Greenspan’s fears to turn to reality. “No sooner had Greenspan spoken than the housing bubble burst. Prices across the United States plunged. House builders were left with unsold stocks and the sub-prime mortgage lenders found not only that they had lent funds to people who had no realistic prospect of paying back, but the securities against which they had lent were worthless. HSBC alone lost [pounds sterling] 5bn.” (Brummer, 2007, p.17) Financial experts also failed to take into account the likelihood of inflation. This misplaced optimism was to prove a disaster. For example, the belief that inflation is a thing of the past encouraged financial institutions to borrow money long-term at very low interest rates. But when energy prices remained high for a protracted period and demand for commodities from emerging economies increased substantially, it made borrowing money close to impossible. In this scenario, the bond markets started to reverse direction, and longer-term borrowing turned more expensive once again. The financial institutions that had borrowed cheaply did not expect the sudden rise in the cost of transactions. But, most of these financial institutions, including such names as Goldman Sachs, Bear, Stearns & Co., Barclays Capital, etc manage to evade negative consequences, as they had “repackaged debts of all kinds, including sub-prime mortgages, into derivative products known collectively as asset-backed securities” and passed it on to market participants. Speculative rallies further inflated the price of these securities (Roubini, 2008, p.45). The prices of these securities spiraled upwards, seemingly without an upper limit. Their complexity had made price rationalization an impossible task. Sooner rather than later, the speculation inflated bubble collapsed and has led to the severest economic crisis in over seventy years. While the epicenter of the crisis is in the United States, its repercussions have reached all corners of the world, including such emerging economies as China and India. As Alex Brummer explains, this phenomenon could not sustain forever: “Such vehicles--Goldman Sachss Global Alpha fund, for instance, and several operated by Bear Stearns--were able to extract the maximum value from securities by borrowing against them and selling them on. Fabulous returns were made using sophisticated computer models. But as the sub-prime mortgage situation became worse and such lenders as the giant Californian company New Century Financial collapsed into bankruptcy, it dawned on nervous investors that the emperor had no clothes.” (Brummer, 2007, p.17) The prevailing financial crisis can also be seen from an historical perspective. For example, many of the events and conditions that led to the present decline of the economy were similar to those leading up to the Great Depression of the 1930s. Then as is now, deregulation is seen as the chief culprit. Especially, during the tenure of the Bush Administration, the financial economy had repeated many of the same mistakes incurred during the 1920s. These excesses include stretching of borrowing limits to underwrite numerous speculative bets with money derived from the vulnerable middle class. Some of these financial mechanisms were poorly regulated, making the eventual economic crash inevitable. But, it would be simplistic to point fingers at the Bush Administration alone. The seeds for the disaster were sown further back in American political history. For example, in the last three decades, the Presidents of both parties, with the support of the Congress repealed important protective mechanisms from the original New Deal legislation. As a result, instances of exorbitant profits for business corporations have risen while real productive growth has been replaced by complex financial products such as derivatives. This, as a whole had made American economy vulnerable to recession (Roubini, 2008, p.46). Alongside derivatives, overpriced equities, inflated real estate prices and other complex financial instruments have played a role in creating the economic bubble. The bubble is further inflated by speculative borrowing, which feeds on itself, as it did during the Great Depression. This is so because an inflated asset is suitable collateral for further borrowing. To state that deregulation played a role in creating the bubble would be an understatement. In fact, the deregulated business and financial environment inevitably leads to periodic recessions. For example, in the years leading up to the current crisis, “the ratio of stock prices to corporate earnings is not quite as high as it was in 1929 or 2000, but it is still very high by historic standards” (Kuttner, 2007, p.20). As the author further explains, “For decades, real-estate prices have appreciated faster than incomes. This could not go on forever, because a house is worth only what some buyer can afford to pay for it. Lately, housing prices got an extra nudge from artificially cheap mortgages extended to people who didnt really qualify for credit. Mortgage companies could make these sketchy loans because some other speculator was willing to take the loans off their books, and because they expected housing prices to keep rising, adding a cushion of equity. Thanks to deregulation, the entire game operated largely beyond the purview of bank examiners.” (Kuttner, 2007, p.21) When initial signs of an economic recession were visible in the horizon, the policy makers did not act expeditiously. Toward the end of Bush Administration’s tenure, there were ominous signs of an impending recession, but the actions taken since then are not substantial enough. For example, in his final State of the Union speech, President Bush mentioned about the need for an economic stimulus package. There were talks of a $150 billion bailout package that would include tax rebates and other incentives to encourage consumer spending and investment in the near future. Moreover, under the proposed plan, taxpayers would get rebate checks, which would put disposable money directly in the hands of consumers - an idea that got bipartisan political support. Yet, in spite of encouragement in the House of Representatives, the plan does not measure up when seen in the backdrop of the severity of the economic crisis. For instance, the unemployment rate has reached its highest level in last sixty years. Added to that is the dismal state of the manufacturing industry. The consolidation of the European Union and its common currency Euro is posing a serious threat to the strength of American dollar. Considering all these factors, the measures taken so far prove inadequate. The plan is also ridden with technical flaws. As William Hoar points out, “With both major parties offering spurious solutions for the economy, the bipartisan fix is bound to be even worse for the nation in the long run than a partisan one. The shot in the arm that the politicians are pushing is a shot of more debt--involving the spending or rebating of money that the government does not have. All that this remedy will boost is the budget deficit.” (Hoar, 2008, p. 42) While some aspects of the Bush stimulus plan are theoretically sound, the benefits of the stimulus plan might not reach all sections of the population and does little to create new jobs. Neither do they encourage higher productive output. In order to boost productivity and invite more investments, the reduction in business taxes should be accompanied by reduction in spending for a longer duration of time. Unfortunately, this economic principle was unheeded by the Bush Administration. The eight years under the leadership of George Bush had put the economy under stress in other indirect ways as well. For example, the invasion of Iraq in 2003 has had a negative impact on the domestic economy. Not only did this illegal invasion and occupation cost thousands of American lives, it had usurped a greater share of the federal budget for building expensive ammunition and in the incurring of other military expenses. The proponents of the rebates plan argued that the initiative will infuse new money into the ailing economy, thereby helping revive demand and production. But since only the top forty percent of the American populace pay most of the taxes, the rebate checks will only reach two fifths of all consumers. At this juncture, the issue took on a political hue, as the Democratic Party has its support base in the middle and lower classes, which would benefit only marginally from this plan. So, political maneuvering had come in the way of decisive counter measures from the government. Leaders of the Democratic Party also played the race card in thwarting the tax rebate proposal. For instance, Senator Hillary Clinton (presently the Secretary of State) argued that “for the White House to propose spending over $100 billion to jumpstart the economy, while shortchanging assistance to the 50 million families which struggle the most and are most likely to inject those funds into the economy makes no sense.... It would disproportionately leave out African American and Hispanic families who have, on average, lower incomes than white families." (Hillary Clinton, taken from Hoar, 2008, p. 42) Hence bipartisan politics had played a major role in thwarting implementation of a robust and decisive economic stimulus plan. This is true during the last couple of years of the Bush tenure, as well as the initial months of the Obama tenure. When President Obama took the reigns of White House, the task set in front of him was ominous and daunting. The token measures of economic remedy advanced by the Bush Administration were to prove insubstantial. Hence, the responsibility of turning the economy around fell squarely on his shoulders. But, even he could not escape the hindrances created by bipartisan politics. Many economists have expressed their lack of satisfaction over the stimulus package that President Obama has brought forth. One of the issues of contention is the bailing out of private banks using tax-payer money. With the bankruptcy of Lehman Brothers, a series of bankruptcy claims followed. A few time-tested financial institutions, if not actually bankrupt, were not far from it. Obama Administration’s proposal to bail out the ailing banks and set right what are called “toxic assets” of these banks and financial insitutions would gain support from both Democrats and Republicans. But, some analysts believe that it is not the most prudent method of redeeming the situation. Nobel Laureate Paul Krugman is one among many economists who feel that the measures taken so far are not sufficient. In his July 9 column for the New York Times, Krugman asserts that “as soon as the Obama administration-in-waiting announced its stimulus plan — this was before Inauguration Day — some of us worried that the plan would prove inadequate. And we also worried that it might be hard, as a political matter, to come back for another round” (Krugman, 2009). Krugman sums up the efforts of the Obama Administration succinctly, “It’s also reasonable for administration economists to call for patience, and point out, correctly, that the stimulus was never expected to have its full impact this summer, or even this year. But there’s a difference between defending what you’ve done so far and being defensive. It was disturbing when President Obama walked back Mr. Biden’s admission that the administration ‘misread’ the economy, declaring that ‘there’s nothing we would have done differently’. There was a whiff of the Bush infallibility complex in that remark, a hint that the current administration might share some of its predecessor’s inability to admit mistakes. And that’s an attitude neither Mr. Obama nor the country can afford.” (Krugman, 2009) In the final analysis, it appears that the governments under the leadership of George Bush and later Barack Obama have not taken bold and substantive measures to cope with the prevailing economic crisis. The Federal Reserve, which has enormous influence in shaping the economic direction of the nation, has not played a major role in reviving the economy. Through adjusting the federal Funds Rate or Discount Interest Rates, the Federal Reserve can act as a catalyst in reviving the ailing economy. Furthermore, “in the absence of a workable political system that would allow the use of either tax or fiscal policies to control the economy, the Fed is responsible for using its monetary policy tools to make adjustments to control both inflation and economic growth. While the Feds primary interest continues to be preventing inflation, increasingly its actions are a result of growth trends taking place within the economy” (Gnuschke, 2007, p.5). At this juncture, what is required is a collaborative effort from the Obama team and other government agencies in drawing up a comprehensive recovery plan for the economy. The Great Depression could be viewed in retrospect as a blessing in disguise, as it induced introduction of radical reforms in the form of the New Deal. But the measures taken so far by the Bush and Obama Administration are nowhere near the measures taken under the leadership of Franklin Roosevelt through his New Deal program. The major component of the New Deal package was Social Security and Medicare for senior citizens. In the case of President Obama, by implementing a nationalized universal health care system, he can equal the achievement of his esteemed predecessor. Indeed, as Paul Krugman and other eminent economists point out, unless the new administration is ready to take political risks and make bold decisions, the recovery of the housing market and the broader economy remains far off. The completion of its implementation would decide the future of the housing market as well as that of the broader economy. Works Cited: Brummer, Alex. "This Pandemonium Will Hurt Us All; Americas Housing Bubble Has Burst: Its the Price of Making Easy Money from the Poorest in Society, and We Could Have Seen It Coming." New Statesman 20 Aug. 2007: 17. Gnuschke, John E. "The Fed Strikes Again .: This Time It Was the Housing Market That Suffered, So When Will the Recovery Begin?." Business Perspectives Summer 2007: 4+. Hoar, William P. "The Stimulus Sham." The New American 3 Mar. 2008: 42+. "Is the American Economy Ready for a New New Deal?." Daily Herald (Arlington Heights, IL) 26 Feb. 2008: 11. Kuttner, Robert. "The Bubble Economy: The Financial Meltdown Is the Logical Consequence of Deregulation. Will We Reverse Field in Time to Prevent Another 1929?." The American Prospect Oct. 2007: 20+. Kuttner, Robert. "New President, New Crisis." The American Prospect Apr. 2008: 3. Roubini, Nouriel. "The Coming Financial Pandemic: The U.S. Financial Crisis Cannot Be Contained. Indeed, It Has Already Begun to Infect Other Countries, and It Will Travel Further before Its Done. from Sluggish Trade to Credit Crunches, from Housing Busts to Volatile Stock Markets, This Is How the Contagion Will Spread." Foreign Policy Mar.-Apr. 2008: 44+. Krugman, Paul, Column in New York Times, dated 10th July, 2009. retrieved from (http://www.nytimes.com/2009/07/10/opinion/10krugman.html?_r=1) Read More