Global Economy Web.. how did we get here?

Guest Post by Mani.

Let me make an attempt in explaining this whole mess in layman terms. This is a very complex concept yet simple. Depends on to what extent one would like to understand this. Let us begin with the fact that the economic crisis is more or less worldwide. Let us try and understand how this whole financial web is structured and how countries are interdependent. Each country has its own economic structure and size.

A typical indicator of a country’s economic strength is measured by its GDP (Gross domestic product). By definition what it means is "value of all final goods and services produced in a country in one year". The key components of a country’s economy are national income and output, unemployment rate and inflation. These are the key measures of economic strength of a country. Countries that have higher positive scores in these areas are considered economically strong.

How does the Government run a country?

This is very similar to how you run your home. To run your home you need income, you need governance, you have certain rules, you have needs and wants. To fulfill your needs and wants like shelter, food, utilities, education, entertainment etc, you need to spend money and buy these goods and services. So you see an income side and an expense side. When you budget for your expenses on a monthly or yearly basis you earmark some of your funds towards various categories like house, utilities, education, food, entertainment etc. The budget amount minus the income will give the surplus or deficit. If your income is greater than your expense you have a surplus and vice versa.

Same is the case with the country and the government. Government has categories of expenses like country’s infrastructure, defense, law and order and many more governance related expenses. The income for the country primarily comes from tax incomes and investments that the government has made in various markets and countries.

The following diagram is an attempt to show the macro economic structure:  

 Going back to the concepts of how the countries are interdependent in this world wide economic web. Countries trade between each other. Countries invest in each other. In simple terms, countries like the US when they have deficit in their budget they sell government bonds and treasury bills to investors. In many cases the investors could be a different country. They buy up U.S. companies, real estate, and toll roads. They also purchase U.S. financial assets. They finance the U.S. government budget deficit by purchasing Treasury bonds and bills. They help to finance the U.S. mortgage market by purchasing Fannie Mae and Freddie Mac bonds. They buy financial instruments, such as mortgage-backed securities and other derivatives, from U.S. investment banks, and that is how the U.S. financial crisis was spread abroad.

One reason the U.S. trade deficit is so large is the practice of U.S. Corporation off shoring their production of goods and services for U.S. markets. When these products are brought into the U.S. to be sold, they count as imports.

Where did this crisis start?

Financial deregulation was an important factor in the development of the crisis. The most reckless deregulation occurred in 1999, 2000, and 2004.

In 2004, Henry M. Paulson Jr.(current secretary of treasury), was then the head of the investment bank Goldman Sachs, convinced SEC (Securities and exchange commission – similar to SEBI in India) commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence.

In place of time-proven standards, computer models engineered by hotshots determined acceptable risk. As one result, Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!

It was computer models that led to the failure of Long-Term Capital Management in 1998, the first systemic threat to the financial system.

How the housing bubble was created?

[Subprime lending is a financial term that was popularized by the media during the "credit crunch" of 2007 and involves financial institutions providing credit to borrowers deemed "subprime" (sometimes referred to as "under-banked"). Subprime borrowers have a heightened perceived risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience.]

Lax mortgage lending policies grew out of pressures placed on mortgage lenders during the 1990s by the US Department of Justice and federal regulatory agencies to race-norm their mortgage lending and to provide below-market loans to preferred minorities. Subprime mortgages became a potential systemic threat when issuers ceased to bear any risk by selling the mortgages, which were then amalgamated with other mortgages and became collateral for mortgage-backed securities.

Federal Reserve chairman Alan Greenspan’s inexplicable low interest rate policy allowed the systemic threat to develop. Low interest rates push up housing prices by lowering monthly mortgage payments, thus increasing housing demand. Rising home prices created equity to justify 100 percent mortgages. Buyers leveraged themselves to the hilt and lacked the ability to make payments when they lost their jobs or when adjustable rates and interest escalator clauses pushed up monthly payments. Greed was the primary root cause of this.

Wall Street analysts pushed financial institutions to increase their earnings, which they did by leveraging their assets and by insuring debt instruments instead of maintaining appropriate reserves. This spread the crisis from banks to insurance companies.

These phenomena have forced banks and investment banks to fail. This coupled with the economic recession has caused hundreds of thousands of jobs. When people lose their jobs, they lose their ability to pay back their debt and they default. Enormous default has caused a major strain on the banking system and insurance systems. This has created an infinite loop of catastrophe. This has created credit crisis which means that the banks are tightening their lending process and in many cases stopped lending. There are millions of small businesses in the US that depend heavily on the credit and even the ordinary house hold in America run on lot of credit. This is triggering more job losses and hence aggravating the economic crisis. People are not able to sell their houses as there are no buyers. Why no buyers? Because of the credit issues, banks are not lending money to people who want to buy houses. This is in turn causing liquidity issues in the system. Overall the whole economy is in a total mess.

The US government is trying to rescue this by pumping in $700 billion to bail the economy out. Earlier I mentioned about how government get money to meet their expenses. When your GDP is falling and when your economy is weakening, it is difficult for the government to borrow money. The interest rates will be very high and this in turn will cause a lot of strain in the financial system. Also when the government decides to print more money, this will sky rocket the inflation through the roof and will impact the economy negatively.

Coming to the question of how ICICI bank was impacted due to this?

Like I have explained above, Indian economy is also dependant on the global economy and our financial markets are impacted because the foreign institutional investors have started pulling their money out of India and that is why you see the market plummet the way it did in the last few weeks. ICICI bank had a good exposure to Lehmann Brothers which went bankrupt recently. So the investors and depositors of ICICI bank in India thought, ICICI bank will go under and that was the reason for the panic.

Tough times ahead.