Monday, December 21, 2009

Economics of the Naughties

At the turn of the millennium, the landscape of economics was quite different. It was a period when major economies like the US and UK briefly had budget surpluses. It was a period of great optimism with people talking about the end of business cycle. For many analysts the world economy was living proof of the triumph of market forces, the efficient market hypothesis, and belief in the strength of unchecked capitalism. Yet, at the end of the decade, the global economy is still reeling from the biggest crisis since the Great Depression of the 1930s.

Here's a brief overview of some of the major economic events in the past decade.

The 2001 Recession

The terrorist attacks of 2001, contributed to a sharp downturn in the US economy leading to a mild recession. Faced with plummeting markets and falling output, the Federal Reserve acted quickly to cut interest rates and restore economic growth. The ease with which the Federal Reserve averted a prolonged downturn led to a round of self-congratulation amongst leading policy makers. As Paul Krugman noted 1997, it really did seem that:
“If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” (When Greenspan was nearly God)

It was also a period of financial deregulation, and financial innovation. Rising house prices encouraged a rash of new mortgage types. Never had it been so easy to get a mortgage. The combination of low interest rates and financial deregulation encouraged a new generation of homeowners to take out mortgages that previously would have been unthinkable. Based on a great sense of optimism of (seemingly) permanently rising house prices, banks seemed willing to lend a mortgage to just about anyone who could sign on a dotted line.

In the middle of a boom, the US cut income taxes and the UK increased government spending. Both of which caused a structural budget deficit. This worried few people at a time of prosperity, but was to become much more significant later.

Boom and Bust

With low inflation, low unemployment and strong growth. It appeared policy makers had achieved the holy grail of economic stability and constant growth. Talk of the end of the business cycle was common.

But, this stability masked an asset boom and a rise in unsustainable subprime lending, that nobody seemed to be aware about. At the start of 2006, few if any could have predicted how fragile the global financial system was. Healthy profits masked a much different story.

After keeping interest rates too low for too long, in 2005-06, the Federal Reserve finally began to increase interest rates. Nothing spectacular, interest rates were increased to 5%. But, even this modest rise in interest rates sparked one of the most spectacular wave of loan defaults the world economy has ever seen. It was only after a modest rise in interest rates that people started to realise how absurd many mortgage deals had been made.

After rising inexorably and against many optimistic forecasts (see: Books they wish they hadn't written ), US House prices started to fall and nervous banks started to realise alot of their sub-prime mortgages had all the foundations of a sand castle, based on the assumption the sea would always keep retreating.

In other times, this wave of mortgage defaults may have stayed in America. But, thanks to financial deregulation and a collective amnesia in analysing risk, the financial community had very nicely spread these toxic subprime loans all around the global financial system, rebundling them into seemingly anonymous Collateral Debt Obligations CDOs. If you don't understand what a CDO is, it seems many professional bankers didn't really know what they were buying either.

The result was that suddenly the liquidity evaporated from the global banking system. Everyone was hurrying to try and improve their balance sheets and recall toxic loans. But, it was too late, no-one wanted to lend to each other anymore. The cleverest and riskiest banking strategies now appeared for what they were - a recipe for self-bankruptcy. It all seemed like a bad joke, except, it was a very expensive joke with the taxpayer paying - see humorous look at sumprime crisis)

For more details see step by step Credit Crunch explained -

In the summer and autumn of 2008, it appeared no financial institution was safe. Just when you thought it could get no worse, another huge financial company announced they were on the verge of bankruptcy. Northern Rock, Bradford & Bingley, JP Mogan, Citigroup (to list but a small number who received government bailouts). Mostly, the taxpayer rode to the rescue and bailed out the banks with mind blowing sums. But, for whatever reason, when it came to Lehman Brothers, the American authorities decided to say "sorry, but, no". It was perhaps a brave and courageous decision. But, it was a decision they were to quickly regret. Financial markets and consumers panicked - the great assumption that no bank could possibly fail was suddenly exposed as a myth. Now, no bank now was safe. The only thing to do well was gold and mattresses as people sought to hoard their wealth in gold or cash under the bed.

The crisis precipitated the biggest fall in GDP since the great depression. In fact the start of the 2008 recession was just as severe as the Great Depression. With collapsing house prices, banks on the verge of bankruptcy, and confidence hammered, there was a real possibility of another depression.

To be fair after making so many mistakes in allowing the bubble and credit crunch, the response of governments to the crisis was reasonable. At least some of the mistakes of the Great Depression had been learnt. Though it is a bitter pill to swallow, governments prevented more bank collapses with bailouts. Interest rates were slashed, expansionary fiscal policy was pursued and even the unorthodox monetary policy of quantitative easing was pursued to avoid the great threat of deflation.

The most pessimistic forecasts of another depression have been averted. But, that doesn't mean all is well. Far from it. Banks still nurse fragile balance sheets, economies are being propped up with unprecedented government intervention. Public debt has ballooned creating real threats of government default in various western economies. The recovery will be very difficult. Trying to balancing record debt against the need to maintain growth.

It was also a decade where the problems of global warming became increasingly apparent. But, a problem the global community seem unable or unwilling to tackle. If the scientific forecasts for global warming prove correct, the credit crisis could seem a minor problem compared to the devastation caused by rising sea levels and weather crisis.


Lessons from the Economics of the Naughties.

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