What brought on the worst post-war recession?
THE US economy contracted 6.2% in the final quarter of 2008. Unemployment rate has now reached an all-time high of 8.1%, General Motors, long considered as the flagship of American business enterprises has just declared that its auditors have raised substantial doubts about its ability "to continue as a going concern" and all the economic indicators predict that things are going to get worse in the coming months. The World Bank has just predicted that global economy would shrink in 2009 for the first time since World War II.
The US economy with its nearly $14 trillion annual GDP is by far the largest in the world. Whatever happens to it has repercussions all over the world. Already both countries of eastern and western Europe are sliding into deep recession. Japan's economy contracted 12.7%. In China millions of factory workers are being laid off. Even the economies of the developing nations of south and south-east Asia are feeling the pinch and are gradually slowing down creating a world-wide economic crisis of huge magnitude. That is why it is important for all us, no matter where we live, to analyse the process that led the US economy into this catastrophic situation. How did it start? What failed in such a reputedly sophisticated market? Who were responsible for these failures?
It would, in my opinion, be difficult to identify one single reason for this recession. A combination of factors like greed, unfettered capitalism, a callous sense of smugness and a complete failure of the existing regulatory system contributed to the creation of this catastrophic situation. Equally, it would be unfair to put the blame only on the federal regulators. Actually, besides the greedy bankers, the unscrupulous rating agencies and the government should collectively and individually bear responsibility for this failure.
It all started with a simplistic assumption that asset values, particularly in the real estate sector would never come down. This is what led to the creation of the housing bubble and eventually the sub-prime mortgage meltdown. The ever-innovative "financial engineers" taking advantage of the Bush-era lax attitude to regulatory functions of the state - the Fed chairman Alan Greenspan was a party to this neo-conservative attitude - did something utterly reckless. "Mortgages were bundled and sold to investment banks which in turn sliced and diced the claims to produce artificial assets (the CDOs) that Moody's and Standard and Poor's were willing to classify as AAA." In other words, they were, in theory, as good as US treasury securities. When their bosses were flying around the world in their private jets without bothering to find out what their subordinates were really up to, these so-called investment bankers who became experts in "finding sophisticated ways to enrich themselves by hiding risks and fooling investors" passed the risk of these toxic assets to the American International Group (AIG) through credit default swaps. Because of AIG's triple "A rating status", it became easy to market these toxic assets all over the world contaminating the global financial system. This was a fraud on a massive scale. In the absence of a derivatives regulator because no such position exists in the US, neither the Treasury, nor the Fed, nor the SEC did anything to stop this madness.
Then with the first sign of difficulties in the housing market when asset values started to decline leaving the debt burden intact, a large number of these securities were downgraded which set in motion a domino effect in economic activities around the world. In retrospect, it is now clear that the Treasury should have taken appropriate measures to contain the foreclosures tsunami. The turmoil in the sub-prime mortgage market soon spread to other parts of the securities market like short-term commercial papers, creating a huge liquidity crisis. Economic activity involving both consumer spending and corporate investments continued to decelerate raising the prospect of a deflationary situation for the first time in many years. Worst of all, no one knew exactly what the individual bank's exposure was to these wilting assets. This is one of the reasons why even now banks are reluctant to trust each other. No wonder, people lost confidence in the banking system, as a whole.
In the words of Nobel laureate Paul Krugman, "Consumers, their wealth decimated and their optimism shattered by collapsing home prices and a sliding stock market, have cut back their spending and sharply increased their saving. Developers of commercial real estate, watching rents fall and financing costs soar, are slashing their investment plans. Businesses are cancelling plans to expand capacity, because they are not selling enough to use the capacity they have. And exports, which were one of the US economy's few areas of strength over the past couple of years, are now plunging as the financial crisis hits America's trading partners."
The Fed, which under Greenspan, not only allowed the sub-prime mortgage market to get out of control, but also unwittingly allowed the emergence of an unregulated shadow financial system and maintained unacceptably low lending rates for too long when domestic savings were falling. The SEC can also be accused of being negligent in fulfilling its obligations. It allowed the securities firms to raise their leverage almost three times. It forgot to take into account the basic principle that the higher the leverage of a firm, the greater are its chances of a financial collapse as "an eventual need to repay loans requires sales that drive prices lower leading the need to repay more loans and so on." Under leverage of 33 to 1, a mere 3% drop in asset values will inevitably lead to the collapse of the company
Finally, the ultimate responsibility for this crisis must fall on the shoulders of the Treasury (even after making due allowance for Bush/Cheney's ideological interference in economic matters) because it failed in its overall responsibility to keep a close watch on all aspects of the economic activities of the nation.
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