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Financial Crisis in USA and the Lesson for India

By: Dr.Dipak Basu
Oct-07-2008
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(The author is a Professor in International Economics in Nagasaki University, Japan)
 


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"An open, competitive and liberalized financial market can effectively allocate scarcer resources in a manner that promotes stability and prosperity far better than government intervention,"" Henry Paulson, the U.S Treasury secretary said in Shanghai in March 2007. This year it sounds like a big joke given the fact that both the United States and UK government s are nationalizing banks and financial institutions in order to avoid a complete meltdown of their financial system. On 7th September, 2008 the US government has nationalized two huge US banks, Fannie Mae( Federal National Mortgage Association) and Freddie Mac( Federal Home Mortgage Corporation). That means in effect that the government is about to pay for the losses of the shareholders and investors in these banks - $5.4 trillion of guaranteed mortgage-backed securities (MBS) and debt outstanding. These liabilities are equal to all the publicly held debt of the United States. The proposed program, if accepted, to buy a mountain of defaulted housing loans and other worthless assets from banks and finance companies will cost an estimated $700 billion to $1 trillion U.S. dollars.

This money will come from U.S. taxpayers, most of whom are ordinary workers. It amounts to taking around $2500 U.S. dollars from every U.S. citizen - and giving it to the banks and finance companies. This money could have been used for health care, for improved education, for scientific research, for social welfare program; for environmental protect; or other socially useful purposes. Instead these are going to support a false doctrine.

The media is not telling us the real reason behind the crisis that is as serious as 1930"s crash of the share market in USA if not more so due to the globalization of finance in these days of electronic fund transfers and interdependency of the financial institutions in major capitalist country. What is at stake is the Anglo-American liberalized economic system promoted since 1980"s, which accepts only the free market and a privatized economy without public ownership.

There are two reasons behind this present crisis; both of them are the result of this liberalization of the economy. The first is the idea that people can take care of their housing needs without any help from the government. The second is to consider liability as asset by building a whole mountain of mathematical superstructure to turn gambling bets as respectable assets. Neither of these can happen if there is a public ownership of financial institutions and if the government takes the responsibility for the basic needs of the people.

Housing Needs in USA:

In USA, chronic poverty afflicts wide sections of the working class, particularly those employed in the predominantly low-paid and casual service industry. According to the American Conference of the Mayors in 2004, there are at least 34 millions of homeless people who have received some kind of assistence but there many many more who could not get any help at all. Of all adults requesting food assistance, 34 percent were employed. Children and their parents accounted for 66 percent of all recipients of food aid. Families now make up 40 percent of the total homeless population in the United States. 25 percent of homeless families do not receive any welfare benefits because they are unable to provide any home address. Children constitute 43 percent of the homeless. Adults in families account for 35 percent. Single adults comprise the remaining 22 percent.

Poverty in USA rose continuously with nearly 36 million people, or 12.5 percent of the population, living at or below a subsistence level. About 18 percent or 13 million of the American children live below the poverty level. These figures vastly underestimate the real poverty rate, since the official poverty level for a family of four, $18,660, is absurdly low. People living at or below this income level are not simply poor, but destitute. The Census Bureau reported that the number of Americans without any medical insurance had reached 45 million.

Origin of the Crisis:

Given these dire conditions it is natural people will seek some kind of means to get a shelter. The market system cannot provide free housing for the people but a planned economy can as it was guaranteed under the Soviet system. The market can at best provide cheaper or readily available loans for the people to buy a home. During the 1930"s depression in USA, Fannie Mae was created by President Roosevelt, as a public sector mortgage proving institution. However, it was privatized in 1968 and in 1970 Freddie Mac was also created with financial support from the US government to provide some competition. They together cover almost 90 percent of the mortgage market of USA. In 1993 President Bill Clinton ordered new regulations to increase access to mortgage credit for inner city and distressed rural communities. The new rule allowed Fannie and Freddie to provide loans upto 97.5 percent of their total deposit when ordinary banks can give loans upto 90 percent of their total deposits. This means by 2007, Fannie and Freddie owned or guaranteed nearly half of the $12 trillion U.S. mortgage market.and do not have much reserve to fall back upon if the borrowers cannot pay back their housing loans.

Most of the people who took advantage of these housing loans are not normally qualified to take any loans as they are poor or even unemployed. Then, the banks in USA did an extraordinary trick by changing the definition of liability of these loans into assets calling then Mortgage Backed Securities, which were sold to the banks all over the world.

In other words, the foreign countries were asked to subsidise the housing needs of the American poor but they were told that these are good investments as the housing prices were then going up at an astronomical rates in both USA and in every other Anglo-Saxon countries. To fuel that bubble in the housing market, interest rates were kept at a historically low rate in every Anglo-Saxon countries like USA, UK, Australia, Canada and New Zealand.

A Wrong Economic Policy:

Economic policy of these free market Anglo-Amnerican economies were then directed towards some convictions that unemployment helps keep wages low and is a good thing; and that wage rises are always inflationary. It is this orthodoxy that has caused wages and other forms of compensation to fall as a share of GDP in all developed countries over the past three decades. This fall in compensation has forced people to supplement incomes by borrowing more and more. Added to the monthly payments of their housing loans, very soon they found that their incomes are unable to pay for even their basic needs of food and other essential expenses.

In that situation even a small increase in interest rate can trigger a crisis in family budgets and people have started giving up their houses as they are unable to keep up with the payments for their housing loans. That has caused the lenders to have a pile of used houses which they cannot sell anymore. As a result these financial institutions cannot pay the dividends for the Mortgage Backed Securities they have sold to the world"s banking system. Thus, the crisis spread from USA to the rest of the world like wild fire.

Meanwhile, it looks like the U.S. administration is now doing exactly what it always advise the developing countries not to do -- not to subsidize the domestic economy via negative real interest rates or wider fiscal deficit. At the same time, international financial institutions such as the IMF are expressing support for U.S. authorities, while they were always very critical against similar policies of any developing countries. There is one rule for the rich and another for the poor.

The U.S. Federal Reserve and Treasury are now trying to eliminate these now worthless Mortgage Backed Securities or toxic debt of financial institutions, reduce the stock of "virtual" money, such as various structured products and derivatives, which contain this toxic debt, and eventually "monetise" that stock of "virtual" money created by private financial institutions i.e., to replace the virtual money by real money.

Creation of virtual money in the virtual world of mathematics:


The creations of these virtual money or derivatives are nothing but some kind of bets in a gambling casinos, where different financial institutions are betting for the future values of various financial instruments, like rate of interests and exchange rate of various countries and currencies and prices of various commodities, along with the future values of the Mortgage Backed Securities. The betting cannot be done without attaching some prices for these betting. Here comes the Bible of financial economics, a book, "Mathematics of Finance" written by Robert Merton, who along with Myron Sholes got Nobel Prize in Economics for their mathematical invention to attach values for these bet. Robert Merton and Myron Sholes later have founded a company to put their theory into practice and the company went bankrupt with Billions of Dollars of debt. However, even after that the enthusiasm of the Anglo-American financial markets for pure gambling in the names of financial derivatives went higher and higher resulting into more and more bankruptcies like Barring Bank or Equitable Life. The game went on describing what can be dangerous financial risks as assets just by attaching values on them. The fundamental idea is the basic assumption in Mathematical Statistics that past can predict the future.
However, there is one very important lesson from the past is missing here: the experience of 1930"s crash of the US Stock market, that speculative bubble would burst sooner or later and no mathematics can predict when that would happen.

Greed is Good:

Another factor that has contributed to the crisis is the greed of the corporate managers of these financial institutions. Getting intoxicated by the creation of the virtual money using bets on the financial futures they have rewarded themselves astonishing salaries which sometime higher than national incomes of most countries.

Much of the so-called losses of these financial services companies are due to the excessive salary granted to hundreds of senior executives who have siphoned off depositor"s money in terms of their salaries and commissions and now asking the public to pay for these losses. Wall Street chief executives treated themselves to some of their fattest pay packages ever. Citigroup"s Sanford Weill was paid $44.6 million as his annual income for his work as chairman and CEO. Merrill Lynch"s president and CEO, E. Stanley O"Neal, received $28 million as his annual income. James Cayne, chairman and CEO of Bear Stearns, another big investment house that went bankrupt recently, earned more than $39 million per year recently. In simple words the senior executives of all private financial institutions in the Anglo-American countries looted the depositor"s money but got away with when in Australia still today aborigine boys can get jail sentences for stealing a pencil.

Forbes magazine listed 587 individuals and family units worth $1 billion or more. The combined wealth of these billionaires reached $1.9 trillion. The wealth of these few hundred people exceeds the gross domestic product of the world"s 170 poorest countries combined, and equals nearly 4 percent of the annual production of the entire world. The world"s top three billionaires alone possess more assets than the combined Gross National Product of all the least developed countries and their combined population of 600 million people.

While 1.3 billion people struggle to live on less than $US1 a day, the world"s richest 200 people have their net worth more than $1 trillion. About 840 million people are malnourished, and close to one billion find it difficult to meet their basic consumption requirements. More than 880 million people lack access to health services, and 2.6 billion people have no access to basic sanitation. Their needs cannot be satisfied by the market system when one of the richest countries of the world cannot satisfy the basic needs of almost one third of its population using the same market system

Conclusion:

After the crash of 1930"s, the faith on the market economy was replaced by an almost socialist policy package of President Roosevelt that the public ownership of the means of production and distribution are needed to provide the basic needs of the people and government interventions and strict regulations are necessary to regulate the market so as to allocate resources in the best way possible. Today similar ideas are being introduced once again by nationalizing the banks and financial institutions in both USA and UK. This should be a lesson for India who has introduced the market system in 1991 with results that has satisfied the fat cats of the Wall Street who are pouring short term investments on India to make the economy more and more vulnerable to the turmoil of the Anglo-American financial system, but could not provide basic facilities of life to the 70 percent of the population of India who are poor by any definition.

Since 1991 The IMF and the World Bank, and the US Treasury along with their counterparts in Britain are inducing India to go along their road, which would be fatal at the end. India has partially privatized a number of financial institutions. India was about to give away its public pension funds to the stock market. After looking at the experience of USA and the UK, India should learn that the Anglo-American model does not work. They have failed to lift up the living standard of their own poor and thus cannot provide any lesson for India.

Anglo-American economics, whether of David Ricardo of 18th century or Paul Samuelson or Robert Merton of 20th century, looks beautiful in the virtual world but it is meaningless in the real world. Our Prime Minister who has learned only a very diluted form of that economics has no clue how to solve India"s perennial problem of poverty with the virtual instrument of the Anglo-American economics. There was no financial melt down in the Soviet Union, but every citizens were assured of adequate housing free of charge where the state used to provide all utilities, electricity, water, gas, heating, free of charge as well. Anglo-American model, which depend on the private mortgage market and the whims of the real estate agents could not provide adequate housing for everyone. Those who have attempted to overcome that problem by taking loans which they could not afford, ended up as both homeless and loan-defaulter at the end and the Anglo-American financial system that is supposed to provide efficient market solution to the housing problem failed miserably at the end of the day.


Dr.Dipak Basu

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