MACRO-ECONOMIC POLICIES: DOES IT WORK IN A CRISIS? – PART1 – BY Dr. BOBBY SRINIVASAN AND Dr. SUDHAKAR BALACHANDRAN

October 14, 2014 | Posted by bobbysrinivasan << back to blog

Since the sub-prime crisis of 2008, the global economic scenario has become somewhat warped and it has become a challenging task to predict the future economic growth of a country. Why and how did this happen? To answer the question, we should trace back to the starting point which is 1999-2000, when the dot-com bubble wiped out several trillion dollars. Nearly 160 dot com companies went belly up in the US during that period. To avoid a serious recession, the US Federal reserve under the leadership of Dr. Alan Greenspan reduced the discount rate from 6% to 1% in a short period of time. This enabled the US economy to survive this stress. However, too much liquidity was pumped into the economy which later became the reason for the 2008 sub-prime crisis.
Lesson 1: To prevent an economic slowdown from becoming a full blown recession, countries choose to pump in large amounts of money. This definitely gives a temporary respite but the long run outcome is not certain.
Lesson 2: Alternatively, the federal reserve of a country could buy back the bonds that they issued and release cash. In both cases, interest rates will come down because of increased money supply.
Reverting back to the sub-prime crisis, there are several theories why this come about which literally damaged the global economy almost beyond repair. The timely intervention by the US government using the QE1, QE2 and QE3 saved the rest of the global economy from falling into a hell hole. If this had not taken place, the global economy could have slipped into a prolonged depression.
Who is responsible for this sub-prime crisis? Financial pundits blamed the bankers as irresponsible and blamed them for lending money to the sub-prime customers who couldn’t afford to pay back. These customers bought houses at very high prices which later on fell precipitously. Schiller’s house price index showed that prior to the crisis, the house prices had climbed up 77% before this collapse took place. They also blamed the inefficient government regulators who did not foresee the sudden liquidity crunch. One of the most influential columnists of the Financial Times of London, Mr. Wolf, gave a different view as to why this sub-prime happened in the first place. He said that the main culprits are China, Germany and some oil exporting countries. They had huge trade surpluses while the US and some other countries had corresponding deficits. The trade-surplus countries couldn’t spend all their export earnings and so they ploughed the excesses into dollar denominated investments (prominently US treasury bonds) and euro securities. Such huge amounts money flowed into the US economy and pushed down the interest rates to historically low levels. The resulting easy credit induced dubious lending led by housing mortgages.
The question to be asked is “why didn’t the bankers exercise caution before lending?”
Lesson 3: Bankers became greedy and wanted to maximize their profits. They rushed to lend their plentiful money to real estate speculation. This led to the ballooning of prices which could not be sustained.
Lesson 4: The market regulators went in to sleep hoping that the free market system could resolve these market excesses automatically. Unfortunately, this did not happen.
We could discuss at length as to who should be blamed until the cows come home but not certain whether a clear answer would be found. What is real is what happened to the companies and banks because of this crisis.
Observation 1: Many companies and banks, which previously had a so-called strong portfolios, drifted into a serious liquidity crisis. The US Federal Reserve, using the quantitative easing pumped in $850 billion and rescued many companies from going bankrupt. This included the Citibank, AIG. Of course, the Lehman was allowed to go broke.
Observation 2: Due to the uncertainty, all stock markets plunged in value. The US Dow Jones index went from a high of 14500 to 6000 or so. The Indian sensex dropped from 21000 to 8000 in a very short period of time before it recovered to the current level of 26000 today.
The overall conclusion is that with all our knowledge, experience and research in macroeconomics, we still could not clearly figure out as to why the sub-prime happened. It destroyed trillions of dollars of people’s wealth. Naïve investors were literally made broke. Let us now try to find out as to what could have precipitated the crisis in the next blog.

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