The Recent Subprime Crisis - Essay Example

?The of the economy and how is it affecting the people? Introduction The recent subprime crisis is generally construed as problem related to the banking sector ignoring the basic issues which have culminated into an economic meltdown. The business and the banking communities criticizing the role of government, its regulations and controls in the name of ‘free enterprise’ now call for government intervention in defusing the crisis when the things have gone out of control. Banking Guide states “The risks of negative equity (where mortgages are greater than the value of the property) became a reality and mortgage defaults hit record highs. Banks have lost the trust which is a pre-requisite to the efficient functioning of credit markets”. Downplaying the ideological conflicts is detrimental to the welfare of the people as well as the concept of ‘free enterprise’, because the need for a strong regulatory frame work is essential for a welfare state. This paper seeks to analyze the factors leading to the present state of economy, its impact on the people, conditions necessary for the revival of the economy and outlines the reform processes which have direct and positive effects on the people. These reforms should act as a strong catalytic force for the stimulation packages by the governments to be more effective in the long run, and are necessary for a sustainable development. Causes and factors leading to the present state of economy Savings & consumption While money saved is only meant for consumption ultimately, it is also the foundation for investment. Over the period of time, the people neglected the aspect of savings in life and its effects on economy have been largely ignored in the modern societies. Toba (148) states “Both the classics, and also J. M. Keynes, considered the individual saving as a primordial source of investments. The sacrificing of the present consumption was considered as the basis of the first stage of the investment process, respectively the savings stage. Nowadays, the main productive investments are constituted based on the credits which have been gotten from the banks”. Savings comes to the rescue of the people at the time of recession, and this culture in a society ensures uninterrupted consumption even at the time of recession, albeit at a lower level. In a study by Verma, R. & Wilson, E. J. (2005, p. 16-17) it was found that the per worker household and private corporate savings affecting GDP support the Solow growth model, whereby domestic private sector savings promote long run economic growth. The recession impacts the society severely when the people can’t fall back on savings which leads to sudden disruptions in the consumption. The cumulative effect of decrease in consumption or demand affects the business which leads to production cuts, consequently increased unemployment. The vicious cycle continues to the detriment of the welfare of the people and the state. Subprime crisis and Debt culture Borrowing is a part of the US culture which is deep rooted into the society in the case of individuals or business enterprises which is an important cause for the collapse of the economy. When it has become a rat race to entice the people to borrow, the banks and the financial institutions have developed a tendency to ignore the basic tenets of banking, principally to be more competitive in the business, increase the market share and profitability without realizing that the entire industry has been moving towards catastrophe, and the crisis is not restricted to the US. According to Bayne, N. (2008, p. 7) the collapse in September 2007 of Northern Rock in the UK was a bad shock for the Bank of England and blames FSA’s weak supervision and lack of effective deposit protection scheme for the disaster. Actually, the situation has become like catching the tail of a tiger, without any possibility of backtracking in their policies. The collapse of the entire edifice could be caused by any flimsy trigger as the equilibrium in the economy has been very precarious. All of a sudden the debts have become bad and unquantifiable not with reference to a single bank, but all the banks in the banking system. The fund flow in the banking system has been arrested, and the level of exposure of different banks which was unknown to each other has created suspicion in the whole banking sector. Only when the flow of capital and liquidity, the fundamental principles essential in the banking system has fallen victim to the economic turmoil and the banks’ financial resources have been locked up in subprime mortgage and the housing projects to an alarming extent at very high valuations, the government wakes up to the realities. The government has embarked on a bailout plan using tax payers’ money which was formulated under the Treasury Secretary, Henry Paulson, who had been the Chairman and Chief Executive Officer of Goldman Sachs earlier. Pittman, M. (2008) states that “Without the government money, Goldman, Merrill Lynch & Co., Morgan Stanley, Deutsche Bank AG and other firms could have become some of the biggest creditors in a bankruptcy filing by AIG, the world's largest insurer, because of its billions in losses on subprime bonds and corporate debt.” Non plan expenditure The plan expenditure by the government acts as a catalyst for the economic growth in a country. The trend over the period of time not only in the US but also in various countries reflects a steady decrease of allocation to plan expenditure in the budget. The decrease in spending on infrastructural projects such as roads, power generation and construction of railways also affects the pace of growth in the economic development. This is mainly on account of relentless increase in non plan expenditure on administrative costs, salaries, pensions or other populist measures by the government with an eye on elections which can’t serve the long term objectives of a country. Therefore, for a balanced growth, the desired proportion of plan expenditure for the developmental purposes in the budget needs to be maintained. Outsourcing BPO: Business process outsourcing to the emerging economies like India, Pakistan and Fareast Asian countries from the developed countries have been on rise, and it is not restricted to call centers as it is generally believed, but extends to other important spheres of economy which have impact on employment for professionals and skilled and semi-skilled workers locally . For example, technical processes, clinical analysis of blood, tissues, etc., research, medical tourism have been slowly slipping out of the labor force in the developed countries on account of cost competitiveness of the developing countries consequent upon the developments in telecommunications during the recent years which could not be prevented by any force. But, the underlining reason is not cost per se, but the improvement in the level of education in the emerging economies, especially the Commonwealth countries such as India and Pakistan where English is the medium of instruction in the educational institutions. The developing countries are in competition with the citizens of US and other developed countries in employment. Therefore, the US or the other developed countries need to focus more on education to be competitive in the world market. Production Outsourcing: Post Kyoto Protocol, instead of dealing with the environmental issues in the right spirit by modifying the production processes to reduce greenhouse gas emissions as envisaged in the proposals, the US and western companies have cleverly started shifting their manufacturing facilities to the underdeveloped or developing countries which resulted into flight of capital and adverse impact on employment situation in these countries. Foreign Direct Investment The US companies have been increasingly making capital investments in the emerging Asian and Latin American economies. It will take very long time for the benefits of these investments realized firstly due to gestation period. Secondly, the repatriation in the near future is questionable, because the profits earned in these businesses would be reinvested in the same countries for growth and expansion as dictated by several factors with limited or no tangible benefits to the US economy. The capital formation within the US for the economic development and employment generation is severely hampered in the process. Present state of the economy and its impact on people Ward, V. (2010) states in prologue that “When it (Lehman Brothers) filed for bankruptcy, credit markets around the world trembled, and U.S. Treasury Secretary Henry Paulson Jr. and Federal Reserve Chairman Ben S. Bernanke realized with terror that they were facing the worst economic catastrophe since the Great Depression of the 1930s.” The company’s style of functioning with regard to leveraging and derivatives reflects the management’s inefficiency, their lack of financial acumen, infighting at rank and file at the top echelon and its greed in pushing its luck too far. The other companies of its league are no different and thus ended up in the bailout queue. The purpose of the financial package announced by the Federal Reserve has been nothing to do with the welfare of the people. The public money has consequently refilled the coffers of the Banks to mitigate their hardships which has been amply in their shares rallied in the Wall Street, but failed to address the hardships faced by people. Though there are several dimensions to the issue, the focus was on the survival and future of these banks. In spite of the package, Realty Trac (2010) states that foreclosure activity for July, 2010 is at “near-record levels of bank repossessions, which increased on a year-over-year basis for the eighth straight month.” Increasing budget deficits The economic slowdown coupled with decreasing tax revenue and the impact of bailout package would put more pressure on budget for the years to come, and financing these deficits without negative repercussions on interest rates and inflation would be daunting task for the government. For instance, public borrowing by the government would increase the interest rates with the attendant pressure on inflation. How interest rates can affect the people Keeping inflation under control is the top priority at the time of recession, because the common people who are already affected by unemployment would be worse hit due to inflation. Any upward revision of interest rates would fuel inflation. Also, when there is revival expected in the economy, the major issue for the government is to keep inflation under control, otherwise, the benefits of growth would be offset by inflation. The consumption driven US economy is interlinked to debt. The shrinkage in demand on account of unemployment and poor consumer confidence leads to production cuts. The initial downtrend on account of these factors could lead to a prolonged period of stagnation. The central banks have limited leeway to overcome this situation because reducing interest rates can’t be resorted at will as it will affect the pensioners. The paradoxical situation is that the community of senior citizens in the developed countries is growing at a faster rate on account of lower birth rate and increased life expectancy. Unemployment &Inflation Generally, the correlation between unemployment and inflation has inverse relationship in the short run in an economy. Higher unemployment accompanies with lower inflation. When inflation is high unemployment tends to be lower. It has been a challenge to the governments to keep both under control. PricewaterhouseCoopers UK (2008, p. 17) is of the view that although the crisis in the US sub-prime market is regarded as the trigger of the current financial climate, the roots of the credit crunch lie in the aftermath of the last global financial crisis in 2001, which was precipitated by the dot-com stock market crash of 2000. Perhaps this observation indicates the lack of alertness on the part of the governments to foresee the impending disaster for taking corrective measures at the right time. According to their assessment, “The potential for job losses largely depends on the duration of the current level of instability and expectations of things getting much worse before they get any better”. (p. 21) There are limitations for the central bank to deal with the situation through its monetary policies by adjustments in the interest rates or money supply. The growth at the time of recession will be severely affected by increasing the interest, whereas the pensioners would be hit hard by any reduction in the interest rates. Similarly, increase in money supply could add to inflationary pressures. Environmental concerns Post Kyoto Protocol the governments need to take into account the impact of environmental commitments made by the country which are expected to affect the economies of different countries differently, and the developed countries that have been primarily responsible for the present state of the environment need to make more sacrifices to protect the environment. The economic impact of these issues should be assessed and quantified so that the government could make the transition phase smooth and prepare the people for the future. For instance, manufacturing of bio-fuels have increased the food prices world over because the area under food crops has been steadily decreasing. Increase in food prices caused by this shift to bio-fuels would affect the people badly. The impact of government action and revival of the economy For revitalizing economy at the time of depression, the government needs to take action in line with the Keynesian theory. Actions to regenerate consumption would push up the general demand which will have a cascading effect on the economic revival. The National Road Project of the Federal government in 18th century is an example of government’s intervention in revitalizing the economy. This project was instrumental in increasing interstate movement of people and goods. The project was financed through partial utilization of the sale proceeds of public lands. Together with the expansion of rail road, the project paved way for a rapid economic development. A comprehensive national plan keeping in mind the environmental responsibility of the present generation without compromising the welfare of the future generations for a sustainable development is the need of the hour. Spending cuts is not a solution to the revival of the economy; rather it is the quality of spending which determines the direction. Rationalization of non-plan expenditure and the use of funds so released in deploying plan-expenditure is necessary, because the government needs play a crucial role of employment provider in the area of infrastructural development which should form a basis for growth and lead to participation of private sector in the revival process. Also, this strategy should be supported by reform processes for eliminating inefficiencies in the system and the roadblocks to the progress. Reform process Education Reforms The people of the country are increasingly exposed to international competition in the backdrop of liberalization and globalization. Various international agreements and treaties prevent restrictions on competition placed by the governments. In order to tackle the problems effectively, the government should take measures to attack the root cause of the problem, deteriorating standards of education. Also, all the obstacles in providing education to the children of the economically weaker sections should be effectively removed through a rigorous planning process, because the economic development in future hinges on the quality and the level of consumption from the growing population of this section and equipping the younger generation with education and skills to meet the global competition holds the key to progress. Wage reforms The main cause of concern in a society is great disparities in the income levels. When the purchasing power of the people is affected on account of inflation or interest rates, the situation becomes worse, and an equitable policy should aim for maintenance of purchasing power parity to mitigate the hardship to the people. For addressing this issue of erosion in purchasing power, the policy with regard to wages should be guided by a comprehensive policy which links the wages to inflation or the other economic indicators for the employers to follow the guidelines. This will encourage budgeting at all levels including families. Since violent fluctuations in consumption are avoided, the impact of slowdown on people will be moderate. Banking reforms The inflation results into decline of real income of the people. The food inflation could be more painful especially to the poor people. According to Arrighi, the concentration of economic power on wall Street, the stagnation of incomes for all but the rich, the structural trade deficit, the military overreach, the switch from being the world’s biggest creditor nation to its biggest debtor add up to a simple conclusion: We are in the twilight years of the long American century. Absence of stability in the interest and exchange rates affect the people badly. The system should be in a position to foresee and give warning signals about the impending crisis and ensure reasonable risk management practices are followed in addition to maintaining stability in the interest and exchange rates Therefore, the banking reforms with these objectives would avoid crash-landing of the economy. Lin, J., Vinals, J. & Dadush, U., (2010) states that, “Financial institutions should pay for their costs to society through a financial levy and by adopting remuneration schemes that discourage excessive risk-taking. In addition, ratings agencies, which had a hand in creating the crisis, must be better regulated, particularly with regard to their ratings of complex products. At the same time, responsibility also rests on investors, who must do their own due diligence, and on officials, who should reduce their reliance on ratings, as the European Central Bank is doing.” Tax Reforms Pintus, P. A. & Wen, Y. (2009, p. 26) states “The history of economic thought has long suggested that boom-bust business cycles may be driven by over-investment fueled by credit expansion. … However, in general equilibrium, income stimulates consumption, consumption reduces savings, yet investment requires savings to finance”. The taxation policy of a country should be reoriented to give maximum thrust to the savings in the society. This must be possible through a combination of concessions and differential tax structure introduced in taxation the taxation policy to encourage savings among the public. These savings of the people forms the corner stone for investments; investments in new projects generates employment opportunities and increases the income level of the people. The government should set this economic cycle in motion for the realistic growth in the economy. Foreign Direct Investment According to the Economic Times (6 Jul 2010) “China has more than doubled its record investment in Japanese government bonds this year, buying a net 541 billion yen in the first four months alone,…The reserve, already the world's largest, grew 25.25 percent to a record 2.447 trillion dollars at the end of March from 1.9537 trillion dollars a year earlier, the People's Bank of China said in April.”   However, the China’s direct investment in America is insignificant. The Appendix I 1 illustrates the US trade deficit with China during the year 2010. (US Census Bureau, 2010) When America’s deficit with Japan was growing at an alarming rate in 1970s, Japanese companies have made huge investments in the US by starting businesses and construction of factories which created employment and provided support for economic development. Whereas, the present position with regard to China is detrimental to the US economy, and the US trade deficit with China has been increasing steadily. This is mainly due to regulation of the exchange rate of renminbi by China to keep it more or less at a constant level against the dollar, thereby making the American products costlier in China. The US may initiate dialogues with the countries (Brazil, Russia, India & China) and other emerging economies like South Korea and Australia for foreign direct investments. Conclusion The bailout package has been some extent successfully achieved its primary objective of creating a semblance of stability in the financial sector which is very crucial because, the confidence of the public on financial sector of the country is important for the country’s growth and development. The government based on the experience gained in the crisis needs to enforce stricter controls on the financial sector and regulate its functions. A nationwide debate is essential for expanding the area and scope of public ownership. Despite the general criticisms leveled against the government in dealing with the crisis, it is necessary to understand that the situation has been extraordinary. The crisis is also partially cyclical in nature and the decisive actions on the part of the government has prevented the collapse of the economic order in the country. The restructuring of the financial sector in terms of capital adequacy, risk management and controls to strengthen the base of these institutions for stability in the long run is very important. Lack of domestic savings and unemployment responsible for the present state of economy need to be effectively addressed through economic reforms and restructuring of the financial sector. Appendix I Trade with China: 2010 NOTE: All figures are in millions of U.S. dollars on a nominal basis, not seasonally adjusted unless otherwise specified. Month Exports Imports Balance January 2010 6,888.8 25,185.1 -18,296.3 February 2010 6,855.1 23,363.8 -16,508.8 March 2010 7,403.6 24,300.2 -16,896.6 April 2010 6,591.2 25,905.7 -19,314.5 May 2010 6,752.7 29,036.8 -22,284.1 June 2010 6,715.0 32,866.5 -26,151.5 TOTAL 41,206.4 160,658.2 -119,451.8 Source: US Census Bureau, Foreign Trade Statistics. References Arrighi, G. The Long Twentieth Century : money, power, and the origins of our times, London, Verso. Bayne, N. (2008) ‘FINANCIAL DIPLOMACY AND THE CREDIT CRUNCH: THE RISE OF CENTRAL BANKS’, Journal of International Affairs, Fall 2008, Volume 62, Issue 1. Lin, J., Vinals, J. & Dadush, U., 2010. Lessons from the Global Financial Crisis, 17 June 2010, Carnegie Endowment for International Peace, http://www.carnegieendowment.org/events/?fa=eventDetail&id=2938 Pintus, P. A. & Wen, Y. (2009), Leveraged Financing, Over Investment, and Boom-Bust Cycles, Research Division, Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/wp/2008/2008-014.pdf Pittman, M. (2008), Goldman, Merrill Collect Billions After Fed's AIG Bailout Loans, 29 Sep 2008, Bloomberg, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTzTYtlNHSG8 PricewaterhouseCoopers (2008), III – Assessing the economic impact of the credit crunch, UK Economic Outlook March 2008. Realty Trac, (2010). Foreclosure Activity Increases 4 Percent in July, http://www.realtytrac.com/content/press-releases/foreclosure-activity-increases-4-percent-in-july-5946 The Economic Times (2010), China beats previous record investment in Japan bonds, 6 Jul 2010, http://economictimes.indiatimes.com/news/international-business/China-beats-previous-record-investment-in-Japan-bonds/articleshow/6133503.cms Toba, D. (2008), ‘PEOPLE’S CONSUMPTION AND SAVINGS IN CORRELATION WITH THE INVESTMENTS FROM THE ECONOMY’, The Young Economists Journal, Volume 1, Issue 10, pp. 148-153. US Census Bureau (2010), Trade in Goods (Imports, Exports and Trade Balance) with China, http://www.census.gov/foreign-trade/balance/c5700.html#1985 Verma, R. & Wilson, E. J. (2005), ‘A Multivariate Analysis of Savings, Investment and Growth in India’, p. 1-20. School of Economics, University of Wollongong, Australia, viewed 9 April 2011, http://www.uow.edu.au/content/groups/public/@web/@commerce/@econ/documents/doc/uow012207.pdf Ward, V., 2010. The Devil's Casino: Friendship, Betrayal, and the High Stakes Games Played. John Wiley & Sons, New Jersey. Read More