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.
THE GLOBAL FINANCIAL CRISIS-
Causes & measures to avoid another crisis
It has been rightly said by many newspapers all over the world that "When US sneezes, the whole world catches cold." The United States was the world's leading economic power in the second half of the 20th century and London was a leading financial centre of the world. When the markets fell in 2008, their powerful status in the global financial sector came under a threat. This report is a research into the MAIN causes of the global financial crisis. The essay also proposes recommendations for the UK government in order to reduce chances of another crisis. The financial crisis has been defined by Gerald (2009, P. 27 - 44) as the worst global economic downturn since the Great Depression of the 1930s. Deep recession has struck advanced economies while the emerging markets are facing a sharp economic slowdown.
The financial crisis has been a topic of great discussion in order to understand what exactly happened and who can be blamed for it. The essay presents an analysis done by different authors, reasons given by them and concludes the main causes/roots of the crisis along with steps that should be taken by UK government to reduce danger of another crisis.
According to Booth (2009, P. 52) the roots of the financial crisis 2006-2009 go back to the great depression of 1930s when credit was tight and mortgages were hard to sell. Therefore, in order to revive the markets, the government had to step in to form many regulations and laws. Amongst them was the Banking Act of 1933 (Glass-Steagall Act) which made it illegal for any one institution to form any kind of combination of a commercial bank, aninvestment bank and/or aninsurance company. TheGramm-Leach-Bliley Act of 1999 is anactof the106th United States Congress(1999-2001) which repealed part of theGlass-Steagall Act of 1933, opening up the market amongbankingcompanies,securitiescompanies and insurancecompanies. Booth (2009) argues that if Glass-Steagall law would still have been in place the pure-play investment banks likeLehman Brothers, Citigroup and the insurance companies that were allowed to deal in securities like theAmerican International Group would not have run into trouble. Sorkin (2009)
In the beginning of 2001, the interest rates were 6 percent when Alan Greenspan, the chairman of US Federal Reserve from August 1987 to February 2006, and his Fed governors saw a slowdown in the economy due to the puncturing of the 'dot com' stock market boom in 2000 and the emergence of accounting scandals of Enron and WorldCom and thus lowered the interest rates Faber (2009, P. 13-19). Due to seven separate cuts, interest rates fell to 3.5 percent by August 2001. Greenspan had to reduce the interest rates aggressively in 2001 due to the devastating events of September 11 which had become a global issue. The interest rates dropped to half, within three months. Borrowing cost had plummeted to levels not seen in 50 years which continued till early 2007 due to the July 2005 bombings in London's transport system. Booth, et. al (2009) & BBC news (2005).
According to Rowley (2009, P. 26-31) and Faber (2009, P. 13-19), Easy money fuelled a house price bubble and a surge in personnel indebtedness. Thus, a debt bubble formed as money became almost free if you could borrow it. Low interest rates led to widespread surge in the indebtedness throughout the US economy. The rise in consumer debt reflected the response of consumers to the low interest rates. In October 2008 consumer debt stood at $2.58 trillion. As the credit terms tightened, following the financial crisis of September 2008, the leveraged impact on household consumption became very sharp. Another reason for cheap credit was the influx of capital from China in the United States. US trade deficit is clearly reflected in China's capital surplus. US companies paid lot of money for goods made in China to gain competitive advantage and thus making the government's inability to manage the US trade deficit another major cause for the crisis.
A bank is a place that will lend you money if you can prove that you don't need it. Bob Hope- Quote garden (2010). A large number of unscrupulous realtors encouraged their clients to write liar contracts, in which borrowers were encouraged to overstate their income and net wealth to qualify for higher mortgages leading to increase in Sub-prime lending. The excess of the housing bubble thus reflected a combined failure of private market and government agencies ultimately needing the government and its independent agencies to bailout the undeserving. For e.g., the world's largest insurance company, AIG which had ventured unwisely and extensively into financial markets, was bailed out by the Bush administration on the dubious ground that "it's too big to fail"- Rowley (2009, P. 31-35)
I had a cheque returned earlier. "Insufficient Funds" Mine or the banks ? Pyers Symon- BBC news (2008). Shadow banking system has also been responsiblefor adding to thesubprime mortgage crisisand thus ultimately the globalcredit crunch. According to Davidson (2009, P. 17) theshadow financial systemincludes non-bank financial institutions that has a critical role in helping business by lending money to operate.
The low-wage economies The low-wage economies that fuelled the high-risk finance were another cause- Manson (2009). In the intervening decades, low-paying jobs (service) replaced high-wage jobs (manufacturing) for instance- the most popular job in Michigan was to work in the restaurant or a fast food joint. 155,000 people across the state started earning their living this way. Second in job league table was 150,000 shop assistants and then came 108,000 cashiers. Not one these occupations pay more than $10 an hour. Therefore due to low earnings
Michigan workers have been earning a wage that would not even lift a family of four. Now the question arises if the wages had fallen, how come people were still buying the Ford cars, Sony televisions, Nike shoes etc. as we can't have mass consumption if there are no high paying jobs? Manson (2009) believes that it came from credit, like credit cards, short term payday loans, zero percent car finance, and self certified mortgages etc. Thus lending money to people, who had no possible way to return it on time, turned out to be a bad decision.
The implications of the financial crisis were huge. "Today, there are three kinds of people: the have's, the have-not's, and the have-not-paid-for-what-they-have's" Earl Wilson Quote garden (2010). According to BBC news (2009), the size of the real per capita debt increased in George W. Bush's administration. Deficits had increased less under younger president Bush than they had during Reagan administration. These deficits were also an automatic result of recession and partly the side effect of the war on terror after 9/11. In February 2009, the total US federal debt was $12.35 trillion. Of this around $6.45 was held by the public and $5.9 trillion in the form of intra-governmental holdings. The per capita burden of debt roughly tripled from 1980 to 2008. Rowley and Smith (2009, P. 26-27)
When written in Chinese the word "crisis" is composed of two characters - one represents danger and the other represents opportunity.- John F. Kennedy (1959) - Quotegarden.com. The current financial crisis began in financial markets in the United States and its effects have spread into the real economy around the world. Thus the response must also be a global one, involving all parts of society. The UK government can take the following steps to reduce the danger of another crisis.
According to the analysis of the Organization for Economic Co-operation and Development- OECD (2010), Americans tend to spend more than they save. The UK and US have been marked by a combination of high debt levels and low savings rates in recent years. Thus the people need to realise the importance of the savings culture. The Government should also try to encourage people and address this urgently through the reform of benefits and pensions systems to restore the economic and social benefits of a low time preference culture.
SMEs help in creating jobs, support stability, innovation, macroeconomic growth and act as a growth engine and thus play an integral part of developing and developed nations. In OECD countries [Organisation for Economic Co-operation and Development- OECD is a set of 30 countries who develop and discuss social and economic policy]. 95 % of the enterprises in the OECD countries are SMEs which account for two thirds of total employment and is also the key source of new job creation. In many countries SMEs also play a major role of economic recovery and help to return to sustainable growth. In fact, some of the most innovative and fastest growing companies such as Wal-Mart (1962), Starbucks (1971), Microsoft (1975) and Virgin Atlantic (1982) were started during recessions.
The "the London summit", a recent meeting of the world leaders at the G20 summit hosted by Gordon Brown, will also play an important role in organising and deciding new economic measures to overcome the crisis. The UK government decided to implement the following steps: it will prevent the collapse of the banking sector by providing temporary liquidity which will protect people and their savings. Lower interest rates will also help in increasing consumer's demand which will in return support the economy.
Government will also support investments in low-carbon infrastructure to tackle climate change and create incentives for companies to move to a low-carbon economy. The UK government truly believes in effective transition to a low-carbon economy which includes- a renewable shift, research and development, commercial use of the low-carbon cars and also the skilled people needed to work in these areas. ACCA (2009)
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2. Davidson, A. 2009. How the Global financial markets really work. London, UK & Philadelphia, US, Kogan Page Ltd.
3. Faber, D. 2009. And then the Roof caved in. New Jersey, US, John Wiley & Sons Inc.
4. Gerald, D. 2009, "The Rise and Fall of Finance and the End of the Society of Organizations", Academy of Management Perspectives, 4. Gerald, D. 2009, "The Rise and Fall of Finance and the End of the Society of Organizations", Academy of Management Perspectives, Volume 23, Number 3, pp. 27 - 44
5. Mason, P. 2009. Meltdown: the end of the age of Greed. London, Great Britain, Verso.
6. Milne, A. 2009. The fall of the house of credit: what went wrong in the banking and what can be done to repair the damage, Cambridge, UK, Cambridge University press.
7. Rowley, C. & Smith, N. 2009. Economic Contractions in the United States: A failure of Government. Virginia, US. The Locke Institute.
8. Zandi, M. 2009. Financial Shock: A 360 Look at the subprime Mortgage Implosion and How to avoid the next Financial Crisis. New Jersey, US, Pearson Education Ltd
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Source: Essay UK - http://www.essay.uk.com/free-essays/business/causes-measures-to-avoid-another-crisis.php
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