The Economic Collapse of 2008 - Research Paper Example

Introduction Every once in a while comes an economic or financial event that stops us in our tracks, puts a brake on the system and challenges present wisdom. The new millennium had brought along with it new hopes and aspirations. However, the banking crisis of 2007-2008 precipitated the deepest global recession since the 1930s and has led to calls for significantly tighter controls over banks’ activities. All across the globe, people have been hit by food inflation, rise in unemployment and the vagaries of weather which have disrupted growth plans and the consistency of daily life. When events like this occur, we automatically look back at the control systems that are supposed to alert us and in fact prevent such a fiasco from assuming alarming proportions. In this case, obviously something went wrong somewhere or the signs were ignored. This paper will look at the main factors that led to the collapse, the consequences of the collapse, who should be held accountable for it, where we stand today and how it has impacted on our hopes for the future. Main Factors Which Led to the Collapse It all started with an excess of lending in the sub–prime mortgage sector of the USA. The economy was going well and life was good. It seemed that the good times were here to last and there was no letting up. And then it finally happened. Bankers who had previously considered even people with a bad credit history as good enough for taking a loan now began to cut back on lending in the interests of risk control and compliance. As the economy shrunk and credit dried up, bankers began to call on the sub-prime mortgages and the consumers were left with nowhere to turn to. Imagine their predicament as interest rates rose up and they had to let go of their precious mortgages. It was havoc and pandemonium in the housing sector. As the crisis deepened, even the banks that had not provided adequately for bad debts in the real estate sector were affected. Merrill Lynch and Lehman Brothers in the USA and Morgan Stanley in the UK were institutions that were brought down by the crisis; others have had to sell off, divest and re-organize themselves. For institutions like international banks, who have diversified their investment portfolios across the world in different continents to spread risk, it was inevitable that their holdings were impacted in some way or the other. AIG and Citibank in the USA, Deutsche Bank in Europe, Citigroup in the USA and Standard Chartered in the UK were all offered stimulus packages that have helped them recover rather than join the ranks of the bankrupt companies. To date in excess of 400 small and large banks have had to bite the dust. One contributing factor it seems that too much power had been given to Fannie Mae and Freddie Mac in relation to credit and control over the housing and real estate sector in the USA. The burgeoning housing sector has been hard to control. With their disbanding, and control in the hands of another regulatory agency, things are expected to become better. Another factor that has us bogged down is our insistence on continuing the War on Terror, a war we cannot win so easily. After nine years of fighting in Afghanistan and five in Iraq, we have little to show for it. We are spending millions of dollars per day and the average US citizen is being mired in debt without his consent. The 9/11 attacks were a blessing in disguise to the faltering Bush Administration who wasted no time passing the Patriot Act, creating Homeland Security and terrorizing citizens with different alert levels, racial profiling and enhanced security checks at airports. Bush had famously announced the names of countries he regarded as the Axis of Evil nations in a speech. He vetoed many of the expenses on the War on Terror, over the combined judgment of Congress representatives. The result is trillions of dollars in debt which we cannot possibly correct in our lifetimes. Many have criticized the Bush regime for exacerbating the War on Terror and have likened it to a war for oil. This is because the blood of American soldiers is being shed so far off from their homeland. And contracts for reconstruction in Iraq are being paid for by clandestine oil shipments. The militant jahadi or terrorist is using asymmetric warfare, guerilla strategies and suicide attacks to win the war. He has taken up arms with a religious fervor and outlook which helps in recruiting others in the Muslim World to the ranks of Al-Qaeda and sister organizations. The world is still not a safe place, and the clash of civilizations is being played out in every Muslim country in a crisis today. With their radical anti-Western outlook, the poverty stricken unemployed youth proudly join the ranks of Al-Qaeda and sister organizations all over the world- their aim being to ruin America and its allies. At the heart of the banking crisis lies the root cause of it all. Actually it is never one factor but a combination of factors that interact or add on to the unfolding crisis and make it inevitable. Let us compare the collapse of 2008 to the Great Depression of the 1930s. We see that prior to the 1930s crash was the period of the Roaring Twenties, a time of unprecedented growth and stability. People had borrowed against everything they had and even resorted to margin trading to take advantage of the stock market boom. It seemed that the bull market would last forever. But by July 8, 1932 the DJIA had lost 88 percent of its value and closed at 41.22, its lowest point in the 20th century. By 1933 the depression had spread to all countries including Australia, France, Germany and the United Kingdom (Bernanke, 2004). Coming to the 2007-2008 crises, this time around the impetus was greed to earn more commissions and fees in a healthy economic climate, and that pre-empted the banking and real estate sector to allow loans to the sub-prime customers, who have had bad credit ratings and history of foreclosures in the past. For these people, it must have seemed like a boon that the banking sector was allowing them the privilege of a mortgage loan. Anyway interest rates were also not too high and there were even instances of people taking new mortgages at lower rates. It was an offer that seemed too good to forgo. This situation was allowed to continue so that sizeable amounts of fees and commissions were earned from the sub-prime borrowers. It reflected well on most companies’ balance sheets as well. Then one day it all came apart when one bank after another decided to tighten their credit risk portfolio and called upon the sub-prime sector to pay up its outstanding or face foreclosure. One of the mistakes noted from the 1930s Depression Era was that the Federal Reserve did not step in to rescue failing businesses and by the time it did, it was too late. This had further exacerbated the crisis. This time around, the Government did make a plan to rescue key sectors of the economy and came to the aid of AIG, Citibank, General Motors and others. But even then it was criticized for its slow and lopsided response. The key to recovery is in stimulating consumer and business confidence to kick-start the economy again, but this will take some time. Unemployment has peaked at 10 percent and remained there for a long time. Too many lives have been affected through unemployment, loss of shelter, medical cover and other calamities for them to forget so easily and start anew. Consequences of the Collapse Since the economy of the USA is one of the largest in the world, it was inevitable that an economic slump in the USA would have an impact on its trading partners. The first signs of a crisis were noticed in the stock exchanges across the world, where declines announced that various countries were also being impacted. Trade and commerce declined as one after another Germany, France, the UK, Italy, Greece and many other nations succumbed to the crisis. Even the oil rich emirates of the UAE were affected. It is a crisis that has touched every part of the world in some manner or the other. The crisis has brought about changes in Government in the UK and the USA, and Barack Obama and David Cameron are faced with the arduous task of getting their economies back on track. In the UK things were largely happening in a similar vein. Lending on mortgage loans had assumed alarming proportions as had consumer credit; it was said that the UK economy in 2007-2008 was the most indebted in the world. Another reason that the crisis has spread so quickly across the world is that the financial systems of the world are intertwined. As many international banks have a worldwide presence, the impact felt in one country or another will affect the bank’s operations and reputation across the globe. It is a sad but true fact that greed for wealth is what precipitated all the economic and financial crises that man has visited upon himself. This is as true of the 1930s Depression Era (De Long) as it is of the 2008 crisis. The point though is that if there indeed exists a system of checks and balances to monitor such events and in effect give a warning signal to the management and the companies they represent, why does it not go off? The sad truth is that apart from any whistleblower making it evident, management is often in the know and a party to what is happening because things are good and they want to take advantage of the present situation while it lasts. It will increase shareholder value as well as bring them bonuses and salary increments. This is the very reason why it has been emphasized that the function of corporate governance be given to knowledgeable people who are unrelated to the businesses they oversee or its stakeholders and have no personal interest in the business apart from seeing it operate ethically and according to the principles of good corporate citizenship. In the civilized world of Western culture, we have always favored a system of free enterprise, where each one is free to live the live he or she wants, provided that it does not injure or interfere with the rights and freedom of another. We follow the ideals of capitalism, where wealth is allowed to accumulate in the hands of the capitalists and they use the same wealth to create businesses and accumulate even more money. In the end they end up owing a sizeable part of the economy of a nation, called private enterprise. These owners of private enterprise are often seen creating their own lobbies and rights groups in order to induce Government to accede to their desires regarding policy decisions that would further favor their interests. On the political front, we prefer the rule of a Democratic Government which is elected by a majority of the people. Once elected- Republican or Democrat- they think that they have the people’s mandate to run the nation till next election day (Bernanke, 2000). What we do not see or are blinded to are the evils of capitalism and private enterprise. We do not see that the capitalists or owners of large corporations control the strings of Government and have the real power to kick-start or stall the economy. According to a documentary by Annie Leonard called ‘The Story of Stuff’, 31 percent of the economy of the world is controlled by large corporations (Leonard, 2010). They have in effect more power than Presidents or Prime Ministers and can often dictate policy and influence decisions. One of the glaring merits of democracy is that it counts the votes of the people, but does not weigh them. In other words a peasant has the same weight in his vote as does a Leeds or Harvard graduate. This state of affairs has disillusioned many of us so much that we do not even care to vote any more. Who's Accountable? Various villains have been identified as the possible catalysts for this crisis, but the blame has to rest with fat cat bankers who first roped in borderline clients and gained fees and commissions on the one hand, while foreclosing later on the other. The consumer has no place to go, and even the Government had paid them a deaf ear. It has happened once too often. No wonder the majority of the population blames the unscrupulous bankers who are still pocketing hefty bonuses and salaries, despite making the lives of many people a misery through loss of car and house. The USA has unfortunately been the scene of most of the corporate scandals and errors of the last decade. Enron, World.com and Madoff Investments are some examples. While the Sarbanes-Oxley Act 2002 did make some good recommendations regarding separation of ownership and control, and the disclosures relating to directors of corporations, few punishments were made. In consequence, calamities like the sub-prime mortgage crisis continue to unfold on Wall Street. A positive step is the enactment of the Wall Street & Consumer Protection Act signed in July 2010 under which it is proposed to have a Consumer Financial Protection Agency to regulate items of consumer credit such as car loans, credit card loans and mortgages. It is not hard to see in hindsight how and why the systems have failed in the past. Either the corporate governance team was inadequately qualified to monitor business activities, or was deliberately kept in the dark or feared loss of remuneration and benefits from serving the company. It is also hard work balancing the interests of all shareholders. For example, management and workers interests may conflict- as might also the interests of creditors and shareholders. Sometimes the company is run by a domineering personage. Sometimes the actions of one person can bring down a bank; at other time it is a collusion of higher management. Yet integrity and a sense of duty must supersede all these considerations, which admittedly is quite a tall order. Where Are We Today? People in the USA are highly critical of the role of Government after what happened in the housing sector. At present even the passage of the Health Bill by the Obama Administration has run into problems. Despite two stimulus packages that were announced and given, first by the outgoing Bush and second by the incoming Obama, we managed to protect only a few key industries- the car manufacturing sector in Detroit being an example. To date the unemployment rate remains at 10 percent, with people apprehensive that the worst is not over yet. Business and output has definitely not stabilized. Obama has used harsh words to criticize the bankers and their shenanigans, but I doubt if they will ever reform. The need for checks and balances is very necessary so that no one abuses the power and responsibility that he has while holding public office. We have adopted this system in the three arms of the Government- the Executive, the Legislature and the Judiciary. If any one branch is seen as superseding its authority, the other branches can hold it back. In the same way, it was hoped that corporate governance and the existence of a Corporate Governance Board/ team of experts elected or appointed to public and private corporations would do well to prevent unethical behavior on the part of executives or employees and keep the interests of all stakeholders in mind while reviewing the proposed action plans of the organization for the coming year. Corporate Governance has very candidly been defined by the OECD which regards it as ‘a set of relationships between a company’s board, its shareholders and other stakeholders. It provides the structure through which the objectives of the company are set, the means of attaining these and monitoring performance are determined’ (OECD, 1999). This definition captures the entities of all who are involved as well as the working relationships among them with respect to the functions and responsibilities of corporate governance. The question is how can we avert another crisis? The answers once again lie in following the principles of good corporate governance. No one individual should be allowed to have too much power and all key decisions must be approved by a majority of the Board of Directors. There must be an adequate system of internal control not only for audit purposes but for management purposes as well. Employee and management feedback to Human Resources or directly to the Corporate Governance Board should be encouraged while their confidentiality ensured. The names and addresses and email contacts of the members of the Corporate Governance Board should be known and accessible to all stakeholders of the corporation and published in the financial reports. Laws such as Sarbanes Oxley Act of 2002 and the UK Code of Corporate Governance should be implemented in these countries in their true spirit without any qualms. Hopefully the continuing emergence of wise and prudent controls and safety measures from our best social thinkers and intellectuals will help in reducing such crises in the future. References Bernanke, B. (2000). A Refresher Course for Central Bankers. Foreign Policy Magazine, 1 Sep 2000. Bernanke, B. (2004). Essays on the Great Depression. Princeton University Press. DeLong, B. Depressions and Panics, 1840–1933. Economics: American Economic History. University of California at Berkeley. Leonard, A. (2010). The Story of Stuff. Free Press. OECD (1999). Definition of Corporate Governance. Read More