Deepening global financial crisis

By S P SETH

It is quite daunting to get a handle on the worsening financial situation of Western economies, including the United States. Not long ago, the European Union of 27 countries, and its euro zone of 17 countries with a common currency, was the hallmark of regional consolidation, setting an example for many other regions. But it is having serious problems that might put the whole project at risk. The question is: what went wrong?

What has gone wrong is that the entire edifice of capitalism increasingly became like a pyramid structure based on sand dunes of flakey finances. It became an exercise, in most cases, of bundling up and bunching up several financial instruments of dubious/toxic value and to trade them as real products. And so long as the governments, banks, hedge funds, insurance agencies and the likes continued to paddle this illusion, everybody seemed happy. And to keep the merry go round, there was more credit available than ever and people were encouraged to borrow from banks and other credit institutions to buy houses and whatever they wanted. The new economy supposedly had got rid of inflation and the upward curve was there to say with more of the same.

While China was busy being the factory of the world producing cheap consumer goods and building up trade surpluses with the United States and Europe, the latter were wittingly or unwittingly running down their manufacturing base. China’s cheap goods helped to keep the inflation down in the United States, Europe and elsewhere in the world. And to keep up the momentum of its manufacturing exports, China happily invested significant amount of its trade surpluses in the US bonds and treasury notes, thus providing it with cheap credit.

And we know that when the economic bubble burst in 2008, Western economies were like the emperor with no clothes. The economic bubble first burst in the United States where, among other things, the housing market collapsed with people unable to repay their mortgages. The collapse of the US housing market sent shock waves into Europe because many of their banks had invested into US-origin toxic financial products, including mortgage stocks. Which meant that Europe too got involved into the huge pyramid credit scheme designed in the United States by its banks and other financial institutions.

The resultant global financial crisis was sought to be dealt with in two ways. First, the failing banks were bailed out by the state in both the United States and Europe. Which meant that the private losses of banks and other affected institutions were socialized and turned into sovereign debt at the cost of public finance. Second: The states undertook measures to stimulate their economies by borrowing more money on top of what they already owed so as to stem recession. But it hasn’t worked quite like that. The US economy, for instance, is in deep trouble with official unemployment at 9.2 per cent with 14 million unemployed. The anticipated recovery was supposed to create more employment and more revenue to kick start the economy that, in turn, will pay off the debt over a period of time. It was the usual formula of the boom and bust cycle, one following the other and so on.

Even as the US is stuck in economic rut, its politicians are trying to score political points in the fashion of Emperor Nero fiddling while Rome was burning. The US debt is about to reach its present limit of $14.3 trillion. And if by August 2, the debt limit is not raised, the country will not be able to pay many of its bills, like interest payments on its debt, salaries and welfare entitlements and so on. In the event, it will not only seriously dent the United States’ economic credibility but also worsen the global economic crisis. Two of the international rating agencies have threatened to downgrade US’ top level (AAA) credit rating.

The political controversy in the US centers on the need to rein in US debt through a mix of spending cuts and tax increases. The Republicans oppose any kind of tax increase, and advocate significant spending cuts to slash welfare entitlements. President Obama and Democrats in the Congress broadly favor a mix of the two. They are engaging in political brinkmanship, particularly the Republicans, waiting which side will blink first. And if it is not resolved by August 2, the US and the world, by most accounts, might be in even greater economic trouble.

Even if the immediate crisis is resolved and the debt ceiling raised, the US economy remains in serious trouble. The stimulation packages haven’t worked to revive the economy meaningfully, if at all. The Federal Reserve’s efforts by injecting more liquidity through printing money and buying bonds haven’t done the trick. Neither has keeping the official interest rate at around the lowest point revived the confidence. With millions of people unemployed and under-employed and many unable to repay their mortgages and other loans, the consumer confidence is at a low point. The morale in the United States is quite low because people can’t see much hope over the horizon.

At the same time, in Europe, Greece is teetering, Ireland and Portugal are already on drip with their respective rescue packages, with Spain and Italy not too far behind. The European Union, and its euro zone, is not sure if successive bailouts of sick economies are worthwhile if they will have to eventually default on their debts. If they default, it will affect the balance sheets of German, French and other banks exposed to the debts of these economies. Which, in turn, might require their governments to bail out their banks. It is a vicious circle, with no escape hatch.

Among the major world economies, China has weathered the crisis relatively better. But it has serious problems of its own---inflation, for one. But that is another story.

Note: This article was first published in Daily TimesDeepening global financial crisis

By S P SETH

It is quite daunting to get a handle on the worsening financial situation of Western economies, including the United States. Not long ago, the European Union of 27 countries, and its euro zone of 17 countries with a common currency, was the hallmark of regional consolidation, setting an example for many other regions. But it is having serious problems that might put the whole project at risk. The question is: what went wrong?

What has gone wrong is that the entire edifice of capitalism increasingly became like a pyramid structure based on sand dunes of flakey finances. It became an exercise, in most cases, of bundling up and bunching up several financial instruments of dubious/toxic value and to trade them as real products. And so long as the governments, banks, hedge funds, insurance agencies and the likes continued to paddle this illusion, everybody seemed happy. And to keep the merry go round, there was more credit available than ever and people were encouraged to borrow from banks and other credit institutions to buy houses and whatever they wanted. The new economy supposedly had got rid of inflation and the upward curve was there to say with more of the same.

While China was busy being the factory of the world producing cheap consumer goods and building up trade surpluses with the United States and Europe, the latter were wittingly or unwittingly running down their manufacturing base. China’s cheap goods helped to keep the inflation down in the United States, Europe and elsewhere in the world. And to keep up the momentum of its manufacturing exports, China happily invested significant amount of its trade surpluses in the US bonds and treasury notes, thus providing it with cheap credit.

And we know that when the economic bubble burst in 2008, Western economies were like the emperor with no clothes. The economic bubble first burst in the United States where, among other things, the housing market collapsed with people unable to repay their mortgages. The collapse of the US housing market sent shock waves into Europe because many of their banks had invested into US-origin toxic financial products, including mortgage stocks. Which meant that Europe too got involved into the huge pyramid credit scheme designed in the United States by its banks and other financial institutions.

The resultant global financial crisis was sought to be dealt with in two ways. First, the failing banks were bailed out by the state in both the United States and Europe. Which meant that the private losses of banks and other affected institutions were socialized and turned into sovereign debt at the cost of public finance. Second: The states undertook measures to stimulate their economies by borrowing more money on top of what they already owed so as to stem recession. But it hasn’t worked quite like that. The US economy, for instance, is in deep trouble with official unemployment at 9.2 per cent with 14 million unemployed. The anticipated recovery was supposed to create more employment and more revenue to kick start the economy that, in turn, will pay off the debt over a period of time. It was the usual formula of the boom and bust cycle, one following the other and so on.

Even as the US is stuck in economic rut, its politicians are trying to score political points in the fashion of Emperor Nero fiddling while Rome was burning. The US debt is about to reach its present limit of $14.3 trillion. And if by August 2, the debt limit is not raised, the country will not be able to pay many of its bills, like interest payments on its debt, salaries and welfare entitlements and so on. In the event, it will not only seriously dent the United States’ economic credibility but also worsen the global economic crisis. Two of the international rating agencies have threatened to downgrade US’ top level (AAA) credit rating.

The political controversy in the US centers on the need to rein in US debt through a mix of spending cuts and tax increases. The Republicans oppose any kind of tax increase, and advocate significant spending cuts to slash welfare entitlements. President Obama and Democrats in the Congress broadly favor a mix of the two. They are engaging in political brinkmanship, particularly the Republicans, waiting which side will blink first. And if it is not resolved by August 2, the US and the world, by most accounts, might be in even greater economic trouble.

Even if the immediate crisis is resolved and the debt ceiling raised, the US economy remains in serious trouble. The stimulation packages haven’t worked to revive the economy meaningfully, if at all. The Federal Reserve’s efforts by injecting more liquidity through printing money and buying bonds haven’t done the trick. Neither has keeping the official interest rate at around the lowest point revived the confidence. With millions of people unemployed and under-employed and many unable to repay their mortgages and other loans, the consumer confidence is at a low point. The morale in the United States is quite low because people can’t see much hope over the horizon.

At the same time, in Europe, Greece is teetering, Ireland and Portugal are already on drip with their respective rescue packages, with Spain and Italy not too far behind. The European Union, and its euro zone, is not sure if successive bailouts of sick economies are worthwhile if they will have to eventually default on their debts. If they default, it will affect the balance sheets of German, French and other banks exposed to the debts of these economies. Which, in turn, might require their governments to bail out their banks. It is a vicious circle, with no escape hatch.

Among the major world economies, China has weathered the crisis relatively better. But it has serious problems of its own---inflation, for one. But that is another story.

Note: This article was first published in Daily Times