CAUSES OF THE CURRENT ECONOMIC CRISIS by Karim Pal

This week in Economics Society, Karim examined some of the causes of the economic crisis facing the world economy now.

The areas explored in this talk included:

  • American housing bubble and subprime mortgage crisis.
  • Greek Debt
  • Crash of the Icelandic Banks
  • The underlying cause – Deregulation of markets

 

Subprime Mortgages

These are mortgages that banks gave to people with poor credit ratings, who would not otherwise have been able to obtain a loan. Given the high risk of these loans not being paid back banks charged higher interest rates (there are many different ways of calculating this, the most common is through indices such as LIBOR plus an extra margin). One of the most common types of subprime loan is the Adjustable Rate Mortgage (ARM), where borrowers start off paying low interest rates, but then must pay higher rates later on. These types of loans became incredibly popular in America, especially amongst immigrants and those who could not previously obtain loans; people felt they could now buy their own houses. By 2005 1/5th of all mortgages in America were subprime.

Banks believed these loans were safe even though there was an element of risk of people defaulting since banks could repossess the property purchased by the loan. Properties were considered to be a safe investment since there was an expectation that the property prices would keep rising. These mortgages were ‘securitised’ by bundling them together and then selling them on the mortgage bond market. These were classed as involving low risk, even though the underlying assets were risky. These were traded internationally.

The diagram below compares the traditional mortgage lending model to the sub-prime mortgage lending:

1 - sub prime mortgages 

American housing bubble

The prices of houses fuelled in America and this was a reason why banks regarded sup-prime mortgages as safe investments. Higher demand for housing pushed prices up; there was a ‘mania’ for home ownership. House ownership grew from 64% which had been stable at since 1980 to 69.2%. More people now felt they could afford their own house partly because of the new ease of obtaining mortgages. Interest rates for standard mortgages were historically low, this pushed people towards spending rather than saving. Sub-prime mortgage lending fuelled prices even more creating the housing price bubble. Owning your own home was also attractive because it seemed a good investment- people saw house prices rising and thought it a better place to have their money than in a bank, a property as something safe to invest in that would retain its value.

2 - house prices

 The bubble bursts…

As time went by lenders began taking larger risks with who they were lending to. This is because they now had a huge amount of fund available due to being able securitise risky mortgages. It was also compounded by the low interest rates they could borrow at. By 2006 mortgage rates had begun to climb, the Fed had increased its rates from 1% in 2004 to 5.25%, with a risk it could rise higher. In the meantime house sales decreased and median price started to decrease. Slowly as more and more people were hit by the increased ARM rates more mortgages were defaulted on. As banks saw this they became more and more risk averse, decreasing lending, causing house prices to drop even further as the demand dropped. As more people defaulted banks and investors started making huge losses as even repossessing the house the mortgage was taken out to buy would not make their money back as house prices crashed. This led to financial crises in banks and even bankruptcy as seen at Lehman Brothers. This crisis spread worldwide due to the international distribution of mortgage bonds dragging the EU and other US banks into it.

The diagram below shows the failure of the sub-prime mortgage model:

3 - sub prime mortgage crisis

Greek debt crisis

Greece is now ranked as the country least likely in the world to pay back its debts, lower than all of Africa. Karim described the reasons that led to the Greek crisis.

Since Greece joined the Eurozone it has been living far above its means- easy credit was available due to having an AAA rating of the EU countries given the strong economies that form it like Germany. To join the Euro and stay as a member states must have a 3% of GDP borrowing cap. To meet this demand Greece concealed a lot of its borrowing meaning it was hard to find out what the deficit actually was. They used the ease of borrowing given their credit rating to increase expenditure both public and private. From 1999 to 2007 for example public sector wages grew by 50% for no apparent reason other than the fact they could now afford to. Big public debts were also run up from the 2004 Olympics. Another factor leading to Greece’s downturn was the fact its taxation system was weak. 30-40% of economic activity in Greece goes untaxed – this is a huge amount of revenue lost by the government (the average in Europe is 18%). This is caused by a lack of effective enforcement of taxation laws. The surge in Greek Spending is shown below:

4 - Greek Spending

Following a scandal in late 2008 the Greek government was removed and replaced with a new one. On entering government they found a lot less money than they expected and realised they would struggle to repay loans, so had to reveal their debt crisis to the world. From a budget deficit originally estimated at 3.7%- still higher than the amount allowed, this had to be recalculated revealing it was actually around 15%. Not only this but the Greek total deficit was in total actually €300 billion, 163% of GDP. Debt levels reached the point where the country was no longer able to repay them and was forced to ask for help from its European partners and the IMF in the form of massive loans (to repay its other loans). They were granted on the condition Greece put in place harsh austerity measures and reformed its taxation system.

Iceland’s banking crisis

Before the 20th Century Iceland’s main source of trade and income was through fishing. However, at the start of the new millennia Iceland’s financial sector expanded. By 2006 Iceland’s Banks had assets of over 140 billion Euros, compared to just a few billion in 2003. One of the main causes of this explosion was due to the rapid deregulation of their financial markets from the early 90’s, and the regulation of the fishing markets. This allowed them to fish more effectively, more sustainably and more efficiently, and so made some people very rich and giving other people the opportunity to engage in another activity. People turned to education and suddenly there were an abundance of highly educated people who didn’t want to fish for a living. They turned to banking.

High interest rates set by the central bank kept foreign money flowing onto the island, strengthening the Krona and making imported goods easily affordable. They dodged the expense of borrowing at those rates by borrowing at lower interest rates in foreign currencies (Japanese yen, Swiss francs) to finance homes and other big purchases. The money was also used to fund a reckless banking culture in Iceland where huge risks were taken; it became a huge sector of their economy. An IMF inspector sent to Iceland after the crash was quoted saying “Iceland is no longer a country. It is a hedge fund.”

The crisis began when Glitnir Bank had a payment due of €600 million on October 15 for bonds issued 5 years earlier. Mid-Sept collapse of Lehman Brothers brought worldwide lending to a halt. The debt was due and the bank lacked the funds to pay it. The government offered to buy 75% of bank for €600 million and as soon as deal went through, the credit rating for Iceland dropped. Iceland’s other banks were soon dragged down as the Krona’s value plummeted and their credit ratings were decreased.

The underlying cause of these crises

Karim argued that the cause of these crises in different economies could be underpinned to be the rapid deregulation of the banking systems around the world. Over same period there has been a vast amount of financial innovation and this saw the rapid expansion worldwide in the finance sector. The promise of government bailouts combined with this have seen flaws and cracks in the system emerge as people within the banks have taken huge risks with the lure of high profits.

Karim concluded that deregulation allowed the market failures that caused the crisis to be put in place. The discussion concluded with calling for the greater and effective regulation of the banks.

Suggestions for further reading:

  • Boomerang by Michael Lewis
  • End this depression now! by Paul Krugman
  • The return of depression economics by Paul Krugman

The discussion ended with questions regarding whether increased market regulation in other sectors caused the crisis in the first place and whether increased regulation would in fact be the way forward. Thank you to all those who attended. Any further discussion on this area is welcome.

 

Next week in Economics Society Sir John Vickers, Professor of Economics at Oxford University, will be presenting on ‘The future of Monetary Policy’. 

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