US Financial Crisis

Nov 07, 2008 (Asia Pulse Data Source via COMTEX) -- USFL | Quote | Chart | News | PowerRating -- The US is currently experiencing a severe credit crunch, which is the gravest financial crisis since the Great Depression of the 1930s. The crisis has already spread out to Europe and Asia, and it is expected to be global soon. Many economists believe that the US economy has entered a recession that might be longer than usual sending the whole world into a slowdown. Here I attempt to address the question of how the US financial system got there.

First, I would like to define the financial crisis. Since finance is the study of cash flows, every financial crisis is associated with the problem of cash flows, which we call a credit crunch or a liquidity crisis. In all previous financial crises, the problem started with the asset side of companies' balance sheets. We know that subtracting liabilities from assets gives us the net worth of a company. A precipitous depletion of assets can make the net worth of the firm zero or even negative sending the firm into bankruptcy.

Say, the assets of a company heavily depend on housing prices. Now a collapse of housing prices can crumble the asset side of the company's balance sheet and throw the firm out of business. A quick injection of cash can save a firm from bankruptcy. Now if this becomes a common problem across the board, liquidity shortage turns into a full-scale financial crisis in a country. This is the case with the US financial crisis of 2008.

To find the main causes of the financial crisis, we quickly point out subprime mortgages, aggressive lending, mortgage securitization, and credit default swap. These reasons, however, only form the surface of the problem. If we dig deeper, we find that the cheap money policy during the Greenspan era caused many of these problems.

While the effective Federal funds rate, henceforth the Fed rate, was in the vicinity of 12-18 percent in the early 1980s, it has recently come down to the area of 2 percent. Despite having fluctuations, the Fed rate shows a downward trend since 1982 when Paul Volcker, the Fed chair, raised interest rates to curb hyperinflation. The Fed rate has remained steadily low in the 1-5 percent range since 2001. The country never experienced interest rates this low for a couple of years in a row since the regime of President Nixon.

Low interest rates made mortgages very inexpensive, created an artificial demand for houses, sent the housing prices high, encouraged aggressive lending, made mortgage backed securitization very attractive, and thereby created a bubble in the housing market. The bubble burst in August 2007 and began to deflate the asset side of the companies like Fannie Mae, Freddie Mac, JP Morgan, AIG, and so on. None of these would have happened had the US monetary authority not engineered cheap money policy in the first place.

The second cause was the lack of prudent supervision, particularly on the newly developed synthetic financial products such as derivatives like options, swaps, and futures. Credit default swaps (CDS), which were invented by Wall Street in the late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default.

The market for the CDS grew enormously. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion - roughly twice the size of the entire US stock market, and thrice the size of the US economy. Also in sharp contrast to traditional insurance, the swaps are totally unregulated. Subprime mortgages were $35 billion in 1994 and they grew to $1 trillion in 2007.

Why did the regulatory bodies overlook their abnormal growth? Because they thought that new products were doing great for their business. No problem. However, there is always a problem when anything is growing too fast. This fact is the lesson of history and unfortunately we keep on forgetting it. The great lesson of this financial crisis is that we ensure prudent supervision on any newly developed synthetic products. Greenspan calls it counterparty surveillance.

The share of manufacturing in US GDP was three times higher than that of finance in 1950. Now finance has grown double the amount of manufacturing. However, supervision on finance has not progressed in tandem. The treasury secretary Henry Paulson admitted that the US financial regulatory structure has become suboptimal, outdated, and duplicative.

Greed and deregulation are the two words that came from the two US political parties as the main causes of the financial crisis. While greed as a cause of this crisis is hard to quantify, deregulation as a cause of this crisis is hard to justify. The US economy reaped the golden harvests of deregulation for the last 25 years. The country enjoyed the longest boom in history as a reward of deregulation. Even communist China does not want to abandon its deregulation and free market economy. Both China and India embarked on liberalization and registered spectacular growth in the last two decades.

While tight money was the main cause of the Depression, easy money was at the centerpiece of the financial crisis of 2008. A lack of financial intelligence, of course, has aggravated the crisis to a critical extent.

Dr. Biru Paksha Paul is Assistant Professor of Economics and Finance at the State University of New York at Cortland.

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