SlideShare ist ein Scribd-Unternehmen logo
1 von 27
GLOBAL MELTDOWN: ROAD AHEAD


Contents

Publisher’s Desk

Preface

   1. Introduction

   2. Economic Crisis – Nature and extent of different economic crisis from early 19th century
          till the present global crisis of 2008.

              a. Prior to Bretton Wood Institutions

              b. Post Bretton Wood Institutions

   3. Causes of Present Global Crisis and its Analysis

   4. Financial Stimulus and Bailout Packages

   5. Wayout for a new Global Economic System

   6. Conclusions and Summary
GLOBAL MELTDOWN: ROAD AHEAD



                                             PREFACE
People were worried about global warming but got the global meltdown. Unfortunately not the
meltdown of the toxic garbage in the environment emitting GHG or CO2 but the meltdown of the
sizzling economy founded on the edifice of Inequality, Poverty, Unsustainable Consumption and
unbalanced growth. People were worried about rising food and fuel prices, now they are worried
about the falling prices causing deflation, unemployment and closure of industries. The roads in
US were crowded with trucks and automobiles but now people are afraid of driving on empty
roads. The gas stations were busy with queues, now they are closing down in queues. The
housing prices were roaring and soaring but now people are ignoring and snoring with
foreclosures. The banks were flushed with funds, now their money chests are crushed. The stock
market prices were touching the sky, now they are touching the floor. People were going for
overconsumption now they are forced to under consumptions. People were going to US for Jobs,
now they are returning home without Jobs. People were looking at Obama for Change, now
Obama is looking at People for change.

The global financial crisis has earth shattering effects on the global financial system which has
clamped down the production and employment to a standstill situation. The banks are becoming
insolvent and are filing for bankruptcies. There is almost complete erosion in the value of wealth
of the households. The corporates are announcing production cut, job cut, wage cut and many of
them are closing down their shutters. The contraction in economy is alarmingly high in US,
Japan, China and Russia apart for several other countries in Europe and Asia. India is not an
exception and the third quarter results for 2008-09 are very disappointing with GDP growth
slipping down to 5.3 percent, lowest in past six years as per latest advance estimates given by
Central Statistics organization of Govt. of India. There is contraction in agricultural growth by
2.2 percent and in manufacturing by 0.2 percent. There have been announcements for fiscal
incentives by reduction in the excise and service taxes but the shrinkage in the economy
continues. At this juncture the Govt. of United States of America and the Federal Reserve are
trying to provide financial stimulus packages with trillions of dollars for rebuilding and
revitalizing the confidence of the investors and the consumers, but the crisis is so deep and
bottomless that it is yet to buzz or take a note of any such measures.

The move is from Market to Mark to Marx. There is failure of the market economy. The balance
sheet of the financial institutions are in red as they are obliged to mark the securities at the
market price which are ruling at almost one tenth of their original value. The Government is
recapitalizing and nationalizing the banks by following the principles of ‘economic nationalism’
or moving the way of Marxism or Socialism. Alas Marxism has already surrendered and failed
two decades before in Russia with the fall of Berlin Wall in 1989 and soon thereafter it left
China which hurriedly adored Capitalism. Today both, Capitalism and Marxism are at their ruins
and the world is demanding a new economic order. The US Government is trying to bring back
protectionism with stipulation of ‘Buy American’ through the financial stimulus package. Is it
the repetition of Smoot-Hawley Tariff Act of Great Depression which deepened the crisis
further? There is wide spread monetization of fiscal deficits which will certainly lead to a crash
in the current value of US dollar and will cause substantial erosion in the value of wealth
possessed by the people around the world. China is in a dilemma where to keep its foreign
exchange reserve of $1.9 trillion equal to almost 30% of the total international reserve.



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                  Page 2
GLOBAL MELTDOWN: ROAD AHEAD



The present financial architecture created under the aegis of Bretton Wood Institutions in the
name of IMF, World Bank and WTO has proved to be irrelevant and is unable to provide any
solution to the present global meltdown. The world community is looking for a change in the
global economic system for which a meeting of G-20 is scheduled in the first week of April 2009
at London. The present booklet is a humble attempt to analyse the ongoing global economic
crisis. The author has tried to analyse the present crisis in the context of several economic crises
of the past including the very first economic panic of 1819 in the post industrial revolution
period and the Great Depression of 1929 representing the crises of the 19 th and the 20th century.
The present crisis, the first ever in the 21st century of such a great magnitude is identified to be
an outcome of erratic and excessive consumption of US households, the greed of financial
institutions and the heavy debt burden of the households along with irrational borrowing by the
Government of United States.
The World has experienced the failure of communism as well as the failure of capitalism. The
time is for introspection to look for the ‘Third Way’ which will be more humanistic in nature,
environment friendly and will be based on sustainable consumption. The World is looking for a
change and the present generation has an obligation to provide for a solution for a sustainable
and balanced development model for just and equitable share of growth to downtrodden people
around the world. The present crisis should be taken as an opportunity and a blessing in disguise
to remove the toxic elements from the present economic system to be replaced by a harmonious
economic system.




© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                    Page 3
GLOBAL MELTDOWN: ROAD AHEAD



                                                 Introduction
The present global meltdown is a culmination of several factors, the most important being
irrational and unsustainable consumption in the West particularly in United States
disproportionate to its income by consistent borrowings fueled by savings and surpluses of the
East particularly China and Japan. The second important factor is the greed of the investment
bankers who induced housing loans by uncontrolled leveraging on an optical illusion of
increasing prices in the housing sector. The third important factor is the failure of the regulating
agencies who ignored the warning signals arising out of the ballooning debts, derivatives and
financial innovation on the assumption that the Collateral Debt Obligation (CDO), the Credit
Default Swapping (CDS) and Mortgaged Backed Securities (MBS) would continue to remain
safe with the mortgage guarantees provided by Government Sponsored Enterprises (GSEs)
namely Fannie Mae and Freddie Mac which had enjoyed the political patronage since inception.
There are other several factors including shadow banking system, financial leveraging by the
investment bankers and lack of adequate disclosures in the financial statements leading to
fallacious ratings by the rating agencies.

Though the depth of the crises seem like a bottomless pit, as the situation is worsening and
alarming as the defaults are likely to avalanche from the initial shock of subprime security to
prime security and especially the Alt-A1 mortgaged loans which amount to US$ 1.5 trillion and
the likely further default could be to the tune of US$ 600 billion, a size equal to the subprime
mortgages. Once this happens, the bankruptcy which has been limited to investment bankers
with some troubles in the banking sector may bring a further serve catastrophe in the entire
banking and financial sector and may ultimately turn the present recessionary trend to a situation
much deeper than what happened in the Great Depression of 1930s.

The financial stimulus provided by the US Administration partly to fund the toxic assets and
partly by way of recapitalization and nationalization of banks and to certain other sectors of the
economy with the stipulation of ‘Buy American’ may be a repetition of protectionism under the
garb of economic nationalism as infused by Smoot Hawley Tariff Act2 on June 17th, 1930.

All the economic crises whether termed as economic slowdown or recession or depression are
generally found to have link with the boom and boost theory of trade cycle in a free market
economy, the empirical studies of several crises dating as back as the panic of 1819 shows the

1
  Alt-A mortgage is a type of loan where the risk profile falls between prime and the subprime generally this kind of
loan is given to the borrowers with clean credit histories but the loan amount is generally higher than the value of
security and thus the mortgage is comparatively more risky than those backed by prime securities at a
comparatively higher rate of interest.
2

The Smoot-Hawley Tariff Act of June 1930 raised U.S. tariffs to historically high levels. Such policies contributed to
a drastic decline in international trade. For example, U.S. imports from Europe declined from a 1929 high of $1,334
million to just $390 million in 1932, while U.S. exports to Europe fell from $2,341 million in 1929 to $784 million in
1932. World trade declined by some 66% between 1929 and 1934.


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                                      Page 4
GLOBAL MELTDOWN: ROAD AHEAD



failure of the banking system as the primary cause of all the major crisis. The panic of 1819
marked the beginning of new phase of American economic history following the Anglo
American war of 1812 (1812-1815), which resulted in widespread foreclosures, bank failure,
unemployment and a slump in agriculture and manufacturing sector. It was perhaps the first ever
economic crises after the Industrial revolution and the re-establishment of the dollar.

Recession implies negative growth for two consecutive quarters. However, the National Bureau
of Economic Research (NBER) of US explains recession as a significant decline in activity
spread across economy, lasting more than a few months, visible in industrial production,
employment, real income, and wholesale-retail trade. Some economists view recession as a
period when growth falls significantly below its long term potential.

On December 1 2008, the NBER officially declared that the U.S. economy had entered recession
in December, 2007. According to latest statement made by Federal Reserve Chairman Mr. Ben
Bernanke the worst is yet to come for US. Fed believes that the economy will contract in 2009
between 0.5 and 1.3 percent against the earlier forecast of shrinking by only 0.2 or expansion by
1.1 percent and this may be the first since 1991 when there was contraction for the full year. The
third quarter shrinkage has happened with a contraction of 6.2 percent biggest ever since
1982.The unemployment forecast for the full year is 8.8 percent. These forecasts have been
announced by Fed after the fresh financial stimulus announced by Obama administration for US$
789 through a law on 17th February 2009.

The financial crisis has moved into an Industrial crisis now as countries after countries are
sharing negative results in their manufacturing and services sectors. In Germany, the machine
tool orders in December 2008 were 40 percent lower as compared to last year. In China, more
than 50 percent of the 9000 toy manufactures and exporters have gone bust. The industrial hubs
of Shenzhen and Guangzhou providing employment to tens of millions of migrant workers are
turning out to be ghost towns. In the past one year, one third to half of total factories
manufacturing cheap toys, cloths, shares and electronics have closed down.

Japan the second largest economy of the world next only to US has contracted by 3.3 percent in
the fourth quarter in 2008, the biggest contraction in the past 35 years despite the Japan’s central
bank keeping the interest rates as low as 0.1 percent. According to several forecasts, the
contraction in the whole of 2009 will be around 4 percent, twice as severee as in America and
Europe.

The latest figures published by Office for National Statistics on 23rd January, 2009 confirmed
that Britain has officially slipped into recession. The British economy contracted by 1.5% in the
last three months of the fourth quarter in 2008. This makes it the worst performance in over 28
years.

India is not an exception and the third quarter results for 2008-09 are very disappointing with
GDP growth slipping down to 5.3 percent as per latest advance estimates given by Central
Statistics organization of Govt. of India. There is contraction in agricultural growth by 2.2



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                    Page 5
GLOBAL MELTDOWN: ROAD AHEAD



percent and in manufacturing by 0.2 percent. There have been announcements for fiscal
incentives by reduction in the excise and service taxes but the shrinkage in the economy
continues.

French President Nicholas Sarkozy, current president of European Union, has spoken of a need
“to rethink the entire financial and monetary system… to create the tools for worldwide
regulation”.

German Finance Minister Peer Steinbrueck declared that "The USA will lose its superpower
status in the global financial system. The world financial system is becoming multipolar."

The present global crisis can be termed as a financial tsunami. The depth of the crisis is yet to be
determined. It started with sub prime crisis last year and has gradually expanded to all spheres of
economic life including the real economy resulting into global slowdown.

Two Important meetings at global level have taken place between G7 group and the G20 group
of countries. The voice of the most of the developing countries held on 15th November 2008 was
that there is a need to change the present financial architecture created through Bretton Wood
Institution in which the voice of developing countries need to be heard and that there is need for
creating a new economic system by formation of United Nations Economic Council. The world
is looking for a change and solution which may come through the forthcoming G20 meeting to
be held in London on 2nd April 2009 under the chairpersonship of Barak Obama, the new
president of US, a prime mover and a pivotal force behind bringing change in the slow world.

The G20 Meet may be looked as Bretton Woods-II after 64 years of Bretton Woods Conference
held in July 1944. It will be in fitness of things if global wisdom prevails to dismantle the present
Bretton Wood System functioning under Anglo-Saxon Model of the Global Financial System.
Joseph Stiglitz, the former Chief Economic Advisor of IMF and a noble laureate and several
other right thinking economists have been talking about the irrelevance of the present financial
architecture and to re-visit the Bretton Wood Institutions (BWIs).

The whole world is in the grip of Economic Slow-Down which may lead to Global Recession or
Depression since after the Great Depression of 1930’s. The genesis of the crisis which started in
the form of Sub-Prime crisis in USA in around 2007, lies in the new financial innovations and
unregulated derivative transactions coupled with unbridled leveraging by the Investment Bankers
since the year 2000. The Notional value of all outstanding global contracts for derivative
transactions at the end of 2007 reached to US$ 600 trillion, growing at a stunning pace during the
years 2001-2007. This astronomical amount of outstanding derivatives contracts of US$ 600
trillion is approximately 11 times of the global value of GDP which is about US$ 55 trillion. Just
a decade before, this value was only US$ 75 trillion which was merely 2.5 times of the Global
GDP at that time. These figures have been estimated by the Bank of International Settlement.
These derivatives instruments have been termed as the “financial weapons of mass destruction”
by the world famous investor Warren Buffet as a warning in the year 2003.


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                     Page 6
GLOBAL MELTDOWN: ROAD AHEAD



It would be pertinent to take stock of the nature and extent of various economic crises which had
taken place over the last two centuries especially after or at the inception of the industrial
revolution.3 The first recorded economic panic took place in United States in the year 1819 after
the Anglo-American War during 1812-1814. However, there is a noticeable difference between
the economic crises which took place in the 19th century and those which had taken place in the
20th and the 21st century. It has been thought proper to analyse these economic crises in two parts,
one before the establishment of the Bretton Wood Institutions in 1944 and the other which took
place thereafter. The first category of economic crises can also be categorized as period covering
industrial revolution to World War II during colonialism and the second category as an era of
post-colonial world from 1945 till 2008 and beyond.

The first documented business cycle is in the Bible, where Joseph tells the Pharaoh to expect
seven years of plenty followed by seven lean years. This is probably defined by an old joke
which says when your neighbour loses his job; it is called an economic slowdown. When you
lose your job, it is a recession. But when an economist loses his job, it becomes a depression.




3
 [The Industrial Revolution started in Britain with the mechanization of textile industries in the
late 18th and the early 19th century. The period of Industrial Revolution is 1780s to 1840s]


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                    Page 7
GLOBAL MELTDOWN: ROAD AHEAD



 Economic Crisis – Nature and extent of different economic crisis from early
             19th century till the present global crisis of 2008
The Twin nature of financial cum Banking crisis of United States

The history and experience of banking crisis since 1970s and particularly after withdrawal of
commitment by US to exchange 35 US dollar in lieu of one ounce of gold in 1973 that led to the
failure of Bretton Wood System, offer a large array of lessons for the policy makers. According
to IMF data base there were 124 systematic banking crisis since 1970s and more noticeable are
of Japan in late 1980s, Nordic bank crisis in early 1990s and the East Asian banking crisis in
1997. Each of these crises is preceded by property bubble bust accompanied by credit boom as
we can see in the present US sub-prime crisis turned banking crisis of 2007-2008. There are
however differences in the nature and the extent of these crisis. Though East Asian crisis lasted
for less than two years in South Korea, Malaysia, Indonesia, Thailand and Philippines, because it
followed quick action by contracting lending and with restrictions on investments and
borrowings. The biggest support for quick recovery to East Asian crisis was the pull in
international demand and consequent export led growth. In Japan, the experience was not good
as the slump in the economy continued over a decade due to slow action from Japanese
authorities. Japan’s central bank took too long to fight deflation and its fiscal stimulus was
withdrawn too early with increase in taxes in 1997 and there was delay in recapitalization of
banking sector which took place in 1998, almost after a decade but Japan could forbear all these
recessionary pressure for such a long period mainly because that it remained a surplus country
with huge savings and forex reserves and was also under an advantageous position because of
demand for its exports, in the world market.

The vital difference therefore in the banking crisis in Japan and in East Asian countries and those
in Sweden was that the world was not passing through the severe demand construing as we
notice in the present global crisis. The other impartment reasons which distinguishes the present
US banking crisis is the character of the crisis which is twofold: One in the banking sector and
the other in the financial sector or what can be termed as the “Shadow Banking System” of US
led by the so called financial innovation and derivatives in the fragmented US banking and
financial sector. The surge in banking is another factor as the private sector debt surged from
US$ 22 trillion in 2000 (Equivalent to 222% of US GDP) to $ 41 trillion (almost 294% of US
GDP) in 2007. This was accompanied by a very higher percentage of nonperforming loans in US
as compared to Japan or Sweden. According to the IMF, such non-performing loans in Sweden
were just 13% at the peak of the crisis in early 1990s wherever in Japan it was a little higher at
around 35% of GDP but still much lower as compared to US where it amounts to around US $
5.7 trillion or almost 40 per cent of its GDP. If one looks at the huge borrowings of US from the
rest of the world which is more than US $ 10 trillion, one can only wonder as to how the World’s
largest debtor nation can afford to have almost zero rate of interest and its currency artificially so
strong at this hour of crisis. A country on the verge of bankruptcy, with its currencies



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                      Page 8
GLOBAL MELTDOWN: ROAD AHEAD



appreciating against all major currency of the world at this juncture is the seventh wonder of the
world and one can only predict that the US dollar is heading for a crash in very near future unless
some miracle happens with its economy.

Economic Crisis Prior to Bretton Wood Institutions

Economic crises during the colonial era – The major crises that took place during this period
are the economic panic of 1819, 1869, 1873, 1884, 1893, 1896, 1901, 1907 and the Great
Depression of 1929. We shall give a brief description of some of these crises and their impact on
the global economy and the economic system in the following paragraphs.

Economic panic of 1819 – The first major financial crises that took place in United States was
in 1819 as the first experience of boom bust cycle to the modern economists. It was by and large
failure of the banking system. This crisis was an aftermath of Anglo-American War of 1812.
During this time America was a thinly populated country of merely seven million people largely
depending upon agriculture. The three major cities namely New York, Philadelphia and Boston
inhabited only 7% of the country’s population and were trading depots channeling exports to and
import from abroad. There was boom in the economy after the war which continued upto 1818.
However, the decline started in 1819 with a total export falling from $93 million in 1818 to $70
million in 1819-1820 and imports falling from $122 million in 1818 to $87 million in 1819.
Imports from Great Britain fell from $42 million in 1818 to $14 million in 1820 and especially
the imports of cotton and woolen from Britain from over $14 million each in 1818 to about $5
million. By 1821, the depression had begun to clear and was in a slow path of recovery. The
panic had resulted in widespread foreclosures, bank failures, unemployment and a slump in
agriculture and manufacturing.

Economic panic of 1869 – The 1869 crisis took place on September 24th 1869 by way of a
scandal to corner the gold market by a group of speculators held by James Fisk and Jay Gould by
involving one of the close relative of Ulysses S. Grant, the then President of United States
(March 4, 1869 – March 4, 1877). This was to make speculative gains from the price of sudden
spurt in gold price as the US Government had assured buyback of Dollar with gold as the money
in Dollar was issued during American Civil War. However, the Federal Government sold $4
billion in gold and the premium plummeted within minutes. This caused a severe panic in New
York Gold Exchange and the investors lost heavily. This crisis took place because of the gold
conspiracy.

Economic panic of 1907 –The major economic crises that took place in 1869 was followed by
the panic of 1907, being the first financial crises of the 20th century with a major impact on the
New York Stock Exchange which fell close to 50% from its peak of the previous year. The Fed
Reserve had not come into existence and in the absence of any Central Bank as the lender of the
last resort, J P Morgan then the famous financer came forward by infusing huge money to rescue
US Treasury and generate confidence in the banking system as he did during the panic of 1893.



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                   Page 9
GLOBAL MELTDOWN: ROAD AHEAD



Although there is no established empirical link between the depression of 1907 and the First
World War of 1911 and the similar repetition of the events by the prolonged Great Depression of
1929-1938 and the beginning of the second world war 1939 (1939-1945). There seems to be
some impending danger of major economic conflicts between China and US during the present
crisis. The visit of Ms. Hillary Clinton the Secretary of State, to China is very crucial in this
respect as China holds the key with large amount of investments in US treasury bonds and
withdrawal or diversion of such investment may bring the entire US economy to its bottom and
China may ask for some heavy price in political terms. The peace in South-Asia is also equally
important. The establishment of Bretton Wood Institutions4 in July 1944 have not been a panacea
to the repetition of global economic crises and the global economic conflicts.

The Great Depression of 1929: It was the largest and most important worldwide economic
downturn in modern history after the roaring boom period of twenties which is also known as the
golden age of innovation in several field of technology. On August 24, 1921, the Dow Jones
Industrial Average stood at a value of 63.9. By September 3, 1929, it had risen more than six
fold, touching 381.2. The crisis originated in the United States and its starting date is counted
from the stock market crash or the Wall Street Crash on October 29, 1929, known as Black
Tuesday. On Black Tuesday, the Dow Jones Industrial Average fell 38 points to 260, a drop of
12.8% The depression ended after almost nine or ten years but coincided with the beginning of
the World War II around 1939.

The decline in the American economy was the factor that pulled down most other countries due
to protectionist policies, such as the 1930 U.S. Smoot-Hawley Tariff Act and retaliatory tariffs in
other countries, exacerbated the collapse in global trade. By late in 1930, a steady decline set in
which reached bottom by March 1933.

By the end of the week of November 11, the index stood at 228, a cumulative drop of 40 percent
from the September high. The markets rallied in succeeding months but it was like a dead cat
bounce that led unsuspecting investors into the worst economic crisis of modern times. The Dow
Jones Industrial Average lost 89% of its value before finally bottoming out in July 1932.

There were multiple causes for the first downturn in 1929 but according to historians, structural
factors like massive bank failures and the stock market crash, while some economists attribute it
to the decision of British Government to return to the Gold Standard at pre-World War I parities
(US$4.86:£1).

Irving Fisher argued that the predominant factor leading to the Great Depression was over
indebtedness and deflation. After the panic of 1929, and during the first 10 months of 1930, 744
4
 John Maynard Keynes, an economist from UK and Harry Dexter White, an economist from US
was the intellectual founding founders of the Bretton Wood System. Bretton Woods established a
system of payment based on Dollars in which all International currencies were defined in
relation to the Dollar which US had agreed to return in terms of one ounce of gold in exchange
of $35 and thus making the Dollar as good as gold or the Dollar becoming the world currency
and most of the international transactions were denominated in Dollar.


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                  Page 10
GLOBAL MELTDOWN: ROAD AHEAD



US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion
in deposits had been frozen in failed banks or those left unlicensed after the March Bank
Holiday.

In 1937 the American economy took an unexpected nosedive, lasting through most of 1938.
Production declined sharply, as did profits and employment. Unemployment jumped from 14.3%
in 1937 to 19.0% in 1938. As the Depression was on, Roosevelt announced a ‘New Deal’, spent
on public works, farm subsidies, and other devices to restart the economy, but never completely
gave up trying to balance the budget. Keynes General Theory on Employment and Growth,
which was published in 1936 provided the real mantra to tide over the Great Depressions.

Economic Crisis Post Bretton Wood Institutions

The period after the Second World War and especially after the Great Depression of 1929-38,
witnessed a period of economic stability in the global economic system for about three decades,
till the time United States maintained its obligation to exchange one ounce of gold against $35.
This period may be termed as a period of economic stability when the war ravaged countries
were busy in rebuilding their economic infrastructure. The problem started with the first oil price
hike by the OPEC group of countries in 1973 and the buildup of petro dollar, which caused huge
amounts of deficit causing balance of payment crisis in United States which imposed unilateral
embargo on the gold window and ultimately was forced to withdraw its commitment to exchange
gold in lieu of dollar which was the major currency for all international transactions and foreign
exchange reserves.

The post Bretton Wood Economic System has also witnessed several economic crisis particularly
after refusal of returning gold in lieu of US dollar which formed the backbone of Bretton Wood
System which motivated countries around the world to accept US Dollar as international reserve
currency and the rest is history with a series of economic failures and crises culminating between
1980’s till date over the past three decades.

A short list of some major financial crises since 1980

    •   1980s: Latin American debt crisis, beginning in Mexico

    •   1989-91: United States Savings & Loan crisis

    •   1990s: Collapse of the Japanese asset price bubble

    •   1992-3: Speculative attacks on currencies in the European Exchange Rate Mechanism

    •   1994-5: 1994 economic crisis in Mexico: speculative attack and default on Mexican debt

    •   1997-8: Asian Financial Crisis: devaluations and banking crises across Asia

    •   1998: 1998 Russian financial crisis: devaluation of the ruble and default on Russian debt



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                  Page 11
GLOBAL MELTDOWN: ROAD AHEAD



    •   2001-2: Argentine economic crisis (1999-2002): breakdown of banking system

    •   2008: Global financial crisis

The debt crisis of the 1980’s which started in August 18, 1982 in Mexico and other Latin
American countries was in aftermath of first oil shock of 1973 when the petro dollar was
recycled from oil rich countries to American Banks who in turn lent blindly to Latin American
countries who failed to repay the same and had to be bailed out by IMF through Brady and
Baker plans which finally took the color of Washington Consensus in 1989. The policy
prescriptions in the name of economic reform under structural adjustment program became a
financial rule in all subsequent year for the countries falling in the trap of either currency crisis
or the stock market crisis in the recent three decades of liberalization and globalization.

The repeat of the some of the major crisis is the collapse of the Japanese asset price bubbles in
1990s after the Plaza Accord, the speculative attacks on the European exchange rate mechanism
during 1992-93, the Peso crisis due to speculative attacks and hot money flow in Mexico during
1994-85, the East Asian Financial crisis during 1997-98, followed by Russian financial crisis and
the Argentine economic crisis during 1998-2002. There have been several reasons behind these
economic crisis but a few glaring pointers are the burg coming current deficits, net money flow,
capital account convertibility coupled with speculative bubbles in stock market and the real
estate prices. The present crisis is unprecedented in the history of economic globalism
perpetrated and nurtured and flourished from the Wall Street since after the Second World War
and post creation of the financial architecture of IMF and World Bank and possibly this is the
first occasion where the resource of IMF has failed to provide any bailout package as the
quantum of crisis runs into trillions of dollar across the globe with a major chunk of impact
taking place in United States. Therefore, the present crisis is termed as the global crisis and looks
for a global solution. Brief highlights of some of the major crisis are as below:-

The Crash of 1987

The mid-1980s were a time of strong economic optimism. From August 1982 to its peak in
August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2722. The rise in
market indices for the 19 largest markets in the world averaged 296 percent during this period.
The crash on October 19, 1987, a date that is also known as Black Monday, was the climactic
culmination of a market decline that had begun five days before on October 14th. The DJIA fell
3.81 percent on October 14, followed by another 4.60 percent drop on Friday October 16th. On
Black Monday, the Dow Jones Industrials Average plummeted 508 points, losing 22.6% of its
value in one day. The Crash was the greatest single-day loss that Wall Street had ever suffered in
continuous trading up to that point. Between the start of trading on October 14th to the close on
October 19, the DJIA lost 760 points, a decline of over 31 percent.

Despite fears of a repeat of the 1930s Depression, the market rallied immediately after the crash,
posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                    Page 12
GLOBAL MELTDOWN: ROAD AHEAD



October 22. It took only two years for the Dow to recover completely; by September 1989, the
market had regained all of the value it had lost in the 1987 crash.

No definitive conclusions have been reached on the reasons behind the 1987 Crash. Stocks had
been in a multi-year bull run and market P/E ratios in the U.S. were above the post-war average.
Aside from the general worries of stock market overvaluation, blame for the collapse has been
apportioned to such factors as program trading, portfolio insurance and derivatives, and prior
news of worsening economic indicators (i.e. a large U.S. merchandise trade deficit and a falling
U.S. dollar which seemed to imply future interest rate hikes).[5]

One of the consequences of the 1987 Crash was the introduction of the circuit breaker or trading
curb on the NYSE.

1997 Asian Financial Crisis

The Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning
in July 1997, and raised fears of a worldwide economic meltdown (financial contagion). This
was preceded by the Peso Crisis in Mexico in 1994-95, which was more a equity crisis and arose
primarily due to hot money flow.

The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision
of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to
support it in the face of a severe financial overextension that was in part real estate driven.
Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in
1993-96, and then shot up beyond 180% during the worst of the crisis.

Although most of the governments of Asia had seemingly sound fiscal policies, the International
Monetary Fund (IMF) stepped in to initiate a $40 billion program to stabilize the currencies of
South Korea, Thailand, and Indonesia, economies particularly hard hit by the crisis. The efforts to
stem a global economic crisis did little to stabilize the domestic situation in Indonesia, however.
By 1999, however, analysts saw signs that the economies of Asia were beginning to recover.

Until 1997, Asia attracted almost half of the total capital inflow from developing countries. The
economies of Southeast Asia in particular maintained high interest rates attractive to foreign
investors looking for a high rate of return. As a result the region's economies received a large
inflow of money and experienced a dramatic run-up in asset prices. At the same time, the
regional economies of Thailand, Malaysia, Indonesia, Singapore, and South Korea experienced
high growth rates, 8-12% GDP, in the late 1980s and early 1990s. This achievement was widely
acclaimed by financial institutions including the IMF and World Bank, and was known as part of
the "Asian economic miracle".

In 1994, noted economist Paul Krugman published an article attacking the idea of an "Asian
economic miracle". He argued that East Asia's economic growth had historically been the result
of capital investment, leading to growth in productivity. However, total factor productivity had
increased only marginally or not at all. Krugman argued that only growth in total factor
productivity, and not capital investment, could lead to long-term prosperity. Krugman's views


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                  Page 13
GLOBAL MELTDOWN: ROAD AHEAD



would be seen by many as prescient after the financial crisis had become full-blown, though he
himself stated that he had not predicted the crisis nor foreseen its depth.

Argentine economic crisis (1999–2002)
The Argentine economic crisis was part of the situation that affected Argentina's economy
during the late 1990s and early 2000s. The critical period started with the decrease of real GDP in
1999 and ended in 2002 with the return to GDP growth, but the origins of the collapse of
Argentina's economy, and their effects on the population, can be found in action before. As of
2005, arguably the crisis was over, though many challenges remain for the country.

The state eventually became unable to pay the interest of this debt and confidence in the Austral
collapsed. Inflation, which had been held to 10 to 20% a month, spiraled out of control. In July
1989, Argentina's inflation reached 200% that month alone, topping 5,000% for the year.

The Present Global crisis of 2008

Beginning on September 16, failures of large financial institutions in the United States, due
primarily to exposure to securities of packaged subprime loans and credit default swaps issued to
insure these loans and their issuers, rapidly evolved into a global crisis resulting in a number of
bank failures in Europe and sharp reductions in the value of equities (stock) and commodities
worldwide. In the United States, 15 banks failed in 2008, while several others were rescued
through government intervention or acquisitions by other banks. On October 11, 2008, the head
of the International Monetary Fund (IMF) warned that the world financial system was teetering
on the "brink of systemic meltdown" The sequence of the event can be summarized as below for
understanding at a glance.

    •   Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2 billion. The sale
        was conditional on the Fed's lending Bear Sterns US$29 billion on a nonrecourse basis.

    •   The GSEs Fannie Mae and Freddie Mac were both placed in conservatorship in
        September 2008. The two GSEs have more than US$ 5 trillion in mortgage backed
        securities (MBS) and other debt outstanding.

    •   Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion.

    •   Scottish banking group HBOS agreed on 17 September 2008 to an emergency acquisition
        by its UK rival Lloyds TSB, after a major decline in HBOS's share price stemming from
        growing fears about its exposure to British and American MBSs. The UK government
        made this takeover possible by agreeing to waive its competition rules.

    •   Lehman Brothers declared bankruptcy on 15 September 2008, after the Secretary of the
        Treasury Henry Paulson, citing moral hazard, refused to bail it out.




© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                  Page 14
GLOBAL MELTDOWN: ROAD AHEAD



    •   AIG received an $85 billion emergency loan in September 2008 from the Federal
        Reserve, which AIG is expected to repay by gradually selling off its assets. In exchange,
        the Federal government acquired a 79.9% equity stake in AIG.

    •   Washington Mutual (WaMu) was seized in September 2008 by the USA Office of Thrift
        Supervision (OTS). Most of WaMu's untroubled assets were to be sold to J.P. Morgan
        Chase.

    •   British bank Bradford & Bingley was nationalised on 29 September 2008 by the UK
        government. The government assumed control of the bank's £50 billion mortgage and
        loan portfolio, while its deposit and branch network are to be sold to Spain's Grupo
        Santander.

    •   In October 2008, the Australian government announced that it would make AU$4 billion
        available to nonbank lenders unable to issue new loans. After discussion with the
        industry, this amount was increased to AU$8 billion.

    •   In November 2008, the U.S. government announced it was purchasing $27 billion of
        preferred stock in Citigroup, a USA bank with over $2 trillion in assets, and warrants on
        4.5% of its common stock. The preferred stock carries an 8% dividend. This purchase
        follows an earlier purchase of $25 billion of the same preferred stock using TARP funds.

Causes of Present Global Crisis and its Analysis

The most astonishing aspect of the trouble is that the financial innovation in the form of
derivatives has taken place under the naked eyes of the regulating agencies and in response to
several incentives created by Government all over the world. The toxic assets with high
leverages were created at different tax havens and thereby over passing the capital adequacy
norms. The new instrument in the form of Credit Default Swaps (CDS) was created to cover the
risk of credit defaults by paying premium to unregulated hedge funds. The CDS market
multiplied with a galloping speed of doubling each year from 2001 to 2007. In the year 2001 the
value of CDS outstanding was only US$ 919 billion and reached to US$ 62.2 trillion by the end
of 2007, more than 60 times over a period of 7 years and then marginally declined to US$ 54.6
trillion by the mid 2008

The root of the crisis therefore lies in the greed with which the banks and the financial
institutions have worked in the past ten years. These institutions provided housing loans to the
US households without adequate securities with a motivation to borrow at a lower interest rate
which was just around 1% in June 2004 and without proper coverage of security on the
assumption that the housing prices will keep on rising and will take care of the rising uncovered
debts. The problem started with the increase in the interest rate by almost six times from 1
percent in June 2004 to 6 percent in June 2006 with increasing burden in EMIs on the
households who started defaulting and sought redemption of debts by foreclosure.


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                Page 15
GLOBAL MELTDOWN: ROAD AHEAD



The National Debt of US increased to US$ 9 trillion with increased consumption at home by
paying the imports through borrowing from the exporting countries on the assumption that US
dollar will continue to rule the world as International Reserve Currency. High consumption
through imports coupled with borrowing led to collapse of local industries and increase in the
interest rate and decline in the value of US dollar vis-à-vis other world currencies. This led to
sub-prime crisis and the failure of the entire banking system with the collapse of the Government
sponsored mortgaged guaranteed companies viz. Fannie Mae and Freddie Mac. The US
Government nationalized these mortgage guaranteed companies by pumping US$ 200 billion in
order to bailout them from the financial crisis.

The bailout package as initially announced for AIG (American International Group), the
insurance company on September 16th amounted to USD 85 billion. There was a further rescue
package announced, comprising USD 153 billion including the initial package on 10th November,
2008. Though initially there was some controversy in State intervention. The bankruptcy of AIG
could have endangered the entire financial system because of the large size of toxic credit
derivatives and mortgaged backed securities.

The five investment bankers including Bear Steams, Lehman Brothers, Merrill Lynch, JP
Morgan and Goldman Sachs, all went into trouble. Lehman Brothers, with high leveraged
capital, which was more than 35 times of its own capital went bankrupt. Bear Stems was
salvaged by JP Morgan and Merrill Lynch by Bank of America with direct support from US
Federal Reserve and the US Treasury.

The present meltdown is unique in nature in content as compared to the Asian Meltdown in 1997
and several other financial Jolls in the form of equity crisis, currency crisis, debt crisis, banking
crisis spread over a span of 80 years since the treat depression of 1930’s. It took almost 8 to 9
years to tide over the great depression of 1929 which was medicated to the Keynesian formula of
Pump priming through huge Public Investment. The present crisis on the other hand is of cyclical
nature after a continuous boon of 7-8 years in all spheres of the economy including the financial
sector and the real sector. The forces of globalization have gone deep down the economies
throughout the world and with the support of information technology and telecommunication the
geography has become irrelevant to the free flow of goods, services and capital. The present
crisis therefore may not last beyond 17 to 24 months with the information net working and
greater co-operation as compared to the past crisis.

Sub Prime Crisis, the root cause of the global crisis

Subprime lending is the practice of lending, mainly in the form of mortgages for the purchase of
residences, to borrowers who do not meet the usual criteria for borrowing at the lowest
prevailing market interest rate. These criteria pertain to the down payment and the borrowing
household's income level, both as a fraction of the amount borrowed, and to the borrowing
household's employment status and credit history. If a borrower is delinquent in making timely



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                    Page 16
GLOBAL MELTDOWN: ROAD AHEAD



mortgage payments to the loan servicer (a bank or other financial firm), the lender can take
possession of the residence acquired using the proceeds from the mortgage, in a process called
foreclosure.

The crisis began with the bursting of the United States housing bubble and high default rates on
sub-prime mortgages and adjustable rate mortgages (ARM). The foreclosures exceeded 1.3
million during 2007 up 79% for 2006 which increased to 2.3 million in 2008 and 81% increase
over 2007.

Financial product called mortgaged backed securities (MBS) which in turn derive their value
from the mortgage installment payments and housing prices had enabled financial institutions
and investors around the world to invest in U.S. housing markets. Major banks and financial
institutions which had invested in such MBS incurred losses of approximately US $ 435 billion
as of July 2008 which has mounted further and is now near to the value of US $ 1 trillion. The
value of all outstanding residential mortgage owed by US households was US$ 10.6 trillion as of
Mid 2008 of which $ 6.6 trillion were held by mortgaged pools Consisting of Collectivized debt
obligation (CDO) already mortgage backed securities (MBS) (CDO and MBS) and the remaining
US$ 3.4 trillion by traditional depository institutions.

The owners of stock in US corporation alone has suffered loss of about US$ 8 trillion between 1
January and 11 October 2008 as the value of their holding declined from US $ 20 trillion to US $
12 trillion.

Causes of the Subprime Crisis

A recent study conducted by a research scholar, Stan J. Liebowitz of The Independent Institute,
brings out startling facts showing a close nexus of the politicians by giving providing political
patronage and shelter to the Government Sponsored Enterprises (GSEs) namely Fannie Mae and
Freddie Mac while giving guarantee to the housing loans to appease a particular section of the
society without adequate coverage of the security and by ignoring the standard norms of lending
with prudency. The subprime mortgage meltdown has been at the root of the present financial
crisis in United States.

The housing market experienced an unprecedented boom in the crisis which kept soaring from
the early start of the 21st century until the end of 2006. The mortgage defaults started surfacing
and reached the unprecedented level by the mid of 2007 and thereby bringing the tremor in the
financial system which had invested heavily in housing loans and the derivatives in securitized
mortgages. The first catastrophe took place when Bear Stearns was sold to JP Morgan at a throw
away price in April 2008. The biggest adverse impact was on Fannie Mae (The Federal National
Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation); the
two Government Sponsored Enterprises (GSEs) were granted a very quick bailout package by
the US Treasury. A record breaking level of mortgage foreclosures took place for the subprime
mortgages. This led to a sharp decline in the value of securities which were based on these


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                 Page 17
GLOBAL MELTDOWN: ROAD AHEAD



mortgages. Most of the investment bankers including Fannie Mae and Freddie Mac reached to
the brink of bankruptcy.

According to this study, the failure to recognize these mortgages as risky during the time of
boom was mainly because that the mortgage underwriting standards had been underlined by
direct intervention of several Government agencies since early 1990s. The Government wanted
to provide home ownership among poor and those belonging to minority by prescribing lower
underwriting standards with no stipulation of any down payment and ignoring the credit scores
and the employment history of the borrowers while determining the monthly installments. This
was considered an innovation in mortgage lending and led to a bubble in the price of housing.
Most of these housing loans were given at lower interest rate with an option for adjustable-rate-
mortgages (ARMs). It is worth noting that the rate of interest increased from about 1% in June
2004 to about 6% in June 2006. The builders were allowed to build, developers to develop,
lenders to lend, in order to encourage private homes without there being any direct help from
Government which had only helped financing indirectly by providing guarantees through GSEs.

In the early 1930s housing loan was a low priority for US banks and in order to alleviate their
reluctance the Federal Government created Federal Housing Administration (FHSA) in 1934
which was taken over by a new institution called Fannie Mae in 1938. The Federal Government
passed two legislations namely the Community Re-investment Act (CRA) 1977 and the Home
Loan Mortgage Disclosure Act (HMDA) in 1975. In 1981, the Federal Government further
expanded the disclosure requirement under HMDA including comparison of reactions of
application by race which indicated that the minorities were denied home mortgages by more in
numbers as compared to whites and this was further substantiated by a survey conducted by
Federal Reserve Bank of Boston. The Boston Fed report was further fructified by Fannie Mae
report in 2002. The 1992 Federal Housing Enterprises Financial Safety and Soundness Act
(FHEFSSA) mandated a more liberal approach to housing loans to lower income borrowers
which spurred Fannie Mae to make an announcement of a trillion dollar commitment. Thus, the
GSEs encouraged secondary market innovations of the mortgage security as a part of moral
hazard. The banking sectors would lend money were feeling comfortable as the loans were
seemingly guaranteed by GSEs and they in turn mortgage securities which gave birth to
derivatives and collateral debt obligations (CDOs). The process of creativity and innovation for
housing mortgage loan linked securities went on and on from collateral debt obligations to credit
default swaps (CDS).

It is not very surprising to note that under priority lending obligations for housing loans there
were primitive provisions for the financial institutions ranging from $10,000 in individual
actions and a fine upto $500,000 for 1% of its net worth in class actions as provided in Equal
Credit Opportunity Act. They are further restraining the credit institutions from using any
arbitrary or unreasonable measures of credit worthiness. There was also an illusion that led to
housing price bubble that no one would default when they could easily sell the house at a profit.
This led rating agencies to give these housing loans AAA ratings. The rating agencies were also


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                Page 18
GLOBAL MELTDOWN: ROAD AHEAD



making huge profits from rating mortgage backed securities as the government required many
financial institutions to invest only in highly rated securities as certified by nationally recognized
statistical rating organizations as approved by Securities Exchange Commission and there were
only three such approved rating agencies namely Standard and Poor’s, Moody’s and Fitch.

Thus there was a clear nexus between the GSEs, the Security Exchange Commission and the
rating agencies which in tandem led to the housing price bubble and later to the burst and
consequential mortgage defaults. In other words, these ‘mortgage innovations’ were US
Government’s responsibility and were completely ignored. These innovations were precursor to
mortgage meltdown and regulators, politicians, GSEs and the academicians were the true culprits
responsible for it. In the process of undue importance to the housing loan by the GSEs the
speculators took advantage by borrowing at cheap rates and creating an artificial demand in the
housing sector when there were foreclosures from the real borrowers with the increase in the rate
of interest under the flexible interest options, there was catastrophic and drastic fall in the
housing prices leading to the collapse of the whole financial system over a period of less than six
months in the later half of 2007 and towards the beginning of 2008. The smoke turned out to be a
big fire when the investment bankers started filing bankruptcy under chapter 11, one after
another.

In March 2007, the United States' subprime mortgage industry collapsed due to higher-than-
expected home foreclosure rates, with more than 25 subprime lenders declaring bankruptcy,
announcing significant losses, or putting them up for sale. The stock of the country's largest
subprime lender, New Century Financial, plunged 84% amid Justice Department investigations,
before ultimately filing for Chapter 11 bankruptcy on 2 April 2007 with liabilities exceeding
$100 million. The manager of the world's largest bond fund PIMCO, warned in June 2007 that
the subprime mortgage crisis was not an isolated event and will eventually take a toll on the
economy and whose ultimate impact will be on the impaired prices of homes.

Subprime and Alt-A (including "stated income" or "liar's loans" which are basically loans made
to home buyers without the verification of borrowers' incomes; home buyers tend to overstate
their incomes in order to get the loan amounts they desire to purchase their dream homes, thus
called the "liar's loans") loans account for about 21 percent of loans outstanding and 39 percent
of mortgages made in 2006. In April 2007, financial problems similar to the subprime mortgages
began to appear with Alt-A loans made to homeowners who were thought to be less risky.
American Home Mortgage said that it would earn less and pay out a smaller dividend to its
shareholders because it was being asked to buy back and write down the value of Alt-A loans
made to borrowers with decent credit; causing company stocks to tumble 15.2 percent. The
delinquency rate for Alt-A mortgages has been rising in 2007. In June 2007, Standard & Poor's
warned that U.S. homeowners with good credit are increasingly falling behind on mortgage
payments, an indication that lenders have been offering higher risk loans outside the subprime
market; they said that rising late payments and defaults on Alt-A mortgages made in 2006 are
"disconcerting" and delinquent borrowers appear to be "finding it increasingly difficult to


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                     Page 19
GLOBAL MELTDOWN: ROAD AHEAD



refinance" or catch up on their payments. Late payments of at least 90 days and defaults on 2006
Alt-A mortgages have increased to 4.21 percent, up from 1.59 percent for 2005 mortgages and
0.81 percent for 2004, indicating that "subprime carnage is now spreading to near prime
mortgages."

The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, with
over 7.5 million first-lien subprime mortgages outstanding. In the third quarter of 2007, subprime
ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the
foreclosures begun during that quarter. By October 2007, approximately 16% of subprime
adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun
foreclosure proceedings, roughly triple the rate of 2005. By January 2008, the delinquency rate
had risen to 21%. and by May 2008 it was 25%.

The value of all outstanding residential mortgages, owed by USA households to purchase
residences housing at most 4 families, was US$9.9 trillion as of yearend 2006, and US$10.6
trillion as of midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly
1.3 million properties, a 79% increase over 2006. As of August 2008, 9.2% of all mortgages
outstanding were either delinquent or in foreclosure. 936,439 USA residences completed
foreclosure between August 2007 and October 2008.

Credit risk arises because a borrower has the option of defaulting on the loan he owes.
Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they
issued. Over the past 60 years, a variety of financial innovations have gradually made it possible
for lenders to sell the right to receive the payments on the mortgages they issue, through a
process called securitization. The resulting securities are called mortgage backed securities
(MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by
mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential
mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4
trillion by traditional depository institutions.

When homeowners default, the payments received by MBS and CDO investors decline and the
perceived credit risk rises. This has had a significant adverse effect on investors and the entire
mortgage industry. The effect is magnified by the high debt levels (financial leverage)
households and businesses have incurred in recent years. Finally, the risks associated with
American mortgage lending have global impacts, because a major consequence of MBS and
CDOs is a closer integration of the USA housing and mortgage markets with global financial
markets.

Investors in MBS and CDOs can insure against credit risk by buying credit defaults swaps
(CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their
counterparties increased. This created uncertainty across the system, as investors wondered if
CDS issuers would honor their commitments.




© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                 Page 20
GLOBAL MELTDOWN: ROAD AHEAD



In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15
November 2008, leaders of the Group of 20 cited the following causes:

"During a period of strong global growth, growing capital flows, and prolonged stability earlier
this decade, market participants sought higher yields without an adequate appreciation of the
risks and failed to exercise proper due diligence. At the same time, weak underwriting standards,
unsound risk management practices, increasingly complex and opaque financial products, and
consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers,
regulators and supervisors, in some advanced countries, did not adequately appreciate and
address the risks building up in financial markets, keep pace with financial innovation, or take
into account the systemic ramifications of domestic regulatory actions."

Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to
$7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable
personal income. During 2008, the typical USA household owned 13 credit cards, with 40% of
households carrying a balance, up from 6% in 1970.




© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                Page 21
GLOBAL MELTDOWN: ROAD AHEAD




                          BAILOUT PACKAGES AND WAY OUT

The Federal government's efforts to support the global financial system have resulted in
significant new financial commitments, totaling $7 trillion by November, 2008 and by mid
February 2009 the total bailout figure is estimated to be approximately US$ 8.5 trillion. These
commitments can be characterized as investments, loans, and loan guarantees, rather than direct
expenditures. In many cases, the government purchased financial assets such as commercial
paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in
frozen markets. As the crisis has progressed, the Fed has expanded the collateral against which it
is willing to lend to include higher-risk assets.

Government of China has also announced a financial package of US$ 585 billion to pump prime
the economy by making huge public investment and by providing subsidies to protect domestic
economy which is otherwise exposed to external market and is likely to be severely affected
because of the cuts in imports by all the major importing countries.

Economic Stimulus Act of 2008

It was passed by the US Congress on 13 February 2008, authorizing Bush administration for an
economic stimulus package costing $152 billion, mainly taking the form of income tax rebates
for the year 2008.

Housing and Economic Recovery Act of 2008

The Housing and Economic Recovery Act of 2008 included six separate major Acts intended to
restore confidence in the American mortgage industry. These measures speak about creation of a
new Federal regulator to ensure the safe and sound operation of the GSEs (Fannie Mae and
Freddie Mac) and Federal Home Loan Banks. This Act authorities Federal Housing.
Administration to generate upto $ 300 billion in new 30 year fixed rate mortgage for subprme
brokers.

Emergency Economic Stabilization Act of 2008

The Act was passed on October 3, 2008, creating a $ 700 billion bailout package for the troubled
asset relief programme to purchase the toxic assets on the bad loans of the failing banks. The
effect of this bailout on the US fiscal deficit for the year 2009 is to increase it to a level beyond $
1 trillion and the federal debt to $ 11.2 trillion from the present level of $10.6 trillion.

Financial Package announced by Obama Administration

Barak Omama seems to be in a fix or in a sea as his financial stimulus packages of US$ 789
brillion has failed to bring any thrill in the economy as most of his announcements are back
loaded to 2010 and beyond as evident from the blue print of February 10th released by his
treasury secretary Mr. Tim Geithner. It has failed to show any tangible aggressive plan which


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                      Page 22
GLOBAL MELTDOWN: ROAD AHEAD



could break the spiral of uncertainty and gloom that has gripped the investors and the consumers.
The stimulus package has thus failed to boost the confidence of investors, leading Dow Jone
index to dip by 297 points crusting to 7553, close to November low, on 17th February 2009.

Penny Pinching and lukewarm approach at a time when the entire financial system is broken
down, may end up paying more price than the aggressive and more rational approach with
innovative solutions that could tread boldly and salvage the devastating economy.

‘Buy American Debate’

The financial stimulus of US$ 789 billion as approved by US Congress contains a rigorous
provision containing a condition of “Buy-American.” There was an odd debate on the issue and
few compared it with Smoot Hawley Act of 1930 to haunt Americans and there has been same
watering down by requiring only that stimulus fund which spends in a way does not violate US
trade agreements under various FTAs including NAFTA. However, same controversy remains
with the members of the WTO, who may retaliate to this negative approach of protection.

This is not the first occasion that US has included such provision in the stimulus package as US
has already passed The Buy American Act in 1933 to prefer US made products in its purchases.

As of June 30, 2008, residential mortgages owed by USA households totaled US$10.6 trillion.
As of August 2008, 9.2% of these mortgages were either seriously delinquent or in foreclosure.

Bailout A Bombshell ?

The present financial bailout package of US Government amounts to US $ 8.5 trillion and is far
in excess of the aggregate of the several bailout packages announced or dolled out in the past, as
may be evident from the following figures.




                                             US$ billion

Invarsion of Iraq                              597

Life Time Budget of NASA                       851

S & L Bailouts of 1980s                        256

Louisiance Purchase                            217

Korean War                                     454




© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                 Page 23
GLOBAL MELTDOWN: ROAD AHEAD



A study conducted by the San Francisco Chronicle brings the total bailout package to $8.5
trillion (including the $ 700 billion Wall Street bailout; $ 600 billion to Fannie Mae and Freddie
Mac; 168 billion in stimulus cheque and the present stimulus package announced by Obama
Administrations amounting to $ 789 billion). According to Hepburn, the President of Hepburn
Capital Management in Prescott, AZ, “Everyone is going to lose something. The winners will be
those who end up losing the least.”

The source of the bailout package of US$ 8.5 trillion is not known exactly as to how much is
coming from fresh borrowings and how much is in the form of minting money. It is also to be
established as to how much of it is in the form of fiscal incentives and how much is in the form
of financial pay outs. However even if part of the aggregate bailout package of US $ 8.5 trillion
is in the form of cash, it will amount to glut of dollar in the global market and may turn out to be
a “Bombshell” wiping out huge wealth of those holding dollar or dollar reserves.

It is a matter for evaluation and research for several sovereign wealth Funds and for central
banks of various countries who have invested in US treasures as the panic button for a crash in
value of US dollar may be pushed anytime from now.

Way-out of the Present Crisis

Politicians and academicians across the World from Beijing to Berlin to Brasilia are looking at
the present economic crisis as the outcome of a scrambled global financial infrastructure
dominated by the United States. They may ask for big changes in the present economic system
in the forth coming second G-20 meeting in April at London whether US like them or not.

The global thinking and debate about the financial crisis is quite different from the one in the
U.S., over the issue as to whether the present mess is the result of too much government
interference in the housing market or too little government regulation of financial markets. In the
rest of the world, it is due to inadequate and inconsistent financial regulation. A consensus seems
to have emerged among the world’s finance ministers and central-bank chiefs that the underlying
cause of the crisis was an unbalanced and out-of-control system of global capital flows in which
disproportionate consumption in U.S. ran up huge debts while big savers like China and other
Asian Countries had huge surpluses and reserves.

The political head of the People’s Republic of China, Mr. Wen Jaibao has made a very critical
remark on what had gone wrong in the US financial market, when he was in Davos recently, He
said, “The crisis is attributable to a variety of factors and the major ones are: inappropriate
macroeconomic policies of some economies and their unsustainable model of development
characterized by prolonged low savings and high consumption; excessive expansion of financial
institutions in the blind pursuit of profit; lack of self-discipline among financial institutions and
rating agencies and the ensuring distortion of risk information and asset pricing; and the failure
of financial supervision and regulation to keep up with financial innovations, which allowed the
risks of financial derivatives to build and spread.”



© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                    Page 24
GLOBAL MELTDOWN: ROAD AHEAD



Angela Merkel, the German Chancellor, has advocated a sort of United Nations Economic
Council, much like the Security Council. Brown and others have urged reform and
recapitalization of the Bretton Woods international financial institutions (IFIs), with a much
greater role handed to the International Monetary Fund, to which Japan, quietly re-establishing
the credibility in international financial debates it had in the 1980s, has pledged $100 billion.

The crisis has two sides. The narrower one is a consequence of the collapse of the U.S. housing
market. This put pressure on bankers, both in the U.S. and elsewhere, who held toxic assets
supposedly backed by real estate and it squeezed U.S. consumers, who for a generation had been
the spendthrift engine of the global economy. The broader one is a function of massive global
imbalances between debtor and creditor nations that have developed over the last few decades
and imbalances will have to be unwound, preferably by fundamental changes to domestic policy
that encourage saving in the U.S. and spending in China. In the developed world, as the credit
crunch bites, economies are heading for the worst recession and a demand contraction in the
western world is likely to severally affect the export-oriented economies, especially in East Asia.

The overall impact of the financial crisis has been felt as a tsunami throughout the world cutting
across all theories of decoupling to insulated economies in some part of the world. The whole
world is reeling through the pains of global crisis with decline in the growth rate and loss of
employment apart from erosion in the value of wealth which is as high as US$ 15 trillion and
may increase further. The economic problems are escalating and the economic thinkers need to
develop an alternate economic order for the future so that there is revival and rehabilitation of the
devastated world economy.

The blessing in disguise could be a new world economic order devoid of extremes of
communism and capitalism and which would be based on integral humanism. A new world order
would be created devoid of poverty and environment pollution based upon sustainable
consumption where people can feel a harmony between the social issues, the political issues and
the economic issues a new world where competition is accompanied with compassion and people
can live without the fear of terrorism, a different world where peace and prosperity can co-exist
for the well being of the whole universe. Let us awake and look for a holistic solution to the
present global crisis.

The temporary bailout process of the present financial crisis which began prior and subsequent to
G-8 meeting in Washington was followed by G-20 meetings of the Heads of States including
India and China on 15th November 2008 but could not arrive at any concrete long term solutions.
The G-20’s is scheduled to meet on 2nd April 2009 under newly elected U.S. President Barrack
Obama who has already formed his economic team with a vision to bring a long term solution to
the Wall Street and the Main Street. However the crisis is deep and any bailout or way-out
package will take at least minimum period of 18 to 24 months to restore confidence in the minds
of the consumer, the banks and the Investors. The distinguished features of the present crisis with
that of several other crisis in the past few decades is that the contagion effect in earlier crisis was


© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                      Page 25
GLOBAL MELTDOWN: ROAD AHEAD



local or regional whereas the tremor of the Tsunami type of present crisis has touched the shores
of all the countries, big or small, rich or poor, developing or developed.



G-20 Meeting: The first meeting of the G-20 leaders on financial markets and the world
economy was held in Washington, D.C. on November 14-15, 2008. The Summit resulted from
an initiative by French and European Union President Nicolas Sarkozy and United Kingdom
Prime Minister Gordon Brown. Since many economists and politicians called for a new Bretton
Woods system (a monetary management which was instituted after World War II) to overhaul
the world’s financial structure, the meeting has sometimes been described by the media as
Bretton Woods II. The G-20 comprises countries considered to be systemically important, but
omits over 170 governments (192 governments are members of the United Nations).

The outcome of the summit came out in the form of a declaration stating inter-alia about the root
causes of the global crisis, common principles for reforms in financial markets, reaffirmation of
the commitment to free market principles and to have a follow up meeting by April 30, 2009.




© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                Page 26
GLOBAL MELTDOWN: ROAD AHEAD




                                    Conclusions and Summary

    The Challenges arising out of Global crisis and the need for International Currency

The history and analysis of the global crisis indicate that the trade cycles are the natural way of
corrections in the irrational economic behavior. The irrationality may be manifested either by
excessive consumption, or excessesive inequality or the imbalances or in the speculation in real
estate or in capital market. It may also resemble in the form of macroeconomic indicators by
high current account deficit, high amount of fiscal deficit and the debt service ratios. The
artificial bubble is bound to bust. The global crisis prior to Bretton Wood and before the second
World war had a different character than what we notice in the post Bretton wood era. The pre-
war crisis was confined to US and few developed countries in Europe. There is no instance of a
pre war crisis in a poor or a developing countries except sufferings due to famine or other natural
calamities. However the post war crisis has been resembled from debt crisis of Latin America in
1980s to currency crisis of East Asia in 1997.

The post war crisis in the post Bretton wood era or to say in post colonial era of the present form
of globalization has been identified to be the result of some speculative attack either in the
currency market or in the stock market. The boom and bust has been the result of speculation and
the financial innovation and not the demand supply factor in the commodity. Therefore there is
the need to understand the underlying root causes of the crisis and to remove them by thorough
deliberation by participation of all research organizations and the political system. Though there
is need to revise the entire system of the present financial architecture but there is an immediate
need to place a capping on the borrowings of a sovereign state as certain percentage of its GDP
with certain coefficients of population and or the poverty and unemployment. There is also a
need to reformulate the exchange rate system which should have some basis similar to the gold
standard so that there is some credibility and capping on the money in circulation and for
maintaining the foreign currency reserve.

The present global crisis has taken the shape of the Great depression of 1929 at least in US and
Japan. The biggest losers will be US, Japan and China. The biggest gainers may be India, Brazil
and few other developing countries with their own domestic savings and domestic market. The
world will have to undergo the impact in different forms, somewhere it will be economic
slowdown, somewhere recession and somewhere depression. However the correction was
overdue and would result in removing toxicity and fallacies from the present global economic
system. Let us wait for a better change and a better tomorrow.




© Copyright, Dr. Dhanpat Ram Agarwal, 2009                                                  Page 27

Weitere ähnliche Inhalte

Was ist angesagt?

Global Investment Returns Yearbook 2012
Global Investment Returns Yearbook 2012Global Investment Returns Yearbook 2012
Global Investment Returns Yearbook 2012Credit Suisse
 
GLOBAL WORLD ECONOMIC PROBLEMS
GLOBAL WORLD ECONOMIC PROBLEMSGLOBAL WORLD ECONOMIC PROBLEMS
GLOBAL WORLD ECONOMIC PROBLEMSAby Palackal
 
The end of globalization with the new coronavirus pandemic
The end of globalization with the new coronavirus pandemicThe end of globalization with the new coronavirus pandemic
The end of globalization with the new coronavirus pandemicFernando Alcoforado
 
The great depression
The great depressionThe great depression
The great depressionRizze
 
Iraq War
Iraq WarIraq War
Iraq Warzmiers
 
Apres Nous Le Deluge
Apres Nous Le DelugeApres Nous Le Deluge
Apres Nous Le DelugeShamik Bhose
 
Unit 1 the great depression pp notes
Unit 1 the great depression pp notesUnit 1 the great depression pp notes
Unit 1 the great depression pp notesjizbicki
 
Cross comparision analysis of financial crisis
Cross comparision analysis of financial crisisCross comparision analysis of financial crisis
Cross comparision analysis of financial crisisShubham Khandelwal
 
THE GREAT DEPRESSION OF 1929
THE GREAT DEPRESSION OF 1929THE GREAT DEPRESSION OF 1929
THE GREAT DEPRESSION OF 1929SagarDuttPhuloria
 
Recession In The World Since 1900s
Recession In The World Since 1900sRecession In The World Since 1900s
Recession In The World Since 1900ssunny soni
 
Changing story of retirement
Changing story of retirementChanging story of retirement
Changing story of retirementMichael Green
 
Cost of the crisis in the USA
Cost of the crisis in the USACost of the crisis in the USA
Cost of the crisis in the USAManfredNolte
 
Inflation Targeting in Canada Re-evaluated
Inflation Targeting in Canada Re-evaluatedInflation Targeting in Canada Re-evaluated
Inflation Targeting in Canada Re-evaluatedEconomic Policy Dialogue
 

Was ist angesagt? (20)

Global Investment Returns Yearbook 2012
Global Investment Returns Yearbook 2012Global Investment Returns Yearbook 2012
Global Investment Returns Yearbook 2012
 
GLOBAL WORLD ECONOMIC PROBLEMS
GLOBAL WORLD ECONOMIC PROBLEMSGLOBAL WORLD ECONOMIC PROBLEMS
GLOBAL WORLD ECONOMIC PROBLEMS
 
The West _ Final Copy
The West _ Final CopyThe West _ Final Copy
The West _ Final Copy
 
The end of globalization with the new coronavirus pandemic
The end of globalization with the new coronavirus pandemicThe end of globalization with the new coronavirus pandemic
The end of globalization with the new coronavirus pandemic
 
finalproject
finalprojectfinalproject
finalproject
 
FDC Bi-Monthly Economic and Business Update. October 26, 2016
FDC Bi-Monthly Economic and Business Update. October 26, 2016FDC Bi-Monthly Economic and Business Update. October 26, 2016
FDC Bi-Monthly Economic and Business Update. October 26, 2016
 
The great depression
The great depressionThe great depression
The great depression
 
D Angelo Final Paper
D Angelo Final PaperD Angelo Final Paper
D Angelo Final Paper
 
Iraq War
Iraq WarIraq War
Iraq War
 
Apres Nous Le Deluge
Apres Nous Le DelugeApres Nous Le Deluge
Apres Nous Le Deluge
 
Unit 1 the great depression pp notes
Unit 1 the great depression pp notesUnit 1 the great depression pp notes
Unit 1 the great depression pp notes
 
C Rises And Newzealand Economy
C Rises And Newzealand EconomyC Rises And Newzealand Economy
C Rises And Newzealand Economy
 
USA
USAUSA
USA
 
Cross comparision analysis of financial crisis
Cross comparision analysis of financial crisisCross comparision analysis of financial crisis
Cross comparision analysis of financial crisis
 
THE GREAT DEPRESSION OF 1929
THE GREAT DEPRESSION OF 1929THE GREAT DEPRESSION OF 1929
THE GREAT DEPRESSION OF 1929
 
Recession In The World Since 1900s
Recession In The World Since 1900sRecession In The World Since 1900s
Recession In The World Since 1900s
 
Changing story of retirement
Changing story of retirementChanging story of retirement
Changing story of retirement
 
Cost of the crisis in the USA
Cost of the crisis in the USACost of the crisis in the USA
Cost of the crisis in the USA
 
Inflation Targeting in Canada Re-evaluated
Inflation Targeting in Canada Re-evaluatedInflation Targeting in Canada Re-evaluated
Inflation Targeting in Canada Re-evaluated
 
The power of macroeconomics part 1
The power of macroeconomics  part 1The power of macroeconomics  part 1
The power of macroeconomics part 1
 

Andere mochten auch

Eurozone Crisis and Financial Contagion
Eurozone Crisis and Financial ContagionEurozone Crisis and Financial Contagion
Eurozone Crisis and Financial ContagionAnurag Verma
 
Contracts and Systemic Risk in Europe
Contracts and Systemic Risk in EuropeContracts and Systemic Risk in Europe
Contracts and Systemic Risk in EuropeLuca Amorello
 
Global Law & Finance
Global Law & FinanceGlobal Law & Finance
Global Law & FinanceLuca Amorello
 
The power of Soft Law
The power of Soft Law The power of Soft Law
The power of Soft Law Luca Amorello
 
Rethinking Sovereign Debt
Rethinking Sovereign DebtRethinking Sovereign Debt
Rethinking Sovereign DebtLuca Amorello
 
Impact of recession toward malaysia economy
Impact of recession toward malaysia economyImpact of recession toward malaysia economy
Impact of recession toward malaysia economyClarie Chazz
 
I derivati di credito
I derivati di creditoI derivati di credito
I derivati di creditoLuca Amorello
 
Global Financial Crisis and its Impact on the Indian Economy
Global Financial Crisis and its Impact on the Indian EconomyGlobal Financial Crisis and its Impact on the Indian Economy
Global Financial Crisis and its Impact on the Indian EconomyShradha Diwan
 
Global financial crisis 2008
Global financial crisis 2008Global financial crisis 2008
Global financial crisis 2008valliappan1991
 
Global Economic Crisis
Global Economic CrisisGlobal Economic Crisis
Global Economic Crisiszain_kapoor
 

Andere mochten auch (12)

Eurozone Crisis and Financial Contagion
Eurozone Crisis and Financial ContagionEurozone Crisis and Financial Contagion
Eurozone Crisis and Financial Contagion
 
Contracts and Systemic Risk in Europe
Contracts and Systemic Risk in EuropeContracts and Systemic Risk in Europe
Contracts and Systemic Risk in Europe
 
Global Law & Finance
Global Law & FinanceGlobal Law & Finance
Global Law & Finance
 
Banking & Biology
Banking & BiologyBanking & Biology
Banking & Biology
 
The power of Soft Law
The power of Soft Law The power of Soft Law
The power of Soft Law
 
Rethinking Sovereign Debt
Rethinking Sovereign DebtRethinking Sovereign Debt
Rethinking Sovereign Debt
 
Contagion effect
Contagion effectContagion effect
Contagion effect
 
Impact of recession toward malaysia economy
Impact of recession toward malaysia economyImpact of recession toward malaysia economy
Impact of recession toward malaysia economy
 
I derivati di credito
I derivati di creditoI derivati di credito
I derivati di credito
 
Global Financial Crisis and its Impact on the Indian Economy
Global Financial Crisis and its Impact on the Indian EconomyGlobal Financial Crisis and its Impact on the Indian Economy
Global Financial Crisis and its Impact on the Indian Economy
 
Global financial crisis 2008
Global financial crisis 2008Global financial crisis 2008
Global financial crisis 2008
 
Global Economic Crisis
Global Economic CrisisGlobal Economic Crisis
Global Economic Crisis
 

Ähnlich wie Financial Crisis - Thinkline

An afro arab spring - socio-political trajectories in stemming the tide of th...
An afro arab spring - socio-political trajectories in stemming the tide of th...An afro arab spring - socio-political trajectories in stemming the tide of th...
An afro arab spring - socio-political trajectories in stemming the tide of th...Costy Costantinos
 
The Cause Of Global Financial Crisis
The Cause Of Global Financial CrisisThe Cause Of Global Financial Crisis
The Cause Of Global Financial CrisisBeth Johnson
 
U.S. Economic Crisis Essay
U.S. Economic Crisis EssayU.S. Economic Crisis Essay
U.S. Economic Crisis EssayLaura Olson
 
Global recession towards world economic depression
Global recession towards world economic depressionGlobal recession towards world economic depression
Global recession towards world economic depressionFernando Alcoforado
 
The Cause And Effects Of The Great Recession
The Cause And Effects Of The Great RecessionThe Cause And Effects Of The Great Recession
The Cause And Effects Of The Great RecessionNicole Savoie
 
The world before an insoluble economic crisis
The world before an insoluble economic crisisThe world before an insoluble economic crisis
The world before an insoluble economic crisisFernando Alcoforado
 
Covid19 Pandemic: Looming Global Recession and Impact on Bangladesh
Covid19 Pandemic: Looming Global Recession and Impact on BangladeshCovid19 Pandemic: Looming Global Recession and Impact on Bangladesh
Covid19 Pandemic: Looming Global Recession and Impact on BangladeshMd. Tanzirul Amin
 
ECO 202 – Written Assignment Scoring Rubric Complete th.docx
ECO 202 – Written Assignment Scoring Rubric  Complete th.docxECO 202 – Written Assignment Scoring Rubric  Complete th.docx
ECO 202 – Written Assignment Scoring Rubric Complete th.docxtidwellveronique
 
Essay On The Recession
Essay On The RecessionEssay On The Recession
Essay On The RecessionCindy Collins
 

Ähnlich wie Financial Crisis - Thinkline (20)

Essay About The Global Financial Crisis
Essay About The Global Financial CrisisEssay About The Global Financial Crisis
Essay About The Global Financial Crisis
 
Essay On Economic Crisis
Essay On Economic CrisisEssay On Economic Crisis
Essay On Economic Crisis
 
An afro arab spring - socio-political trajectories in stemming the tide of th...
An afro arab spring - socio-political trajectories in stemming the tide of th...An afro arab spring - socio-political trajectories in stemming the tide of th...
An afro arab spring - socio-political trajectories in stemming the tide of th...
 
The Cause Of Global Financial Crisis
The Cause Of Global Financial CrisisThe Cause Of Global Financial Crisis
The Cause Of Global Financial Crisis
 
The Day After
The Day AfterThe Day After
The Day After
 
Economic Crisis
Economic CrisisEconomic Crisis
Economic Crisis
 
U.S. Economic Crisis Essay
U.S. Economic Crisis EssayU.S. Economic Crisis Essay
U.S. Economic Crisis Essay
 
Essay On Economic Recession
Essay On Economic RecessionEssay On Economic Recession
Essay On Economic Recession
 
Global recession towards world economic depression
Global recession towards world economic depressionGlobal recession towards world economic depression
Global recession towards world economic depression
 
The Cause And Effects Of The Great Recession
The Cause And Effects Of The Great RecessionThe Cause And Effects Of The Great Recession
The Cause And Effects Of The Great Recession
 
World economy toward bankruptcy
World economy toward bankruptcyWorld economy toward bankruptcy
World economy toward bankruptcy
 
Presentation
PresentationPresentation
Presentation
 
The Threat Of Global Economy
The Threat Of Global EconomyThe Threat Of Global Economy
The Threat Of Global Economy
 
The world before an insoluble economic crisis
The world before an insoluble economic crisisThe world before an insoluble economic crisis
The world before an insoluble economic crisis
 
The Great Recession
The Great RecessionThe Great Recession
The Great Recession
 
Covid19 Pandemic: Looming Global Recession and Impact on Bangladesh
Covid19 Pandemic: Looming Global Recession and Impact on BangladeshCovid19 Pandemic: Looming Global Recession and Impact on Bangladesh
Covid19 Pandemic: Looming Global Recession and Impact on Bangladesh
 
ECO 202 – Written Assignment Scoring Rubric Complete th.docx
ECO 202 – Written Assignment Scoring Rubric  Complete th.docxECO 202 – Written Assignment Scoring Rubric  Complete th.docx
ECO 202 – Written Assignment Scoring Rubric Complete th.docx
 
Essay On The Recession
Essay On The RecessionEssay On The Recession
Essay On The Recession
 
Global Financial Crisis Essay
Global Financial Crisis EssayGlobal Financial Crisis Essay
Global Financial Crisis Essay
 
The 2008 Financial Crisis Essay
The 2008 Financial Crisis EssayThe 2008 Financial Crisis Essay
The 2008 Financial Crisis Essay
 

Mehr von Dr. Dhanpat Ram Agarwal (6)

WTO Referencer
WTO ReferencerWTO Referencer
WTO Referencer
 
The Swiss Connection
The Swiss ConnectionThe Swiss Connection
The Swiss Connection
 
Double Taxation Avoidance Agreement (DTAA)
Double Taxation Avoidance Agreement (DTAA)Double Taxation Avoidance Agreement (DTAA)
Double Taxation Avoidance Agreement (DTAA)
 
Dollar Drums
Dollar DrumsDollar Drums
Dollar Drums
 
Multilateralism at Crossroads
Multilateralism at CrossroadsMultilateralism at Crossroads
Multilateralism at Crossroads
 
Robbery of the Soil
Robbery of the SoilRobbery of the Soil
Robbery of the Soil
 

Kürzlich hochgeladen

Hungarys economy made by Robert Miklos
Hungarys economy   made by Robert MiklosHungarys economy   made by Robert Miklos
Hungarys economy made by Robert Miklosbeduinpower135
 
What Key Factors Should Risk Officers Consider When Using Generative AI
What Key Factors Should Risk Officers Consider When Using Generative AIWhat Key Factors Should Risk Officers Consider When Using Generative AI
What Key Factors Should Risk Officers Consider When Using Generative AI360factors
 
The unequal battle of inflation and the appropriate sustainable solution | Eu...
The unequal battle of inflation and the appropriate sustainable solution | Eu...The unequal battle of inflation and the appropriate sustainable solution | Eu...
The unequal battle of inflation and the appropriate sustainable solution | Eu...Antonis Zairis
 
Contracts with Interdependent Preferences
Contracts with Interdependent PreferencesContracts with Interdependent Preferences
Contracts with Interdependent PreferencesGRAPE
 
Sarlat Advisory - Corporate Brochure - 2024
Sarlat Advisory - Corporate Brochure - 2024Sarlat Advisory - Corporate Brochure - 2024
Sarlat Advisory - Corporate Brochure - 2024Guillaume Ⓥ Sarlat
 
2024.03 Strategic Resources Presentation
2024.03 Strategic Resources Presentation2024.03 Strategic Resources Presentation
2024.03 Strategic Resources PresentationAdnet Communications
 
ACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTES
ACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTESACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTES
ACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTESKumarJayaraman3
 
Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...
Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...
Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...Matthews Bantsijang
 
Taipei, A Hidden Jewel in East Asia - PR Strategy for Tourism
Taipei, A Hidden Jewel in East Asia - PR Strategy for TourismTaipei, A Hidden Jewel in East Asia - PR Strategy for Tourism
Taipei, A Hidden Jewel in East Asia - PR Strategy for TourismBrian Lin
 
Solution manual for Intermediate Accounting, 11th Edition by David Spiceland...
Solution manual for  Intermediate Accounting, 11th Edition by David Spiceland...Solution manual for  Intermediate Accounting, 11th Edition by David Spiceland...
Solution manual for Intermediate Accounting, 11th Edition by David Spiceland...mwangimwangi222
 
Stock Market Brief Deck for March 19 2024.pdf
Stock Market Brief Deck for March 19 2024.pdfStock Market Brief Deck for March 19 2024.pdf
Stock Market Brief Deck for March 19 2024.pdfMichael Silva
 
ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.
ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.
ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.KumarJayaraman3
 
Buy and Sell Urban Tots unlisted shares.pptx
Buy and Sell Urban Tots unlisted shares.pptxBuy and Sell Urban Tots unlisted shares.pptx
Buy and Sell Urban Tots unlisted shares.pptxPrecize Formely Leadoff
 
Stock Market Brief Deck for 3/22/2024.pdf
Stock Market Brief Deck for 3/22/2024.pdfStock Market Brief Deck for 3/22/2024.pdf
Stock Market Brief Deck for 3/22/2024.pdfMichael Silva
 
Monthly Market Risk Update: March 2024 [SlideShare]
Monthly Market Risk Update: March 2024 [SlideShare]Monthly Market Risk Update: March 2024 [SlideShare]
Monthly Market Risk Update: March 2024 [SlideShare]Commonwealth
 
Work and Pensions report into UK corporate DB funding
Work and Pensions report into UK corporate DB fundingWork and Pensions report into UK corporate DB funding
Work and Pensions report into UK corporate DB fundingHenry Tapper
 
MARKET FAILURE SITUATION IN THE ECONOMY.
MARKET FAILURE SITUATION IN THE ECONOMY.MARKET FAILURE SITUATION IN THE ECONOMY.
MARKET FAILURE SITUATION IN THE ECONOMY.Arifa Saeed
 
RWA Report 2024: Rise of Real-World Assets in Crypto | CoinGecko
RWA Report 2024: Rise of Real-World Assets in Crypto | CoinGeckoRWA Report 2024: Rise of Real-World Assets in Crypto | CoinGecko
RWA Report 2024: Rise of Real-World Assets in Crypto | CoinGeckoCoinGecko
 

Kürzlich hochgeladen (20)

Hungarys economy made by Robert Miklos
Hungarys economy   made by Robert MiklosHungarys economy   made by Robert Miklos
Hungarys economy made by Robert Miklos
 
What Key Factors Should Risk Officers Consider When Using Generative AI
What Key Factors Should Risk Officers Consider When Using Generative AIWhat Key Factors Should Risk Officers Consider When Using Generative AI
What Key Factors Should Risk Officers Consider When Using Generative AI
 
The unequal battle of inflation and the appropriate sustainable solution | Eu...
The unequal battle of inflation and the appropriate sustainable solution | Eu...The unequal battle of inflation and the appropriate sustainable solution | Eu...
The unequal battle of inflation and the appropriate sustainable solution | Eu...
 
Contracts with Interdependent Preferences
Contracts with Interdependent PreferencesContracts with Interdependent Preferences
Contracts with Interdependent Preferences
 
Effects & Policies Of Bank Consolidation
Effects & Policies Of Bank ConsolidationEffects & Policies Of Bank Consolidation
Effects & Policies Of Bank Consolidation
 
Sarlat Advisory - Corporate Brochure - 2024
Sarlat Advisory - Corporate Brochure - 2024Sarlat Advisory - Corporate Brochure - 2024
Sarlat Advisory - Corporate Brochure - 2024
 
2024.03 Strategic Resources Presentation
2024.03 Strategic Resources Presentation2024.03 Strategic Resources Presentation
2024.03 Strategic Resources Presentation
 
ACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTES
ACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTESACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTES
ACCOUNTING FOR BUSINESS.II BRANCH ACCOUNTS NOTES
 
Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...
Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...
Remembering my Totem _Unity is Strength_ growing in Bophuthatswana_Matthews B...
 
Taipei, A Hidden Jewel in East Asia - PR Strategy for Tourism
Taipei, A Hidden Jewel in East Asia - PR Strategy for TourismTaipei, A Hidden Jewel in East Asia - PR Strategy for Tourism
Taipei, A Hidden Jewel in East Asia - PR Strategy for Tourism
 
Solution manual for Intermediate Accounting, 11th Edition by David Spiceland...
Solution manual for  Intermediate Accounting, 11th Edition by David Spiceland...Solution manual for  Intermediate Accounting, 11th Edition by David Spiceland...
Solution manual for Intermediate Accounting, 11th Edition by David Spiceland...
 
Stock Market Brief Deck for March 19 2024.pdf
Stock Market Brief Deck for March 19 2024.pdfStock Market Brief Deck for March 19 2024.pdf
Stock Market Brief Deck for March 19 2024.pdf
 
Monthly Economic Monitoring of Ukraine No.230, March 2024
Monthly Economic Monitoring of Ukraine No.230, March 2024Monthly Economic Monitoring of Ukraine No.230, March 2024
Monthly Economic Monitoring of Ukraine No.230, March 2024
 
ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.
ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.
ACCOUNTING FOR BUSINESS.II DEPARTMENTAL ACCOUNTS.
 
Buy and Sell Urban Tots unlisted shares.pptx
Buy and Sell Urban Tots unlisted shares.pptxBuy and Sell Urban Tots unlisted shares.pptx
Buy and Sell Urban Tots unlisted shares.pptx
 
Stock Market Brief Deck for 3/22/2024.pdf
Stock Market Brief Deck for 3/22/2024.pdfStock Market Brief Deck for 3/22/2024.pdf
Stock Market Brief Deck for 3/22/2024.pdf
 
Monthly Market Risk Update: March 2024 [SlideShare]
Monthly Market Risk Update: March 2024 [SlideShare]Monthly Market Risk Update: March 2024 [SlideShare]
Monthly Market Risk Update: March 2024 [SlideShare]
 
Work and Pensions report into UK corporate DB funding
Work and Pensions report into UK corporate DB fundingWork and Pensions report into UK corporate DB funding
Work and Pensions report into UK corporate DB funding
 
MARKET FAILURE SITUATION IN THE ECONOMY.
MARKET FAILURE SITUATION IN THE ECONOMY.MARKET FAILURE SITUATION IN THE ECONOMY.
MARKET FAILURE SITUATION IN THE ECONOMY.
 
RWA Report 2024: Rise of Real-World Assets in Crypto | CoinGecko
RWA Report 2024: Rise of Real-World Assets in Crypto | CoinGeckoRWA Report 2024: Rise of Real-World Assets in Crypto | CoinGecko
RWA Report 2024: Rise of Real-World Assets in Crypto | CoinGecko
 

Financial Crisis - Thinkline

  • 1. GLOBAL MELTDOWN: ROAD AHEAD Contents Publisher’s Desk Preface 1. Introduction 2. Economic Crisis – Nature and extent of different economic crisis from early 19th century till the present global crisis of 2008. a. Prior to Bretton Wood Institutions b. Post Bretton Wood Institutions 3. Causes of Present Global Crisis and its Analysis 4. Financial Stimulus and Bailout Packages 5. Wayout for a new Global Economic System 6. Conclusions and Summary
  • 2. GLOBAL MELTDOWN: ROAD AHEAD PREFACE People were worried about global warming but got the global meltdown. Unfortunately not the meltdown of the toxic garbage in the environment emitting GHG or CO2 but the meltdown of the sizzling economy founded on the edifice of Inequality, Poverty, Unsustainable Consumption and unbalanced growth. People were worried about rising food and fuel prices, now they are worried about the falling prices causing deflation, unemployment and closure of industries. The roads in US were crowded with trucks and automobiles but now people are afraid of driving on empty roads. The gas stations were busy with queues, now they are closing down in queues. The housing prices were roaring and soaring but now people are ignoring and snoring with foreclosures. The banks were flushed with funds, now their money chests are crushed. The stock market prices were touching the sky, now they are touching the floor. People were going for overconsumption now they are forced to under consumptions. People were going to US for Jobs, now they are returning home without Jobs. People were looking at Obama for Change, now Obama is looking at People for change. The global financial crisis has earth shattering effects on the global financial system which has clamped down the production and employment to a standstill situation. The banks are becoming insolvent and are filing for bankruptcies. There is almost complete erosion in the value of wealth of the households. The corporates are announcing production cut, job cut, wage cut and many of them are closing down their shutters. The contraction in economy is alarmingly high in US, Japan, China and Russia apart for several other countries in Europe and Asia. India is not an exception and the third quarter results for 2008-09 are very disappointing with GDP growth slipping down to 5.3 percent, lowest in past six years as per latest advance estimates given by Central Statistics organization of Govt. of India. There is contraction in agricultural growth by 2.2 percent and in manufacturing by 0.2 percent. There have been announcements for fiscal incentives by reduction in the excise and service taxes but the shrinkage in the economy continues. At this juncture the Govt. of United States of America and the Federal Reserve are trying to provide financial stimulus packages with trillions of dollars for rebuilding and revitalizing the confidence of the investors and the consumers, but the crisis is so deep and bottomless that it is yet to buzz or take a note of any such measures. The move is from Market to Mark to Marx. There is failure of the market economy. The balance sheet of the financial institutions are in red as they are obliged to mark the securities at the market price which are ruling at almost one tenth of their original value. The Government is recapitalizing and nationalizing the banks by following the principles of ‘economic nationalism’ or moving the way of Marxism or Socialism. Alas Marxism has already surrendered and failed two decades before in Russia with the fall of Berlin Wall in 1989 and soon thereafter it left China which hurriedly adored Capitalism. Today both, Capitalism and Marxism are at their ruins and the world is demanding a new economic order. The US Government is trying to bring back protectionism with stipulation of ‘Buy American’ through the financial stimulus package. Is it the repetition of Smoot-Hawley Tariff Act of Great Depression which deepened the crisis further? There is wide spread monetization of fiscal deficits which will certainly lead to a crash in the current value of US dollar and will cause substantial erosion in the value of wealth possessed by the people around the world. China is in a dilemma where to keep its foreign exchange reserve of $1.9 trillion equal to almost 30% of the total international reserve. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 2
  • 3. GLOBAL MELTDOWN: ROAD AHEAD The present financial architecture created under the aegis of Bretton Wood Institutions in the name of IMF, World Bank and WTO has proved to be irrelevant and is unable to provide any solution to the present global meltdown. The world community is looking for a change in the global economic system for which a meeting of G-20 is scheduled in the first week of April 2009 at London. The present booklet is a humble attempt to analyse the ongoing global economic crisis. The author has tried to analyse the present crisis in the context of several economic crises of the past including the very first economic panic of 1819 in the post industrial revolution period and the Great Depression of 1929 representing the crises of the 19 th and the 20th century. The present crisis, the first ever in the 21st century of such a great magnitude is identified to be an outcome of erratic and excessive consumption of US households, the greed of financial institutions and the heavy debt burden of the households along with irrational borrowing by the Government of United States. The World has experienced the failure of communism as well as the failure of capitalism. The time is for introspection to look for the ‘Third Way’ which will be more humanistic in nature, environment friendly and will be based on sustainable consumption. The World is looking for a change and the present generation has an obligation to provide for a solution for a sustainable and balanced development model for just and equitable share of growth to downtrodden people around the world. The present crisis should be taken as an opportunity and a blessing in disguise to remove the toxic elements from the present economic system to be replaced by a harmonious economic system. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 3
  • 4. GLOBAL MELTDOWN: ROAD AHEAD Introduction The present global meltdown is a culmination of several factors, the most important being irrational and unsustainable consumption in the West particularly in United States disproportionate to its income by consistent borrowings fueled by savings and surpluses of the East particularly China and Japan. The second important factor is the greed of the investment bankers who induced housing loans by uncontrolled leveraging on an optical illusion of increasing prices in the housing sector. The third important factor is the failure of the regulating agencies who ignored the warning signals arising out of the ballooning debts, derivatives and financial innovation on the assumption that the Collateral Debt Obligation (CDO), the Credit Default Swapping (CDS) and Mortgaged Backed Securities (MBS) would continue to remain safe with the mortgage guarantees provided by Government Sponsored Enterprises (GSEs) namely Fannie Mae and Freddie Mac which had enjoyed the political patronage since inception. There are other several factors including shadow banking system, financial leveraging by the investment bankers and lack of adequate disclosures in the financial statements leading to fallacious ratings by the rating agencies. Though the depth of the crises seem like a bottomless pit, as the situation is worsening and alarming as the defaults are likely to avalanche from the initial shock of subprime security to prime security and especially the Alt-A1 mortgaged loans which amount to US$ 1.5 trillion and the likely further default could be to the tune of US$ 600 billion, a size equal to the subprime mortgages. Once this happens, the bankruptcy which has been limited to investment bankers with some troubles in the banking sector may bring a further serve catastrophe in the entire banking and financial sector and may ultimately turn the present recessionary trend to a situation much deeper than what happened in the Great Depression of 1930s. The financial stimulus provided by the US Administration partly to fund the toxic assets and partly by way of recapitalization and nationalization of banks and to certain other sectors of the economy with the stipulation of ‘Buy American’ may be a repetition of protectionism under the garb of economic nationalism as infused by Smoot Hawley Tariff Act2 on June 17th, 1930. All the economic crises whether termed as economic slowdown or recession or depression are generally found to have link with the boom and boost theory of trade cycle in a free market economy, the empirical studies of several crises dating as back as the panic of 1819 shows the 1 Alt-A mortgage is a type of loan where the risk profile falls between prime and the subprime generally this kind of loan is given to the borrowers with clean credit histories but the loan amount is generally higher than the value of security and thus the mortgage is comparatively more risky than those backed by prime securities at a comparatively higher rate of interest. 2 The Smoot-Hawley Tariff Act of June 1930 raised U.S. tariffs to historically high levels. Such policies contributed to a drastic decline in international trade. For example, U.S. imports from Europe declined from a 1929 high of $1,334 million to just $390 million in 1932, while U.S. exports to Europe fell from $2,341 million in 1929 to $784 million in 1932. World trade declined by some 66% between 1929 and 1934. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 4
  • 5. GLOBAL MELTDOWN: ROAD AHEAD failure of the banking system as the primary cause of all the major crisis. The panic of 1819 marked the beginning of new phase of American economic history following the Anglo American war of 1812 (1812-1815), which resulted in widespread foreclosures, bank failure, unemployment and a slump in agriculture and manufacturing sector. It was perhaps the first ever economic crises after the Industrial revolution and the re-establishment of the dollar. Recession implies negative growth for two consecutive quarters. However, the National Bureau of Economic Research (NBER) of US explains recession as a significant decline in activity spread across economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade. Some economists view recession as a period when growth falls significantly below its long term potential. On December 1 2008, the NBER officially declared that the U.S. economy had entered recession in December, 2007. According to latest statement made by Federal Reserve Chairman Mr. Ben Bernanke the worst is yet to come for US. Fed believes that the economy will contract in 2009 between 0.5 and 1.3 percent against the earlier forecast of shrinking by only 0.2 or expansion by 1.1 percent and this may be the first since 1991 when there was contraction for the full year. The third quarter shrinkage has happened with a contraction of 6.2 percent biggest ever since 1982.The unemployment forecast for the full year is 8.8 percent. These forecasts have been announced by Fed after the fresh financial stimulus announced by Obama administration for US$ 789 through a law on 17th February 2009. The financial crisis has moved into an Industrial crisis now as countries after countries are sharing negative results in their manufacturing and services sectors. In Germany, the machine tool orders in December 2008 were 40 percent lower as compared to last year. In China, more than 50 percent of the 9000 toy manufactures and exporters have gone bust. The industrial hubs of Shenzhen and Guangzhou providing employment to tens of millions of migrant workers are turning out to be ghost towns. In the past one year, one third to half of total factories manufacturing cheap toys, cloths, shares and electronics have closed down. Japan the second largest economy of the world next only to US has contracted by 3.3 percent in the fourth quarter in 2008, the biggest contraction in the past 35 years despite the Japan’s central bank keeping the interest rates as low as 0.1 percent. According to several forecasts, the contraction in the whole of 2009 will be around 4 percent, twice as severee as in America and Europe. The latest figures published by Office for National Statistics on 23rd January, 2009 confirmed that Britain has officially slipped into recession. The British economy contracted by 1.5% in the last three months of the fourth quarter in 2008. This makes it the worst performance in over 28 years. India is not an exception and the third quarter results for 2008-09 are very disappointing with GDP growth slipping down to 5.3 percent as per latest advance estimates given by Central Statistics organization of Govt. of India. There is contraction in agricultural growth by 2.2 © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 5
  • 6. GLOBAL MELTDOWN: ROAD AHEAD percent and in manufacturing by 0.2 percent. There have been announcements for fiscal incentives by reduction in the excise and service taxes but the shrinkage in the economy continues. French President Nicholas Sarkozy, current president of European Union, has spoken of a need “to rethink the entire financial and monetary system… to create the tools for worldwide regulation”. German Finance Minister Peer Steinbrueck declared that "The USA will lose its superpower status in the global financial system. The world financial system is becoming multipolar." The present global crisis can be termed as a financial tsunami. The depth of the crisis is yet to be determined. It started with sub prime crisis last year and has gradually expanded to all spheres of economic life including the real economy resulting into global slowdown. Two Important meetings at global level have taken place between G7 group and the G20 group of countries. The voice of the most of the developing countries held on 15th November 2008 was that there is a need to change the present financial architecture created through Bretton Wood Institution in which the voice of developing countries need to be heard and that there is need for creating a new economic system by formation of United Nations Economic Council. The world is looking for a change and solution which may come through the forthcoming G20 meeting to be held in London on 2nd April 2009 under the chairpersonship of Barak Obama, the new president of US, a prime mover and a pivotal force behind bringing change in the slow world. The G20 Meet may be looked as Bretton Woods-II after 64 years of Bretton Woods Conference held in July 1944. It will be in fitness of things if global wisdom prevails to dismantle the present Bretton Wood System functioning under Anglo-Saxon Model of the Global Financial System. Joseph Stiglitz, the former Chief Economic Advisor of IMF and a noble laureate and several other right thinking economists have been talking about the irrelevance of the present financial architecture and to re-visit the Bretton Wood Institutions (BWIs). The whole world is in the grip of Economic Slow-Down which may lead to Global Recession or Depression since after the Great Depression of 1930’s. The genesis of the crisis which started in the form of Sub-Prime crisis in USA in around 2007, lies in the new financial innovations and unregulated derivative transactions coupled with unbridled leveraging by the Investment Bankers since the year 2000. The Notional value of all outstanding global contracts for derivative transactions at the end of 2007 reached to US$ 600 trillion, growing at a stunning pace during the years 2001-2007. This astronomical amount of outstanding derivatives contracts of US$ 600 trillion is approximately 11 times of the global value of GDP which is about US$ 55 trillion. Just a decade before, this value was only US$ 75 trillion which was merely 2.5 times of the Global GDP at that time. These figures have been estimated by the Bank of International Settlement. These derivatives instruments have been termed as the “financial weapons of mass destruction” by the world famous investor Warren Buffet as a warning in the year 2003. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 6
  • 7. GLOBAL MELTDOWN: ROAD AHEAD It would be pertinent to take stock of the nature and extent of various economic crises which had taken place over the last two centuries especially after or at the inception of the industrial revolution.3 The first recorded economic panic took place in United States in the year 1819 after the Anglo-American War during 1812-1814. However, there is a noticeable difference between the economic crises which took place in the 19th century and those which had taken place in the 20th and the 21st century. It has been thought proper to analyse these economic crises in two parts, one before the establishment of the Bretton Wood Institutions in 1944 and the other which took place thereafter. The first category of economic crises can also be categorized as period covering industrial revolution to World War II during colonialism and the second category as an era of post-colonial world from 1945 till 2008 and beyond. The first documented business cycle is in the Bible, where Joseph tells the Pharaoh to expect seven years of plenty followed by seven lean years. This is probably defined by an old joke which says when your neighbour loses his job; it is called an economic slowdown. When you lose your job, it is a recession. But when an economist loses his job, it becomes a depression. 3 [The Industrial Revolution started in Britain with the mechanization of textile industries in the late 18th and the early 19th century. The period of Industrial Revolution is 1780s to 1840s] © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 7
  • 8. GLOBAL MELTDOWN: ROAD AHEAD Economic Crisis – Nature and extent of different economic crisis from early 19th century till the present global crisis of 2008 The Twin nature of financial cum Banking crisis of United States The history and experience of banking crisis since 1970s and particularly after withdrawal of commitment by US to exchange 35 US dollar in lieu of one ounce of gold in 1973 that led to the failure of Bretton Wood System, offer a large array of lessons for the policy makers. According to IMF data base there were 124 systematic banking crisis since 1970s and more noticeable are of Japan in late 1980s, Nordic bank crisis in early 1990s and the East Asian banking crisis in 1997. Each of these crises is preceded by property bubble bust accompanied by credit boom as we can see in the present US sub-prime crisis turned banking crisis of 2007-2008. There are however differences in the nature and the extent of these crisis. Though East Asian crisis lasted for less than two years in South Korea, Malaysia, Indonesia, Thailand and Philippines, because it followed quick action by contracting lending and with restrictions on investments and borrowings. The biggest support for quick recovery to East Asian crisis was the pull in international demand and consequent export led growth. In Japan, the experience was not good as the slump in the economy continued over a decade due to slow action from Japanese authorities. Japan’s central bank took too long to fight deflation and its fiscal stimulus was withdrawn too early with increase in taxes in 1997 and there was delay in recapitalization of banking sector which took place in 1998, almost after a decade but Japan could forbear all these recessionary pressure for such a long period mainly because that it remained a surplus country with huge savings and forex reserves and was also under an advantageous position because of demand for its exports, in the world market. The vital difference therefore in the banking crisis in Japan and in East Asian countries and those in Sweden was that the world was not passing through the severe demand construing as we notice in the present global crisis. The other impartment reasons which distinguishes the present US banking crisis is the character of the crisis which is twofold: One in the banking sector and the other in the financial sector or what can be termed as the “Shadow Banking System” of US led by the so called financial innovation and derivatives in the fragmented US banking and financial sector. The surge in banking is another factor as the private sector debt surged from US$ 22 trillion in 2000 (Equivalent to 222% of US GDP) to $ 41 trillion (almost 294% of US GDP) in 2007. This was accompanied by a very higher percentage of nonperforming loans in US as compared to Japan or Sweden. According to the IMF, such non-performing loans in Sweden were just 13% at the peak of the crisis in early 1990s wherever in Japan it was a little higher at around 35% of GDP but still much lower as compared to US where it amounts to around US $ 5.7 trillion or almost 40 per cent of its GDP. If one looks at the huge borrowings of US from the rest of the world which is more than US $ 10 trillion, one can only wonder as to how the World’s largest debtor nation can afford to have almost zero rate of interest and its currency artificially so strong at this hour of crisis. A country on the verge of bankruptcy, with its currencies © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 8
  • 9. GLOBAL MELTDOWN: ROAD AHEAD appreciating against all major currency of the world at this juncture is the seventh wonder of the world and one can only predict that the US dollar is heading for a crash in very near future unless some miracle happens with its economy. Economic Crisis Prior to Bretton Wood Institutions Economic crises during the colonial era – The major crises that took place during this period are the economic panic of 1819, 1869, 1873, 1884, 1893, 1896, 1901, 1907 and the Great Depression of 1929. We shall give a brief description of some of these crises and their impact on the global economy and the economic system in the following paragraphs. Economic panic of 1819 – The first major financial crises that took place in United States was in 1819 as the first experience of boom bust cycle to the modern economists. It was by and large failure of the banking system. This crisis was an aftermath of Anglo-American War of 1812. During this time America was a thinly populated country of merely seven million people largely depending upon agriculture. The three major cities namely New York, Philadelphia and Boston inhabited only 7% of the country’s population and were trading depots channeling exports to and import from abroad. There was boom in the economy after the war which continued upto 1818. However, the decline started in 1819 with a total export falling from $93 million in 1818 to $70 million in 1819-1820 and imports falling from $122 million in 1818 to $87 million in 1819. Imports from Great Britain fell from $42 million in 1818 to $14 million in 1820 and especially the imports of cotton and woolen from Britain from over $14 million each in 1818 to about $5 million. By 1821, the depression had begun to clear and was in a slow path of recovery. The panic had resulted in widespread foreclosures, bank failures, unemployment and a slump in agriculture and manufacturing. Economic panic of 1869 – The 1869 crisis took place on September 24th 1869 by way of a scandal to corner the gold market by a group of speculators held by James Fisk and Jay Gould by involving one of the close relative of Ulysses S. Grant, the then President of United States (March 4, 1869 – March 4, 1877). This was to make speculative gains from the price of sudden spurt in gold price as the US Government had assured buyback of Dollar with gold as the money in Dollar was issued during American Civil War. However, the Federal Government sold $4 billion in gold and the premium plummeted within minutes. This caused a severe panic in New York Gold Exchange and the investors lost heavily. This crisis took place because of the gold conspiracy. Economic panic of 1907 –The major economic crises that took place in 1869 was followed by the panic of 1907, being the first financial crises of the 20th century with a major impact on the New York Stock Exchange which fell close to 50% from its peak of the previous year. The Fed Reserve had not come into existence and in the absence of any Central Bank as the lender of the last resort, J P Morgan then the famous financer came forward by infusing huge money to rescue US Treasury and generate confidence in the banking system as he did during the panic of 1893. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 9
  • 10. GLOBAL MELTDOWN: ROAD AHEAD Although there is no established empirical link between the depression of 1907 and the First World War of 1911 and the similar repetition of the events by the prolonged Great Depression of 1929-1938 and the beginning of the second world war 1939 (1939-1945). There seems to be some impending danger of major economic conflicts between China and US during the present crisis. The visit of Ms. Hillary Clinton the Secretary of State, to China is very crucial in this respect as China holds the key with large amount of investments in US treasury bonds and withdrawal or diversion of such investment may bring the entire US economy to its bottom and China may ask for some heavy price in political terms. The peace in South-Asia is also equally important. The establishment of Bretton Wood Institutions4 in July 1944 have not been a panacea to the repetition of global economic crises and the global economic conflicts. The Great Depression of 1929: It was the largest and most important worldwide economic downturn in modern history after the roaring boom period of twenties which is also known as the golden age of innovation in several field of technology. On August 24, 1921, the Dow Jones Industrial Average stood at a value of 63.9. By September 3, 1929, it had risen more than six fold, touching 381.2. The crisis originated in the United States and its starting date is counted from the stock market crash or the Wall Street Crash on October 29, 1929, known as Black Tuesday. On Black Tuesday, the Dow Jones Industrial Average fell 38 points to 260, a drop of 12.8% The depression ended after almost nine or ten years but coincided with the beginning of the World War II around 1939. The decline in the American economy was the factor that pulled down most other countries due to protectionist policies, such as the 1930 U.S. Smoot-Hawley Tariff Act and retaliatory tariffs in other countries, exacerbated the collapse in global trade. By late in 1930, a steady decline set in which reached bottom by March 1933. By the end of the week of November 11, the index stood at 228, a cumulative drop of 40 percent from the September high. The markets rallied in succeeding months but it was like a dead cat bounce that led unsuspecting investors into the worst economic crisis of modern times. The Dow Jones Industrial Average lost 89% of its value before finally bottoming out in July 1932. There were multiple causes for the first downturn in 1929 but according to historians, structural factors like massive bank failures and the stock market crash, while some economists attribute it to the decision of British Government to return to the Gold Standard at pre-World War I parities (US$4.86:£1). Irving Fisher argued that the predominant factor leading to the Great Depression was over indebtedness and deflation. After the panic of 1929, and during the first 10 months of 1930, 744 4 John Maynard Keynes, an economist from UK and Harry Dexter White, an economist from US was the intellectual founding founders of the Bretton Wood System. Bretton Woods established a system of payment based on Dollars in which all International currencies were defined in relation to the Dollar which US had agreed to return in terms of one ounce of gold in exchange of $35 and thus making the Dollar as good as gold or the Dollar becoming the world currency and most of the international transactions were denominated in Dollar. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 10
  • 11. GLOBAL MELTDOWN: ROAD AHEAD US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday. In 1937 the American economy took an unexpected nosedive, lasting through most of 1938. Production declined sharply, as did profits and employment. Unemployment jumped from 14.3% in 1937 to 19.0% in 1938. As the Depression was on, Roosevelt announced a ‘New Deal’, spent on public works, farm subsidies, and other devices to restart the economy, but never completely gave up trying to balance the budget. Keynes General Theory on Employment and Growth, which was published in 1936 provided the real mantra to tide over the Great Depressions. Economic Crisis Post Bretton Wood Institutions The period after the Second World War and especially after the Great Depression of 1929-38, witnessed a period of economic stability in the global economic system for about three decades, till the time United States maintained its obligation to exchange one ounce of gold against $35. This period may be termed as a period of economic stability when the war ravaged countries were busy in rebuilding their economic infrastructure. The problem started with the first oil price hike by the OPEC group of countries in 1973 and the buildup of petro dollar, which caused huge amounts of deficit causing balance of payment crisis in United States which imposed unilateral embargo on the gold window and ultimately was forced to withdraw its commitment to exchange gold in lieu of dollar which was the major currency for all international transactions and foreign exchange reserves. The post Bretton Wood Economic System has also witnessed several economic crisis particularly after refusal of returning gold in lieu of US dollar which formed the backbone of Bretton Wood System which motivated countries around the world to accept US Dollar as international reserve currency and the rest is history with a series of economic failures and crises culminating between 1980’s till date over the past three decades. A short list of some major financial crises since 1980 • 1980s: Latin American debt crisis, beginning in Mexico • 1989-91: United States Savings & Loan crisis • 1990s: Collapse of the Japanese asset price bubble • 1992-3: Speculative attacks on currencies in the European Exchange Rate Mechanism • 1994-5: 1994 economic crisis in Mexico: speculative attack and default on Mexican debt • 1997-8: Asian Financial Crisis: devaluations and banking crises across Asia • 1998: 1998 Russian financial crisis: devaluation of the ruble and default on Russian debt © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 11
  • 12. GLOBAL MELTDOWN: ROAD AHEAD • 2001-2: Argentine economic crisis (1999-2002): breakdown of banking system • 2008: Global financial crisis The debt crisis of the 1980’s which started in August 18, 1982 in Mexico and other Latin American countries was in aftermath of first oil shock of 1973 when the petro dollar was recycled from oil rich countries to American Banks who in turn lent blindly to Latin American countries who failed to repay the same and had to be bailed out by IMF through Brady and Baker plans which finally took the color of Washington Consensus in 1989. The policy prescriptions in the name of economic reform under structural adjustment program became a financial rule in all subsequent year for the countries falling in the trap of either currency crisis or the stock market crisis in the recent three decades of liberalization and globalization. The repeat of the some of the major crisis is the collapse of the Japanese asset price bubbles in 1990s after the Plaza Accord, the speculative attacks on the European exchange rate mechanism during 1992-93, the Peso crisis due to speculative attacks and hot money flow in Mexico during 1994-85, the East Asian Financial crisis during 1997-98, followed by Russian financial crisis and the Argentine economic crisis during 1998-2002. There have been several reasons behind these economic crisis but a few glaring pointers are the burg coming current deficits, net money flow, capital account convertibility coupled with speculative bubbles in stock market and the real estate prices. The present crisis is unprecedented in the history of economic globalism perpetrated and nurtured and flourished from the Wall Street since after the Second World War and post creation of the financial architecture of IMF and World Bank and possibly this is the first occasion where the resource of IMF has failed to provide any bailout package as the quantum of crisis runs into trillions of dollar across the globe with a major chunk of impact taking place in United States. Therefore, the present crisis is termed as the global crisis and looks for a global solution. Brief highlights of some of the major crisis are as below:- The Crash of 1987 The mid-1980s were a time of strong economic optimism. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2722. The rise in market indices for the 19 largest markets in the world averaged 296 percent during this period. The crash on October 19, 1987, a date that is also known as Black Monday, was the climactic culmination of a market decline that had begun five days before on October 14th. The DJIA fell 3.81 percent on October 14, followed by another 4.60 percent drop on Friday October 16th. On Black Monday, the Dow Jones Industrials Average plummeted 508 points, losing 22.6% of its value in one day. The Crash was the greatest single-day loss that Wall Street had ever suffered in continuous trading up to that point. Between the start of trading on October 14th to the close on October 19, the DJIA lost 760 points, a decline of over 31 percent. Despite fears of a repeat of the 1930s Depression, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 12
  • 13. GLOBAL MELTDOWN: ROAD AHEAD October 22. It took only two years for the Dow to recover completely; by September 1989, the market had regained all of the value it had lost in the 1987 crash. No definitive conclusions have been reached on the reasons behind the 1987 Crash. Stocks had been in a multi-year bull run and market P/E ratios in the U.S. were above the post-war average. Aside from the general worries of stock market overvaluation, blame for the collapse has been apportioned to such factors as program trading, portfolio insurance and derivatives, and prior news of worsening economic indicators (i.e. a large U.S. merchandise trade deficit and a falling U.S. dollar which seemed to imply future interest rate hikes).[5] One of the consequences of the 1987 Crash was the introduction of the circuit breaker or trading curb on the NYSE. 1997 Asian Financial Crisis The Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown (financial contagion). This was preceded by the Peso Crisis in Mexico in 1994-95, which was more a equity crisis and arose primarily due to hot money flow. The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven. Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in 1993-96, and then shot up beyond 180% during the worst of the crisis. Although most of the governments of Asia had seemingly sound fiscal policies, the International Monetary Fund (IMF) stepped in to initiate a $40 billion program to stabilize the currencies of South Korea, Thailand, and Indonesia, economies particularly hard hit by the crisis. The efforts to stem a global economic crisis did little to stabilize the domestic situation in Indonesia, however. By 1999, however, analysts saw signs that the economies of Asia were beginning to recover. Until 1997, Asia attracted almost half of the total capital inflow from developing countries. The economies of Southeast Asia in particular maintained high interest rates attractive to foreign investors looking for a high rate of return. As a result the region's economies received a large inflow of money and experienced a dramatic run-up in asset prices. At the same time, the regional economies of Thailand, Malaysia, Indonesia, Singapore, and South Korea experienced high growth rates, 8-12% GDP, in the late 1980s and early 1990s. This achievement was widely acclaimed by financial institutions including the IMF and World Bank, and was known as part of the "Asian economic miracle". In 1994, noted economist Paul Krugman published an article attacking the idea of an "Asian economic miracle". He argued that East Asia's economic growth had historically been the result of capital investment, leading to growth in productivity. However, total factor productivity had increased only marginally or not at all. Krugman argued that only growth in total factor productivity, and not capital investment, could lead to long-term prosperity. Krugman's views © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 13
  • 14. GLOBAL MELTDOWN: ROAD AHEAD would be seen by many as prescient after the financial crisis had become full-blown, though he himself stated that he had not predicted the crisis nor foreseen its depth. Argentine economic crisis (1999–2002) The Argentine economic crisis was part of the situation that affected Argentina's economy during the late 1990s and early 2000s. The critical period started with the decrease of real GDP in 1999 and ended in 2002 with the return to GDP growth, but the origins of the collapse of Argentina's economy, and their effects on the population, can be found in action before. As of 2005, arguably the crisis was over, though many challenges remain for the country. The state eventually became unable to pay the interest of this debt and confidence in the Austral collapsed. Inflation, which had been held to 10 to 20% a month, spiraled out of control. In July 1989, Argentina's inflation reached 200% that month alone, topping 5,000% for the year. The Present Global crisis of 2008 Beginning on September 16, failures of large financial institutions in the United States, due primarily to exposure to securities of packaged subprime loans and credit default swaps issued to insure these loans and their issuers, rapidly evolved into a global crisis resulting in a number of bank failures in Europe and sharp reductions in the value of equities (stock) and commodities worldwide. In the United States, 15 banks failed in 2008, while several others were rescued through government intervention or acquisitions by other banks. On October 11, 2008, the head of the International Monetary Fund (IMF) warned that the world financial system was teetering on the "brink of systemic meltdown" The sequence of the event can be summarized as below for understanding at a glance. • Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2 billion. The sale was conditional on the Fed's lending Bear Sterns US$29 billion on a nonrecourse basis. • The GSEs Fannie Mae and Freddie Mac were both placed in conservatorship in September 2008. The two GSEs have more than US$ 5 trillion in mortgage backed securities (MBS) and other debt outstanding. • Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion. • Scottish banking group HBOS agreed on 17 September 2008 to an emergency acquisition by its UK rival Lloyds TSB, after a major decline in HBOS's share price stemming from growing fears about its exposure to British and American MBSs. The UK government made this takeover possible by agreeing to waive its competition rules. • Lehman Brothers declared bankruptcy on 15 September 2008, after the Secretary of the Treasury Henry Paulson, citing moral hazard, refused to bail it out. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 14
  • 15. GLOBAL MELTDOWN: ROAD AHEAD • AIG received an $85 billion emergency loan in September 2008 from the Federal Reserve, which AIG is expected to repay by gradually selling off its assets. In exchange, the Federal government acquired a 79.9% equity stake in AIG. • Washington Mutual (WaMu) was seized in September 2008 by the USA Office of Thrift Supervision (OTS). Most of WaMu's untroubled assets were to be sold to J.P. Morgan Chase. • British bank Bradford & Bingley was nationalised on 29 September 2008 by the UK government. The government assumed control of the bank's £50 billion mortgage and loan portfolio, while its deposit and branch network are to be sold to Spain's Grupo Santander. • In October 2008, the Australian government announced that it would make AU$4 billion available to nonbank lenders unable to issue new loans. After discussion with the industry, this amount was increased to AU$8 billion. • In November 2008, the U.S. government announced it was purchasing $27 billion of preferred stock in Citigroup, a USA bank with over $2 trillion in assets, and warrants on 4.5% of its common stock. The preferred stock carries an 8% dividend. This purchase follows an earlier purchase of $25 billion of the same preferred stock using TARP funds. Causes of Present Global Crisis and its Analysis The most astonishing aspect of the trouble is that the financial innovation in the form of derivatives has taken place under the naked eyes of the regulating agencies and in response to several incentives created by Government all over the world. The toxic assets with high leverages were created at different tax havens and thereby over passing the capital adequacy norms. The new instrument in the form of Credit Default Swaps (CDS) was created to cover the risk of credit defaults by paying premium to unregulated hedge funds. The CDS market multiplied with a galloping speed of doubling each year from 2001 to 2007. In the year 2001 the value of CDS outstanding was only US$ 919 billion and reached to US$ 62.2 trillion by the end of 2007, more than 60 times over a period of 7 years and then marginally declined to US$ 54.6 trillion by the mid 2008 The root of the crisis therefore lies in the greed with which the banks and the financial institutions have worked in the past ten years. These institutions provided housing loans to the US households without adequate securities with a motivation to borrow at a lower interest rate which was just around 1% in June 2004 and without proper coverage of security on the assumption that the housing prices will keep on rising and will take care of the rising uncovered debts. The problem started with the increase in the interest rate by almost six times from 1 percent in June 2004 to 6 percent in June 2006 with increasing burden in EMIs on the households who started defaulting and sought redemption of debts by foreclosure. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 15
  • 16. GLOBAL MELTDOWN: ROAD AHEAD The National Debt of US increased to US$ 9 trillion with increased consumption at home by paying the imports through borrowing from the exporting countries on the assumption that US dollar will continue to rule the world as International Reserve Currency. High consumption through imports coupled with borrowing led to collapse of local industries and increase in the interest rate and decline in the value of US dollar vis-à-vis other world currencies. This led to sub-prime crisis and the failure of the entire banking system with the collapse of the Government sponsored mortgaged guaranteed companies viz. Fannie Mae and Freddie Mac. The US Government nationalized these mortgage guaranteed companies by pumping US$ 200 billion in order to bailout them from the financial crisis. The bailout package as initially announced for AIG (American International Group), the insurance company on September 16th amounted to USD 85 billion. There was a further rescue package announced, comprising USD 153 billion including the initial package on 10th November, 2008. Though initially there was some controversy in State intervention. The bankruptcy of AIG could have endangered the entire financial system because of the large size of toxic credit derivatives and mortgaged backed securities. The five investment bankers including Bear Steams, Lehman Brothers, Merrill Lynch, JP Morgan and Goldman Sachs, all went into trouble. Lehman Brothers, with high leveraged capital, which was more than 35 times of its own capital went bankrupt. Bear Stems was salvaged by JP Morgan and Merrill Lynch by Bank of America with direct support from US Federal Reserve and the US Treasury. The present meltdown is unique in nature in content as compared to the Asian Meltdown in 1997 and several other financial Jolls in the form of equity crisis, currency crisis, debt crisis, banking crisis spread over a span of 80 years since the treat depression of 1930’s. It took almost 8 to 9 years to tide over the great depression of 1929 which was medicated to the Keynesian formula of Pump priming through huge Public Investment. The present crisis on the other hand is of cyclical nature after a continuous boon of 7-8 years in all spheres of the economy including the financial sector and the real sector. The forces of globalization have gone deep down the economies throughout the world and with the support of information technology and telecommunication the geography has become irrelevant to the free flow of goods, services and capital. The present crisis therefore may not last beyond 17 to 24 months with the information net working and greater co-operation as compared to the past crisis. Sub Prime Crisis, the root cause of the global crisis Subprime lending is the practice of lending, mainly in the form of mortgages for the purchase of residences, to borrowers who do not meet the usual criteria for borrowing at the lowest prevailing market interest rate. These criteria pertain to the down payment and the borrowing household's income level, both as a fraction of the amount borrowed, and to the borrowing household's employment status and credit history. If a borrower is delinquent in making timely © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 16
  • 17. GLOBAL MELTDOWN: ROAD AHEAD mortgage payments to the loan servicer (a bank or other financial firm), the lender can take possession of the residence acquired using the proceeds from the mortgage, in a process called foreclosure. The crisis began with the bursting of the United States housing bubble and high default rates on sub-prime mortgages and adjustable rate mortgages (ARM). The foreclosures exceeded 1.3 million during 2007 up 79% for 2006 which increased to 2.3 million in 2008 and 81% increase over 2007. Financial product called mortgaged backed securities (MBS) which in turn derive their value from the mortgage installment payments and housing prices had enabled financial institutions and investors around the world to invest in U.S. housing markets. Major banks and financial institutions which had invested in such MBS incurred losses of approximately US $ 435 billion as of July 2008 which has mounted further and is now near to the value of US $ 1 trillion. The value of all outstanding residential mortgage owed by US households was US$ 10.6 trillion as of Mid 2008 of which $ 6.6 trillion were held by mortgaged pools Consisting of Collectivized debt obligation (CDO) already mortgage backed securities (MBS) (CDO and MBS) and the remaining US$ 3.4 trillion by traditional depository institutions. The owners of stock in US corporation alone has suffered loss of about US$ 8 trillion between 1 January and 11 October 2008 as the value of their holding declined from US $ 20 trillion to US $ 12 trillion. Causes of the Subprime Crisis A recent study conducted by a research scholar, Stan J. Liebowitz of The Independent Institute, brings out startling facts showing a close nexus of the politicians by giving providing political patronage and shelter to the Government Sponsored Enterprises (GSEs) namely Fannie Mae and Freddie Mac while giving guarantee to the housing loans to appease a particular section of the society without adequate coverage of the security and by ignoring the standard norms of lending with prudency. The subprime mortgage meltdown has been at the root of the present financial crisis in United States. The housing market experienced an unprecedented boom in the crisis which kept soaring from the early start of the 21st century until the end of 2006. The mortgage defaults started surfacing and reached the unprecedented level by the mid of 2007 and thereby bringing the tremor in the financial system which had invested heavily in housing loans and the derivatives in securitized mortgages. The first catastrophe took place when Bear Stearns was sold to JP Morgan at a throw away price in April 2008. The biggest adverse impact was on Fannie Mae (The Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation); the two Government Sponsored Enterprises (GSEs) were granted a very quick bailout package by the US Treasury. A record breaking level of mortgage foreclosures took place for the subprime mortgages. This led to a sharp decline in the value of securities which were based on these © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 17
  • 18. GLOBAL MELTDOWN: ROAD AHEAD mortgages. Most of the investment bankers including Fannie Mae and Freddie Mac reached to the brink of bankruptcy. According to this study, the failure to recognize these mortgages as risky during the time of boom was mainly because that the mortgage underwriting standards had been underlined by direct intervention of several Government agencies since early 1990s. The Government wanted to provide home ownership among poor and those belonging to minority by prescribing lower underwriting standards with no stipulation of any down payment and ignoring the credit scores and the employment history of the borrowers while determining the monthly installments. This was considered an innovation in mortgage lending and led to a bubble in the price of housing. Most of these housing loans were given at lower interest rate with an option for adjustable-rate- mortgages (ARMs). It is worth noting that the rate of interest increased from about 1% in June 2004 to about 6% in June 2006. The builders were allowed to build, developers to develop, lenders to lend, in order to encourage private homes without there being any direct help from Government which had only helped financing indirectly by providing guarantees through GSEs. In the early 1930s housing loan was a low priority for US banks and in order to alleviate their reluctance the Federal Government created Federal Housing Administration (FHSA) in 1934 which was taken over by a new institution called Fannie Mae in 1938. The Federal Government passed two legislations namely the Community Re-investment Act (CRA) 1977 and the Home Loan Mortgage Disclosure Act (HMDA) in 1975. In 1981, the Federal Government further expanded the disclosure requirement under HMDA including comparison of reactions of application by race which indicated that the minorities were denied home mortgages by more in numbers as compared to whites and this was further substantiated by a survey conducted by Federal Reserve Bank of Boston. The Boston Fed report was further fructified by Fannie Mae report in 2002. The 1992 Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) mandated a more liberal approach to housing loans to lower income borrowers which spurred Fannie Mae to make an announcement of a trillion dollar commitment. Thus, the GSEs encouraged secondary market innovations of the mortgage security as a part of moral hazard. The banking sectors would lend money were feeling comfortable as the loans were seemingly guaranteed by GSEs and they in turn mortgage securities which gave birth to derivatives and collateral debt obligations (CDOs). The process of creativity and innovation for housing mortgage loan linked securities went on and on from collateral debt obligations to credit default swaps (CDS). It is not very surprising to note that under priority lending obligations for housing loans there were primitive provisions for the financial institutions ranging from $10,000 in individual actions and a fine upto $500,000 for 1% of its net worth in class actions as provided in Equal Credit Opportunity Act. They are further restraining the credit institutions from using any arbitrary or unreasonable measures of credit worthiness. There was also an illusion that led to housing price bubble that no one would default when they could easily sell the house at a profit. This led rating agencies to give these housing loans AAA ratings. The rating agencies were also © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 18
  • 19. GLOBAL MELTDOWN: ROAD AHEAD making huge profits from rating mortgage backed securities as the government required many financial institutions to invest only in highly rated securities as certified by nationally recognized statistical rating organizations as approved by Securities Exchange Commission and there were only three such approved rating agencies namely Standard and Poor’s, Moody’s and Fitch. Thus there was a clear nexus between the GSEs, the Security Exchange Commission and the rating agencies which in tandem led to the housing price bubble and later to the burst and consequential mortgage defaults. In other words, these ‘mortgage innovations’ were US Government’s responsibility and were completely ignored. These innovations were precursor to mortgage meltdown and regulators, politicians, GSEs and the academicians were the true culprits responsible for it. In the process of undue importance to the housing loan by the GSEs the speculators took advantage by borrowing at cheap rates and creating an artificial demand in the housing sector when there were foreclosures from the real borrowers with the increase in the rate of interest under the flexible interest options, there was catastrophic and drastic fall in the housing prices leading to the collapse of the whole financial system over a period of less than six months in the later half of 2007 and towards the beginning of 2008. The smoke turned out to be a big fire when the investment bankers started filing bankruptcy under chapter 11, one after another. In March 2007, the United States' subprime mortgage industry collapsed due to higher-than- expected home foreclosure rates, with more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting them up for sale. The stock of the country's largest subprime lender, New Century Financial, plunged 84% amid Justice Department investigations, before ultimately filing for Chapter 11 bankruptcy on 2 April 2007 with liabilities exceeding $100 million. The manager of the world's largest bond fund PIMCO, warned in June 2007 that the subprime mortgage crisis was not an isolated event and will eventually take a toll on the economy and whose ultimate impact will be on the impaired prices of homes. Subprime and Alt-A (including "stated income" or "liar's loans" which are basically loans made to home buyers without the verification of borrowers' incomes; home buyers tend to overstate their incomes in order to get the loan amounts they desire to purchase their dream homes, thus called the "liar's loans") loans account for about 21 percent of loans outstanding and 39 percent of mortgages made in 2006. In April 2007, financial problems similar to the subprime mortgages began to appear with Alt-A loans made to homeowners who were thought to be less risky. American Home Mortgage said that it would earn less and pay out a smaller dividend to its shareholders because it was being asked to buy back and write down the value of Alt-A loans made to borrowers with decent credit; causing company stocks to tumble 15.2 percent. The delinquency rate for Alt-A mortgages has been rising in 2007. In June 2007, Standard & Poor's warned that U.S. homeowners with good credit are increasingly falling behind on mortgage payments, an indication that lenders have been offering higher risk loans outside the subprime market; they said that rising late payments and defaults on Alt-A mortgages made in 2006 are "disconcerting" and delinquent borrowers appear to be "finding it increasingly difficult to © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 19
  • 20. GLOBAL MELTDOWN: ROAD AHEAD refinance" or catch up on their payments. Late payments of at least 90 days and defaults on 2006 Alt-A mortgages have increased to 4.21 percent, up from 1.59 percent for 2005 mortgages and 0.81 percent for 2004, indicating that "subprime carnage is now spreading to near prime mortgages." The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. In the third quarter of 2007, subprime ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures begun during that quarter. By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21%. and by May 2008 it was 25%. The value of all outstanding residential mortgages, owed by USA households to purchase residences housing at most 4 families, was US$9.9 trillion as of yearend 2006, and US$10.6 trillion as of midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure. 936,439 USA residences completed foreclosure between August 2007 and October 2008. Credit risk arises because a borrower has the option of defaulting on the loan he owes. Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they issued. Over the past 60 years, a variety of financial innovations have gradually made it possible for lenders to sell the right to receive the payments on the mortgages they issue, through a process called securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4 trillion by traditional depository institutions. When homeowners default, the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by the high debt levels (financial leverage) households and businesses have incurred in recent years. Finally, the risks associated with American mortgage lending have global impacts, because a major consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with global financial markets. Investors in MBS and CDOs can insure against credit risk by buying credit defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered if CDS issuers would honor their commitments. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 20
  • 21. GLOBAL MELTDOWN: ROAD AHEAD In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes: "During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions." Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income. During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 21
  • 22. GLOBAL MELTDOWN: ROAD AHEAD BAILOUT PACKAGES AND WAY OUT The Federal government's efforts to support the global financial system have resulted in significant new financial commitments, totaling $7 trillion by November, 2008 and by mid February 2009 the total bailout figure is estimated to be approximately US$ 8.5 trillion. These commitments can be characterized as investments, loans, and loan guarantees, rather than direct expenditures. In many cases, the government purchased financial assets such as commercial paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in frozen markets. As the crisis has progressed, the Fed has expanded the collateral against which it is willing to lend to include higher-risk assets. Government of China has also announced a financial package of US$ 585 billion to pump prime the economy by making huge public investment and by providing subsidies to protect domestic economy which is otherwise exposed to external market and is likely to be severely affected because of the cuts in imports by all the major importing countries. Economic Stimulus Act of 2008 It was passed by the US Congress on 13 February 2008, authorizing Bush administration for an economic stimulus package costing $152 billion, mainly taking the form of income tax rebates for the year 2008. Housing and Economic Recovery Act of 2008 The Housing and Economic Recovery Act of 2008 included six separate major Acts intended to restore confidence in the American mortgage industry. These measures speak about creation of a new Federal regulator to ensure the safe and sound operation of the GSEs (Fannie Mae and Freddie Mac) and Federal Home Loan Banks. This Act authorities Federal Housing. Administration to generate upto $ 300 billion in new 30 year fixed rate mortgage for subprme brokers. Emergency Economic Stabilization Act of 2008 The Act was passed on October 3, 2008, creating a $ 700 billion bailout package for the troubled asset relief programme to purchase the toxic assets on the bad loans of the failing banks. The effect of this bailout on the US fiscal deficit for the year 2009 is to increase it to a level beyond $ 1 trillion and the federal debt to $ 11.2 trillion from the present level of $10.6 trillion. Financial Package announced by Obama Administration Barak Omama seems to be in a fix or in a sea as his financial stimulus packages of US$ 789 brillion has failed to bring any thrill in the economy as most of his announcements are back loaded to 2010 and beyond as evident from the blue print of February 10th released by his treasury secretary Mr. Tim Geithner. It has failed to show any tangible aggressive plan which © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 22
  • 23. GLOBAL MELTDOWN: ROAD AHEAD could break the spiral of uncertainty and gloom that has gripped the investors and the consumers. The stimulus package has thus failed to boost the confidence of investors, leading Dow Jone index to dip by 297 points crusting to 7553, close to November low, on 17th February 2009. Penny Pinching and lukewarm approach at a time when the entire financial system is broken down, may end up paying more price than the aggressive and more rational approach with innovative solutions that could tread boldly and salvage the devastating economy. ‘Buy American Debate’ The financial stimulus of US$ 789 billion as approved by US Congress contains a rigorous provision containing a condition of “Buy-American.” There was an odd debate on the issue and few compared it with Smoot Hawley Act of 1930 to haunt Americans and there has been same watering down by requiring only that stimulus fund which spends in a way does not violate US trade agreements under various FTAs including NAFTA. However, same controversy remains with the members of the WTO, who may retaliate to this negative approach of protection. This is not the first occasion that US has included such provision in the stimulus package as US has already passed The Buy American Act in 1933 to prefer US made products in its purchases. As of June 30, 2008, residential mortgages owed by USA households totaled US$10.6 trillion. As of August 2008, 9.2% of these mortgages were either seriously delinquent or in foreclosure. Bailout A Bombshell ? The present financial bailout package of US Government amounts to US $ 8.5 trillion and is far in excess of the aggregate of the several bailout packages announced or dolled out in the past, as may be evident from the following figures. US$ billion Invarsion of Iraq 597 Life Time Budget of NASA 851 S & L Bailouts of 1980s 256 Louisiance Purchase 217 Korean War 454 © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 23
  • 24. GLOBAL MELTDOWN: ROAD AHEAD A study conducted by the San Francisco Chronicle brings the total bailout package to $8.5 trillion (including the $ 700 billion Wall Street bailout; $ 600 billion to Fannie Mae and Freddie Mac; 168 billion in stimulus cheque and the present stimulus package announced by Obama Administrations amounting to $ 789 billion). According to Hepburn, the President of Hepburn Capital Management in Prescott, AZ, “Everyone is going to lose something. The winners will be those who end up losing the least.” The source of the bailout package of US$ 8.5 trillion is not known exactly as to how much is coming from fresh borrowings and how much is in the form of minting money. It is also to be established as to how much of it is in the form of fiscal incentives and how much is in the form of financial pay outs. However even if part of the aggregate bailout package of US $ 8.5 trillion is in the form of cash, it will amount to glut of dollar in the global market and may turn out to be a “Bombshell” wiping out huge wealth of those holding dollar or dollar reserves. It is a matter for evaluation and research for several sovereign wealth Funds and for central banks of various countries who have invested in US treasures as the panic button for a crash in value of US dollar may be pushed anytime from now. Way-out of the Present Crisis Politicians and academicians across the World from Beijing to Berlin to Brasilia are looking at the present economic crisis as the outcome of a scrambled global financial infrastructure dominated by the United States. They may ask for big changes in the present economic system in the forth coming second G-20 meeting in April at London whether US like them or not. The global thinking and debate about the financial crisis is quite different from the one in the U.S., over the issue as to whether the present mess is the result of too much government interference in the housing market or too little government regulation of financial markets. In the rest of the world, it is due to inadequate and inconsistent financial regulation. A consensus seems to have emerged among the world’s finance ministers and central-bank chiefs that the underlying cause of the crisis was an unbalanced and out-of-control system of global capital flows in which disproportionate consumption in U.S. ran up huge debts while big savers like China and other Asian Countries had huge surpluses and reserves. The political head of the People’s Republic of China, Mr. Wen Jaibao has made a very critical remark on what had gone wrong in the US financial market, when he was in Davos recently, He said, “The crisis is attributable to a variety of factors and the major ones are: inappropriate macroeconomic policies of some economies and their unsustainable model of development characterized by prolonged low savings and high consumption; excessive expansion of financial institutions in the blind pursuit of profit; lack of self-discipline among financial institutions and rating agencies and the ensuring distortion of risk information and asset pricing; and the failure of financial supervision and regulation to keep up with financial innovations, which allowed the risks of financial derivatives to build and spread.” © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 24
  • 25. GLOBAL MELTDOWN: ROAD AHEAD Angela Merkel, the German Chancellor, has advocated a sort of United Nations Economic Council, much like the Security Council. Brown and others have urged reform and recapitalization of the Bretton Woods international financial institutions (IFIs), with a much greater role handed to the International Monetary Fund, to which Japan, quietly re-establishing the credibility in international financial debates it had in the 1980s, has pledged $100 billion. The crisis has two sides. The narrower one is a consequence of the collapse of the U.S. housing market. This put pressure on bankers, both in the U.S. and elsewhere, who held toxic assets supposedly backed by real estate and it squeezed U.S. consumers, who for a generation had been the spendthrift engine of the global economy. The broader one is a function of massive global imbalances between debtor and creditor nations that have developed over the last few decades and imbalances will have to be unwound, preferably by fundamental changes to domestic policy that encourage saving in the U.S. and spending in China. In the developed world, as the credit crunch bites, economies are heading for the worst recession and a demand contraction in the western world is likely to severally affect the export-oriented economies, especially in East Asia. The overall impact of the financial crisis has been felt as a tsunami throughout the world cutting across all theories of decoupling to insulated economies in some part of the world. The whole world is reeling through the pains of global crisis with decline in the growth rate and loss of employment apart from erosion in the value of wealth which is as high as US$ 15 trillion and may increase further. The economic problems are escalating and the economic thinkers need to develop an alternate economic order for the future so that there is revival and rehabilitation of the devastated world economy. The blessing in disguise could be a new world economic order devoid of extremes of communism and capitalism and which would be based on integral humanism. A new world order would be created devoid of poverty and environment pollution based upon sustainable consumption where people can feel a harmony between the social issues, the political issues and the economic issues a new world where competition is accompanied with compassion and people can live without the fear of terrorism, a different world where peace and prosperity can co-exist for the well being of the whole universe. Let us awake and look for a holistic solution to the present global crisis. The temporary bailout process of the present financial crisis which began prior and subsequent to G-8 meeting in Washington was followed by G-20 meetings of the Heads of States including India and China on 15th November 2008 but could not arrive at any concrete long term solutions. The G-20’s is scheduled to meet on 2nd April 2009 under newly elected U.S. President Barrack Obama who has already formed his economic team with a vision to bring a long term solution to the Wall Street and the Main Street. However the crisis is deep and any bailout or way-out package will take at least minimum period of 18 to 24 months to restore confidence in the minds of the consumer, the banks and the Investors. The distinguished features of the present crisis with that of several other crisis in the past few decades is that the contagion effect in earlier crisis was © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 25
  • 26. GLOBAL MELTDOWN: ROAD AHEAD local or regional whereas the tremor of the Tsunami type of present crisis has touched the shores of all the countries, big or small, rich or poor, developing or developed. G-20 Meeting: The first meeting of the G-20 leaders on financial markets and the world economy was held in Washington, D.C. on November 14-15, 2008. The Summit resulted from an initiative by French and European Union President Nicolas Sarkozy and United Kingdom Prime Minister Gordon Brown. Since many economists and politicians called for a new Bretton Woods system (a monetary management which was instituted after World War II) to overhaul the world’s financial structure, the meeting has sometimes been described by the media as Bretton Woods II. The G-20 comprises countries considered to be systemically important, but omits over 170 governments (192 governments are members of the United Nations). The outcome of the summit came out in the form of a declaration stating inter-alia about the root causes of the global crisis, common principles for reforms in financial markets, reaffirmation of the commitment to free market principles and to have a follow up meeting by April 30, 2009. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 26
  • 27. GLOBAL MELTDOWN: ROAD AHEAD Conclusions and Summary The Challenges arising out of Global crisis and the need for International Currency The history and analysis of the global crisis indicate that the trade cycles are the natural way of corrections in the irrational economic behavior. The irrationality may be manifested either by excessive consumption, or excessesive inequality or the imbalances or in the speculation in real estate or in capital market. It may also resemble in the form of macroeconomic indicators by high current account deficit, high amount of fiscal deficit and the debt service ratios. The artificial bubble is bound to bust. The global crisis prior to Bretton Wood and before the second World war had a different character than what we notice in the post Bretton wood era. The pre- war crisis was confined to US and few developed countries in Europe. There is no instance of a pre war crisis in a poor or a developing countries except sufferings due to famine or other natural calamities. However the post war crisis has been resembled from debt crisis of Latin America in 1980s to currency crisis of East Asia in 1997. The post war crisis in the post Bretton wood era or to say in post colonial era of the present form of globalization has been identified to be the result of some speculative attack either in the currency market or in the stock market. The boom and bust has been the result of speculation and the financial innovation and not the demand supply factor in the commodity. Therefore there is the need to understand the underlying root causes of the crisis and to remove them by thorough deliberation by participation of all research organizations and the political system. Though there is need to revise the entire system of the present financial architecture but there is an immediate need to place a capping on the borrowings of a sovereign state as certain percentage of its GDP with certain coefficients of population and or the poverty and unemployment. There is also a need to reformulate the exchange rate system which should have some basis similar to the gold standard so that there is some credibility and capping on the money in circulation and for maintaining the foreign currency reserve. The present global crisis has taken the shape of the Great depression of 1929 at least in US and Japan. The biggest losers will be US, Japan and China. The biggest gainers may be India, Brazil and few other developing countries with their own domestic savings and domestic market. The world will have to undergo the impact in different forms, somewhere it will be economic slowdown, somewhere recession and somewhere depression. However the correction was overdue and would result in removing toxicity and fallacies from the present global economic system. Let us wait for a better change and a better tomorrow. © Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 27