Suddenly, everything which looked quite rosy collapsed in a tsunami of loss and fear, as comparisons are made with earlier depressed economic times. Where will it end? And why has it happened?
The western world has made enormous strides in material wellbeing based on the free enterprise of capitalism and credit finance. The productive power of the economy has been vastly enhanced by the knowhow and drive of those with limited funds being able to access investors’ surplus funds. It has therefore become common for successful companies with limited capital, to increase the funds needed to expand their business by ‘leveraging’; i.e. borrowing at interest rates which are lower than the rates of dividends distributed to shareholders. Those providing the funds do so in the confidence that those funds will not be lost through the earning power of the company falling away. Then again, companies must have confidence that the market will provide the customers to sustain the company’s revenue. Customers also must have confidence; on the continuity of their incomes to enable them to buy on credit, a virtually permanent feature of a strongly growing, confident economy. So, confidence is involved in every transaction, at every level—a shaky foundation. It is not surprising that at some point the confidence on which all these interdependent transactions are based, may sometimes falter over a long period. Deep trouble can occur, as it all depends and feeds on itself!
The minor rise and fall of confidence from time to time creates an ‘economic cycle’. But for many, the hugely profitable outcome in the growth of material wellbeing is worth it. All is reasonably calm and well-ordered, as long as the world economy continues to grow. With substantial growth small changes in the economic cycle do not overwhelm us. Strong growth minimises concern over ‘mistakes’ and misjudgments. It simply must not slow down—at any cost!
The whole world is now involved in a global economic system, the vital pivot being Wall Street, New York, with its many financiers and huge banks. Sixty years ago a lecturer in economics described the basis of investment business of America—through the Wall Street Stock Exchange—as the product of a casino! No doubt, that is even truer today.
In the midst of this huge economy, this writhing organism, companies are liquidated, people can lose their jobs, people can go bankrupt, marriages fail, and some will become depressed, and some may even commit suicide. But the whole juggernaut can roll heedlessly on, if casualties are few. Meanwhile, investors and speculators pore over the stock market, the barometer of business confidence—some with confidence, some with fear.
The sub-prime crisis
For most people the purchase of a home is the biggest financial transaction they will ever make and they will need to take out a mortgage loan to buy it. The mortgagee requires regular payments of principal and interest under the contract, failing which the mortgagee will be forced to ’foreclose’, selling the property to recover the unpaid amount of the loan—if possible!To guard against loss the prudent mortgagee gauges whether the borrower can ‘handle’ the repayments and, in addition, limit the loan to a ‘safe’ proportion of the property’s value that could be recovered in the case of default. With normal economic conditions most of these transactions will run their course over many years.
In the worldwide depression in the 1930’s, loss of employment and other factors meant many mortgagors defaulted and tighter conditions on loans to guard against widespread loss were introduced in America by the Glass-Steagall Act, in 1933.
However, over a period of twenty years the protections of this Act were whittled away, due to pressure from the finance industry. It was finally repealed by Congress in 1999, after long and intense lobbying by major financial interests. It was considered that a relaxation of financial regulations was justified to give a more flexible financial system.
But financial geniuses outside the banking system became rich, creating complicated financial ‘derivatives’, with insufficient regard for the risks involved. It appears that home mortgages of 100% of purchase price had been frequent, without concern about loan repayments, leading gullible borrowers to disaster.
Lenders created complicated derivatives—financial instruments called ‘collateralised debt obligations’ which offloaded unquantified risks, with enthusiasm, by bundling and selling mortgage instruments by the hundreds, made a killing. But many mortgagees soon had to foreclose with slim chances of recovering their loans, as many new homes swamping the market, driving prices down further. Heavy asset write downs by major financial organisations, spread rapidly as many borrowers defaulted, shaking confidence in the financial system. With confidence in the financial system thus shattered, panic spread throughout the world with the whole banking system afraid to grant credit. Thus the flow of credit, which sustains the operation of the highly geared business economic system of the real world, dried up in an atmosphere of fear, with business losses imminent, job losses multiplying and retail sales tumbling. How desperate then is the economy where retailers must encourage customers to buy by cut prices and offers of extended of credit for increasing periods, with an increasing chance of loss in the event that the customer may be unable to meet the eventual demand for payment! A day of reckoning had to come.
Governments have responded by spending surpluses strongly to keep the world economy moving. They have gone into deficit, if necessary, by borrowing the necessary funds to retrieve the confidence which is so essential to recovery. It is perhaps important to remember that the depression of the 1930s was only finally laid to rest by the full employment and international spend-up involved everywhere in World War II.
The enemy of confidence is fear. Unless fear is replaced with confidence there can be no recovery. So, doom and gloom purveyors are dangerous. But in the end, only governments have the moral power, supported by the people, to start the ball rolling, which is why Franklin D. Rooseveldt said in his First Inaugural Address, in 1932: “Only Thing We Have to Fear Is Fear Itself”. He was introducing ‘The New Deal’ to restart the flow of credit and employment.
World governments are hoping to do this by government spending once more, to offset the panic caused by the financial mess caused by unwise deregulation in the post-war financial industry, in the US. These interests have much to answer for. For some, regulation is anathema, at any time.
‘After 12 attempts in 25 years, Congress finally repealed Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hailed the change as the long-overdue demise of a Depression-era relic.’!