In this Unit we’re covering the money supply and the tools of monetary policy. R
ID: 1121745 • Letter: I
Question
In this Unit we’re covering the money supply and the tools of monetary policy. Regarding the latter, open market operations, the discount policy, reserve requirements and the interest paid on reserves, are the focus. An argument can also be made for the rate of interest, supply of money and the rate of exchange. Knowing this let’s go back to the 2008-2009 financial crises.
How did it get so bad? Greed is a good starting point. The American economy is built on credit. Credit is a great tool when used wisely. For instance, credit can be used to start or expand a business, which can create jobs. It can also be used to purchase large ticket items such as houses or cars. Again, more jobs are created and people’s needs are satisfied. But in the last decade, credit went unchecked in our country, and it got out of control.
Mortgage brokers, acting only as middle men, determined who got loans, then passed on the responsibility for those loans on to others in the form of mortgage backed assets (after taking a fee for themselves originating the loan). Exotic and risky mortgages became commonplace and the brokers who approved these loans absolved themselves of responsibility by packaging these bad mortgages with other mortgages and reselling them as “investments.”
Thousands of people took out loans larger than they could afford in the hopes that they could either flip the house for profit or refinance later at a lower rate and with more equity in their home – which they would then leverage to purchase another “investment” house.
A lot of people got rich quickly and people wanted more. Before long, all you needed to buy a house was a pulse and your word that you could afford the mortgage. Brokers had no reason not to sell you a home. They made a cut on the sale, then packaged the mortgage with a group of other mortgages and erased all personal responsibility of the loan. But many of these mortgage backed assets were ticking time bombs. And they just went off. The housing market declined, the credit well dried up, and we’re still trying to recover to a degree. (The 2008-2009 Financial Crisis – Causes and Effects by Ryan Guina: http://cashmoneylife.com/economic-financial-crisis-2008-causes/)
Now, our discussion; which tool, or tools, is most important and could have, should have, helped avert that crisis? What would YOU do if you were Federal Reserve Chairman for a day, to ensure we don’t experience this again, and why?
Explanation / Answer
Financial crises have been a part of our global financial landscape for hundreds of years and are likely to be recurring, irregular, and unsystematic parts of our future. Nevertheless, there is hope that this economic roller coaster can be tamed for the benefit of an increasingly integrated global economy. The key is not just to reduce the risk of recurrence but also to curtail the severity and duration of the economic fallout. Ways must be found to ensure that countries, like the United States, recover from the current financial crisis, prevent (or reduce) future recurrences, and create market-oriented solutions for systemic declines in asset prices. One of the prerequisites for making considered policy changes is to understand that a country is neither a company nor an individual. Therefore, the economic tools and reasoning used to analyze microeconomic and macroeconomic issues are bound to differ.
The 2008 housing episode appears significantly worse and is arguably unparalleled in U.S. history. It began with the subprime mortgage lending boom, followed by a significant rise in homeownership rates and a sharp appreciation in house prices. The ensuing subprime mortgage crisis coincided with a real weakening of U.S housing markets beginning in the third quarter of 2006. From their peak in July 2006, U.S. housing markets declined through December 2008 by 33 percent in real terms. This was accompanied by widespread mortgage defaults, especially on homes financed with subprime mortgages, though prime mortgage foreclosures are also at historically high levels.
Another reason being as open market operation: Central banks in developed financial markets discovered decades ago that they can inject bank reserves without lending, by purchasing government securities in the open market. By purchasing government securities, the central bank supports the money stock while avoiding the dangers of nonmarket credit allocation (and the potential for cronyism) associated with making loans to specific banks on non-competitive terms or in purchasing private securities. Federal Reserve policy has traditionally controlled growth in monetary and credit aggregates through such open market operations, varying the federal funds' interest rate as an intermediate target for guiding open market operations. Growth in the monetary aggregate that the Fed directly controls, the monetary base, was matched almost exactly by the Fed’s accumulation of U.S. Treasury securities, virtually the only financial asset the Fed acquired. Before 2008, the quantity of loan that the Fed made to commercial banks was trivial (less than $300 million on a balance sheet of $800 billion at the end of 2007). Loans to nonbank institutions were out of the question.
Most economists and financial analysts identify the following among the main causes of the 2008 global financial crisis: the U.S. Federal Reserve’s low interest rates policy since 2000, with the resulting credit euphoria of both lenders and borrowers; the more relaxed credit initiation and control policies and procedures of lenders; the overwhelmingly optimistic view of future house prices that prevailed in the market; and the widespread use of badly controlled innovative financial engineering tools.
Conclusion:
Australia, which is one of the countries least affected, is proposing to spend the highest proportion of its GDP on fiscal stimulus measures and one of the lowest on budget cuts. Billions have also been spent on a $900 handout to all qualified Australians, both living and dead. Australia will also devote 2.6 percent of its GDP to stimulus investment compared to 0.3 percent for the United States. Such packages attempt to bring forward expenditures and postpone the necessary tax increases to pay for it by huge borrowing programs. Once the effects on the expenditure of increased borrowings are taken into account, I am not aware of evidence that such stimulus programs have anything other than a very short-term transitory effect.
There was too much reliance on credit, which is essential for economic growth and development, but it was allowed to grow at unsustainable rates through risky and excessive leverage. When the housing bubble burst, the government took on enormous amounts of actual and potential debt in an attempt to shore up the financial system and real economy, which only worsened the already staggering deficit. Future administrations will be grappling with the ramifications of those decisions for years to come.
No doubt financial regulation and supervision were weak. No doubt price stability is necessary but insufficient per se to achieve financial stability. Yet there is also no doubt that a monetary policy which turns out to be too lax to achieve price stability is likely to be responsible for fueling excessive credit growth and thereby creating the potential for financial instability. US headline inflation increased from 2.3% on average in 2003 to 3.2% in 2006 and 3.8% in 2008. Core inflation increased from 1.5% in 2003 to 2.5% in 2006 and 2.3% in 2008. Euro area annual inflation reached 3.3% on average in 2008. To contain these upside risks to price stability, a case can be made that interest rates should have been higher than was the case before the crisis.
While we cannot infer what the optimal level of screening at each credit score ought to be, we conclude from our empirical analysis that there was a causal link between ease of securitization and screening. That we find any effect on default behavior in one portfolio compared to another with virtually identical risk profiles, demographic characteristics, and loan terms suggest that the ease of securitization may have a direct impact on incentives elsewhere in the subprime housing market, as well as in other securitized markets.
If I would be the Fed chairman:
We know that institutions had a little financial incentive to worry about the actual risk of the assets in question. Such a misalignment in incentives can help explain the collapse of due diligence across the financial system that characterized the bubble years. Along with other points could be:
- Increased transparency,
- Regulating Credit Default Swaps,
In conclusion, the global economic crisis is an outgrowth of the U.S. subprime crisis. This crisis is really no accident but is rather the culmination of policies adopted by successive U.S. government administrations with the innocuous and, indeed, the laudable aim of promoting greater home ownership and more affordable housing. Congress provides the appearance of giving its constituents something for nothing while setting in place systems and dependencies that assist campaign fundraising and promote a more corrupt environment.
Majorly in my sense, there are at least two policies that could be incorporated into our framework. The first one is a strict enforcement of capital requirements. This would force banks to reduce their loan volume in critical times, thereby lowering aggregate production. Indeed, the reduction of the loan size required to restore loan/capital ratios when capital has fallen below the threshold level will cause a credit crunch and lowers aggregate production. The second type of intervention would be a direct transfer of resources to a troubled banking system. These funds could be obtained by taxing consumers and entrepreneurs. While such an intervention again decreases aggregate investment and hence production, it would, unlike interest rate policy, not enhance banks’ intermediation margins. The examination of the economic costs of these alternative intervention policies opens up important avenues for further research.