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Easy come, easy go

Biru PakshaPaul
While tight money was the main cause of the Depression, easy money was at the centrepiece of the financial crisis of 2008. A lack of financial intelligence, of course, has aggravated the crisis to a critical extent.
THE US is currently experiencing a severe credit crunch, which is the gravest financial crisis since the Great Depression of the 1930s. The crisis has already spread out to Europe and Asia, and is expected to be global soon. Many economists believe that the US economy has entered a recession that might be longer than usual, sending the whole world into a slowdown. Here, I attempt to address the question of how the US financial system got there.
First, I would like to define "financial crisis." Since finance is the study of cash flows, every financial crisis is associated with the problem of cash flows, which we call a credit crunch or a liquidity crisis. In all previous financial crises, the problem started with the asset side of companies' balance sheets. We know that subtracting liabilities from assets gives us the net worth of a company. A precipitous depletion of assets can make the net worth of the firm zero, or even negative, sending the firm into bankruptcy.
Say, the assets of a company heavily depend on housing prices. Now, a collapse of housing prices can ruin the asset side of the company's balance sheet and throw the firm out of business. A quick injection of cash can save the firm from bankruptcy. Now, if this becomes a common problem across the board, liquidity shortage turns into a full-scale financial crisis. This is the case with the US financial crisis of2008.
To find the main causes of the financial crisis, we immediately point to sub-prime mortgages, aggressive lending, mortgage securitisation, and credit default swap. These reasons, however, only form the surface of the problem. If we dig deeper, we find that the cheap money policy during the Greenspan era caused many of these problems.
While the effective Federal funds rate (henceforth the Fed rate) was in the vicinity of 12-18 percent in the early 1980s, it has recently come down to about 2 percent. Despite the fluctuations, the Fed rate has been showing a downward trend since 1982 when Paul Volcker, the Fed chair, raised interest rates to curb hyperinflation. The Fed rate has remained steadily low, in the 1-5 percent range, since 2001. The country has never experienced such low interest rates for a couple of years in a row since the regime of President Nixon.
Low interest rates made mortgages inexpensive, created an artificial demand for houses, sent housing prices high, encouraged aggressive lending, made mortgage backed securitisation very attractive and. thereby, created a bubble in the housing market. Hie bubble burst in August 2007, and began to deflate the asset side of companies like Fannie Mae, Freddie Mac, JP Morgan, AIG, and so on. None of this would have happened had the US monetary authority not engineered the cheap money policy in the first place.
The second cause was the lack of prudent supervision, particularly of the newly developed synthetic financial products such as derivatives like options, swaps, and futures. Credit default swaps (CDS), which were invented by Wall Street in the late 1990s, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default.
The market for the CDS grew enormously. Since 2000, it has ballooned from $900 billion to more than S45.5 trillion -- roughly twice the size of the entire US stock market, and thrice the size of the US economy. Also, in sharp contrast to traditional insurance, the swaps are totally unregulated. Sub-prime mortgages were $35 billion in 1994 and they grew to S1 trillion in 2007.
Why did the regulatory bodies overlook their abnormal growth? Because they thought that the new products were great for their business. No problem. However, there is always a problem when anything grows too fast. This fact is a lesson from history and, unfortunately, we keep on forgetting it. The great lesson of this financial crisis is that we must ensure prudent supervision of any newly developed synthetic products. Greenspan calls it counter-party surveillance.
The share of manufacturing in the US GDP was three times higher than that of finance in 1950. Now, finance is double the amount of manufacturing. However, supervision of finance has not progressed in tandem. Treasury Secretary Henry Paulson admitted that the US financial regulatory structure has become outdated.
Greed and deregulation were the main causes of the financial crisis according to the two US political parties. While greed as a cause of this crisis is hard to quantify, deregulation as a cause of this crisis is hard to justify. The US economy reaped the golden harvests of deregulation for the last 25 years. The country enjoyed the longest boom in history because of deregulation. Even communist China does not want to abandon deregulation and free market economy. Both China and India embarked on liberalisation, and registered spectacular growth in the last two decades.
While tight money was the main cause of the Depression, easy money was at the centrepiece of the financial crisis of 2008. A lack of financial intelligence, of course, has aggravated the crisis to a critical extent.
Dr. Blnj Paksha Paul Is Assistant Professor of Economics and Finance at the State University of Now York at Cortland.