The purpose of this study is to bring to light the mechanism of an economy and banking system. The study focuses on the subprime crisis that has hit the US in the last two years. The study throws some light on the adverse effects of the crisis on the US as well as other economies of the world. The study also mentions the recent shutdown and take-over of Lehman Brothers and also the problems faced by AIG to borrow money.
Literature Review
One of the most important responsibilities for the Fed is that of ensuring monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Fed comes out with the monetary policy in order to ensure certain key objectives like delivering price stability with a low inflation level coupled with an objective to support the government’s economic objectives of growth and employment. To understand how the Fed monitors price related regulations to keep a check on inflation, we may consider a small example of the regulation of house and property prices. To take any decisions related to interest rates keeping in mind the ongoing inflation rate, the Fed must be thorough with the booming property prices and must take steps to ensure that the prices are not artificial.
Government intervenes through its central bank to regulate the prices of many commodities; similarly, it also regulates the prices of houses like any other important commodity. Fed has the responsibility to keep a check on asset prices, including the prices of houses. There can be a number of reasons why the prices of houses may shoot up, as the simple rule of demand and supply has a definite impact. (Demand and Supply for Housing).
Another reason behind a change in property prices can be Mortgages. A mortgage is the money borrowed to buy a house, as for most people buying a house is not easy. Over the years mortgage market has picked up greatly, and the current scenario is totally different from the one that existed in the beginning. Mortgages were supplied only by the building societies. Building societies were non-profit institutions and encouraged only the members for the grant of loans, so the people who were members and had contributed to an extent for a considerable period of time got loans easily and account with building societies became the only means to get mortgages. Soon these societies had to compete with the banks and other financial institutions specialized in granting housing loans. This price war resulted in a greater demand for owner occupied houses, and consequently, the demand for houses grew stronger, resulting in a substantial increase in price. (The UK Housing Market – Factors Influencing the Housing Market: Mortgages).
Besides the above-mentioned factor of mortgages, there are other factors like stamp duty and planning that affect the market for housing. Mortgage interest relief at source (MIRAS) was a tax concession to owning a house. It reduced the house owner’s liability to income tax as the money spent on the interest on the mortgage was considered to be tax-free. This made borrowing cheaper, and, as a result, there was a huge demand for housing, and the prices shot up. With the introduction of MIRAS in 1990, many people were exempted from stamp duty (The UK Housing Market – Factors Influencing the Housing Market: Stamp Duty and Planning).
The central bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. This step is of indispensable importance to the economy, as this is very widely used to contain inflation. The only purpose behind such a step is to contain undue inflationary levels prevailing in an economy. The point to be noted here is that this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices throughout the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is noted that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and, similarly, high-interest rates boost up the savings.
Lower interest rates make an asset, and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in the US will yield better returns to the investors compared to their overseas ventures. This phenomenon usually makes US dollar assets attractive, which pushes up the value of the currency vis a vis other currencies, and a stronger US dollar would mean less money would be shed on imports, and less quantity of exports will take place as there will a lesser demand for products made in the US because of the currency being strong. It is interesting to understand the process of how the bank sets interest rates.
The primary step in this direction starts with the estimates of the money flow that takes place between the government and the Central bank, and the Central bank and commercial banks. The Fed makes sure to rectify all the imbalances, which arise along the path on a daily basis. There can be two phases to the money flow that takes place between the system. First, when more money flows from banks to the government and, second, when more money flows from the government to the banks. In the first case, Fed’s liquid assets come down, which affect the short-term instruments of the money market.
And in the second case, the market finds itself with a cash surplus. The Fed is the bank of the government as well as the bank of all the financial institutions and commercial banks, so it chooses the interest rates for the funds to be provided each day, and this interest rate is passed through the financial system, which influences the interest rates of the country. (How Monetary Policy Works). The diagram given below explains better.
The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Bank of England, influences many parts of an economy, such as market rates, asset prices, including house prices, expectations, and exchange rates. This gives rise to demand which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation. Another important point shown, which deserves mention, is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate, the lesser the price paid for imports and the weaker the currency, the higher the price paid for imports. (How Monetary Policy Works)
A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. When interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and, similarly, high-interest rates boost up the savings.
Subprime Crisis and Its Effects
The subprime crisis started with the subprime lenders lending at higher rates than usual to the borrowers with bad economic history and lesser ability to pay back. Subprime lending runs on the principle of no collateral and higher interests. These debt instruments are then traded and are passed on to other banks or institutions which are ready to take them for the higher interest they get out of them.
Effects on the US and World Economies and Recent Shutdowns
Due to the passing on of the debt instruments, some prominent hedge funds have failed to declare their current asset values. The problem has led to a total crunch of liquidity in the US. The markets witnessed BNP Paribas announced that it had frozen 3 of its hedge funds due to evaporation of liquidity, totalling around 1.6 billion pounds.
The reason was that it was not possible for the bank to value units of the funds due to the effect of the US subprime market on them. The funds contained the bundles of sub prime loans, the demand for which have fallen drastically over the last few months. Banks around Europe feared a total liquidity crunch as they feared that they might run out of cash to sustain day to day lending. ECB went to the extent of injecting 155 billion pounds to ease the system. Investors around the world started backing off from the markets, fearing the ill effects of over exposure to the mortgage markets. (How the US Subprime Mortgage Crisis Affect Irish Markets)
The high liquidity crunch faced by the US has made the Fed cut key interest rates several times over the last year. The liquidity crunch that the US has witnessed had also done bad to the commodity prices and the willingness of the banks and financial institutions to lend each other or even to the consumers. The Bank of England has also cut rates to 4.5 per cent in its latest monetary policy. This would also result in the housing prices falling in the UK as the buyers will not be able to raise mortgage finance, and sellers will be forced to cut down their asking prices. The collapse of Bear Sterns has affected their London operations, with over 2,000 jobs in London. (Q&A: How will the financial crisis hit us?) Another unfortunate incident that took place a few days back was of the 158-year-old firm Lehman Brothers filing for chapter 11 bankruptcy due to the credit crunch. Financial institutions around the world have recorded $ 500 billion in credit losses and write-downs due to the sub prime crisis. At the end of August, the company is believed to have had assets worth $ 600 billion funded with equity of just $ 30 billion. (Lehman Is In Advanced Talks To Sell Key Business)
AIG also faced a liquidity crunch due to the crisis and approached the Fed for funds as a temporary measure. American International Group was hit to the tune of $ 18 billion in losses over the last three quarters due to the guarantees they wrote on mortgage derivatives. (AIG, Facing Liquidity Crunch, Reaches Out to Regulator).
The problem has also had a very deep impact on the equity markets across the globe that has tumbled down to their lowest levels in as many as six years. Dow Jones had plunged to below 8,000 levels for the first time after 2003. The latest story on the crisis is that of the US government making available $750 billion to bail out distressed institutions that have been reporting abysmal earnings quarter on quarter due to write-downs they have faced in the property market. The Fed seems determined to stem the subprime problem and is prepared not to stand down until the crisis is fully resolved, but it remains to be seen whether the rescue measures will have any impact on the economy in the medium term, for the short term, though it seems like the crisis will take at least a couple of years to clear itself. It will be long before the US economy starts to revive and look up once again.
Implications of the Financial Crisis
The global recession has been triggered off across the globe by the subprime crisis in the US. The crisis has not only affected the US economy. It has also affected almost all the countries across the globe. The crisis has certainly given rise to the possibility of a systemic financial crisis, which means that the credit crunch and the liquidity are only going to get worse from here on in. The housing crisis or the subprime crisis is getting worse rather than cooling off. This means that the US economy is only going to get adversely affected. This is going to affect all the major economies of the world. The labour market is also getting affected, and this means that there will be fewer job opportunities in the future for the people seeking jobs. The sale of new homes has fallen by almost 50% in the US, and people have stopped purchasing new homes in the US because of the housing crisis in the country.
The stock market slaughter has weakened almost all the major economies of the world, and this is because of the housing crisis in the US. High oil prices have affected all the people across the globe and especially the importers. Inflation has been constantly on the rise because of the high oil prices, and the same has affected the global economy. The confidence of the investors has taken a real beating because of the financial crisis; people have stopped investing the way they used to before the financial crisis. Countries that trade with the US are going to suffer the most, countries like Mexico, Canada etc. The falling commodity prices will directly affect the commodity exporters in Asia, Africa etc. Credit has become out of trend, and a person who has cash is called the king because of the credit crisis.
“In the case of China, their economic growth is mainly because of two key reasons, namely the high domestic savings and the investments made in infrastructure, exports and in the field of Manufacturing. For the Chinese economy to sustain the manufacturing sector, it is high time that they encourage faster domestic consumption growth. Only in this case will they be able to sustain the growth in the manufacturing sector.” (Long – term Implications of the Financial Crisis).
It is expected that the trade barriers might be raised by China’s policymakers. This will be done in order to protect them from the global recession. In Asia, India is a country that is less vulnerable to recession than most countries because of its control on high imports and tariffs, all this is certainly going to change because of the recession in the west, and it is likely to make the policymakers in India too defensive to ensure protection from recession. The bailout must provide financial stability, or else the burden of the future taxpayers will be increased because public funds will have to be utilized in order to ensure stability.
All the leading companies will have to get accustomed to working in a tougher and tighter environment than earlier. The global recession is severely going to affect the conditions of work in almost all the countries, and instead of grumbling, everyone has to accept the reality and work toward making the situation better. The success rate of the companies is going to fall sharply. Those who identify the opportunities and take the appropriate action earlier than others will succeed in their endeavours. These were the implications of the current financial crisis that the world is facing.
All the top Economies of the World are facing the brunt of the current financial crisis; the developed countries are among the most affected list of countries because of the financial crisis. The growth in these countries has taken a real beating. Shipping rates are considered to be the leading indicators of the global economy, and the same are declining at an alarming rate. This gives an overview of the financial growth which will take place in future. Some countries are still going strong as far as growth is concerned. It is expected that the growth will be short-lived and the good days are soon going to be over for such countries. The year 1930 saw the worst period in the history of the US. It is believed that the magnitude of the recent crisis is more or less the same as in 1930. Bailouts of trillion dollars are believed to be insufficient in rescuing the world out of the present crisis. The markets in the US and the UK have declined by more than 40%, and the effect of this bailout package is yet to be seen by the world on the whole. In Asian countries like India and China, the imports have increased, which means that the growth has slowed down; the same will have a very bad effect on all the rest of the Asian countries because India and China are the powerhouses of the Asian Economy. The crisis is triggering off various unwanted actions like the exports across the world have weakened to unprecedented levels this will hamper economic growth, the investment rates have fallen down, countless people are getting sacked all these are indicators of what is in store for the future. Looking at all these indicators, it is very fair to say that the financial crisis has definitely slowed the growth, and the experts are to be believed the worst is yet to come.
Globalization of the Financial Market
Global markets can be defined as markets, where buying and selling become a reality at the very same price irrespective of the location. The introduction of the euro contributed immensely to the globalization of the financial markets. The introduction of the euro closely knit all the people of the euro. It became a whole lot easier to buy any goods from any European country, earlier it was difficult as different European countries used different currencies. A very fine example of the globalization of the financial market is the introduction of the euro.
Globalization is a process of integrating one economy with another economy. It is a process in which the various economies across the globe become more interdependent. Globalization sustained its growth after the rude 9/11 shock. This time around, globalization is being held responsible for job cuts in various countries and pay cuts. The reality is that the globalization of the financial market has really slowed down because of the financial crisis. Various bailouts have failed till now to restore the same order as in the past.
Globalization is a very complex process and involves a lot of segments. Financial globalization is one segment that comes under the broad section of globalization. Financial globalization mainly revolves around the enhancement in technology in relation to the transmission in communication. This is because financial globalization mainly involves many countries. A healthy transmission system is very imperative for the growth of financial globalization. One of the major changes that financial globalization has brought is to eliminate the Bretton Woods system; it has been replaced by the market led system. Exchange rates, Liquidity conditions, etc., have come into play and are major forces in determining how the world economy is progressing. Financial globalization is very risky because it involves various risks, and the cost of the same is also very high, so the ultimate aim is to minimize the cost and the risk factor involved in financial globalization between different countries and different regions. Every country aims at reaping sweet rewards by making the most of financial globalization, but in the present scenario, it is very difficult to imagine such a case becoming a reality.
Conclusion
The world is amidst a very bad financial crisis. It is supposed to be the heaviest since the great depression, which occurred in the year 1929. The sharp decrease in Wall Street has triggered off many a reaction; it’s inevitably a trickle down reaction which is affecting almost all the economies of the world. The real economy has taken a real beating, and because of the same, the EU also has fallen sharply and will continue to do so in the near future if the reports are to be believed. As the crisis spread across the globe, inequality and unemployment will both rise to alarmingly high levels. Sacking in major companies has already started, and cost-cutting is another thing that is being carried out by the top companies. This will inevitably lead to weaker social protection. When the top economies of the world get affected, the effect will surely pass on to the weaker economies. This will increase poverty in the world. The price of oil and food products has increased drastically post-financial crisis. The crisis triggered off in the US because of excessive lending against the property. The same is also known as the subprime crisis. The only way to overcome the crisis is to place a limit on free trade across the globe and to keep a check on capital mobility. By doing so, we can ensure the economic safety of various economies across the globe.
Works cited
- “AIG, Facing Liquidity Crunch, Reaches Out to Regulator” CNBC.
- “Demand and Supply for Housing” tutor2u. 2008. tutor2u. Web.
- “How Monetary Policy Works” bankofengland 2008. Bank of England.
- “How will the Financial Crisis hit Us?” This is Money 2008. Web.
- “How the US Subprime Mortgage Crisis Affect Irish Markets”. 2008. Irish Mortgage Brokers
- “Long – term Implications of the Financial Crisis”. Cato Institute. 2008.
- “Lehman Is In Advanced Talks To Sell Key Business”. CNBC. 2008.Web.
- “The UK Housing Market – Factors Influencing the Housing Market: Mortgages” 2008. bized. biz/ed.