Wednesday, October 15, 2008

Threadbare Times

By Tashdid Hasan

Dozens of financial institutions declared bankruptcy in a matter of weeks. The real estate markets slumped after years of record highs, doubling foreclosure rates. Access to credit has dwindled over the past year which has affected everyone from college students to the pizza delivery man. To pull the market out from the mire of this economic malaise, the central bank is injecting capital into major investment banks and bank holding companies such as Goldman Sachs and Citibank among others. As we all know by now, a financial crisis in US housing market which in turn spread into the credit, the domestic and the global stock market has been the cancer of the current economic debacle.

But before we get to the present crisis, let’s take detour to understand how we got to where we are today. Starting from the first quarter of 2001, the federal funds rate – the rate banks charge each other as interest for borrowing money – was gradually cut down to 1 percent throughout and after the recessionary period of 2001, which is very low. The goal of a low federal funds rate was to increase liquidity to encourage borrowing in order to promote consumer spending and investing. Also, regulations were relaxed for consumers who wanted to borrow money. For instance, poor credit score and volatile financial solvency were not an issue. Therefore, the plan worked out well for some time. Right after the recession which was stimulated by the tech bubble of the 1990s and the terrorist attacks of 9/11, the economy began to grow at a steady rate from 2002 onward, as increasing yet comparatively low interest rates worked their ways, until it reached a peak and started to fall during the third quarter of 2007.

There are a number of reasons behind this financial mess. The problem started from the housing bubble. In 2001 the federal funds rate was cut down in order to prevent deflation, which worked out well. However, easier access to credit was pampering these Wall Street investment banks to lend money with less regulation. This lending ended in consumers, and in most cases, people with inadequate credit score having access to more credit than they can afford to pay back. Besides, mortgage and bank holding companies came out with various complex financial products like sub-prime mortgages combined with too good to be true introductory rates with adjustable rates and conditions. As a result, the sub-prime mortgage default rates increased sharply. Lenders of the sub-prime market lost confidence due to increasing number of defaults and foreclosures. Combined with lack of real property originated by over pricing of houses, the housing market collapsed. Assets became illiquid. Illiquidity caused mortgage and financial firms withdraw credit from the market. The final outcome: decline in manufacturing business led by consumer spending resulting in increasing number of unemployed with a GDP growth of almost zero for two consecutive quarters.

To address the core problem, the Fed’s proposal to bailout the financial institutions upset many people. Some people wondered: Why shouldn’t $700 billion go to the bottom – the small businesses and consumers – who are suffering the most? They are not responsible for the “housing slump” and the “credit crisis.” Why should taxpayers pay for the irresponsibility of the CEO’s who are untouched by this financial crisis? After all, consumer spending contributes for about 70 percent our economy, and if the money is distributed to Main Street instead of Wall Street, it will definitely boost the economy.

Let’s see how feasible this strategy would be.

In May 2008, economic stimulus checks, which are basically a second tax rebate, were sent out to encourage consumers to spend more and to prevent a recession – at least in the books. The result was instant. Consumer spending went up fast. Real disposable income increased to more than 5.5% while Real GDP was 2.8%, after an average growth of almost zero for two consecutive quarters. Americans were relieved from some of their financial burdens as a result of the economic relief that the stimulus checks afforded them. And that was the end of the benefits.

In contrast, the inflation rate started to soar. From 3.9 per cent in April, the rate of inflation reached its peak to 5.6 percent in August. Currently, the inflation rate is 5.4 percent. High inflation will affect our economy in the long run as prices rise and benefits received from the stimulus checks disappear soon. Due in part to the fact, that inflation devalues any country’s currency. Take for example Zimbabwe the inflation rate there is 231,000,000 percent. If someone buys bread in the morning at 100 dollars, then in the next day the price increases to 633,000 dollars hypothetically speaking. Stimulus checks are a short-term relief that in the long run destroys a country’s financial stability by increasing inflation.

In a free market economy, as in the United States, the value of a currency can be decreased in several ways. One of them is to award free money or stimulus checks. This “free money” increases the supply of money in the economy which dilutes the value of the currency. In the U.S., the dollar has already lost its value. Inflation occurred. Prices for goods and services went skyrocketed. $168 billion handed directly to the consumers caused the rate of inflation to increase by 1.7 percent only three months ago. Can you imagine what will $700 billion cause our economy? And more importantly, how will it affect us in the long run?

Let’s have a look at the bailout plan, or rather, the financial rescue plan. This Emergency Economic Stabilization Act of 2008 authorizes U.S. Dept. of the Treasury to purchase distressed assets – especially mortgage-backed-assets – from the nation’s banks. The purpose of the plan is very simple. By purchasing bad assets, the treasury will try to restore confidence in the market and dispel uncertainty regarding the worth of the remaining assets. By reinstating confidence in the credit market, Feds hope to unfreeze it. This means that financial institutions, and eventually, the general public will have access to credit, which is necessary for economic growth. Unless financial institutions and banks have capital, there will be zero investment. If there is no investment, then there will be no jobs, and unemployment will shrink consumer spending. Since 70% of our GDP is dependent on consumer spending, unemployment will create a lasting disaster for our economy, possibly, a depression. It is to be noted that $700 billion is not big enough bandage to the cover the damage caused by the housing meltdown in which trillions of dollars worth of equity lost their value. That’s why it is more like the patching up a bruise. The government is trying to inject some liquidity by buying those bad assets – resulted from high home prices and mortgage defaults. The goal is to regulate financial institutions to prevent them from creating complex and toxic financial products such as lending more money than people can afford to pay back in teaser introductory rates that have been choking the flow of credit. Therefore, to stabilize the economy, money has to exchange hands, as Professor Kone puts it. To ensure that this happens, the Central Bank will have greater oversight on investment and will serve as a moderator, stepping into the financial market only when it is on jeopardy.

It is true that Wall Street is mostly responsible for this economic crisis. However, it is quite impossible to deny the importance of Wall Street – which contributes more than 35 percent – to our economy. However, financial institutions need to be regulated in order to prevent crisis such as this one. This bailout plan will allow the government to rein in these investment banks. I only hope we’ve learned our lesson.

By the way, this $700 billion bailout plan will add to our national debt, which translates to higher taxes – either directly or indirectly – that can be said for sure.

1 comment:

  1. Ha, you can't escape from me.

    "From 2000 to 2007, the federal funds rate was cut down to 1 per cent - which, in central banking jargon, is zero."

    I think you have the dates wrong. The FFR was not cut down to 1% from 2000-2007. Also I haven't heard anything about 1 equaling zero in central bank jargon. There's a big difference between 100 basis points and zero basis points. What has Prof. Kone been teaching in his class?


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