Thursday, March 5, 2009

Questions on Economic Crisis

A student from Malaysia, wished to interview me for a school project. These are his questions and my answers.

What are your views on the economical downturn?

It's the most serious economic crisis since the Great Depression. The fall in output is very steep. But, also there are a lot of unknowns. - How much bank losses will there be? Will bank lending be able to return to normal? Are there more hidden bad debts? How much debt can the government take on without losing confidence of markets? Will conventional fiscal and monetary policy be sufficient to boost growth?

To a large extent we are in uncharted territory. It is different to previous boom and bust recessions and has features of a depression rather than just recession.

What do you think about the current rescue plan?

The Governments need to do two things
  1. Prevent major banks going bankrupt. Effectively this requires nationalisation. There is a hesitancy to do this. But, just buying junk assets is inadequate. US has a reluctance to use nationalisation. But, I think there's no other way.
  2. Prevent deflation and try to counter the big fall in private spending and investment. Therefore expansionary fiscal policy (like US stimulus plan) and lower interest rates are needed. However, this appears to be insufficient, given magnitude of downturn. Therefore, quantitative easing will be needed to avoid deflationary pressure. I feel if government allow deflation to set in, it would be very serious problem.
Generally, governments and monetary authorities are trying to do the right thing by increasing demand.
But, we also have to be careful short term measures to deal with crisis don't create long term problems. But, this is too complicated to go into in this post.

How long do you think it will last?

Difficult to say. Maybe 9-12 months before positive growth returns. But, even that may not signal end of crisis. It's not just the economy but the wider financial situation that is in difficulty, and the problems won't just vanish.

Why does it affect the world?
  • The banking system is interconnected. Shortage of credit in one country is soon a global phenomena. Many banks had some direct or indirect exposure to American subprime debt. So when a few Florida mortgage companies lost money, banks around the world were affected.
  • The economy is globally interconnected. E.g. countries like Japan and Germany rely on exports for a significant % of GDP. Therefore they have suffered from downturn even though they didn't experience the same credit bubble as in UK / US. The fall in Japanese exports show how badly affected the economy is.
  • See also: Causes of financial / economic crisis
What caused the collapse of a substantial housing bubble?

The US housing bubble was based on unconventional mortgages which relied on house prices rising, low deposits and high income multiples. When house prices stopped rising, these mortgages were withdrawn and so demand fell. Banks became reluctant to lend because
  • they had lost money
  • house prices were falling
Also, many mortgages were missold. They were sold when interest rates were very low (1%). When US interest rates increased many simply couldn't afford the payments. Normal lending criteria were ignored and defaults rose.
Also, there was a sudden change in sentiment. When house prices were rising, builders, banks and buyers were bullish; wanting to believe house prices would keep rising. When house prices fell, everyone wanted to leave market, exacerbating the initial fall.

For more detail - see: Why roof fell in on US housing Market.

Do you think it is the main factor of the economical crisis?

1. A big factor is the subprime mortgage losses. Banks and financial institutions lost huge sums on mortgages that people couldn't pay. Other banks were affected because they had bought repacked mortgage bundles. Banks around the world lost huge sums so they stopped normal lending. This decline in lending has caused lower investment and spending.
2. House price fall. Related to first point. The decline in house prices has caused people to spend less and confidence has plummeted.

See: other causes of current recession

Are there Ways to predict and prevent another huge economical downturn?

Future macro Policy needs to look beyond just inflation and growth statistics. We need to monitor carefully credit and asset prices. We can't allow another unsustainable credit bubble. Even if means forcing banks to ration credit in boom periods. Also, we can't expect to control economy and finance sector just through one policy measure - interest rates.
What would you do to solve the problem?

There is no magic solution to wave the problem away. It is very important we avoid deflation, even if it means quantitative easing and increasing money supply. Fiscal Policy has an important role as well as the lower interest rates. But, in a way the economy was so highly leveraged that a painful readjustment is necessary to some extent. Hopefully, the crisis will usher in a new period of more responsible lending and banking.


supernova said...

"Are there Ways to predict and prevent another huge economical downturn?"

A quite funny but profound and true response is:

"There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know."
Donald Rumsfeld

Baz said...

Hi Tejvan,

Its been a while, but I still very regularly visit this blog. If you don't mind answering this, what business channels on television would you recommend for business and economics enthusiasts like myself? I get Bloomberg, CNBC, and Fox Business Channel, but I have found myself being rather fond of Bloomberg. Are there any other resources, such as websites, I should frequent too?

Thx from PA, USA,


Tejvan Pettinger said...

I live in UK, so don't follow US news. I like Economists and Bloomberg website and British newspapers like independent and Guardian