Tan Kin Lian's Blog: Root cause of the global financial crisis

Thursday, June 10, 2010

Root cause of the global financial crisis

The problems occuring in many countries are inter-related. Starting with the meltdown of the housing bubble in the US and Europe, we now see the problems with the government deficits in Greece and other countries. The crisis has been temporarily managed with the huge injection of public funds, but this increases the public debt and many observers expect that things will get worse in the months ahead.

What causes all of these problems? Was it deregulation? Was it deficit spending by governments? What is a possible solution? Please share your views?

11 comments:

Anonymous said...: How come Bernanke said there were be no double-dip recession? Or is he hiding the truth?; June 10, 2010 10:47 AM
Anonymous said...: modern economy are financed on current borrowings pledged and repaid with future earnings. this exercise is based on trust and the presumption that the future, in general, will not deteriorate.

trust that the current borrowings are translated into overall economic gains, i.e building infrastructure, investments, boosting capacity, are abused by greedy people who transform the borrowings manifolds through some arcane financial mathematical alchemy. these deriavatives products are then repackaged and sold to "innocent" buyers and the leveraged debt responsibility passed onto those "hopeful" souls.

when all things remain fine and continue to grow, these leveraged debts continue to do their magic creating an illusion of wealth and optimism.

however, it is naive to believe things continue perpetually in an upward fashion. and when things turn south, human basic survival instincts takeover and all rush for the same little exit. what little sense of optimism dissipates along with the numerical worth on that piece of paper.

while it is easy to blame the government for embarking on overly loose monetary and aggressive fiscal policies and hence chalking up deficits running in the tens of zeroes, one has to remember that without buyers, sellers cannot do magic alone.

the possible solution to the current mess are simple, 2 options..1 - continue this perpetual debt running with the risk of inflation, continue to rollover the debts over n over n over till the bubble burts.

2 - head for the reset button. adopt fiscal prudence and austerity. reset all the debts to zero. but that means some wealth will be taken off.

truth is always harsher than lies.; June 10, 2010 11:18 AM
Anonymous said...: To Anon 11;18am

Agreed with your views and suggested options.

I believe all gov will go with option 1.
It is easy and they can drag this on for many years.. remember that at one time, everyone in the world believed that the world was flat? and anyone who argued otherwise would be put to death?

Some truths will take many years ( generations ) for it to be accepted.

What then should common people do?

Live life as normally as we can and worry less about this insurmountable issue.

Excellence is measured by how much profits is being made. Not by a better designed pencil.; June 10, 2010 1:35 PM
Anonymous said...: As I see it,

The main root cause of the Financial Crisis is government mismanagement.

Interest Rates were kept too low by the Fed for too long. That lead to a Housing Bubble. That same mistake is being repeated again. Only this time the consequences is being felt in Asia while having little effect on the US and Europe.

Ordinary consumers would then push housing prices up until it's no longer affordable. When a market crash came, a lot of consumers can't afford to repay bec they lost their jobs.

Interest Rates are a blunt instrument. Ordinary Consumers who do not qualify a loan in the first place suddenly could afford one!

On another hand, there was never any real attempt to balance the budget. When the governments start to bail out companies, more public debt is added, worsening the budget deficit.

We are now staring at stagflation in the US and Europe while in Asia we are staring at hyperinflation. The US and Europe won't see much growth in their economies while inflation is rising bec of their depreciating currencies. In Asia, we are staring at hyperinflation bec of the low interest rates.

After interest rates have gone up subtantially to fight inflation, Asia would go into a recession. I believe this will truly mark the start of the Great Depression!

This is because Europe and the US would not be able restart their economy for some time. They are in the same situation as Japan!; June 10, 2010 1:37 PM
jamesneo said...: Hi to anonymous: option 1 will only lead to one final consequence hyperinflation and drastic devaluation of ones currencies.

Austerity might not be the best solution as it disproportionately affect the middle and lower class citizens through the reduction in pensions or in our case cpf payout, higher taxes, reduced subsidies for medical, transport and education. In many cases, it might be better to impose a tax on land itself rather than affect the very productive labor that can help steer the economy. Some fiscal prudence is of course necessary for example make the pay rises for public sector stagnant. In many of the countries faced with huge debt, one of the biggest problems is an over bloated public sector with salaries that are much higher than the private sector. Thus trimming the public sector is a better solution than affecting the private sector who employed most of the citizens.; June 10, 2010 3:05 PM
Anonymous said...: The engines of modern economies like the USA are driven by consumer spending.

- consumers are now unemployed

- consumers' salaries are being frozen or cut by the modern management thinking of "cheaper, better, faster"

- jobs are not being created because expensive IT systems is replacing human workers

- you spend $5 million on an IT system, it is a one-time expenditure from one company's pocket into another company.

- you spend $5million on workers' salaries, the money gets circulated and re-circulated through the economy many times over. Many other jobs are created as a result of workers spending their salaries. This is called the "velocity of money." Google the term

Similarly, how much goods & services can a $5 million/year CEO buy? Versus the same $5 million spread around 200 workers.

- so if consumers have no jobs or money, how are they going to find the money to spend in order to get the economy going again

- corporations want to reduce spending

- the only big spender left is the government

- what these high salaried CEOs don't want to understand is that every time they sack a worker, they are sacking a consumer .... their customer.

Sincerely,
Mr Obvious Man; June 10, 2010 6:49 PM
Anonymous said...: Greed is the main reason.; June 10, 2010 7:21 PM
Tan Kin Lian said...: In my opinion, the root cause of the problem is the cut income tax rates during the past two decades. Previously, most high income people have to pay income tax rate at up to 90% on excessively high incomes. There is no point for them to make earn so much or to make so much profit.

This high tax regime led to a more even distribution of income. The gap between the high and low income levels was perpahs 20 times, rather than the 500 times (my guess) that happened today.

When people do not earn that high salaries, they do not create financial instruments to take big bets on the market.

Ther was no need for doctors, lawyers and bankers to earn several millions dollars yearly. So, there was less overcharging of consumers.

Governments collect more tax from the high income earners and were able to balance their budgets. They did not have to borrow to fund their deficits.

When the marginal income tax rates came down two decades ago, it started a trend that has worsened to the current crisis level. This is my view about the root cause of the global financial crisis - reduction in high marginal tax rates on large incomes.; June 10, 2010 9:27 PM
JSLEE said...: I think its a combination of the repeal of Glass-Steagal, large global banks, low interest rates, lack of regulatory oversight which have led to the financial engineering & unethical sale of unrealistic & risky products/instruments.
Increased discretionary spending from the rich from the tax breaks further inflates the bubble when they put these money into such investments. Rmemeber that the rich are much more able to get credit & leverage into their investment or speculative interests.; June 10, 2010 11:12 PM
STG said...: i have my reservations on the views that income tax breaks for the high income is a main contribution to the mess, if there is any impact from that i would say its minimal.

as i do not have the real stats, thinking along a crude example might help, i.e a rich folk saves on his income tax and buys a SGD20Mio GCB, which is equivalent to 20 Units of SGD0.5 Mio HDB 5 Room Flat and thats only 10 storeys worth of a 4 Unit layout HDB Block. Imagine the number of HDB blocks that sprouted up along the "expensive" and "hot" estates and compare that to the limited GCB that is available in SG, u can see that public housing can easily outweight that of private.

Of cos, u can factor in the private housing in the form of condos n ECs, that are in the range of 1mio to 10mio. but remember many of them are mass market, and many of those are not exactly your high income, many have been living on leveraged lifestyles where austerity would have been a better financial choice but the illusion of ever-growing, ever-increasing, ever-blooming, ever-increasing house prices have led to a mad rush to these private housing despite their stretched fiancial means.

increasing salaries of workers and the point of velocity of money (MV) is true if the propensity to spend is high. however given the last financial crisis in 2008, it is observed that such free spending behaviour is starting to change and people are saving more and spending less. of cos, you can say the Chinese are spending like crazy, but their rich people are only a small component of the world economy not the majority. believing china can save the world is akin to thinking that our top 5% population in SG can spend their way thru to save SG economy in a downturn.

yes, i did mention in my option 1 that rollin over is a viable solution. and indeed, i think that will be the way it will be. as another reader has pointed out, it will eventually lead to hyperinflation and finally a meltdown (look up german hyperinflation n zimbawean). crucial point is how long can this game of rollover continue without crashing the whole economy. and not so much about whether it is "correct" or not.

look at spain or greece, no matter how bad it is, their government bonds were rolloverd for another 2-3 years at higher yields (thats all..)

inflation is here to stay..thats for sure..; June 11, 2010 9:48 AM
Anonymous said...: Without doubt, it has been a colloboration of sorts among governments to co-ordinate and agree to continue the spending.

It is too big to fail.
the consequence of failure is horrendous.

So, this spending and encouragement to spend will continue.. no point in finding out who is to blame.
Like one blogger at

http://gregpytel.blogspot.com/

says: its a speeding train with no brakes. At some point, it will derail.

we are but a small cog in this saga
and we cannot do anything to help or solve.. help yourself, stay fit, eat right, sleep and enjoy the sunshine.. winter will come but we know not when.; June 11, 2010 11:22 AM