WAY THE FINANCIAL CRISIS OF BEGAN IN USA? Ilie SIMON ASE Bucuresti ICBE 2009 Brasov

AGENDA INTRODUCTION SUBPRIME MORTGAGES DECISION TO HAVE A BUBBLE OR CHEAP MONEY POLICY DECISION TO HAVE A RECESSION OR THE END OF CHEAP MONEY POLICY BUBBLES ARE WANDERING THROUGH THE ECONOMY

SUBPRIME MORTGAGES The real estate market had declined significantly in 2006 The home prices have been rising at a faster rate than incomes and rents for several years The average house price to incomes reached 190% in 2005, compared to 100% in 1952 During the total subprimes cumulated about $1.8 trillion Assuming that by 2008, 50% ($900 billion) are in default, out of which $500 billion has to be written off, that means 5% of the total mortgage market, or 3.3% from GDP.

DECISION TO HAVE A BUBBLE OR CHEAP MONEY POLICY During a period of three and a half years, the longest in the last period, the FED slashed the federal founds rate, from 6.50% in May 2000 to 1% in June 2003, far below any rational market pricing This rate of 1% prevailed since June 2004 A 1% nominal rate, the lowest in the last 50 years, means minus 2.05% in real terms In previous situation the lowest rate stopped at 3% The FED misjudged the warning signals for downturns that were visible beginning the second half of 2000

DECISION TO HAVE A RECESSION OR THE END OF CHEAP MONEY POLICY By mid 2004 FED announced the end of cheap money, and the rate has moved upward in a couple of years from 1% to 5.25% The former president of the FED announced on February 2007 that after 6 years of recovery it is possible to have a recession at the end of that year, while the actual president of the FED told the Congress that the economy might strengthen in 2007! Since December 17, 2008 the FED funds rate is at its all- time low, between zero and 0.25%, following 10 rate cut in a little over a year The mortgages rates have remained relatively flat. The dotcom bubble did not burst completely, but ended in the housing bubble crash

Deviating the crash toward the real estate market In the 6 years period, ending 2006, $ 4.5 trillion mortgage debt (partly shaky) was generated, doubling the mortgage debt to $ 9.5 trillion. Anyway, the business cycle in this industry seems to be of about years, and the previous home crisis took place in So, the recession was going to happened, anyway, by the FED, in order to save the US capital market, representing near 140% of the GDP (roughly $ 20 trillion), has deviated the bubble towards the real estate market, representing only 70% of the GDP The bubble returned later to the capital market, but its destructive force was mainly consumed in the mortgage market. Such a method will split the costs of recession, and eventually to be cover by a kind generalized social insurance fund! Loss bearing can be spread among a much grater universe of possible loss bearers, in order to be politically stable.

Let the dollar fall The economy begins to be confronted with capital outflow; even domestic investors increased their buying of long-term overseas securities. This was creating problems in financing the current account deficit reaching roughly $800 billion per year. The USA must attract about $70 billion per month of foreign investment, but the sentiments of foreign investors begin to change, building downward pressure on the dollar. If the Fed raises interest rates to encourage capital inflow, the real estate market will collapse even faster which will slow consumer spending and contract GDP. The alternative is to let the dollar fall, conducive to inflationary pressure. In other words, there are two separate but related crises; an economic crisis and a dollar crisis. Many factors played a role in bringing about the recession; however, the main cause was the combination of the greatly unequal distribution of wealth, and the constant inducement of a behavior that in America everything is possible almost instantly, even to own a house

US expanded credit at a much faster rate than the economy grew The bubble was not created by wages keeping pace with productivity but by the expansion of personal debt The flow of mortgage repayment to financial institutions is not being used to expand output and employment on a scale that could repay escalating private debts. In reality, more and more local income and assets are appropriated by foreign shareholders and creditors Meantime the US debt was up 10.1% to $4.085 trillion and accounts nearly 60% of all the credit issued globally in 2006, putting pressure on interest rates due to crowding out effect. Consequently, US expanded credit at a much faster rate than the economy grew. This was borrowing to maintain a higher standard of living and attempt to pay for it tomorrow.

Exaggerated gap in wealth distribution Exaggerated gap in wealth distribution accompanied by wage stagnation forces employees to seek credits When wages fail to keep pace with productivity then demand naturally decreases and business contracts. The only way to induce more buying is by easing interest rates or expanding personal credit, and that is when bubbles begin to appear. That's what happened to the stock market before 1929 and to the real estate market in The availability of credit has kept the housing market afloat but, ultimately, the result was the same. The bubbles are building up of accumulated excess, as a result of a persistent postponement of economic policy remedy

Comparison In the USA and Great Britain there is excessive reliance on asset inflation to keep public deficits down and private consumption behavior exuberant. In continental Europe there is excessive influence of public policy by large public sector salaried employees, who are asking mainly for the state policy to address market failures.

The bubbles moves from one danger point to another The bubbles moves from one danger point to another: commodity prices, including oil, new financial products, dotcom stocks, real estates, bonds, junk bonds, exchange rates, etc... New: its crash can now be deviated from one market to the other to reallocate the cost!!! By , the USA stepping in to prevent a world economic crisis has resulted in a series of policy fixes that have merely postponed the inevitable and necessary corrections. Eventually the crises are there