Tuesday, October 09, 2012
World Economic Crisis – causes and solutions
The financial meltdown that started in 2008, which originated in the subprime mortgage market in US housing sector ultimately threatened the entire world economy and we have still not recovered from it fully. The root causes are :
1.US government’s ambitions in promoting home ownership among all sections of its citizens, for which government backed financial giants Freddie Mac and Fannie Mae were created and subsidized. This incentivized the private sector banks to dump the ‘toxic assets’ into the willing hands of the government entities. Also tax concessions were given for the incentivizing home loans to subprime categories, whom otherwise would not have been serviced by the lenders.
2.The interest rates in US markets were artificially held down to near 1 % levels from the years 2000 to 2004 (and even after) by the US Federal Reserve Board with the objective of ‘pulling up’ the economy from the recession caused by the dot com bubble collapsing in 2000. This unleashed the mother of all credit booms as the real rate of interest was higher than the rate set by Federal Reserve.
3. The US government budget deficits rose continuously to fuel the unsustainable levels of spending for defense, social security and for the Iraq and Afghan wars. US trade deficits (net of imports over export revenues) too rose to alarmingly high levels. All these should have depreciated the value of US dollar in an ideal currency market. But the exporting nations like China, Japan, OPEC (which sells most of its oil to US) artificially propped up the value of the US dollar (so as to help their export booms) by buying US treasury bills limitlessly. If (a very big IF) this has not been done, US dollar would have sunk like stone and hence the US consumer and government spending would not have reaching these crisis levels. But as US dollar is the reserve currency of the world and most of the international trade and investments are done in dollars, this self correction of currency values that is the basis of any undistorted market did not occur in currency markets of the world.
4.The wall street banks are held as the prime villains in this drama. But this is only partially true. They could act recklessly not because of lack of regulations but mainly due to the unprecedented money supply created due to the above three factors. The entire world was awash with unsustainable money supply in those booming years.
5. Creation of the Euro currency in Europe was another major blunder which exuberated the distortions to an ideal money market. The corrective measures that come to play in a undistorted currency market (where the value of a nations currency is determined by the inherent strength of its economy, its budget deficits, inflation and interest rates) could not happen within Euro areas as well as in US money markets.
The US and the world seem not to have learnt any worthwhile lessons from this major crisis and in future similar booms and busts will recur as public memory is short and economic illiteracy is widespread.
The corrective measures that should be put in place now are :
11. Massive reduction in US budget deficits by reducing US military and other expenditures. Closing of government backed housing loan mortgage institutions.
22. China and other Asian exporting nations should abandon (or at least reduce) the distortions they create in artificially propping up the US dollar. Especially the Chinese role in this is huge and unsustainable in the long run.
33. Euro currency should be abandoned in a calibrated manner or otherwise the Euro area will collapse due to internal contradictions in the long run. This will pull down the world economy when it occurs. Ireland and Spain suffer needlessly due to Euro while basically they remain solvent and were growing economies in the past.
44. All the nations should try to reduce their budget deficits and contain unwanted and wasteful expenditures, especially military spending. (this is a tall order and idealistic, but if it continues unabated then crisis will recur)