After The Subprime Crisis

A Chronological Update and Analysis of the Events Following the Subprime Crisis.

In a previous article, we analyzed the causes and consequences of the subprime crisis. In short, irresponsible government actions were the root cause of the crisis. Now, the government tries to interfere on a massive scale in the hopes to stem the consequences of the crisis. The subject of this article is the analysis of the events following the subprime crisis.

As mentioned in the previous article, the current economic and financial crisis in the U.S.A. has its roots in profligate and asinine actions of the government over the past four decades. Some would think that by now the government bureaucrats would realize that ideologically-motivated interference with the free market would give way to a common-sense approach, but the evidence proves otherwise. The aftereffects following the collapse of the housing markets built on subprime mortgages have resulted in a cataclysmic destruction of the US financial system. Naturally, it did not end there, because the financial system is closely intertwined with every business which uses financial transactions, leading to unavailability of resources to continue their day-to-day operations.

In light of these facts, some might ask how did this morph into a worldwide recession? In a growing global economy, trade is no longer a state activity constrained by local actions, rather it is supra-regional and continental. To facilitate a faster growing GDP, many countries have lowered barriers to free trade, which did prove advantageous. But some have forgotten to include one significant risk factor into their calculations - the risk associated with incompetent government officials intent on paying back their political constituents by means of social engineering. Forgetting that factor, investors from overseas bought large numbers of Mortgage Backed Securities, estimated at 20% at the end of 2006 [4]. As subprime mortgages disintegrated, the highly leveraged investment and commercial banks found themselves with enormous holes in capital funds required to finance daily operations. Logically, other banks with significant investments in the US financial system found themselves dealing with same problem. As the crisis spread, countries with advanced financial systems have seen their GDP and consumer spending contract. Developing countries with economies based on exports to first world countries saw their economies grind to a halt as trade slowed down. Ironically and understandably, leaders from autocratic countries (Russia and China)have blamed US style capitalism for the global recession [1].

With the global recession in effect, countries have used different means to remedy the problem. But before we get to that part, it is important to explain what the term entails and the types of recessions. Recession is commonly defined as a reduction in GDP over a period of at least two quarters. Of the several types of recessions, two pertain the most in our current crisis: the L-curve shaped and the V-curve shaped recession. In a L-curve shaped recession, the GDP decreases. After it stabilizes, it takes a long time to recover. In a V-curve shaped recession, the GDP decreases, and after reaching the bottom recovers back to its pre-recession levels rather rapidly (relative to the L-curve shaped recession). As the GDP of the countries around the world shrinks, and debt is purged from the economy, it is necessary to face the reality that this is going to be an L-curve shaped recession, something that most closely resembles the Great Depression, maybe not for all countries, but certainly a very large number of them. Almost assuredly, any global recovery will be weighed down by the slowdown in the U.S.A. , because the U.S.A. is responsible for approximately 21% of the worlds GDP [8]. In other words, in order for the world to recover from a recession, the U.S.A. must recover first.

To make up for the capital lost by financial institutions, the US government instituted a bailout program intended to re-capitalize them (Troubled Assets Relief Program or TARP) worth $700 billion. So far, most funds from TARP have been used up, but it becomes clear that even $700 billion in TARP funds have not been enough, so currently there are talks of another bailout program to restore credit in the market. Infusion of TARP and other monies into the system from September 2008 to Jan 2009 has more than doubled the monetary base, as shown in figure below[3].

Fiscal policies subject to political pressure and borrowing from foreign countries have caused the US national debt to increase by approximately 57% from 09/30/2000 to 09/30/2008, as shown in the following chart.

With federal deficit rising to at least 5% of the GDP for next 5 to 10 years , according to the Office of Management and Budget [11], and ever worsening future fiscal outlook[2], the government seems bent on borrowing even more money from overseas investors. However the sheer magnitude of the deficit will force the Federal Reserve Bank to print large sums of currency (for better understanding of how the Federal Reserve manipulates the currency check this link), ultimately resulting in increased inflation down the road. Increased inflation will result in devaluation of the federal debt, and also of the money saved by the citizens. Inflation in the end will have to be brought down by dramatically increased interest rates. Inflation and increased interest rates will have a long term detrimental effect on the US economy, and by extension, the World Economy.

Why the federal government chooses to have high federal budget deficits and high inflation can be easily explained with game theory. Below is an example game theory case (adapted from Games of Strategy by Avinash Dixit and Susan Skeath, 2nd Edition) with two players: Congress and the Federal Reserve. Congress controls the policies responsible for budget balance or budget deficit, while the Federal Reserve controls the interest rates (high/low). Payoffs are indicated with numbers, the higher the number the higher the payoff for the player. The first number represents the payoff for Congress, and the second number represents the payoff for the Federal Reserve. This is a simultaneous game, with Congress under pressure from various interest groups to lower the taxes and increase spending, and Fed under pressure to lower the interest rates, which it is inclined to do as long as it doesn't cause rising inflation. Payoff 4 with a budget deficit and low interest rate is the best solution for Congress because they get to spend more money without causing inflation, while at the same time paying low interest rates for the budget deficit. The next best solution for Congress is payoff 3 with a balanced budget and lower interest rates, where lower payments to service debt are used for spending and tax cuts. Payoff 1 indicates the worst outcome for Congress because with a balanced budget (i.e., no excess federal spending) and rising inflation they fail their constituents interests. In the case of the Fed, payoff 4 is the best solution because a balanced budget and low interest rates allows them to have low inflation. A budget deficit (Payoffs 2 and 1) is not good for the Fed since the risk of inflation is increased and the Fed would be forced to increase interest rates. As the game develops each side chooses their strategy such that the individual's player mayimizes the payoff. Congress is the dominant player, since the Fed has to react to the move by Congress. Naturally, Congress chooses its dominant strategy of budget deficit because it offers the highest possible reward of 4. However, the Fed needs to respond with high interest rates because this leads to the second-worst payoff for the Fed (2 instead of 1). In the end, Congress only gets a payoff of 2, because the Fed has to raise interest rates in response to the loose fiscal discipline. Of course, Congress could have chosen fiscal discipline (payoff of 3), allowing the Fed to lower interest rates (payoff of 4). This second solution with a total payoff of 7 is better overall than the more likely scenario (total payoff of 4) described before. This solution is unlikely, however, as Congress has a dominant strategy.

What can we expect in the future? The so-called stimulus package is unlikely to create a noticeable number of jobs, because most of the planned spending -- actually around 90 percent -- is not an investment, but rather political spending [12-13]. While we cannot expect inventment into the economy, we will nonetheless have massive debt [14]. The figure to the right illustrates the sheer abyss of deficit we are facing (do I remember that Mr. Bush was critisized for his 2004 budget deficit?). This deficit will have to be paid off, eventually. How? Tax the wealthy? This strategy would not work as there are too few "wealthy" to tax. It might alleviate envy complexes in Mr. Obama's constituency, but it will not noticeably reduce a $2 trillion debt. Tax the poor? This would not work either. First, a large amount of the people don't pay taxes at all, and second, this is exactly Mr. Obama's constituency. Other countries? This might work, but it would de-value the Dollar and hurt imports. Specifically, goods for consumption (China) and energy would get more expensive.

This leaves only one avenue. Inflation. And its consequence: rising interest rates.

Please compare this scenario to Mr. Obama's election promises [15]. To quote from the document where Mr. Obama promised more fiscal discipline:

"The cost of our debt is one of the fastest growing expenses in the federal budget. This rising debt is a hidden domestic enemy, robbing our cities and states of critical investments in infrastructure like bridges, ports, and levees; robbing our families and our children of critical investments in education and health care reform; robbing our seniors of the retirement and health security they have counted on. ... If Washington were serious about honest tax relief in this country, we'd see an effort to reduce our national debt by returning to responsible fiscal policies."
Barack Obama, Speech in the U.S. Senate, March 13, 2006

Now look at the figure to the right. Is this the level of debt we can expect from somebody who so vehemently critisized the Bush administration's level of debt? Is this fiscal responsibility? Mr. Obama and his fellow liberals in Congress have indeed created a new "hidden domestic enemy" of unprecedented strength. This enemy, a mirror image of the liberals who created it, is here to stay.

This is where we are heading: a federal deficit that is too big to be paid back, massive inflation, and dramatically increased interest rates. This is what we got: a federal deficit that robs our cities and states of critical investments in infrastructure, that robs our families and our children of critical investments in education and health care reform; that robs our seniors of the retirement and health security they have counted on.

Thank you, Mr. Obama, for the clarification.


[1]    Russia, China Blame Woes on Capitalism
[2]    2008_Financial_Report_of_the_United_States_Government
[3]    Adjusted monetary base
[4]    Securities owned by foreigners
[5]    The Economist
[6]    Gloomy Portents for Global Trade
[7]    FT: The game changer by George Soros
[8]    CIA Factbook: World GDP
[9]    Wall Street Journal: How does the Fed inject money into the economy?
[10]    The US natinal debt
[11]    OMB nominee paints bleak picture
[12]    What is Congress stimulating?
[13]    The stimulus tragedy
[14]    The Stimulus Package Is More Debt We Don't Need
[15]    Mr. Obama's election promises - fiscal

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