The Impact of the Global Credit Crises on the US Economy - Case Study Example

Assessing the Impact of the Global Credit Crises on the US Economy Introduction: Beginnings of Crisis...........2 The Federal Reserve.................................3 Bad Balances............................................4 The Problem with AIG..............................5 What the Future Holds..............................6 Lessons from Japan...................................7 Positive Effects..........................................8 Conclusion.................................................9 Introduction: Beginnings of Crisis The global credit crisis of the years 2007-2009 was the worst the world had seen since the Great Depression in the 1930s. Unemployment skyrocketed and growth receded. For a time it appeared as though the entire financial system was on the point of collapse. There are many possible causes for this problem and for many years to come historians will debate the question of how the American economy found itself in such a mess. Certainly one of the key problems was the ease with which credit was obtainable, the opacity of the market in mortgage-backed securities, and the subprime mortgage market (Berlatsky, 2010, p. 12). Together these factors led to a contagion in the system which it was almost impossible to lance. The asset bubble in the housing market was unsustainable. The inflated values of houses was simply not realistically measured against the fact that a growing section of the population was unable to meet its mortgage obligations. The fact that these bad mortgages were bundled up and sold as securities, and the fact that many large investment banks had badly-weighted portfolios with a significant number of these securities, allowed the contagion in the system to spread rapidly and fatally. The consequences of these problems and the collapse of numerous banks is still unfolding. The last chapter on the financial crisis of 2007-2009 has yet to be written (Kansas, 2009, p. 15). What we can, however, begin to look at is the scale of the crisis and to critically assess its impact on the American economy. Almost important as these issues is what consequences the crisis will have on the American economy. All of these things are vital questions which must be understood if we are to avoid similar problems in the future. The Federal Reserve The monetary system in the United States is controlled by the Federal Reserve, an independent board which controls the monetary supply. Over the last few years, as the credit crisis spun out of control, a lot of serious attention was directed towards the Federal Reserve. Its policies were on everyone's lips and were subject to great debate. It had a number of opponents that believed and argued forcefully that its policies were the reason that the United States was in the situation it was in. They felt that its monetary policy had been too loose. It had reduced interest rates to such a level that almost anyone could take out a large loan, regardless of whether they could pay it back or not. This in part was responsible for the creation of an asset bubble in the housing market. What is especially interesting about the criticism of the Federal Reserve is that its critics did not approach the issue from the same side of the political spectrum (Easton, 2010, p. 1). Both the left and the right side of the political spectrum attacked the Federal Reserve, with one side (the left) suggesting that the Fed was too greedy and the other side (the right) saying that it was stifling and manipulating markets and was distorting the lending market. One of the positive impacts of the crisis on the American economy is that this process is only now being corrected and improved. This is a necessary correction. Some people have said that actions put in place by the Fed to put liquidity into the economy helped lessen the problem. However, critics of the Fed such as Ron Paul and Bernie Sanders—respectively of the political right and left—argue that the whole problem occurred because of the Fed's previous policies (Easton, 2010, p. 1). They argue that American monetary policy is deeply flawed and will not improve the economy any time soon. Indeed, this is a question that it is too early to determine an answer to. Bad Balances     When discussing how the American economy was impacted by the global financial crisis, it is vital to put the Federal Reserve's current situation into context. We need to understand its role in his mess. Many economists believe the Credit Crunch crisis started because of a big asset boom in the United States. Banks and other lenders gave away loans at extremely low interest rates to people who simply who could not afford to pay back the money. Credit ratings were not really important. Indeed, the companies that performed credit ratings on banks dropped the ball on their responsibilities too. This resulted in a huge boom in housing prices in part because there were too many buyers in the market (Kansas, 2009, p. 34). The result was that there was high demand and a low supply. That is a recipe for a bubble. What eventually happened was that people began to default on their mortgage payments. This in itself would not have been a major problem. But the opacity of the market in mortgage-back securities made it very difficult to tell which products were good and which ones were bad. When banks tried to examine their balance sheets, they were unable to say with confidence what debt they owned was good and what debt was bad. When they did make declarations regarding their debts, the markets did not believe them. There was a crisis in confidence. No one knew what the banks were hiding. Part of this problem derives from the complexity of the products that the banks were peddling (Berlatsky, 2010, p. 23). Very few people were able to untangle these products. All that they knew was that they seemed to gain in value every year and appeared to be a good investment. No one knew whether they were sound or not. It is a very poor investment strategy to invest in products that you do not understand. Nevertheless, many sophisticated investors did this. Meanwhile, the Fed stood by and did nothing to assure to the market. Banks began to collapse one by one. While the number of failures did not reach the level of the 1980s, many larger banks have failed. Most notably, Bear Sterns and Lehman Bros. collapsed, which sent shockwaves through the system. The Problem with AIG That was one controversy that clearly had repercussions on the American economy during this period: the bailout of AIG. For several months this was an issue on the lips of all members of the American electorate. Pundits were very upset. AIG is a company that took many risks on the stock market and invested substantially in the subprime mortgage market. Nevertheless, because the company was so big, the government could not not permit it to fail. If it failed it would have caused even bigger problems in the economy. Too many insurance policies would fail and too many people would be put out of work. So the government was forced to bailout AIG. Then AIG decided to pay bonuses to many of the executives in the company. This made people furious. AIG employees were even getting death threats. The media and politicians were jumping all over them. It was a terrible mess (Bansal, 2010, p. 23). Edward Liddy, the chief executive officer of AIG, said that the Federal Reserve had always known that around $165 million of the bailout money that AIG received was going to pay bonuses to high level management. Everyone agreed that the risk was too great not to pay the promised bonuses. But this was problematic. And when it was revealed to the American people, the response was furious. AIG made retention contracts with those executives in the financial services division that were necessary to wind-down $2.7 Trillion in AIG business. These employees were contracted to manage and close out their book of business to AIG’s satisfaction and will not have a job when their work is completed. These were not performance bonuses but rather a …”please stay to help us clean up our company even though you will not have a job after” bonus (Ayers, 2008, p. 1). Many believed it was offensive for AIG to go ahead with these bonuses when so many other people were suffering in the severe recession. But it was even worse for the government to not be open about the facts around this case. The truth is there wouldn't be a AIG, any employees or even bonuses, if the American taxpayers hadn’t bailed out the company almost $180 billion. Without taxpayer help, AIG's bonus recipients would be unemployed. Then the executives turn around and reward themselves for their “hard” work. This had a serious impact on the American public's perception of its government and further eroded confidence in the American economy (Bansel, 2010, p. 8). Part of the result of this action was a severe turning away from the American government's response to the crisis. People began to feel more and more that they were on their own. What the Future Holds The United States currently has similar problems to Japan in the late 1980s. This has been a topic of much discussion. The impact of the financial crisis on the American economy, mirror some of the effects that Japan has been facing for nearly two decades, following the collapse of its own asset bubble (Powell, 2002, p. 1). Perhaps there is a lesson in this for us. There has been so much liquidity in recent years that people felt that they could buy everything on credit without having the assets to back up their debt. They went on a spending spree. There was massive over-consumption. For a long time people thought nothing would ever go wrong. While everyone was becoming wealth, financial products and instruments were becoming more complex while at the same time people were over-extending themselves in terms of the amount of debt that they were taking onto their personal balance sheets. When homeowners with sub-prime mortgages began to default there was a serious crisis of confidence. Banks realized that many of their loans would not be repaid and that their own debts would be called in. The truth is that the bubble had suddenly burst. This is a good description, in the words of Newsweek magazine: Since the early 1980s, American economic growth has depended on a steady rise in consumer spending supported by more debt and increasing asset prices (stocks, homes). Just as the mid-1980s signalled the end of Japan's export-led growth, the present U.S. slump signals the end of upbeat, consumption-led growth. But its legacy is an overbuilt and overemployed consumption sector, from car dealers to malls (Samuelson, 2009, p. 1). Lessons from Japan The question then must be what can the United States do to avoid the situation that befell Japan? How can we learn from the effects on the Japanese economy and ensure that the effects on the American economy are not permanent. This is a very hard question to answer (Krugman, 2001, p. 1). Some economists suggest that the massive stimulus package signed by President Obama is a useful beginning as it is necessary to first add more liquidity in the system as soon as possible. Others believe that nationalizing banks might be an important solution and that the government made a big mistake by refusing to save Lehman Brother Investment Bank from failing in the fall of 2008. This may be so, but we are now faced with high unemployment, low growth, and a potential deflationary period. America must look to the future now, not the past. However, I think there is an argument that many American banks and the American economy on a whole is much more adaptable and flexible than the Japanese one. That said, it is very concerning that the President has been warning that the United States may face a Lost Decade—a clear reference to the situation in Japan during the 1990s (Samuelson, 2009, p. 1). As a critic in the New York Times put it, explicitly comparing Japan in the 1990s, to the United States in 2009: Instead, the Japanese first tried many of the same remedies that the Bush administration tried and the Obama administration is trying — ultra-low interest rates, fiscal stimulus and ineffective cash infusions, among other things. The Japanese even tried to tap private capital to buy some of the bad assets from banks, as Mr. Geithner proposed. One reason Japan’s leaders were so ineffectual for so long was their fear of stoking public outrage. With each act of the bailout, anger grew, making politicians more reluctant to force real reform, which only delayed the day of reckoning and increased the ultimate price tag. Japanese taxpayers are estimated to have recouped less than half what it cost the government to bail out the banks (Tabuchi, 2009, p. 1). Positive Effects A positive thing that Americans have done so far is to make a big deal of the crisis. They have understood its seriousness, unlike the Japanese two decades ago. President Obama continues to warn of its dire impact and says it is one of the biggest challenges in the nation’s history. Some opponents suggest this is fear-mongering, but others say it is a useful way of focusing the mind and bringing people together to work on the recovery of the United States economy. This is an important consequence of the crisis (Berlatsky, 2010, p. 80). There can be no doubt that the world is in a serious credit crisis. The United States and Canada, for example, recently posted huge drops in GDP. Many of the Eastern European countries appear to be on the edge of bankruptcy, and countries that were once seen as some of the most stable places in the world to invest are now nationalizing banks and dealing with massive drops in growth, rising unemployment, and threats of political populism and demagoguery. In the midst of these deeply unfortunate and difficult times, what can the economic history of Japan tell us about the course of action other countries such as America should consider to tackle these difficult problems? The answers to this question are not easy. There are many things economists point to in the Japanese strategy—if it can be called that—to alleviate the problems of the Lost Decade (Krugman, 2001, p. 1). But the main point observers of the period seem to make is that the Japanese government was not nimble or flexible enough to deal with such a complex problem on such a huge level. They acted too slowly and in half measures. Some people say that President Obama is acting slowly, refusing to wipe out shareholders of failing companies and nationalize failing banks at the first sign of trouble. That may be true. However, there is an additional danger: seeing to close a parallel between the Japanese Lost Decade and the current crisis in the American economy. Though there are similarities between the two, the economies of Japan and America are also very different things. They are not perfect comparators.. However, by using Japan as a playbook to help deal with the current problems, American government officials and economists may be barking up the wrong tree and superimposing the solutions for one problem on another, different problem. That is the hard part: in this situation there are too many unknowable unknowables (Berlatsky, 2010, p. 12). Conclusion The financial crisis imposed severe and devastating effects on countless individuals and many previously successful businesses (Kansas, 2009, p. 10). Unemployment remains high and growth is still sluggish. The final chapter of this crisis remains to be written. However, one positive thing to remember in the midst of all the heartache is that the financial systems based on capitalism are resilient. There are problems that continue for sclerotic economies such as Japan, but for those countries willing to make the changes to short up their system, wealth-generation is right around the corner. We must continue to study this crisis and assess its impact on the American economy in order to ensure that it never occurs again. Work consulted Ayer, Bridget, March 18, 2009. “AIG Bailout.” Get Smart Blog. http://www.thegetsmartblog.com/2009/03/aig-bailout-bonus-debacle/ Bansal, Paritosh, 2010. AIG's near-collapse yields gold for Wall Street. Reuters. http://www.reuters.com/article/idUSTRE62P0KM20100326 Berlatsky, Noah (Editor), 2010. The Global Financial Crisis. Greenhaven Press. Cowie, Ian. “Oriental risks and rewards for optimistic occidentals.” Daily Telegraph. August 4, 2004. http://www.telegraph.co.uk/finance/personalfinance/2891993/Oriental-risks-and-rewards-for-optimistic-occidentals.html Easton, Nina, January 25, 2010. “The Fed Bashers. ” Fortune Magazine. http://money.cnn.com/2010/01/22/news/economy/paul_sanders_fed.fortune/ Helweg, Diana. “Japan: A Rising Sun?” Foreign Affairs. July-August, 2000. Kansas, Dave , 2009. The Wall Street Journal Guide to End of Wall Street as We Know It: What You Need to Know About the Greatest Financial Crisis of Our Time and How to Survive It. Collins Business. Krugman, Paul, 25 April 2001. "Purging the Rottenness." New York Times. Okimoto, Daniel. “Causes of Japan’s Economic Stagnation.” Sorenstein APRC. Stanford University. http://aparc.stanford.edu/research/causes_of_japans_economic_stagnation/ Powell, Benjamin, November 19, 2002. “Explaining Japan’s Recession.” Mises Institute. http://mises.org/story/1099 Samuelson, Robert, February 17, 2009. “Our Lost Decade.” Newsweek. http://www.newsweek.com/id/185116 Tabuchi, Hiroki, February 12, 2009. “Lessons From Japan In Stemming a Crisis.” New York Times. http://www.nytimes.com/2009/02/13/business/economy/13yen.html?ref=business Read More