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Financial Crisis Essay

Introduction:

The economic problems that are plaguing the United States economy at the present are numerous to say the least.  Since the collapse of the Housing market, the United States has experienced what some have come to call an economic recession.  While it remains to be seen if the United States economy is really undergoing a recession at this point in time, this situation can be used as a great opportunity to point out the current struggles of the American economy.

The fundamental flaws and structural weaknesses of the American economy are not only more visible now but also more potentially damaging.  The current weakness that the American currency is experiencing coupled with the exponential increase in oil prices may have arguably not placed the country into recession but have brought its economy pretty close to it.

As such, this brief discourse will try to examine what brought about this economic collapse by identifying the present economic threats to the United States; namely, Pension Underfunding, Public Debt, Overbuilding in Calamity prone areas, Retirement and Social Security and Energy.  This will be done in the light of the effort of the Federal Reserve to address the this issue and will be accompanied by an assessment of the effects of these policies on the current financial situation.

Efforts of the Federal Reserve

The current economic crisis that has rocked the global economy has prompted many countries to take drastic measures in order to deal with the situation.  The Federal Reserve and the National Treasury have also teamed up to deal with this global economic crisis by instituting several reforms and policy changes.  With the goal of providing an immediate and permanent solution to the problem, the Treasury, with the help of the Federal Reserve, has instituted these five fiscal policies to alleviate the situation.

One of these policies is the voluntary capital purchase program.  It is aimed at selling preferred shares of stock to the United States Government on favorable terms that afford the maximum amount of protection to the taxpayer.  Another policy that has been implemented is the systematic risk exception under the FDIC Act which grants the FDIC the power to guarantee, on a temporary basis, the senior debt of all FDIC insured institutions.  The third policy that has been announced is the increased access to funding for all of the businesses in various sectors of the American economy.  The goal of this is to stimulate economic growth on a micro level in order to develop solid economic fundamentals that can help resuscitate the economy.

Other steps that the Federal Reserve and the National Treasury have taken include the strengthening of capital position and funding ability of American Financial Institutions.  These are to be achieved through multilateral agreements such as the reciprocal currency arrangement (Swap Lines) with International Central Banks.  Finally, the heralded US $700 billion bailout plan that was recently enacted into law has also been designed to infuse much needed capital into the market and to protect the exposure of several multinational and local financial institutions.

Despite all of these moves by the Federal Reserve and the National Treasury, however, it still remains to be seen whether or not these “quick fixes” can actually provide real and lasting solutions that have been caused by poor economic fundamentals.

The direct relationship that interest rates, inflation and even higher wages have on the amount of money supply is a matter of importance for the Federal Reserve because as shown in this study, and change in these factors could increase or decrease the money supply and adversely affect the economy of the United States.  The key for the Federal Reserve then remains in being able to closely monitor these factors and be able to anticipate any sudden changes and react accordingly by utilizing the many tools that are at their disposal.

Bailout Effects:

The economic problems that are plaguing the United States economy at the present are numerous to say the least.  Since the collapse of the Housing market, the United States has experienced what some have come to call an economic recession.  While it remains to be seen if the United States economy is really undergoing a recession at this point in time, this situation can be used as a great opportunity to point out the current struggles of the American economy.

The much touted and highly publicized US $700 billion bailout plan is argued to be good for the economy as a “quick fix” to the problem yet there are a number of economists who feel that the real solution to the problem lies in establishing more solid fiscal and monetary market fundamentals.

In order to arrive at a better understanding of this problem, the main reasons for the collapse of the American Economy must first be examined because any solution that is provided must deal with the foundations of the problem.  The fundamental flaws and structural weaknesses of the American economy are not only more visible now but also more potentially damaging.

The current weakness that the American currency is experiencing coupled with the exponential increase in oil prices may have arguably not placed the country into recession but have brought its economy pretty close to it.  As such, this brief discourse will try to examine what brought about this economic collapse by identifying the present economic threats to the United States; namely, Pension Underfunding, Public Debt, Overbuilding in Calamity prone areas, Retirement and Social Security and Energy.

The question on whether or not the US $700 billion stimulation package for the United States economy will be effective depends on so many different factors.  The first criterion that must be examined is whether or not there really is a recession and therefore the need to introduce a new economic stimulus package.  As shown in recent reports, the United States economy has indeed taken a hit from the collapse of the subprime market.  This has led to a loss of jobs and a slowdown in economic growth.  This shows that there indeed may be a basis for the introduction of a stimulating package.

The second, and perhaps more essential question, is on whether or not the stimulus package is enough.  In order to address this question, it is relevant to examine the limitations and effects of the introduction of such a package.  At present, the economic slowdown has resulted in loss of jobs and ultimately lower revenues for the United States government.  The reduced demand for US backed treasury bills and securities also means that the Government is constrained with respect to the size of the economic stimulus package that it will release.

The projected loss of jobs and increase in unemployment rate is not necessarily affected by any economic stimulus package.  This is the reason why the question on whether or not the package should be higher is not really relevant.  Loss of jobs can be attributed to the economic fundamentals of the United States economy such as the shift in production facilities to other countries.  This is not necessarily a function of the current recession that the United States economy is experiencing but instead a result in the lack of solid economic fundamentals over the years.

Assuming that the package will indeed have the intended effect, the hands of the United States government are also tied down by budget constraints.  The treasury department can only allocate and release so much funds and this may or may not be the amount needed to effect that changes that many have proposed.

International Government Intervention:

As the current economic meltdown shows, there is indeed a dire need for government intervention.  At the peak of the Great Depression, John Maynard Keynes advocated for government intervention so solve the problem.  Similarly, the US $700 Billion bailout plan mirrors the type of government intervention that stopped the Great Depression.

The reason this policy was effective was because it negated the effect that other negative forces had upon the economy.  Without the ease by which goods could travel, such as in the present, the economy had to be resuscitated by the government.  As history shows, the solution lies not in letting the market forces dictate the flow of the economy alone but by allowing the government to regulate such flow.

The great danger in allowing a free market economy is that it does not allow for regulations.  We exist in a global market.  An action in one end of the world invariably affects the other side.  As such, care must be exercises, especially with regard to economics because of the repercussions that it might have.  The more complex markets of today have shown that the pursuit of self-interests, while natural of human behavior, must be regulated by external systems in order to ensure a more equitable and efficient allocation of resources.

Secondly, Government Regulation and Control makes sure that other economies “play nice.”  The current trade embargoes and quotas that are in place have a detrimental effect on many of the world’s economies.  As such, the role of the government is to arrive at a certain acceptable stance that does not stifle global economic growth but instead stimulates it.  A government is essential to the progress of the economy because it is able to control not only local factors but international factors as well.  With the globalization of local economies, it becomes imperative for any country looking to advance to not only deal with the local situation but the international situation as well.  This is the added benefit that Government Regulation and Control provides.

Global Impact:

The recent headlines show that economies all over the world are experiencing the economic crunch on all levels.  The tickers on the major stock markets of the world show significant drops that mirror the economic collapse of Asia in 1997.  Previously established economic such as Norway, Japan and even the Middle East are showing signs of market contractions as more and more people shift their investments away from high risk high profit commodities into more secure and stable ones.  Even the Oil Producing countries have experienced slow down in profit as caused by the anticipated lower demand in crude and market contraction.

As it is, the economic crisis that has affected the United States is not an isolated problem that affects only one aspect of the international economy.  A perfect example of this would be the collapse of the subprime market in the United States which precipitated the slowdown of one of the world’s largest financial institutions, the Citigroup.  Due to its exposure to the subprime market, the ensuing collapse led to a massive loss to Citibank which estimated its annual loss at nearly US$ 2 billion.  It therefore shows that due to the interconnectivity of markets all over the world, a collapse in one sector invariably leads to economic stagnation or collapse in others as well.

From a financial perspective, the economic slowdown has also caused a contraction in the money supply thus further slowing down economic growth all over the world.  It has been observed that there has been an increase in the level of Non-performing Loans (NPLs).  Non-performing loans is a term applied to loans that are in arrears and provide no profit for banking institutions.  There has been a noted increase in the NPL to Total Loan Portfolio (TLP) ratio from 14.6 percent as of June 2007 to 17 percent as of June 2008.  This signifies a 2.4% increase in the NPL to TLP ratio in the time span of one year.

As the world braces itself for the worst to come, there seems to be no relief in sight for these global economies.  Efforts to introduce and push for fiscal reform seem to be limited to outrageous government bailouts that do not promise much except to secure the creditors for the meantime.  Real solutions to these problems can only come from a deeper understanding of the fundamentals that are involved.  As such, the next section shall attempt to identify these problems and propose a remedy for them.

Problems and Solutions:

The first problem, Pension Underfunding is a very large problem for the American Economy.  According to certain independent studies, the underfunding that large companies have done for the pension plans will result in a very large public deficit in the future especially if the Pension Benefit Guaranty needs to bail out these companies.  The problem here is that the present workers and future pensioners are working without any future security.  There is no guarantee that upon retirement they will be able to receive anything.  This could spur an attitude of non-spending and result in an economic slowdown.

Another effect that this problem could have is on the healthcare system.  Without the financial security that the pension provides, the American healthcare system could bear the burden of millions of pensioners all seeking aid.  The healthcare cost in the United States is becoming excessive and people are unable to afford or obtain any type of healthcare. It cannot be denied that there is something wrong with the system today. The rate of the uninsured and underinsured is rising every year. Not having health coverage leads to 18,000 deaths a year (Davis 23).

A Universal Health Care system is to ensure that all residents, regardless of their position in life, maintain coverage in the event of injury or the need to pursue a general practitioner.  This type of system would increase taxpayer dollars, burden the government when funding is not available, cut funds from certain programs, and increase the number of patients to each nurse.  Thus, by having a weak pension fund the healthcare system of the United States could be affected thus increasing the financial burden upon the American government.

The Second problem is the ever growing public debt.  The recent economic slowdown as caused by the collapse of the Housing market has shown that there is no solid economic backing for many financial institutions.  In an economy where the public debt has amounted to over seven trillion dollars (US$ 7 trillion), it becomes clear that this problem is something that the future generations will have to deal with.

The problem with having a huge amount of public debt is that it could affect the debt servicing of the country.  At present, the United States spends nearly 10% of its Gross Domestic Product on debt servicing, with the increasing public debt and the maturity of these loans, the United States could have to increase the amount that it spends on paying back these loans.  The end result of this is that there could be a slowdown in the development of public services and also in the construction of public works.

In order to meet these payments, the United States government could be forced to increase taxes and cut back on public spending.  The net effect of this policy will be to make the economic struggle even worse.  Without the necessary government spending, the public would be wary about spending and would instead focus more on saving in order to anticipate future economic reverses.  This would result in a general economic stagnation.

Analogous to the collapse of the Housing sector is the collapse of the very houses that are erected.  It may be unfortunate to state that the woes of the Housing sector have only just begun but that is the case at the present.  The overbuilding that has happened in coastal areas and earthquake territories can result in massive property damages.  As the aftermath of Hurricane Katrina has shown, a single powerful hurricane could instantly wipe out billions of dollars worth of infrastructure.

The reason that this is a problem can be explained through this simple GDP explanation.  The basic GDP equation includes the amount that the government spends on infrastructure and the rechanneling of funds into the private sector.  In this model, the investment that a government makes in preschool programs creates more jobs and better opportunities for young students.  This directly affects the productivity curve of the populace therefore making it into an economic activity.

On the other hand, the new military weapon system is also another way of increasing the GDP because it creates more jobs and increases government spending in that economic sector.  The spending on healthcare and the controls that are placed on the internet can also be considered as economic issues because they directly and indirectly affect the amount of money that people will spend on these activities.  Stringent government regulations on the internet could stifle its economic growth.  Alternatively, by subsidizing the cost of healthcare, the government could make it more available and increase human capital investment.

Since the GDP of the government will be used to deal with the potential property damage should a single calamity occur in any one of these areas, the rest of the economy will suffer because the funds that are needed will be diverted to relief efforts.  The government is currently offering a number of subsidies to these companies and is therefore encouraging people to allow the government to bear the burden.  This is a serious economic flaw that must be addressed.

One of the problems, which are related to the first item, is the low savings rate which results in the reduction of social security.  The lower savings rate means that there could be a shortfall of nearly four trillion dollars (US$ 4 trillion) by the year 2017.  People are not inclined to place their savings in what they consider low return policies and instead have shifted to greater consumer spending.  While in theory this could be good for the economy, in the long run, this could result in more trouble.

With people less inclined to invest their funds or to save their earnings, there is a decrease in the amount of capital funds that are available in the market.  This in turn results in a slowdown of new comers into the market due to the scarcity of capital funds.  Greed as a regulator in a capitalist market functions in a similar way.  In what is termed as the “balancing mechanism” of greed, the capital that is infused into any industry or business will always look for the cheapest source.  Given this behavior, it is logical to assume that this capital will go to places where labor and materials are cheap.

This low cost will not remain forever and will eventually force the prices of the factors of production up and by doing so removing the advantage that was sought after in the first place.  This in effect levels the playing field and regulates the market.  The recent decrease in savings, however, will not create this scenario and will instead force the capital elsewhere and adversely impact the American economy.

Finally, the most serious problem is the large dependence that the United States has on oil.  The recent economic situation of the United States could arguably be better were it not for the exponential increase of oil prices.  As the world’s largest importer of oil, the United States spends a large amount of its funds on energy and energy alternatives.  It can even be argued that the total cost of most goods produced is attributed to oil costs.  The problem here therefore is the reliance that the United States economy has upon oil imports.  Any slight increase can drastically affect the American economy as we can see at present.

Conclusion:

In conclusion, the basic economic principles from the Keynesian era dictate that changes in the monetary and the fiscal policy directly impact inflation and unemployment.  The reason for this is that an increase in money supply means that there is more currency in the market.  This in turn leads to more spending which drives up the prices of goods.  This can be understood in the context of basic supply and demand.

This relation to unemployment, however, is quite different and may depend on many factors. Simplistically speaking, however, unemployment can be reduced by a change in either monetary or fiscal policy that encourages the growth of small to medium scale businesses.  By decreasing interest rates, the money supply increase thus allowing individuals and firms more access to capital that is need to run their own businesses.

One way to look at this problem in the real world setting is to discuss the impact of such in relation to the current economic stimulus that the United States government has planned.  As shown by certain researchers, the projected loss of jobs and increase in unemployment rate is not necessarily affected by any economic stimulus package.  This is the reason why the question on whether or not the package should be higher is not really relevant.  Loss of jobs can be attributed to the economic fundamentals of the United States economy such as the shift in production facilities to other countries.  This would mean that changes in monetary and fiscal policy would not necessarily have a direct effect on the unemployment rate.

So while current theories show that monetary and fiscal policies may indeed impact inflation and unemployment, such is not always the case in certain situations as shown in the example provided.  The basics such as solid economic fundamentals must always be considered when looking at the impact of such changes to see if they can really attain the desired effect.

References:

Baker, D. (2005). The Federal Reserve Board – The Most Important Source of Poverty in the United States Center for Economic and Policy Research Economics Seminar Series.

Baumol, W. and Blinder, A. (2006) Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, United States

Davidson, Scott. (2003). Economics: Perfect Competition and Monopolistic Competition. 2nd

            Series. Bantham Books: 103-105.

Davis, K. (2003). The costs and consequences of being uninsured. Retrieved February 4, 2008, from http://www.cmwf.org

Epstein, L. and Martin, P. (2003). The Complete Idiot’s Guide to the Federal Reserve. Alpha Books. United States

Mishkin, F. (1995) The Economics of Money, Banking, and Financial Markets, New York, Harper Collins. United States.

Stone, Diane. (2007) “Market Principles, Philanthropic Ideals and Public Service Values: The Public Policy Program at the Central European University”, PS: Political Science and Politics

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