History of Recession. The Last Recession

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1 Financial Instability is it a curse or a boom? Is it like that reality check which we need to bring us back to the path of inclusive growth and development or is it a result of Greed and No fear, is it the outcome of politics, or is the side effect of Globalization. Everyone has a different opinion on this, yet no one seems to have a solution. History of Recession If we look at history, World Economy has been in and out of recession since the great depression in US of 1930 s, but the aftermath of these incidents did not cause a domino effect across the world, why so may be lack of economic integration or globalization. That needs to be seen After 1930 s U.S didn t see another recession for next 40 years; probable reasons were: tightly regulated financial markets and prohibition of speculation of public deposits by banks. During period of s there was a huge boom in the financial industry in US and this period saw the deregulation of banks and hence allowed these banks to invest in risky assets with the public deposits. The banks grew and became bigger and bigger, some said Too big to fall, but by 2001 the investment banks fell and caused the investment loss of $5trillion, reason cited lack of regulation. But who started the de-regulation process the government itself. And we saw the IT Bubble Burst, the investment banks sold millions or billions dollars worth of financial instruments (Stocks, Bonds) to general public, telling them that these companies were great investment opportunities, and funnily all these stocks or bonds were rate atleast AA if not AAA The Last Recession During the 1990s, the deregulation of the financial sector lead to birth of complex financial instruments called Derivatives. Derivatives were called the product of Financial Innovation which made markets 1 / 6

2 Safer. Some of the lobbyists in the US government and Senate, helped in complete de-regulation of derivatives, getting a bill passed to completely ban regulation of derivatives The Investment Banks such as Goldman Sachs, Morgan Stanley, and Banks such as Citigroup, JP Morgan, and Insurance companies such as AIG; together produced the first financial weapon of mass financial and economic destruction and the chief reason for 2008 Global Meltdown Collaterized Debt Obligations. Now the banks could pass on their credit risks to general public, by dividing these loans into tranches and getting them rated AAA or AA and selling them to investors who thought they were buying AAA rated securities called Pass through Certificates. After securitization of these loans banks became complacent, they no longer needed to follow up with the borrowers for repayment, they were now interested in selling of these loans since they were insured by agencies such as AIG. AIG was selling credit default swaps. The credit default swaps acted as insurance for investors investing in CDOs, so if the CDOs defaulted, the AIG would pay the investors the compensating balance in exchange of a regular premium the investors paid for the insurance just like we pay for life insurance in India. These credit default swaps could be traded in the secondary market and one could bet on a CDOs getting defaulted. And funnily enough banks started speculating against CDOs which were created on the loans given by the banks at the first instance, meaning banks were now betting on their own loans getting defaulted and were making millions. So when these CDOs actually defaulted, AIG had to pay to the speculators and the investors. The resultant was a massive fall not only of AIG but the entire financial industry. We saw the bankruptcy of AIG, collapse of Lehman brothers and many others. And we saw a major bail out of $700 Billion Dollars for the major banks and financial institutions in US. The investors who had invested in these CDOs across the world lost millions and billions of dollars. More than 15 million people lost their jobs during the time period of The bail out money given to these defaulted banks were used for distributing bonuses to their employees.. The Present and the Future From History we have understood that politics and economics go hand in hand. The de-regulation and bail outs has caused more financial harm to common people than one can ever imagine Present is no different, after S&P downgraded U.S credit rating, there has been a domino effect of negative economic reality across the world, even impacting the ever-growing emerging markets of India and China. The US $14 trillion dollar debt problem off course is a big problem but why is it that this ticking time bomb was not observed earlier. This happened after a 2 / 6

3 disagreement on increasing the debt ceiling in between the Obama Administration and the Congress (mostly controlled by Republicans) Eventually the debt ceiling was raised by $900 billion, which was subject to substantial debt reduction a few months hence. However the horse was already bolted and S&P had downgraded US bonds to AA+. Later it admitted an error of $2 trillion in projecting US debt a decade hence and which lead to the resignation of Mr Deven Sharma the then S&P president under suspicious circumstances. The Possible Solutions can be to either increase tax or decrease government spending. By decreasing spending will result into decreased consumption hence will negatively impact the economy, similarly increasing taxes would also lead to a decrease in consumption. A probable solution is again growth, growth will lead to more jobs, higher productivity, can help government reduce spending, increase taxes. But it is again not as easy as it seems, creating jobs in an economy which is highly dependent on imports from China and outsourcing around the world will not be easy. President Obama on 7 th September 2011 introduced, a $300billion plan, this plan included tax cuts and spending for2012 to boost job creation and stimulate recovery The final say on these plans is yet to come. Hope these policy changes are effective in bringing a much needed change in the US economy How About Europe? The Sovereign Debt Crisis in Europe due to countries like Greece and Ireland has shaken the entire EuroZone and questioned the efficiency of it functioning altogether and it has been further blown out of proportion after downgrading of Italy, Spain In countries around the world, the government controls both fiscal and monetary policy, and hence can always print enough currency to pay its debts. But in Economic integration of Eurozo ne, 17 European countries had given up their currencies in favour of the Euro, the economic policies of these countries is now managed by the European Central Bank. 3 / 6

4 Under a Non EuroZone scenario Greece could have devalued its currency and solved the some of the financial troubles it finds itself now. But today Greece can no longer do that so it s unable to repay its debts. People of Germany, Holland and the Northern European countries are increasingly resentful of being asked time and again to bail out their Southern Counterparts Probable option for countries like Greece, Portugal, Ireland and other weak Europeans countries can be to abandon the euro and revert to their old currencies after massive devaluation while marinating themselves as a part of European Union just like Britain Is Greece the Culprit? According to Maastricht Treaty which is also termed as the pillar structure of the European Union, any EU nation is liable to hefty fines if its debt exceeds 60% limit of the GDP or the budget deficit exceeds the limit of 3% with respect to GDP. Greece never managed to abide the 60% debt limit but only followed the 3% budget deficit ceiling with the help of some very shrewd and creative accounting. Some of the examples were hiding of military expenditures, health care benefits provided to citizens etc. This was all managed by an instrument called cross currency swaps, which allowed the Greece government to swap its loans in dollars to Euro and after a certain amount of time they were swapped back to the dollars. But what seems a regular refinancing activity followed by many countries across the world was a trick by a US bank which devised a special purpose swap based on fictional exchange rates, enabling Greece to generate higher amount of debt from the foreign markets than the actual exchange rate of Euro, for example if Greece issued 10 billion worth of bonds, they were issued at a higher exchange rate so that they could actually borrow billion worth of capital from the foreign markets. This extra capital borrowed helped Greece reduce its deficit and peg it to 3% mark, however it had crossed the limit of 3% in 2004 and currently its deficit lies around 5.2% of the GDP. And since the maturity of these bonds is dated around 2015, so it will technically impact the deficit only by then. Not forgetting to mention US bank which helped Greek government to achieve this were paid a hefty amount of commission or fees for their service. The bank was none other than Goldman Sachs 4 / 6

5 What Now? There are two sides of the story, what if Greece defaults or what if it is bailed out. If Greece does default, a double dip recession is a very likely scenario. Greece will need to move out of EuroZone but can still remain a permanent member of the European Union, like United Kingdom. The move of out EuroZone might just be a blessing in disguise for Greece, as European Central Bank will now no longer supply Greece with Euros and it will be force to start printing drachmas once more. Greece might be able to devalue its currency and also could try and control its fiscal and monetary policy and to stimulate the much needed economic growth in country. The cost of default would be huge and detrimental to the entire world. During the last recession US Government bailed out all the major banks and insurance companies but didn t bail out Lehman brothers considering it as a non Banking financial institution having lesser impact over the global economy. We all know what happened, there was a global crash and Bankruptcy of Lehman brothers acted as the final nail in the coffin. The consequences of a Greek default can be horrendous; it can range of upto 50% of their GDP, which may mean massive losses for banks in the EuroZone holding Greek bonds. The entire financial market may just freeze all together, the market will lose faith in all the countries in trouble and that includes countries like Spain, Italy, Portugal, Ireland and many more. The US and Japanese economy who are also heavily invested in Euro Bonds will suffer badly. Some of the biggest banks in Europe have invested in Greek bonds, French banks such BNP Paribas and Societe General have billions of dollars worth of investments in these bonds, so they are needed to be bailed out by their government or in the worst case scenario banks might be nationalized meaning millions of investors such as stockholders may lose their investments forever. This might be followed in other countries too such as Italy and Spain This may also lead to consolidated EuroZone where only the fittest would survive, countries such as Greece, Portugal, and Ireland may all leave EuroZone and it will be left with countries only with stronger economies. Can the bailout plan work? 5 / 6

6 Recently Germany passed a $590 billion bailout fund to help Greece and other countries such as Portugal, Ireland. And increasingly the bailout plan has got approval from 14 of 17 EuroZone nations But people also agree that this bailout might only solve the near term financial problems but in the longer term Greece will remain on a similar spot and would need more bailouts in near future. Many fear as much as 50% haircut (part of the face value) for the investors in Greek bonds. How will it affect India? There might be impact on exports and FDI which may dry up comparatively to previous few years. If there is a serious recession, the government may consider a fiscal stimulus. The recession may push global prices down and reduce the inflation problem, so it might help the RBI which is trying to control the inflation so far unsuccessfully by loosening the monetary policy. Comparatively Higher Savings rate, high Foreign Exchange reserves and a low current account deficit may mean it can survive a double-dip recession. However exports will be impacted, so will be the GDP growth, but India should be able to cope with recession, as it did in This article has been authored by Abhishek Mukherjee from IMI, Delhi 6 / 6