Transcript WAY THE FINANCIAL CRISIS OF 2007

WAY THE FINANCIAL CRISIS
OF 2007-2009 BEGAN IN USA?
Ilie SIMON
ASE Bucuresti
ICBE 2009
Brasov
AGENDA
• INTRODUCTION
• SUBPRIME MORTGAGES
• DECISION TO HAVE A BUBBLE OR
CHEAP MONEY POLICY
• DECISION TO HAVE A RECESSION OR
THE END OF CHEAP MONEY POLICY
• BUBBLES ARE WANDERING
THROUGH THE ECONOMY
SUBPRIME MORTGAGES
• The real estate market had declined significantly in 2006
• The home prices have been rising at a faster rate than
incomes and rents for several years
• The average house price to incomes reached 190% in
2005, compared to 100% in 1952
• During 2004-2006 the total subprimes cumulated about
$1.8 trillion
• Assuming that by 2008, 50% ($900 billion) are in default,
out of which $500 billion has to be written off, that means
5% of the total mortgage market, or 3.3% from GDP.
DECISION TO HAVE A BUBBLE
OR CHEAP MONEY POLICY
• During a period of three and a half years, the longest in
the last period, the FED slashed the federal founds rate,
from 6.50% in May 2000 to 1% in June 2003, far below
any rational market pricing
• This rate of 1% prevailed since June 2004
• A 1% nominal rate, the lowest in the last 50 years,
means minus 2.05% in real terms
• In previous situation the lowest rate stopped at 3%
• The FED misjudged the warning signals for downturns
that were visible beginning the second half of 2000
DECISION TO HAVE A
RECESSION OR THE END OF
CHEAP MONEY POLICY
• By mid 2004 FED announced the end of cheap money,
and the rate has moved upward in a couple of years
from 1% to 5.25%
• The former president of the FED announced on February
2007 that after 6 years of recovery it is possible to have
a recession at the end of that year, while the actual
president of the FED told the Congress that the economy
might strengthen in 2007!
• Since December 17, 2008 the FED funds rate is at its alltime low, between zero and 0.25%, following 10 rate cut
in a little over a year
• The mortgages rates have remained relatively flat.
• The dotcom bubble did not burst completely, but ended
in the housing bubble crash
Deviating the crash toward the
real estate market
• In the 6 years period, ending 2006, $ 4.5 trillion mortgage debt
(partly shaky) was generated, doubling the mortgage debt to $ 9.5
trillion.
• Anyway, the business cycle in this industry seems to be of about 1718 years, and the previous home crisis took place in 1989-1990. So,
the recession was going to happened, anyway, by 2006-2007.
• the FED, in order to save the US capital market, representing near
140% of the GDP (roughly $ 20 trillion), has deviated the bubble
towards the real estate market, representing only 70% of the GDP
The bubble returned later to the capital market, but its destructive
force was mainly consumed in the mortgage market.
• Such a method will split the costs of recession, and eventually to be
cover by a kind generalized social insurance fund! Loss bearing can
be spread among a much grater universe of possible loss bearers,
in order to be politically stable.
Let the dollar fall
• The economy begins to be confronted with capital outflow; even
domestic investors increased their buying of long-term overseas
securities. This was creating problems in financing the current
account deficit reaching roughly $800 billion per year. The USA
must attract about $70 billion per month of foreign investment, but
the sentiments of foreign investors begin to change, building
downward pressure on the dollar.
• If the Fed raises interest rates to encourage capital inflow, the real
estate market will collapse even faster which will slow consumer
spending and contract GDP.
• The alternative is to let the dollar fall, conducive to inflationary
pressure. In other words, there are two separate but related crises;
an economic crisis and a dollar crisis.
• Many factors played a role in bringing about the recession; however,
the main cause was the combination of the greatly unequal
distribution of wealth, and the constant inducement of a behavior
that in America everything is possible almost instantly, even to own
a house
US expanded credit at a much
faster rate than the economy grew
• The bubble was not created by wages keeping pace with
productivity but by the expansion of personal debt
• The flow of mortgage repayment to financial institutions
is not being used to expand output and employment on a
scale that could repay escalating private debts.
• In reality, more and more local income and assets are
appropriated by foreign shareholders and creditors
• Meantime the US debt was up 10.1% to $4.085 trillion
and accounts nearly 60% of all the credit issued globally
in 2006, putting pressure on interest rates due to
crowding out effect.
• Consequently, US expanded credit at a much faster rate
than the economy grew. This was borrowing to maintain
a higher standard of living and attempt to pay for it
tomorrow.
Exaggerated gap in wealth
distribution
• Exaggerated gap in wealth distribution accompanied by
wage stagnation forces employees to seek credits
• When wages fail to keep pace with productivity then
demand naturally decreases and business contracts.
• The only way to induce more buying is by easing interest
rates or expanding personal credit, and that is when
bubbles begin to appear.
• That's what happened to the stock market before 1929
and to the real estate market in 2007. The availability of
credit has kept the housing market afloat but, ultimately,
the result was the same.
• The bubbles are building up of accumulated excess, as a
result of a persistent postponement of economic policy
remedy
Comparison
• In the USA and Great Britain there is
excessive reliance on asset inflation to
keep public deficits down and private
consumption behavior exuberant.
• In continental Europe there is excessive
influence of public policy by large public
sector salaried employees, who are asking
mainly for the state policy to address
market failures.
The bubbles moves from one
danger point to another
• The bubbles moves from one danger point to
another: commodity prices, including oil, new
financial products, dotcom stocks, real estates,
bonds, junk bonds, exchange rates, etc...
• New: its crash can now be deviated from one
market to the other to reallocate the cost!!!
• By 1987-1989, the USA stepping in to prevent a
world economic crisis has resulted in a series of
policy fixes that have merely postponed the
inevitable and necessary corrections. Eventually
the crises are there