What was shared previously was what I felt an accurate and easy-to-understand graphic description to help assist readers on the cause of the 2007-2008 financial crisis.
For starters, what largely fuelled the crisis was greed. Greed from brokers, investment bankers and investors who all wanted a piece of the action. However, to put down this act of the people is to go against human nature itself. That definitely isn’t the way to tackle the problem.
However, we don’t really want to go into the nitty gritty details of the crisis. That’s what you’ll do if you’re an economist.
In this post, our next focus is what the government did in order to mitigate the crisis.
The Federal Reserve. The Federal Reserve is generally the central bank of USA. (Think ‘box of bank money for every monopoly game).
It began to improvise with new unprecedented policies. It broadened the eligible collateral for its loans (think ‘I’m so desperate I wouldn’t mind lending anyone car just so they’ll get lunch for me’); previously only Treasury bonds were eligible, but now all sorts of more risky securities are eligible, including mortgage-based securities. Most importantly, the Fed extended loans to investment banks for the first time in its history. Investment banks are not regulated by the Fed, so it has always been thought that the Fed had no responsibility to act as “lender of last resort” to investment banks when they are in trouble.
However, when the investment bank Bear Stearns was on the verge of bankruptcy in late March, the Fed decided that it had to act as lender of last resort to Bear Stearns. Since Bear Stearns was heavily indebted to so many different financial institutions, its bankruptcy would have caused very widespread losses and could have resulted in a complete meltdown of the U.S. financial system—nobody lending money to anybody for anything—and a disaster for the economy. That was Fed chief Ben Bernanke’s nightmare, and why the Fed intervened so quickly and decisively as lender of last resort to these investment banks.
Then, in September 2008, when the bankruptcy of Lehman Brothers (at the time the fourth largest investment bank in the U.S.) triggered a worsening of the crisis, the Fed took an even more extraordinary and unprecedented step to bail out an insurance company, AIG, the largest insurance company in the world. AIG had dominated the market for credit default swaps, which are a form of insurance against the default of bonds, including high-risk, mortgage-based securities, as well as a form of speculation that bonds and other securities will default. But AIG was in such financial trouble that the Fed feared the company would not be able to pay off on all the insurance policies that it had sold. And failure by AIG to pay off would mean losses for banks (and others) that had bought this insurance, adding more losses to the already staggering losses suffered by banks. So once again, the Fed decided that it had to bail out AIG in order to “save the financial system.”
So far, the Fed’s unprecedented policies have been mildly successful, but by no means a complete success. At least an all-out financial collapse has been averted (for now). And investor confidence seems to have been restored somewhat by the demonstrated commitment on the part of the Fed to do everything possible to avoid a financial disaster. However, commercial banks and investment banks have still not increased their lending. And the Fed’s policies do not solve and cannot solve the fundamental problems of too much household debt, declining housing prices and rising foreclosure rates.
(source quoted from http://isreview.org/issue/64/us-economic-crisis)
(However, the question remains whether these investment banks, the ones who caused the crisis in the first place, deserve to be saved. There has been a huge debate over the situation and rightfully so.)
Government Intervention. In February 2008, Congress quickly passed an “economic stimulus” bill of $168 billion that included tax rebates for households and tax cuts for businesses. These tax cuts had some positive effect on the economy last summer, but their effect was small and temporary. At best, the tax rebates provided a one-time boost to consumer spending, since these rebates could be spent only once.
1. The incoming Obama administration and Democrats in Congress are working on a second, much larger stimulus package of about $850 billion, which will consist of two-thirds increased spending and one-third tax cuts. This second stimulus package will be somewhat more effective than the first, mainly because it is so much bigger, and also because more of the total money is for increased spending rather than lower taxes.
The positive effects of this second stimulus will be short-lived, like the first one. If the economy is still contracting in 2010, there will probably be a need for a third stimulus plan. But will that be possible? And in the long run, there are possible negative effects of this wildly expansionary fiscal policy. When the recovery finally comes, it will be slower than usual, because interest rates will have to be higher and taxes will have to be higher in order to pay for today’s stimulus spending and tax cuts. Plus, expansionary fiscal policy does not solve the fundamental problem in the economy—the heavy debt burdens of households and businesses that threaten bankruptcies and restrain spending. A significant portion of this debt must be written off if this fundamental problem is to be solved.
2. In July 2008, Congress passed an anti-foreclosure measure, which allows for the refinancing of existing mortgages, which are in default with new mortgages that would have a value of approximately 85 percent of the current market value of the houses, and would be guaranteed by the Federal Housing Administration. However, the lenders must initiate this refinancing, and so far very few lenders have been willing to initiate these new mortgages with write-downs of the principle owed.
3. In early September 2008, Fannie Mae and Freddie Mac, the two giant home mortgage companies that own or guarantee almost half of the total mortgages in the U.S., were in danger of bankruptcy due to the continued deterioration of the home mortgage industry. The Treasury responded by taking over Fannie and Freddie in a conservatorship and guaranteeing to pay all their debts in full. This bailout will probably cost taxpayers hundreds of billions of dollars. William Poole (ex-president of the St. Louis Fed) has estimated that the total cost to taxpayers could be in the neighborhood of $300 billion.
4. Then in late September, as the crisis worsened, Treasury Secretary Paulson requested and Congress approved (in the threatening environment of a rapidly falling stock market) $700 billion to purchase high-risk, mortgage-based securities (“toxic waste”) from U.S. banks. $700 billion is a lot of money; it is $2,300 for every man, woman, and child in the United States. Soon after the law was passed, Paulson changed his mind, and decided to use the $700 billion to “inject capital” into banks (rather than purchase their toxic securities), in the hopes that this would be a better way to encourage banks to increase their lending. So far, the first half of the $700 billion has been spent, as a giant bailout of the banks and their bondholders, but banks have still not been willing to increase their lending. Prospects are similar for the second half of this bank bailout money.
Having to choose between these options represents a stinging indictment of our current financial system. The situation suggests that the capitalist financial system, left on its own, is inherently unstable, and can only “avoid” crises by being bailed out by the government, at the taxpayers’ expense. There is a double indictment here: the capitalist financial system is inherently unstable and the necessary bailouts are economically unjust.
(source quoted from http://isreview.org/issue/64/us-economic-crisis)
(In the end, there definitely is a need for governement intervention. Leaving the economy as it is will spell disaster for the US economy. However, is what the governement enough? Much like initial concerns, the stimulus, coupled with the bail outs, are not enough to push the economy back into tracks. There are also concerns over corruption cases involved. There is much to be done, but I personally feel that we shouldn’t keep assuming the government as miracle workers. Healing also require time after all.)
That’s all for this post. This was a brief summary of what the US government did for the country. Next post will be how our Singapore government tackled the problem here.