The Economic Collapse
An economic collapse refers to a destructive breakdown of a territorial, national, or regional economy. In essence it describes a serious economic depression typified by a drastic increase in unemployment and bankruptcy. A partial or total collapse of an economy is rapidly followed by years of civil unrest, social chaos and economic depression. These effects have had evident impacts on state-controlled and capitalistic economies.
Recently, the most notable type of economic collapse is the 2007 financial crisis. This crisis was activated by the shortfall in liquidity, in the banking system of the US. This crisis led to the collapse of key financial institutions, the dip in the stock markets worldwide, and the plans by national governments to bail out banks. In many fields, the market for housing was also significantly affected and this led to many, prolonged vacancies, foreclosures, and evictions. Since the great depression in the 1930s, economists consider this crisis as the worst ever witnessed. It facilitated the failure of key businesses, the decrease in consumer wealth, a decrease in economic activity, and the considerable financial commitments that were incurred by the states. There are numerous causes that have been proposed and there are many regulatory and market based solutions that could have averted the situation. (Krugman, 2009)
The causes of the Economic collapse.
Easy access to credit
The Federal Reserve lowered the rates of interest between 200 and 2003, from approximately 6.5% to roughly 1.0%. This was done in an attempt to counter the effects of September 11th attacks and dot Com bubble. In addition, the reduced rates were implemented to fight the apparent risk of deflation. The downward pressure witnessed on rates of interest which emerged from the rising and high current account deficit, made it necessary for the United States to borrow cash from foreign countries, this led to the increase in bond prices and the decrease in interest rates. The lowered interest rates led to the many people purchasing houses that were expensive for them. When the people were unable to pay back these loans it led to the shock experienced in the financial system. (Frewen, 2007)
The Housing bubble
During the period between 1997 and 2006, the cost of houses in America was raised by approximately 124%. The average price of houses began to rise as a result of the availability of excess money. On average, the prices of homes were 2.9 times more that the average income of household. The home owners, on the other hand, started to refinance their homes at interest rates that were lower, while others took second mortgages took second mortgages to finance the spending of consumers. The Federal Reserve did not regulate the prices in the housing sector and eventually they rose to unsustainable level. However, when prices started to decline, the borrowers were unable to pay, and most of them defaulted.
Under this form of lending, dishonest lenders acquired unsound and unsafe loans, which were inappropriate. They used such loans for financing homes at lower interest rates a concept known as bait and switch method. These loans were agreed in expansively written contracts, and were exchanged for loan products that were more expensive on the closing day. Such lenders charged a higher interest rate than the amount they were required to pay and thus made a gain. These dealings led to negative amortization, and the victims realized long after the loan transactions were complete.
This refers to lending of credit to borrowers with poor credit history and who have a higher risk of defaulting. By March 2007, there were approximately $1.3 trillion in sub-prime mortgage that was still outstanding. Competitive and government pressures together with easy access to credit also contributed to the sub-prime lending witnessed in the years before the crisis. (Bernanke, 2007)
Overleveraging or increased debt burden.
Financial institutions and households in the US became more and more over leveraged or indebted in the years before the crisis. As a result, their susceptibility to the bursting of the housing bubble increased and further accelerated economic down turn.
During the period preceding the crisis, there were numerous financial innovations such as off balance sheet financing, shadow banking and derivatives. However, the regulatory structure did not keep up with such innovations.
Inaccurate pricing of risk
This refers to the requirement for investors to account for additional risk, which is usually, accounted for in fees or interest rates. For numerous reasons, the participants in markets did not correctly to into account the risk associated with financial innovations like collateralized debt obligations and mortgage backed securities. In addition, the participants did not comprehend the effects of such innovations on the financial systems’ stability.
Could the economic collapse have been averted?
There are numerous measures mainly regulatory that could have averted the financial crisis witnessed in this period. Central banks world wide and the federal reserve of America would have put in place, measures to expand the supplies of money to avert the probability of a deflationary spiral. This would have averted the higher unemployment and lower wages that resulted to the self reinforcing decrease in global consumption.
Important regulatory policies should have been established to address issues of executive pay, consumer protection, capital requirements or bank financial cushions, the regulation of derivatives and shadow banking, and the Federal Reserve would have been given powers to close institutions deemed not to act in the interest of the people.In addition there are other responses that could have been implemented to avert the crisis, they include;
-proper resolution procedures should have been established for winding up financial institutions that are troubled. Institutions that offer services similar to banks, should have been appropriately regulated, and systemic risks could have been avoided by sub-dividing institutions that were too big.
-There should have been proper regulations to limit the amount of leverage that could have been assumed by financial institutions. The government should have also made a provision relating the performance of executives with the amount of compensation.
-in avoiding the counterparty risk, the government should have ensured that organization has the required capital to bear it commitments financially. In addition, the government should have ensured that credit derivatives were regulated and make sure that such credit derivatives were trade on exchanges that were well capitalized.
-the government should have confirmed that all banks adhere to the requirement to maintain enough contingent capital. This means that during boom periods, the banks should have been paying premiums so as to facilitate their reimbursement in times of down turn.
-the government should have also established rules to limit banks from engaging customers in speculative investments that would lead to losses for the customers.
-the government could have avoided the systemic risks by formulating early warning signs. (Woods, 2009)
How long will it take to recover?
The question as to how long it will take the economy to recover is a complex one. The speculative science of economics relies heavily on numerous variables in forecasting outcomes definitively. In essence, the future will be determined not only by the economic fundamentals, but also by the resolutions of corporations, politicians, lawmakers and individuals.
The evaluation of how serious the economic collapse is, and the duration of the resulting recession will last, differ widely. Whereas some experts are in a panic mode, others see it as a mere overreaction. Predicting the future is hard especially when the country is facing new economic challenges with each passing day. This is so because the current problems in the economy are unprecedented and thus it is difficult to say how much longer it will take. The complexity of the causes is what is giving most economists a headache in predicting the duration of the current crisis.
If one was to study this issue from a historical perspective, most down turns that have been experienced should be followed by strong upturns. Looking at past patterns during the periods after World War II, a growth of about 6% should be expected for a country that has undergone a deep depression. However, the economy is unlikely to take a V shaped trend as expected by many economists. This is because there are numerous factors, which are different, from the post war period; they include the high national and household debt level and the severe trade imbalances that are being experienced.
There are those economists who think that realistically, the economy will take decades before it recovers. They propose the following reasons for this argument:
-The American consumers, corporate America, state government, and the US government as a whole have amassed a colossal debt. This debt has been the driving force of the economy, but it will take so long to be repaid.
-As at December 2009 the number of unemployed Americans stood at approximately 6 million. Those who lost those jobs are still unemployed, and find it hard to get new jobs, and the jobs they get pay a lesser salary as compared to their older jobs.
-The dollar is rapidly declining as the reserve currency that was used by the whole world due to its stability. Nevertheless, the dollar is rapidly changing forcing countries to rely on other currencies.
-Many local or state governments are on the verge of bankruptcy or are already bankrupt.
-The United States is undergoing a pension crisis as there is a lack of money for pensions. Nearly all pension funds in public and private sectors are extremely under funded.
-The economy is also experiencing a Medicare and social security crisis as these expenses are getting out of hand.
-The current Federal debt has increased by to $12.3trillion, which is a 50% growth since 2006.
-The revenue collected from taxes which is fundamental for the development of the country is decreasing making it hard for the government to pay its expenses.
-The Federal Reserve and the government of US have engaged in a reckless expansion of the supply of money. This will have a negative effect of the dollar and might take decades to correct. (Clark, 2010)
Bernanke, B. S: The sub-prime mortgage market. (2007). Chicago, Illinois.
Clark, R: Will the US economy recover this time? (2010). OpEdnews.com. retrieved on April 14, 2010 from http://www.economyincrisis.org/content/will-us-economy-recover-time
Frewen, M: The economic crisis. (2007).Kessinger Publishing LLC.
Krugman, P: The Return of Depression Economics and the Crisis of 2008. (2009).W.W. Norton Company Limited.
Woods, T: Meltdown; A free market look at why the stock market collapsed, the economy tanked, and government bailouts will make things worse. (2009). Regnery, Washington, DC.