Until the eve of the 1929 slump—the worst America has ever faced—things were rosy. Cars and construction thrived in the roaring 1920s, and solid jobs in both industries helped lift wages and consumption. Ford was making 9,000 of its Model T cars a day, and spending on new-build homes hit $5 billion in 1925. There were bumps along the way (1923 and 1926 saw slowdowns) but momentum was strong.
Banks looked good, too. By 1929 the combined balance-sheets of America’s 25,000 lenders stood at $60 billion. The assets they held seemed prudent: just 60% were loans, with 15% held as cash. Even the 20% made up by investment securities seemed sensible: the lion’s share of holdings were bonds, with ultra-safe government bonds making up more than half. With assets of such high quality the banks allowed the capital buffers that protected them from losses to dwindle.
But as the 1920s wore on the young Federal Reserve faced a conundrum: share prices and prices in the shops started to move in opposite directions. Markets were booming, with the shares of firms exploiting new technologies—radios, aluminium and aeroplanes—particularly popular. But few of these new outfits had any record of dividend payments, and investors piled into their shares in the hope that they would continue to increase in value. At the same time established businesses were looking weaker as consumer prices fell. For a time the puzzle—whether to raise rates to slow markets, or cut them to help the economy—paralysed the Fed. In the end the market-watchers won and the central bank raised rates in 1928.
It was a catastrophic error. The increase, from 3.5% to 5%, was too small to blunt the market rally: share prices soared until September 1929, with the Dow Jones index hitting a high of 381. But it hurt America’s flagging industries. By late summer industrial production was falling at an annualised rate of 45%. Adding to the domestic woes came bad news from abroad. In September the London Stock Exchange crashed when Clarence Hatry, a fraudulent financier, was arrested. A sell-off was coming. It was huge: over just two days, October 28th and 29th, the Dow lost close to 25%. By November 13th it was at 198, down 45% in two months.
Worse was to come. Bank failures came in waves. The first, in 1930, began with bank runs in agricultural states such as Arkansas, Illinois and Missouri. A total of 1,350 banks failed that year. Then a second wave hit Chicago, Cleveland and Philadelphia in April 1931. External pressure worsened the domestic worries. As Britain dumped the Gold Standard its exchange rate dropped, putting pressure on American exporters. There were banking panics in Austria and Germany. As public confidence evaporated, Americans again began to hoard currency. A bond-buying campaign by the Federal Reserve brought only temporary respite, because the surviving banks were in such bad shape.
This became clear in February 1933. A final panic, this time national, began to force more emergency bank holidays, with lenders in Nevada, Iowa, Louisiana and Michigan the first to shut their doors. The inland banks called in inter-bank deposits placed with New York lenders, stripping them of $760m in February 1933 alone. Naturally the city bankers turned to their new backstop, the Federal Reserve. But the unthinkable happened. On March 4th the central bank did exactly what it had been set up to prevent. It refused to lend and shut its doors. In its mission to act as a source of funds in all emergencies, the Federal Reserve had failed. A week-long bank holiday was called across the nation.
It was the blackest week in the darkest period of American finance. Regulators examined banks’ books, and more than 2,000 banks that closed that week never opened again. After this low, things started to improve. Nearly 11,000 banks had failed between 1929 and 1933, and the money supply dropped by over 30%. Unemployment, just 3.2% on the eve of the crisis, rose to more than 25%; it would not return to its previous lows until the early 1940s. It took more than 25 years for the Dow to reclaim its peak in 1929.
Reform was clearly needed. The first step was to de-risk the system. In the short term this was done through a massive injection of publicly supplied capital. The $1 billion boost—a third of the system’s existing equity—went to more than 6,000 of the remaining 14,000 banks. Future risks were to be neutralised by new legislation, the Glass-Steagall rules that separated stockmarket operations from more mundane lending and gave the Fed new powers to regulate banks whose customers used credit for investment.
A new government body was set up to deal with bank runs once and for all: the Federal Deposit Insurance Commission (FDIC), established on January 1st 1934. By protecting $2,500 of deposits per customer it aimed to reduce the costs of bank failure. Limiting depositor losses would protect income, the money supply and buying power. And because depositors could trust the FDIC, they would not queue up at banks at the slightest financial wobble.
In a way, it worked brilliantly. Banks quickly started advertising the fact that they were FDIC insured, and customers came to see deposits as risk-free. For 70 years, bank runs became a thing of the past. Banks were able to reduce costly liquidity and equity buffers, which fell year on year. An inefficient system of self-insurance fell away, replaced by low-cost risk-sharing, with central banks and deposit insurance as the backstop.
Yet this was not at all what Hamilton had hoped for. He wanted a financial system that made government more stable, and banks and markets that supported public debt to allow infrastructure and military spending at low rates of interest. By 1934 the opposite system had been created: it was now the state’s job to ensure that the financial system was stable, rather than vice versa. By loading risk onto the taxpayer, the evolution of finance had created a distorting subsidy at the heart of capitalism.
The recent fate of the largest banks in America and Britain shows the true cost of these subsidies. In 2008 Citigroup and RBS Group were enormous, with combined assets of nearly $6 trillion, greater than the combined GDP of the world’s 150 smallest countries. Their capital buffers were tiny. When they ran out of capital, the bail-out ran to over $100 billion. The overall cost of the banking crisis is even greater—in the form of slower growth, higher debt and poorer employment prospects that may last decades in some countries.
But the bail-outs were not a mistake: letting banks of this size fail would have been even more costly. The problem is not what the state does, but that its hand is forced. Knowing that governments must bail out banks means parts of finance have become a one-way bet. Banks’ debt is a prime example. The IMF recently estimated that the world’s largest banks benefited from implicit government subsidies worth a total of $630 billion in the year 2011-12. This makes debt cheap, and promotes leverage. In America, meanwhile, there are proposals for the government to act as a backstop for the mortgage market, covering 90% of losses in a crisis. Again, this pins risk on the public purse. It is the same old pattern.
To solve this problem means putting risk back into the private sector. That will require tough choices. Removing the subsidies banks enjoy will make their debt more expensive, meaning equity holders will lose out on dividends and the cost of credit could rise. Cutting excessive deposit insurance means credulous investors who put their nest-eggs into dodgy banks could see big losses.
As regulators implement a new round of reforms in the wake of the latest crisis, they have an opportunity to reverse the trend towards ever-greater entrenchment of the state’s role in finance. But weaning the industry off government support will not be easy. As the stories of these crises show, hundreds of years of financial history have been pushing in the other direction.
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America Financial Crisis
The expression financial crisis broadly applies to a number of cases in which the vital financial assets rapidly lose a great proportion of their nominal value. During the nineteenth and twentieth centuries, numerous financial instabilities have a high link to banking panics and numerous recessions coincided with the panics. Other circumstance often referred to as financial instability consists of stock market crashes and bursting of other money bubbles, currency instability as well as sovereign defaults. Financial instability directly leads to a great loss of paper affluence but hardly result in adjustments within the real economy (Dwyer, 2009).
Different economists and scholars often offer hypothesis about how financial instability grows and how to prevent the undesirable condition. However, there lacks consensus and financial instability continue to be witnesses occasionally. This paper will describe the nature, causes and probable solutions of the major financial crisis experienced in the United States between 2008 and 2012. The paper also addresses the fine details of the crisis highlighting on some issues such as; questions of who was responsible for the undesirable financial condition. Some basic theories relating to the cause of the challenge. The public policies applicable to deal satisfactorily with the identified causes. Some steps taken by congress and Obama government to deal with the matter, and lastly whether the adopted measures were effective or not.
Nature of the crisis
Firstly, the great recession has a direct link with the major banking crisis witnessed during the period. Bank in the entire United States were suffering massive and rapid withdrawal of financial by depositors; a phenomenon known as a bank run. In all the cases, banks and financial institutions lend out majority of the funds they collect in forms of deposits (Dwyer, 2009). Therefore, it was challenging the same institution to back swiftly all the deposits while being demand at once. The occurrence results to a situation where clients lose their deposits. This was to the extent that insurance deposits hardly covered them. Banking panic or systematic banking crisis is a situation in which major financial institutions face runs. Banking crisis was not very eminent during the United States great recession, but it fairly characterized the financial instability.
Secondly, the 2008 crisis was characterized with speculative crashed and bubbles. Witnessing of a speculative bubble is during an even of massive, sustained and persistent overpricing of various classes of assets. A major factor that facilitates the occurrence is the availability of customers who buy an asset based mainly on the speculations of reselling the same asset at a better price, as opposed to computing the revenue the asset will create in the future. In the event that a bubble is experienced, risk of a crash is eminent, as well.
A crash is a situation in which price of assets are conflicting and hence customers will only proceed with the purchase if they expect other market participants to purchase. In such an event, a large proportion might decide to sell causing a fall in prices. Nevertheless, it is quite challenging to make a prediction on whether a financial asset price will actually equate to its fundamental value. Therefore, it is difficult to determine the reliability of the bubbles. Some economists and scholars insist that bubbles never experienced during the United States during the recession. However, all indications show that the situation was almost getting to that level (Nanto & Library of Congress, 2009).
The third characteristic of the great recession was the international financial crisis. For a country that uses the fixed exchange rate, a situation may arise when the financial sector is compelled to devalue the currency of the nations to accommodate speculative attacks. This state of affairs is the balance of payment instability or a currency crisis. In case the state is unable to settle its foreign financial debt, this phenomenon is sovereign default. It is important noting that, at times, both devaluation and default might be because of a voluntary decision by the administration. However, state of affairs emerges as the inevitable consequences of adjustments in financial investor decision that results to a prompt stop in capital returns or an unexpected rise in capital flight. Largely these circumstances described the situation during the great recession in the United States.
Wider economic crisis
Negative gross domestic product growth that extends beyond two quarters is a recession. A substantially severe or prolonged recession often turns out to be a depression. On the other hand, a prolonged period of sluggish but not certainly negative growth in GDP is economic stagnation. Economists during the U.S crisis believed that the undesirable situation was because of financial instability. Some economist and scholars, however, believed that the recession led to financial challenges and not the vice versa. The argument is that in cases where financial crisis act as the initial disturbance that initiates a recession, other components might be more crucial in prolonging and worsening the recession period (Nanto, & Library of Congress, 2009).
Causes of the financial crisis and their consequences
1. Strategic complementary within the financial markets.
Arguments exists that successful and efficient investment demands that each market participant in the financial market to predict the intentions of the other investor. Soros George, a great American economist, described this necessity to predict the aspirations and intentions of the other market investors as reflexivity. On the same note, John Maynard Keynes, a 1930s economist, compared a financial sector to a beauty competition game, where participants attempts to guess the model other players in the contest will consider extremely outstanding. Self-fulfilling prophecies and circularity may be overrated when reliable data is not accessible because of partial disclosures or lack of disclosure altogether.
Moreover, in numerous cases market participants are motivated to coordinate their individual choices. For instance, an investor who feels that other market players are willing to purchase a certain currency in masses may anticipate that the value of that other currency will go up. As such, the investor is also enticed to buy the same currency in anticipation of making high returns. Similarly, a depositor in a certain bank who anticipates that other depositors will withdraw their finances may predict collapsing of a bank and, therefore, he/she may have an incentive to withdraw his investment, as well. Scholars describe the drive to mimic the plans of other investors a strategic complementarity.
Economists and financial analysts argue that if firms and individuals portrays a sufficiently powerful incentive to imitate the actions of the other market players, then there is witnessing of a phenomenon called self-fulfilling prophecies. For instance, if a firm feels that the value of a certain currency will go up, this may result to the eventual rise in its value. Alternatively, if a bank depositor anticipates that the bank will deteriorate, the bank may surely fail. Therefore, there is a perception that financial instability behaves like a vicious circle where investors avoid some financial assets or institution anticipating that others will shun them, as well. This was the case in America during the great financial crisis of 2008.
Leverage, in the financial sector means acquiring investment’s funds through borrowing. There is a frequent assumption that excessive borrowing is the contributor of the financial crisis in America. When an individual or financial institution only invests their own funds, they can in the extremely worst scenarios, lose their own cash. However, when there is borrowing of the better part investment’s funds, the firms and individuals can potentially gain more from their investment but they can lose in excess of what they own, as well. Therefore, borrowing investment funds augments the potential gains from investment, but generates a bankruptcy threat, as well (Dwyer, 2009).
Since the bankruptcy implies a situation where an individual, a firm or a country fails to settle all its financial obligations to lenders, it may extend financial challenges from party to the other. The average level of leverage to an economy usually grows before a financial crisis arises. For instance, borrowing to fund investment within the stock market become increasingly and amazingly common following the 1929, Wall Street Crash. Additionally, some scholars and economists have suggested that financial institutions might fuel fragility by smacking leverage, and thereby fueling the underpricing of risk. Leverage was a major contributor to the instabilities experienced in 2008 in American continent.
3. Asset-liability mismatch
Asset-liability mismatch is another factor argued to have fueled the undesirable financial market in the United States. Witnessing of this phenomenon is where the risks linked to the firm’s assets and debt appear inappropriately aligned. For instance, commercial bank provides deposit accounts to clients. There can be frequent withdrawal of these accounts and the bank utilizes the gains to provide long-term loans to homeowners and businesses (Nanto & Library of Congress, 2009). There is a perception that the mismatch exhibited between short-term liabilities to the banks and the bank’s long-term assets is the main reason why bank run phenomenon arises. Similarly, in 2007-2008 Bear Stearns in U.S. failed because it failed to renew the debt it had used to fund long-term projects in mortgage securities. This case due to the mismatch of assets and liability
In a global context, numerous emerging market administrations fail to sell bonds denominated in their domestic currencies and hence sell which are denominated in the United States dollar instead. This tendency leads to a discrepancy between their assets and denomination of currency of their financial obligations. This results to a threat of sovereign default occasioned by the instabilities in the exchange rate. This mismatch between assets of the United States’ federal government and its liabilities contributed to the instabilities experienced in the continent during the 2008 recession.
Numerous analyses of financial instabilities emphasize on the role of investment errors occasioned by inadequate knowledge or imperfection in the reasoning of individuals behavioral finance analyses mistakes in quantitative and economic reasoning. Torbjorn Eliazon, an American psychologist, has as well analyzed inadequacies in economic reasoning within the oecopathy concept. Historians, markedly, Kindle Berger Charles has shown those crises often appear after massive technical or financial innovations. According to Charles, this is because such innovations present investors and businesspersons with fresh forms of commercial opportunities, a phenomenon that he referred to as displacements of the expectations of investors. Early similar cases consist of 1720, Mississippi and South Sea bubble, which emerged when the idea of investment in company’s stock was unfamiliar and new to many. Another example is the 1929 crash that came after the introduction of improved transportation and electronic technologies.
Recently, numerous financial disabilities followed improvement in the environment of investment facilitated by financial deregulation, as well as the fall of dot com bubble early 2001 arguably started with irrational exuberance regarding internal technology.
Unusualness in the recent financial and technical innovations may assist in explaining how individuals and institutions often overrate the value of their assets. Also, if the initial investors in a fresh class of assets make profits from value of assets as other market participants familiarize themselves with the new innovation, then more others are likely to imitate the trend. This will gradually drive the market price notably higher as others rush to purchase in anticipation of similar gains.
If such trend forces prices to go up far beyond true asset value, a crash becomes exceedingly inevitable and hence the undesirable consequences. If for whatever reason the price slightly falls, so that firms perceive that there is no guarantee of additional profits, then the upward trend may take a reverse route, with the price reduction occasioning an urgency of sales, fueling the fall in prices (Nanto & Library of Congress, 2009). This uncertainty led to the worsening of the 2008 financial crisis in United States.
5. Regulatory failures
The United Stated administration had attempted to mitigate or eliminate financial instability by regulating and restricting the operations of the financial industry. One key objective of this behavior was to ascertain that there was observation of transparency in the sector. Its execution was mainly through making firms financial circumstance acknowledged publicly through ordering regular reporting performed under standardized accounting approaches. Another major aim of institution’s control was to make sure that firms had sufficient assets to settle their commercial obligations, through capital requirements, reserve requirements and other restrictions on leverage.
Nonetheless, some financial instability has a link with the insufficient control. In addition, it has occasional adjustments in regulation procedures to evade a repeat. For instance, Dominique Strauss-Kahn, the former IMF Managing Director blamed the financial challenge of 2008 on control measures’ failure to safeguard against extreme risk-taking within the financial system, particularly in the United States. Similarly, New York Times media house indicated that the major cause of the instability was due to credit default swaps’ deregulation.
However, excessive restriction is associated with intensifying the state of the financial crisis. In specific, the famous Base II Accord was criticized for demanding banks to expand their capital base when risks manifests, which may cause them to lower lending particularly when capital is in low supply, potentially worsening the financial crisis.
There is global regulatory merging interruptions leading to regulatory herding, worsening marketing herding and so aggravate systematic risk. From that perspective, upholding dynamic regulatory regimes may act as a safeguard.
Fraud and embezzlement of funds have contributed to the fall of some financial organs, when firms have enticed depositors with misleading assertions about their unique investment plans, or have misappropriated the resulting income. Good examples include, the fall of the 1994 MMM project in Russia, the 20th century Charles Ponzi scam at Boston, the 1997, Albanian Lottery uprising scam and more recently the fall of Madoff Investment in 2008 (Dwyer, 2009).
Numerous rogue merchants that have occasioned huge losses at the commercial sector have been associated with fraudulent acts in a desire to hide their merchants. Scam in mortgage funding was also cited as one probable contributory factor to the subprime mortgage crisis of 2008. Government executives indicated on 23 September 2008 that FBI was investigating the matter to identify the probable scam by mortgage funding firms Lehman Brothers, Freddie Mac, American International Group and Fannie Mae. Similarly, there are suggestions that numerous financial institutions were negatively affected by the 2008 crisis because their respective managers did not perform their fiduciary duties sufficiently.
Contagion is an expression used to illustrate the idea that financial instabilities may extend from one firm to another, for instance, when commercial banks run spread from several banks to various banks or from one nation to another, for instance, when currency instabilities, stock market or sovereign defaults crashes spread across nations. When the failure a particular financial body risks the stability of numerous other organs, the phenomenon is systemic risk.
One extensively cited case of contagion was the intensive spread of the 1997 Thai Crisis to other nations like South Korea. Nevertheless, economists and scholars usually debate whether observing instabilities in various nations is certainly occasioned by contagion from a single market to various market, or it was instead occasioned by similar underlying challenges that might have affected each nation individually even in the devoid of international linkages.
7. Recessionary effects
Some financial instability has limited effect beyond the financial domain, like the 1987 Wall Street crash, but there are assumptions on other instabilities to be contributors of derailing growth in the other sectors of the economy. Different theories attempt to explain why a financial instability might have caused a recession in the other sectors of the economy. The hypothetical ideas consist of flight to quality, and financial accelerator, Kiyotaki-Moore model, and the flight to liquidity. Some 3rd generation replicas of currency disaster explore how banking and currency crisis can combine to occasion recessions experience like that of 2008 (Nanto & Library of Congress, 2009).
Theories Explaining Financial Crisis
Recurrent massive depressions and recessions in the international economy at a rate of twenty and fifty years have been the subjected to various analysis. This is so since Charles Jean provided the initial hypothesis of crisis that aimed at criticizing the classical political economy principle of equilibrium between demand and supply. Generating an economic instability theory became the main recurring ide throughout Karl Marx’s work.
In a capitalist economy, operational firms return less cash to their employees than the value output. The revenue first covers the initial capital invested. However, in the end it appears that the money returned to the population is less than the amount required to purchase all goods produced. The viability of Marxist hypothesis depends on two factors: firstly, the population size that is in the working class category and amount of tax that returned to the masses by the government in the form of family benefits, welfare and education and health spending (Dwyer, 2009).
Hyman Minsky proposed a post-Keynesian illustration that is most appropriate when dealing with a closed economy. Hyman hypothesized that financial fragility signifies a typical trait of all capitalist economic systems. High fragility results to adverse threat of financial instability. To support the analysis, Minsky gives three tactics the financing companies may select, according to their degree of risk tolerance. These include Ponzi finance, hedge finance and speculative finance.
After the recession, companies choose only hedge because it is the safest. During the recovery, firms select speculative financing. Finally, boom firms have much confidence in their financial capability and hence they choose Ponzi financing. However, this is where trouble starts because firms have taken huge loans and some of the starts. Lenders, on the other hand acknowledge the risks in the financial sector halt giving funds so easily (Dwyer, 2009). Refinancing proves impossible for borrowers and more companies default. Unless there is, injection of fresh money into the economy to facilitate refinancing a real economic problem begins. During the recession, firms start to hedge again, and the cycle is closed.
Mathematical techniques of modeling monetary crises have portrayed that there is positive feedback between decisions of market participants. Positive feedback means that there might be dramatic adjustments value of assets in response to minor changes in the fundamentals of the economy (Joseph, 2008). For instance, some representations of currency crises imply that a static exchange rate might be stable for an extended period, but will crash abruptly in the fall of currency auctions in reaction to an adequate decline of government funds or fundamental economic conditions.
According to diverse theories, positive feedback means that it is possible to attain several equilibrium points. There might be an equilibrium where investors spend comprehensively in asset markets due to the expectations of a rise in value of such assets. However, there might be another equilibrium level where investors flee asset markets due to fear of others freeing the market. This is the sort of argument underlying Dybvings and Diamond concept of bank runs, where investors withdraw all deposits because they fear that others will do the same (Dwyer, 2009). Similarly, in Obstfeld's doctrine of currency instability, when conditions are constant, two possible outcomes are eminent: speculators may decide to attack the domestic currency or they may choose not to attack depending on the expected reactions of the speculators.
To deal with the crisis and to avoid history from repeating itself, the government of United Kingdom led by President Barack Obama must implement two policies. One is credit control and the other one is money supply regulation. Through central bank, the government can order commercial banks to reduce credit lending (Halm-addo, 2010). This can be achieved through increasing lending rates, selective credit control and increasing cash reserve ration. About money supply reduction, the government must reduce its activities to ensure excess money is not supplied into the economy.
The steps that the government and the congress would have implemented to drive the economy out of the recession include reduction in excessive taxation to create demand and reduction of public dept. The government and the congress failed to implement these policies and hence the recession continued to oppress the economy. For instance, high taxes reduced demand hence low profits for the firms. High public debt attracted high level of capital outflow hence causing a negative balance of payment.
In conclusion, the congress and the government failed to the appropriate policies of reducing taxation and public debt. As a result, recession continued until the market forces regulated the economy. Therefore, it is clear that the government and the congress are to blame for the financial crisis that destabilized the American economy.
Dwyer, G. P. (2009). The financial crisis of 2008 in fixed income markets. Atlanta, Ga.: Federal Reserve Bank of Atlanta.
Halm-addo, Albert D. (2010). The 2008 Financial Crisis: The Death of an Ideology. Dorrance Pub Co.
Nanto, D. K., & Library of Congress. (2009). The global financial crisis: Analysis and policy implications. Darby, Pa: Diane Publishing.
Joseph, L. (2008). The finance crisis and rescue: What went wrong? why? what lessons can be learned?. Toronto: University of Toronto Press.