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  • 1. GLOBAL MELTDOWN: ROAD AHEADContentsPublisher‟s DeskPreface 1. Introduction 2. Economic Crisis – Nature and extent of different economic crisis from early 19th century till the present global crisis of 2008. a. Prior to Bretton Wood Institutions b. Post Bretton Wood Institutions 3. Causes of Present Global Crisis and its Analysis 4. Financial Stimulus and Bailout Packages 5. Wayout for a new Global Economic System 6. Conclusions and Summary
  • 2. GLOBAL MELTDOWN: ROAD AHEAD PREFACEPeople were worried about global warming but got the global meltdown. Unfortunately not themeltdown of the toxic garbage in the environment emitting GHG or CO2 but the meltdown of thesizzling economy founded on the edifice of Inequality, Poverty, Unsustainable Consumption andunbalanced growth. People were worried about rising food and fuel prices, now they are worriedabout the falling prices causing deflation, unemployment and closure of industries. The roads inUS were crowded with trucks and automobiles but now people are afraid of driving on emptyroads. The gas stations were busy with queues, now they are closing down in queues. Thehousing prices were roaring and soaring but now people are ignoring and snoring withforeclosures. The banks were flushed with funds, now their money chests are crushed. The stockmarket prices were touching the sky, now they are touching the floor. People were going foroverconsumption now they are forced to under consumptions. People were going to US for Jobs,now they are returning home without Jobs. People were looking at Obama for Change, nowObama is looking at People for change.The global financial crisis has earth shattering effects on the global financial system which hasclamped down the production and employment to a standstill situation. The banks are becominginsolvent and are filing for bankruptcies. There is almost complete erosion in the value of wealthof the households. The corporates are announcing production cut, job cut, wage cut and many ofthem are closing down their shutters. The contraction in economy is alarmingly high in US,Japan, China and Russia apart for several other countries in Europe and Asia. India is not anexception and the third quarter results for 2008-09 are very disappointing with GDP growthslipping down to 5.3 percent, lowest in past six years as per latest advance estimates given byCentral Statistics organization of Govt. of India. There is contraction in agricultural growth by2.2 percent and in manufacturing by 0.2 percent. There have been announcements for fiscalincentives by reduction in the excise and service taxes but the shrinkage in the economycontinues. At this juncture the Govt. of United States of America and the Federal Reserve aretrying to provide financial stimulus packages with trillions of dollars for rebuilding andrevitalizing the confidence of the investors and the consumers, but the crisis is so deep andbottomless that it is yet to buzz or take a note of any such measures.The move is from Market to Mark to Marx. There is failure of the market economy. The balancesheet of the financial institutions are in red as they are obliged to mark the securities at themarket price which are ruling at almost one tenth of their original value. The Government isrecapitalizing and nationalizing the banks by following the principles of „economic nationalism‟or moving the way of Marxism or Socialism. Alas Marxism has already surrendered and failedtwo decades before in Russia with the fall of Berlin Wall in 1989 and soon thereafter it leftChina which hurriedly adored Capitalism. Today both, Capitalism and Marxism are at their ruinsand the world is demanding a new economic order. The US Government is trying to bring backprotectionism with stipulation of „Buy American‟ through the financial stimulus package. Is itthe repetition of Smoot-Hawley Tariff Act of Great Depression which deepened the crisisfurther? There is wide spread monetization of fiscal deficits which will certainly lead to a crashin the current value of US dollar and will cause substantial erosion in the value of wealthpossessed by the people around the world. China is in a dilemma where to keep its foreignexchange reserve of $1.9 trillion equal to almost 30% of the total international reserve.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 2
  • 3. GLOBAL MELTDOWN: ROAD AHEADThe present financial architecture created under the aegis of Bretton Wood Institutions in thename of IMF, World Bank and WTO has proved to be irrelevant and is unable to provide anysolution to the present global meltdown. The world community is looking for a change in theglobal economic system for which a meeting of G-20 is scheduled in the first week of April 2009at London. The present booklet is a humble attempt to analyse the ongoing global economiccrisis. The author has tried to analyse the present crisis in the context of several economic crisesof the past including the very first economic panic of 1819 in the post industrial revolutionperiod and the Great Depression of 1929 representing the crises of the 19th and the 20th century.The present crisis, the first ever in the 21st century of such a great magnitude is identified to bean outcome of erratic and excessive consumption of US households, the greed of financialinstitutions and the heavy debt burden of the households along with irrational borrowing by theGovernment of United States.The World has experienced the failure of communism as well as the failure of capitalism. Thetime is for introspection to look for the „Third Way‟ which will be more humanistic in nature,environment friendly and will be based on sustainable consumption. The World is looking for achange and the present generation has an obligation to provide for a solution for a sustainableand balanced development model for just and equitable share of growth to downtrodden peoplearound the world. The present crisis should be taken as an opportunity and a blessing in disguiseto remove the toxic elements from the present economic system to be replaced by a harmoniouseconomic system.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 3
  • 4. GLOBAL MELTDOWN: ROAD AHEAD IntroductionThe present global meltdown is a culmination of several factors, the most important beingirrational and unsustainable consumption in the West particularly in United Statesdisproportionate to its income by consistent borrowings fueled by savings and surpluses of theEast particularly China and Japan. The second important factor is the greed of the investmentbankers who induced housing loans by uncontrolled leveraging on an optical illusion ofincreasing prices in the housing sector. The third important factor is the failure of the regulatingagencies who ignored the warning signals arising out of the ballooning debts, derivatives andfinancial innovation on the assumption that the Collateral Debt Obligation (CDO), the CreditDefault Swapping (CDS) and Mortgaged Backed Securities (MBS) would continue to remainsafe with the mortgage guarantees provided by Government Sponsored Enterprises (GSEs)namely Fannie Mae and Freddie Mac which had enjoyed the political patronage since inception.There are other several factors including shadow banking system, financial leveraging by theinvestment bankers and lack of adequate disclosures in the financial statements leading tofallacious ratings by the rating agencies.Though the depth of the crises seem like a bottomless pit, as the situation is worsening andalarming as the defaults are likely to avalanche from the initial shock of subprime security toprime security and especially the Alt-A1 mortgaged loans which amount to US$ 1.5 trillion andthe likely further default could be to the tune of US$ 600 billion, a size equal to the subprimemortgages. Once this happens, the bankruptcy which has been limited to investment bankerswith some troubles in the banking sector may bring a further serve catastrophe in the entirebanking and financial sector and may ultimately turn the present recessionary trend to a situationmuch deeper than what happened in the Great Depression of 1930s.The financial stimulus provided by the US Administration partly to fund the toxic assets andpartly by way of recapitalization and nationalization of banks and to certain other sectors of theeconomy with the stipulation of „Buy American‟ may be a repetition of protectionism under thegarb of economic nationalism as infused by Smoot Hawley Tariff Act2 on June 17th, 1930.All the economic crises whether termed as economic slowdown or recession or depression aregenerally found to have link with the boom and boost theory of trade cycle in a free marketeconomy, the empirical studies of several crises dating as back as the panic of 1819 shows the1 Alt-A mortgage is a type of loan where the risk profile falls between prime and the subprime generally this kind ofloan is given to the borrowers with clean credit histories but the loan amount is generally higher than the value ofsecurity and thus the mortgage is comparatively more risky than those backed by prime securities at acomparatively higher rate of interest.2 The Smoot-Hawley Tariff Act of June 1930 raised U.S. tariffs to historically high levels. Such policies contributed toa drastic decline in international trade. For example, U.S. imports from Europe declined from a 1929 high of $1,334million to just $390 million in 1932, while U.S. exports to Europe fell from $2,341 million in 1929 to $784 million in1932. World trade declined by some 66% between 1929 and 1934.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 4
  • 5. GLOBAL MELTDOWN: ROAD AHEADfailure of the banking system as the primary cause of all the major crisis. The panic of 1819marked the beginning of new phase of American economic history following the AngloAmerican war of 1812 (1812-1815), which resulted in widespread foreclosures, bank failure,unemployment and a slump in agriculture and manufacturing sector. It was perhaps the first evereconomic crises after the Industrial revolution and the re-establishment of the dollar.Recession implies negative growth for two consecutive quarters. However, the National Bureauof Economic Research (NBER) of US explains recession as a significant decline in activityspread across economy, lasting more than a few months, visible in industrial production,employment, real income, and wholesale-retail trade. Some economists view recession as aperiod when growth falls significantly below its long term potential.On December 1 2008, the NBER officially declared that the U.S. economy had entered recessionin December, 2007. According to latest statement made by Federal Reserve Chairman Mr. BenBernanke the worst is yet to come for US. Fed believes that the economy will contract in 2009between 0.5 and 1.3 percent against the earlier forecast of shrinking by only 0.2 or expansion by1.1 percent and this may be the first since 1991 when there was contraction for the full year. Thethird quarter shrinkage has happened with a contraction of 6.2 percent biggest ever since1982.The unemployment forecast for the full year is 8.8 percent. These forecasts have beenannounced by Fed after the fresh financial stimulus announced by Obama administration for US$789 through a law on 17th February 2009.The financial crisis has moved into an Industrial crisis now as countries after countries aresharing negative results in their manufacturing and services sectors. In Germany, the machinetool orders in December 2008 were 40 percent lower as compared to last year. In China, morethan 50 percent of the 9000 toy manufactures and exporters have gone bust. The industrial hubsof Shenzhen and Guangzhou providing employment to tens of millions of migrant workers areturning out to be ghost towns. In the past one year, one third to half of total factoriesmanufacturing cheap toys, cloths, shares and electronics have closed down.Japan the second largest economy of the world next only to US has contracted by 3.3 percent inthe fourth quarter in 2008, the biggest contraction in the past 35 years despite the Japan‟s centralbank keeping the interest rates as low as 0.1 percent. According to several forecasts, thecontraction in the whole of 2009 will be around 4 percent, twice as severee as in America andEurope.The latest figures published by Office for National Statistics on 23rd January, 2009 confirmedthat Britain has officially slipped into recession. The British economy contracted by 1.5% in thelast three months of the fourth quarter in 2008. This makes it the worst performance in over 28years.India is not an exception and the third quarter results for 2008-09 are very disappointing withGDP growth slipping down to 5.3 percent as per latest advance estimates given by CentralStatistics organization of Govt. of India. There is contraction in agricultural growth by 2.2© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 5
  • 6. GLOBAL MELTDOWN: ROAD AHEADpercent and in manufacturing by 0.2 percent. There have been announcements for fiscalincentives by reduction in the excise and service taxes but the shrinkage in the economycontinues.French President Nicholas Sarkozy, current president of European Union, has spoken of a need“to rethink the entire financial and monetary system… to create the tools for worldwideregulation”.German Finance Minister Peer Steinbrueck declared that "The USA will lose its superpowerstatus in the global financial system. The world financial system is becoming multipolar."The present global crisis can be termed as a financial tsunami. The depth of the crisis is yet to bedetermined. It started with sub prime crisis last year and has gradually expanded to all spheres ofeconomic life including the real economy resulting into global slowdown.Two Important meetings at global level have taken place between G7 group and the G20 groupof countries. The voice of the most of the developing countries held on 15th November 2008 wasthat there is a need to change the present financial architecture created through Bretton WoodInstitution in which the voice of developing countries need to be heard and that there is need forcreating a new economic system by formation of United Nations Economic Council. The worldis looking for a change and solution which may come through the forthcoming G20 meeting tobe held in London on 2nd April 2009 under the chairpersonship of Barak Obama, the newpresident of US, a prime mover and a pivotal force behind bringing change in the slow world.The G20 Meet may be looked as Bretton Woods-II after 64 years of Bretton Woods Conferenceheld in July 1944. It will be in fitness of things if global wisdom prevails to dismantle the presentBretton Wood System functioning under Anglo-Saxon Model of the Global Financial System.Joseph Stiglitz, the former Chief Economic Advisor of IMF and a noble laureate and severalother right thinking economists have been talking about the irrelevance of the present financialarchitecture and to re-visit the Bretton Wood Institutions (BWIs).The whole world is in the grip of Economic Slow-Down which may lead to Global Recession orDepression since after the Great Depression of 1930‟s. The genesis of the crisis which started inthe form of Sub-Prime crisis in USA in around 2007, lies in the new financial innovations andunregulated derivative transactions coupled with unbridled leveraging by the Investment Bankerssince the year 2000. The Notional value of all outstanding global contracts for derivativetransactions at the end of 2007 reached to US$ 600 trillion, growing at a stunning pace during theyears 2001-2007. This astronomical amount of outstanding derivatives contracts of US$ 600trillion is approximately 11 times of the global value of GDP which is about US$ 55 trillion. Justa decade before, this value was only US$ 75 trillion which was merely 2.5 times of the GlobalGDP at that time. These figures have been estimated by the Bank of International Settlement.These derivatives instruments have been termed as the “financial weapons of mass destruction”by the world famous investor Warren Buffet as a warning in the year 2003.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 6
  • 7. GLOBAL MELTDOWN: ROAD AHEADIt would be pertinent to take stock of the nature and extent of various economic crises which hadtaken place over the last two centuries especially after or at the inception of the industrialrevolution.3 The first recorded economic panic took place in United States in the year 1819 afterthe Anglo-American War during 1812-1814. However, there is a noticeable difference betweenthe economic crises which took place in the 19th century and those which had taken place in the20th and the 21st century. It has been thought proper to analyse these economic crises in twoparts, one before the establishment of the Bretton Wood Institutions in 1944 and the other whichtook place thereafter. The first category of economic crises can also be categorized as periodcovering industrial revolution to World War II during colonialism and the second category as anera of post-colonial world from 1945 till 2008 and beyond.The first documented business cycle is in the Bible, where Joseph tells the Pharaoh to expectseven years of plenty followed by seven lean years. This is probably defined by an old jokewhich says when your neighbour loses his job; it is called an economic slowdown. When youlose your job, it is a recession. But when an economist loses his job, it becomes a depression.3 [The Industrial Revolution started in Britain with the mechanization of textile industries in thelate 18th and the early 19th century. The period of Industrial Revolution is 1780s to 1840s]© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 7
  • 8. GLOBAL MELTDOWN: ROAD AHEAD Economic Crisis – Nature and extent of different economic crisis from early 19th century till the present global crisis of 2008The Twin nature of financial cum Banking crisis of United StatesThe history and experience of banking crisis since 1970s and particularly after withdrawal ofcommitment by US to exchange 35 US dollar in lieu of one ounce of gold in 1973 that led to thefailure of Bretton Wood System, offer a large array of lessons for the policy makers. Accordingto IMF data base there were 124 systematic banking crisis since 1970s and more noticeable areof Japan in late 1980s, Nordic bank crisis in early 1990s and the East Asian banking crisis in1997. Each of these crises is preceded by property bubble bust accompanied by credit boom aswe can see in the present US sub-prime crisis turned banking crisis of 2007-2008. There arehowever differences in the nature and the extent of these crisis. Though East Asian crisis lastedfor less than two years in South Korea, Malaysia, Indonesia, Thailand and Philippines, because itfollowed quick action by contracting lending and with restrictions on investments andborrowings. The biggest support for quick recovery to East Asian crisis was the pull ininternational demand and consequent export led growth. In Japan, the experience was not goodas the slump in the economy continued over a decade due to slow action from Japaneseauthorities. Japan‟s central bank took too long to fight deflation and its fiscal stimulus waswithdrawn too early with increase in taxes in 1997 and there was delay in recapitalization ofbanking sector which took place in 1998, almost after a decade but Japan could forbear all theserecessionary pressure for such a long period mainly because that it remained a surplus countrywith huge savings and forex reserves and was also under an advantageous position because ofdemand for its exports, in the world market.The vital difference therefore in the banking crisis in Japan and in East Asian countries and thosein Sweden was that the world was not passing through the severe demand construing as wenotice in the present global crisis. The other impartment reasons which distinguishes the presentUS banking crisis is the character of the crisis which is twofold: One in the banking sector andthe other in the financial sector or what can be termed as the “Shadow Banking System” of USled by the so called financial innovation and derivatives in the fragmented US banking andfinancial sector. The surge in banking is another factor as the private sector debt surged fromUS$ 22 trillion in 2000 (Equivalent to 222% of US GDP) to $ 41 trillion (almost 294% of USGDP) in 2007. This was accompanied by a very higher percentage of nonperforming loans in USas compared to Japan or Sweden. According to the IMF, such non-performing loans in Swedenwere just 13% at the peak of the crisis in early 1990s wherever in Japan it was a little higher ataround 35% of GDP but still much lower as compared to US where it amounts to around US $5.7 trillion or almost 40 per cent of its GDP. If one looks at the huge borrowings of US from therest of the world which is more than US $ 10 trillion, one can only wonder as to how the World‟slargest debtor nation can afford to have almost zero rate of interest and its currency artificially sostrong at this hour of crisis. A country on the verge of bankruptcy, with its currencies© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 8
  • 9. GLOBAL MELTDOWN: ROAD AHEADappreciating against all major currency of the world at this juncture is the seventh wonder of theworld and one can only predict that the US dollar is heading for a crash in very near future unlesssome miracle happens with its economy.Economic Crisis Prior to Bretton Wood InstitutionsEconomic crises during the colonial era – The major crises that took place during this periodare the economic panic of 1819, 1869, 1873, 1884, 1893, 1896, 1901, 1907 and the GreatDepression of 1929. We shall give a brief description of some of these crises and their impact onthe global economy and the economic system in the following paragraphs.Economic panic of 1819 – The first major financial crises that took place in United States wasin 1819 as the first experience of boom bust cycle to the modern economists. It was by and largefailure of the banking system. This crisis was an aftermath of Anglo-American War of 1812.During this time America was a thinly populated country of merely seven million people largelydepending upon agriculture. The three major cities namely New York, Philadelphia and Bostoninhabited only 7% of the country‟s population and were trading depots channeling exports to andimport from abroad. There was boom in the economy after the war which continued upto 1818.However, the decline started in 1819 with a total export falling from $93 million in 1818 to $70million in 1819-1820 and imports falling from $122 million in 1818 to $87 million in 1819.Imports from Great Britain fell from $42 million in 1818 to $14 million in 1820 and especiallythe imports of cotton and woolen from Britain from over $14 million each in 1818 to about $5million. By 1821, the depression had begun to clear and was in a slow path of recovery. Thepanic had resulted in widespread foreclosures, bank failures, unemployment and a slump inagriculture and manufacturing.Economic panic of 1869 – The 1869 crisis took place on September 24th 1869 by way of ascandal to corner the gold market by a group of speculators held by James Fisk and Jay Gould byinvolving one of the close relative of Ulysses S. Grant, the then President of United States(March 4, 1869 – March 4, 1877). This was to make speculative gains from the price of suddenspurt in gold price as the US Government had assured buyback of Dollar with gold as the moneyin Dollar was issued during American Civil War. However, the Federal Government sold $4billion in gold and the premium plummeted within minutes. This caused a severe panic in NewYork Gold Exchange and the investors lost heavily. This crisis took place because of the goldconspiracy.Economic panic of 1907 –The major economic crises that took place in 1869 was followed bythe panic of 1907, being the first financial crises of the 20th century with a major impact on theNew York Stock Exchange which fell close to 50% from its peak of the previous year. The FedReserve had not come into existence and in the absence of any Central Bank as the lender of thelast resort, J P Morgan then the famous financer came forward by infusing huge money to rescueUS Treasury and generate confidence in the banking system as he did during the panic of 1893.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 9
  • 10. GLOBAL MELTDOWN: ROAD AHEADAlthough there is no established empirical link between the depression of 1907 and the FirstWorld War of 1911 and the similar repetition of the events by the prolonged Great Depression of1929-1938 and the beginning of the second world war 1939 (1939-1945). There seems to besome impending danger of major economic conflicts between China and US during the presentcrisis. The visit of Ms. Hillary Clinton the Secretary of State, to China is very crucial in thisrespect as China holds the key with large amount of investments in US treasury bonds andwithdrawal or diversion of such investment may bring the entire US economy to its bottom andChina may ask for some heavy price in political terms. The peace in South-Asia is also equallyimportant. The establishment of Bretton Wood Institutions4 in July 1944 have not been a panaceato the repetition of global economic crises and the global economic conflicts.The Great Depression of 1929: It was the largest and most important worldwide economicdownturn in modern history after the roaring boom period of twenties which is also known as thegolden age of innovation in several field of technology. On August 24, 1921, the Dow JonesIndustrial Average stood at a value of 63.9. By September 3, 1929, it had risen more than sixfold, touching 381.2. The crisis originated in the United States and its starting date is countedfrom the stock market crash or the Wall Street Crash on October 29, 1929, known as BlackTuesday. On Black Tuesday, the Dow Jones Industrial Average fell 38 points to 260, a drop of12.8% The depression ended after almost nine or ten years but coincided with the beginning ofthe World War II around 1939.The decline in the American economy was the factor that pulled down most other countries dueto protectionist policies, such as the 1930 U.S. Smoot-Hawley Tariff Act and retaliatory tariffs inother countries, exacerbated the collapse in global trade. By late in 1930, a steady decline set inwhich reached bottom by March 1933.By the end of the week of November 11, the index stood at 228, a cumulative drop of 40 percentfrom the September high. The markets rallied in succeeding months but it was like a dead catbounce that led unsuspecting investors into the worst economic crisis of modern times. The DowJones Industrial Average lost 89% of its value before finally bottoming out in July 1932.There were multiple causes for the first downturn in 1929 but according to historians, structuralfactors like massive bank failures and the stock market crash, while some economists attribute itto the decision of British Government to return to the Gold Standard at pre-World War I parities(US$4.86:£1).4 John Maynard Keynes, an economist from UK and Harry Dexter White, an economist from USwas the intellectual founding founders of the Bretton Wood System. Bretton Woods established asystem of payment based on Dollars in which all International currencies were defined inrelation to the Dollar which US had agreed to return in terms of one ounce of gold in exchangeof $35 and thus making the Dollar as good as gold or the Dollar becoming the world currencyand most of the international transactions were denominated in Dollar.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 10
  • 11. GLOBAL MELTDOWN: ROAD AHEADIrving Fisher argued that the predominant factor leading to the Great Depression was overindebtedness and deflation. After the panic of 1929, and during the first 10 months of 1930, 744US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billionin deposits had been frozen in failed banks or those left unlicensed after the March BankHoliday.In 1937 the American economy took an unexpected nosedive, lasting through most of 1938.Production declined sharply, as did profits and employment. Unemployment jumped from 14.3%in 1937 to 19.0% in 1938. As the Depression was on, Roosevelt announced a „New Deal‟, spenton public works, farm subsidies, and other devices to restart the economy, but never completelygave up trying to balance the budget. Keynes General Theory on Employment and Growth,which was published in 1936 provided the real mantra to tide over the Great Depressions.Economic Crisis Post Bretton Wood InstitutionsThe period after the Second World War and especially after the Great Depression of 1929-38,witnessed a period of economic stability in the global economic system for about three decades,till the time United States maintained its obligation to exchange one ounce of gold against $35.This period may be termed as a period of economic stability when the war ravaged countrieswere busy in rebuilding their economic infrastructure. The problem started with the first oil pricehike by the OPEC group of countries in 1973 and the buildup of petro dollar, which caused hugeamounts of deficit causing balance of payment crisis in United States which imposed unilateralembargo on the gold window and ultimately was forced to withdraw its commitment to exchangegold in lieu of dollar which was the major currency for all international transactions and foreignexchange reserves.The post Bretton Wood Economic System has also witnessed several economic crisis particularlyafter refusal of returning gold in lieu of US dollar which formed the backbone of Bretton WoodSystem which motivated countries around the world to accept US Dollar as international reservecurrency and the rest is history with a series of economic failures and crises culminating between1980‟s till date over the past three decades.A short list of some major financial crises since 1980 1980s: Latin American debt crisis, beginning in Mexico 1989-91: United States Savings & Loan crisis 1990s: Collapse of the Japanese asset price bubble 1992-3: Speculative attacks on currencies in the European Exchange Rate Mechanism 1994-5: 1994 economic crisis in Mexico: speculative attack and default on Mexican debt 1997-8: Asian Financial Crisis: devaluations and banking crises across Asia© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 11
  • 12. GLOBAL MELTDOWN: ROAD AHEAD 1998: 1998 Russian financial crisis: devaluation of the ruble and default on Russian debt 2001-2: Argentine economic crisis (1999-2002): breakdown of banking system 2008: Global financial crisisThe debt crisis of the 1980’s which started in August 18, 1982 in Mexico and other LatinAmerican countries was in aftermath of first oil shock of 1973 when the petro dollar wasrecycled from oil rich countries to American Banks who in turn lent blindly to Latin Americancountries who failed to repay the same and had to be bailed out by IMF through Brady andBaker plans which finally took the color of Washington Consensus in 1989. The policyprescriptions in the name of economic reform under structural adjustment program became afinancial rule in all subsequent year for the countries falling in the trap of either currency crisisor the stock market crisis in the recent three decades of liberalization and globalization.The repeat of the some of the major crisis is the collapse of the Japanese asset price bubbles in1990s after the Plaza Accord, the speculative attacks on the European exchange rate mechanismduring 1992-93, the Peso crisis due to speculative attacks and hot money flow in Mexico during1994-85, the East Asian Financial crisis during 1997-98, followed by Russian financial crisis andthe Argentine economic crisis during 1998-2002. There have been several reasons behind theseeconomic crisis but a few glaring pointers are the burg coming current deficits, net money flow,capital account convertibility coupled with speculative bubbles in stock market and the realestate prices. The present crisis is unprecedented in the history of economic globalismperpetrated and nurtured and flourished from the Wall Street since after the Second World Warand post creation of the financial architecture of IMF and World Bank and possibly this is thefirst occasion where the resource of IMF has failed to provide any bailout package as thequantum of crisis runs into trillions of dollar across the globe with a major chunk of impacttaking place in United States. Therefore, the present crisis is termed as the global crisis and looksfor a global solution. Brief highlights of some of the major crisis are as below:-The Crash of 1987The mid-1980s were a time of strong economic optimism. From August 1982 to its peak inAugust 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2722. The rise inmarket indices for the 19 largest markets in the world averaged 296 percent during this period.The crash on October 19, 1987, a date that is also known as Black Monday, was the climacticculmination of a market decline that had begun five days before on October 14th. The DJIA fell3.81 percent on October 14, followed by another 4.60 percent drop on Friday October 16th. OnBlack Monday, the Dow Jones Industrials Average plummeted 508 points, losing 22.6% of itsvalue in one day. The Crash was the greatest single-day loss that Wall Street had ever suffered incontinuous trading up to that point. Between the start of trading on October 14th to the close onOctober 19, the DJIA lost 760 points, a decline of over 31 percent.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 12
  • 13. GLOBAL MELTDOWN: ROAD AHEADDespite fears of a repeat of the 1930s Depression, the market rallied immediately after the crash,posting a record one-day gain of 102.27 the very next day and 186.64 points on ThursdayOctober 22. It took only two years for the Dow to recover completely; by September 1989, themarket had regained all of the value it had lost in the 1987 crash.No definitive conclusions have been reached on the reasons behind the 1987 Crash. Stocks hadbeen in a multi-year bull run and market P/E ratios in the U.S. were above the post-war average.Aside from the general worries of stock market overvaluation, blame for the collapse has beenapportioned to such factors as program trading, portfolio insurance and derivatives, and priornews of worsening economic indicators (i.e. a large U.S. merchandise trade deficit and a fallingU.S. dollar which seemed to imply future interest rate hikes).[5]One of the consequences of the 1987 Crash was the introduction of the circuit breaker or tradingcurb on the NYSE.1997 Asian Financial CrisisThe Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginningin July 1997, and raised fears of a worldwide economic meltdown (financial contagion). Thiswas preceded by the Peso Crisis in Mexico in 1994-95, which was more a equity crisis and aroseprimarily due to hot money flow.The crisis started in Thailand with the financial collapse of the Thai baht caused by the decisionof the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts tosupport it in the face of a severe financial overextension that was in part real estate driven.Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in1993-96, and then shot up beyond 180% during the worst of the crisis.Although most of the governments of Asia had seemingly sound fiscal policies, the InternationalMonetary Fund (IMF) stepped in to initiate a $40 billion program to stabilize the currencies ofSouth Korea, Thailand, and Indonesia, economies particularly hard hit by the crisis. The effortsto stem a global economic crisis did little to stabilize the domestic situation in Indonesia,however. By 1999, however, analysts saw signs that the economies of Asia were beginning torecover.Until 1997, Asia attracted almost half of the total capital inflow from developing countries. Theeconomies of Southeast Asia in particular maintained high interest rates attractive to foreigninvestors looking for a high rate of return. As a result the regions economies received a largeinflow of money and experienced a dramatic run-up in asset prices. At the same time, theregional economies of Thailand, Malaysia, Indonesia, Singapore, and South Korea experiencedhigh growth rates, 8-12% GDP, in the late 1980s and early 1990s. This achievement was widelyacclaimed by financial institutions including the IMF and World Bank, and was known as part ofthe "Asian economic miracle".In 1994, noted economist Paul Krugman published an article attacking the idea of an "Asianeconomic miracle". He argued that East Asias economic growth had historically been the result© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 13
  • 14. GLOBAL MELTDOWN: ROAD AHEADof capital investment, leading to growth in productivity. However, total factor productivity hadincreased only marginally or not at all. Krugman argued that only growth in total factorproductivity, and not capital investment, could lead to long-term prosperity. Krugmans viewswould be seen by many as prescient after the financial crisis had become full-blown, though hehimself stated that he had not predicted the crisis nor foreseen its depth.Argentine economic crisis (1999–2002)The Argentine economic crisis was part of the situation that affected Argentinas economyduring the late 1990s and early 2000s. The critical period started with the decrease of real GDPin 1999 and ended in 2002 with the return to GDP growth, but the origins of the collapse ofArgentinas economy, and their effects on the population, can be found in action before. As of2005, arguably the crisis was over, though many challenges remain for the country.The state eventually became unable to pay the interest of this debt and confidence in the Australcollapsed. Inflation, which had been held to 10 to 20% a month, spiraled out of control. In July1989, Argentinas inflation reached 200% that month alone, topping 5,000% for the year.The Present Global crisis of 2008Beginning on September 16, failures of large financial institutions in the United States, dueprimarily to exposure to securities of packaged subprime loans and credit default swaps issued toinsure these loans and their issuers, rapidly evolved into a global crisis resulting in a number ofbank failures in Europe and sharp reductions in the value of equities (stock) and commoditiesworldwide. In the United States, 15 banks failed in 2008, while several others were rescuedthrough government intervention or acquisitions by other banks. On October 11, 2008, the headof the International Monetary Fund (IMF) warned that the world financial system was teeteringon the "brink of systemic meltdown" The sequence of the event can be summarized as below forunderstanding at a glance. Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2 billion. The sale was conditional on the Feds lending Bear Sterns US$29 billion on a nonrecourse basis. The GSEs Fannie Mae and Freddie Mac were both placed in conservatorship in September 2008. The two GSEs have more than US$ 5 trillion in mortgage backed securities (MBS) and other debt outstanding. Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion. Scottish banking group HBOS agreed on 17 September 2008 to an emergency acquisition by its UK rival Lloyds TSB, after a major decline in HBOSs share price stemming from growing fears about its exposure to British and American MBSs. The UK government made this takeover possible by agreeing to waive its competition rules.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 14
  • 15. GLOBAL MELTDOWN: ROAD AHEAD Lehman Brothers declared bankruptcy on 15 September 2008, after the Secretary of the Treasury Henry Paulson, citing moral hazard, refused to bail it out. AIG received an $85 billion emergency loan in September 2008 from the Federal Reserve, which AIG is expected to repay by gradually selling off its assets. In exchange, the Federal government acquired a 79.9% equity stake in AIG. Washington Mutual (WaMu) was seized in September 2008 by the USA Office of Thrift Supervision (OTS). Most of WaMus untroubled assets were to be sold to J.P. Morgan Chase. British bank Bradford & Bingley was nationalised on 29 September 2008 by the UK government. The government assumed control of the banks £50 billion mortgage and loan portfolio, while its deposit and branch network are to be sold to Spains Grupo Santander. In October 2008, the Australian government announced that it would make AU$4 billion available to nonbank lenders unable to issue new loans. After discussion with the industry, this amount was increased to AU$8 billion. In November 2008, the U.S. government announced it was purchasing $27 billion of preferred stock in Citigroup, a USA bank with over $2 trillion in assets, and warrants on 4.5% of its common stock. The preferred stock carries an 8% dividend. This purchase follows an earlier purchase of $25 billion of the same preferred stock using TARP funds.Causes of Present Global Crisis and its AnalysisThe most astonishing aspect of the trouble is that the financial innovation in the form ofderivatives has taken place under the naked eyes of the regulating agencies and in response toseveral incentives created by Government all over the world. The toxic assets with highleverages were created at different tax havens and thereby over passing the capital adequacynorms. The new instrument in the form of Credit Default Swaps (CDS) was created to cover therisk of credit defaults by paying premium to unregulated hedge funds. The CDS marketmultiplied with a galloping speed of doubling each year from 2001 to 2007. In the year 2001 thevalue of CDS outstanding was only US$ 919 billion and reached to US$ 62.2 trillion by the endof 2007, more than 60 times over a period of 7 years and then marginally declined to US$ 54.6trillion by the mid 2008The root of the crisis therefore lies in the greed with which the banks and the financialinstitutions have worked in the past ten years. These institutions provided housing loans to theUS households without adequate securities with a motivation to borrow at a lower interest ratewhich was just around 1% in June 2004 and without proper coverage of security on theassumption that the housing prices will keep on rising and will take care of the rising uncovered© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 15
  • 16. GLOBAL MELTDOWN: ROAD AHEADdebts. The problem started with the increase in the interest rate by almost six times from 1percent in June 2004 to 6 percent in June 2006 with increasing burden in EMIs on thehouseholds who started defaulting and sought redemption of debts by foreclosure.The National Debt of US increased to US$ 9 trillion with increased consumption at home bypaying the imports through borrowing from the exporting countries on the assumption that USdollar will continue to rule the world as International Reserve Currency. High consumptionthrough imports coupled with borrowing led to collapse of local industries and increase in theinterest rate and decline in the value of US dollar vis-à-vis other world currencies. This led tosub-prime crisis and the failure of the entire banking system with the collapse of the Governmentsponsored mortgaged guaranteed companies viz. Fannie Mae and Freddie Mac. The USGovernment nationalized these mortgage guaranteed companies by pumping US$ 200 billion inorder to bailout them from the financial crisis.The bailout package as initially announced for AIG (American International Group), theinsurance company on September 16th amounted to USD 85 billion. There was a further rescuepackage announced, comprising USD 153 billion including the initial package on 10thNovember, 2008. Though initially there was some controversy in State intervention. Thebankruptcy of AIG could have endangered the entire financial system because of the large size oftoxic credit derivatives and mortgaged backed securities.The five investment bankers including Bear Steams, Lehman Brothers, Merrill Lynch, JPMorgan and Goldman Sachs, all went into trouble. Lehman Brothers, with high leveragedcapital, which was more than 35 times of its own capital went bankrupt. Bear Stems wassalvaged by JP Morgan and Merrill Lynch by Bank of America with direct support from USFederal Reserve and the US Treasury.The present meltdown is unique in nature in content as compared to the Asian Meltdown in 1997and several other financial Jolls in the form of equity crisis, currency crisis, debt crisis, bankingcrisis spread over a span of 80 years since the treat depression of 1930‟s. It took almost 8 to 9years to tide over the great depression of 1929 which was medicated to the Keynesian formula ofPump priming through huge Public Investment. The present crisis on the other hand is of cyclicalnature after a continuous boon of 7-8 years in all spheres of the economy including the financialsector and the real sector. The forces of globalization have gone deep down the economiesthroughout the world and with the support of information technology and telecommunication thegeography has become irrelevant to the free flow of goods, services and capital. The presentcrisis therefore may not last beyond 17 to 24 months with the information net working andgreater co-operation as compared to the past crisis.Sub Prime Crisis, the root cause of the global crisisSubprime lending is the practice of lending, mainly in the form of mortgages for the purchase ofresidences, to borrowers who do not meet the usual criteria for borrowing at the lowest© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 16
  • 17. GLOBAL MELTDOWN: ROAD AHEADprevailing market interest rate. These criteria pertain to the down payment and the borrowinghouseholds income level, both as a fraction of the amount borrowed, and to the borrowinghouseholds employment status and credit history. If a borrower is delinquent in making timelymortgage payments to the loan servicer (a bank or other financial firm), the lender can takepossession of the residence acquired using the proceeds from the mortgage, in a process calledforeclosure.The crisis began with the bursting of the United States housing bubble and high default rates onsub-prime mortgages and adjustable rate mortgages (ARM). The foreclosures exceeded 1.3million during 2007 up 79% for 2006 which increased to 2.3 million in 2008 and 81% increaseover 2007.Financial product called mortgaged backed securities (MBS) which in turn derive their valuefrom the mortgage installment payments and housing prices had enabled financial institutionsand investors around the world to invest in U.S. housing markets. Major banks and financialinstitutions which had invested in such MBS incurred losses of approximately US $ 435 billionas of July 2008 which has mounted further and is now near to the value of US $ 1 trillion. Thevalue of all outstanding residential mortgage owed by US households was US$ 10.6 trillion as ofMid 2008 of which $ 6.6 trillion were held by mortgaged pools Consisting of Collectivized debtobligation (CDO) already mortgage backed securities (MBS) (CDO and MBS) and the remainingUS$ 3.4 trillion by traditional depository institutions.The owners of stock in US corporation alone has suffered loss of about US$ 8 trillion between 1January and 11 October 2008 as the value of their holding declined from US $ 20 trillion to US $12 trillion.Causes of the Subprime CrisisA recent study conducted by a research scholar, Stan J. Liebowitz of The Independent Institute,brings out startling facts showing a close nexus of the politicians by giving providing politicalpatronage and shelter to the Government Sponsored Enterprises (GSEs) namely Fannie Mae andFreddie Mac while giving guarantee to the housing loans to appease a particular section of thesociety without adequate coverage of the security and by ignoring the standard norms of lendingwith prudency. The subprime mortgage meltdown has been at the root of the present financialcrisis in United States.The housing market experienced an unprecedented boom in the crisis which kept soaring fromthe early start of the 21st century until the end of 2006. The mortgage defaults started surfacingand reached the unprecedented level by the mid of 2007 and thereby bringing the tremor in thefinancial system which had invested heavily in housing loans and the derivatives in securitizedmortgages. The first catastrophe took place when Bear Stearns was sold to JP Morgan at a throwaway price in April 2008. The biggest adverse impact was on Fannie Mae (The Federal NationalMortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation); the© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 17
  • 18. GLOBAL MELTDOWN: ROAD AHEADtwo Government Sponsored Enterprises (GSEs) were granted a very quick bailout package bythe US Treasury. A record breaking level of mortgage foreclosures took place for the subprimemortgages. This led to a sharp decline in the value of securities which were based on thesemortgages. Most of the investment bankers including Fannie Mae and Freddie Mac reached tothe brink of bankruptcy.According to this study, the failure to recognize these mortgages as risky during the time ofboom was mainly because that the mortgage underwriting standards had been underlined bydirect intervention of several Government agencies since early 1990s. The Government wantedto provide home ownership among poor and those belonging to minority by prescribing lowerunderwriting standards with no stipulation of any down payment and ignoring the credit scoresand the employment history of the borrowers while determining the monthly installments. Thiswas considered an innovation in mortgage lending and led to a bubble in the price of housing.Most of these housing loans were given at lower interest rate with an option for adjustable-rate-mortgages (ARMs). It is worth noting that the rate of interest increased from about 1% in June2004 to about 6% in June 2006. The builders were allowed to build, developers to develop,lenders to lend, in order to encourage private homes without there being any direct help fromGovernment which had only helped financing indirectly by providing guarantees through GSEs.In the early 1930s housing loan was a low priority for US banks and in order to alleviate theirreluctance the Federal Government created Federal Housing Administration (FHSA) in 1934which was taken over by a new institution called Fannie Mae in 1938. The Federal Governmentpassed two legislations namely the Community Re-investment Act (CRA) 1977 and the HomeLoan Mortgage Disclosure Act (HMDA) in 1975. In 1981, the Federal Government furtherexpanded the disclosure requirement under HMDA including comparison of reactions ofapplication by race which indicated that the minorities were denied home mortgages by more innumbers as compared to whites and this was further substantiated by a survey conducted byFederal Reserve Bank of Boston. The Boston Fed report was further fructified by Fannie Maereport in 2002. The 1992 Federal Housing Enterprises Financial Safety and Soundness Act(FHEFSSA) mandated a more liberal approach to housing loans to lower income borrowerswhich spurred Fannie Mae to make an announcement of a trillion dollar commitment. Thus, theGSEs encouraged secondary market innovations of the mortgage security as a part of moralhazard. The banking sectors would lend money were feeling comfortable as the loans wereseemingly guaranteed by GSEs and they in turn mortgage securities which gave birth toderivatives and collateral debt obligations (CDOs). The process of creativity and innovation forhousing mortgage loan linked securities went on and on from collateral debt obligations to creditdefault swaps (CDS).It is not very surprising to note that under priority lending obligations for housing loans therewere primitive provisions for the financial institutions ranging from $10,000 in individualactions and a fine upto $500,000 for 1% of its net worth in class actions as provided in EqualCredit Opportunity Act. They are further restraining the credit institutions from using any© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 18
  • 19. GLOBAL MELTDOWN: ROAD AHEADarbitrary or unreasonable measures of credit worthiness. There was also an illusion that led tohousing price bubble that no one would default when they could easily sell the house at a profit.This led rating agencies to give these housing loans AAA ratings. The rating agencies were alsomaking huge profits from rating mortgage backed securities as the government required manyfinancial institutions to invest only in highly rated securities as certified by nationally recognizedstatistical rating organizations as approved by Securities Exchange Commission and there wereonly three such approved rating agencies namely Standard and Poor‟s, Moody‟s and Fitch.Thus there was a clear nexus between the GSEs, the Security Exchange Commission and therating agencies which in tandem led to the housing price bubble and later to the burst andconsequential mortgage defaults. In other words, these „mortgage innovations‟ were USGovernment‟s responsibility and were completely ignored. These innovations were precursor tomortgage meltdown and regulators, politicians, GSEs and the academicians were the true culpritsresponsible for it. In the process of undue importance to the housing loan by the GSEs thespeculators took advantage by borrowing at cheap rates and creating an artificial demand in thehousing sector when there were foreclosures from the real borrowers with the increase in the rateof interest under the flexible interest options, there was catastrophic and drastic fall in thehousing prices leading to the collapse of the whole financial system over a period of less than sixmonths in the later half of 2007 and towards the beginning of 2008. The smoke turned out to be abig fire when the investment bankers started filing bankruptcy under chapter 11, one afteranother.In March 2007, the United States subprime mortgage industry collapsed due to higher-than-expected home foreclosure rates, with more than 25 subprime lenders declaring bankruptcy,announcing significant losses, or putting them up for sale. The stock of the countrys largestsubprime lender, New Century Financial, plunged 84% amid Justice Department investigations,before ultimately filing for Chapter 11 bankruptcy on 2 April 2007 with liabilities exceeding$100 million. The manager of the worlds largest bond fund PIMCO, warned in June 2007 thatthe subprime mortgage crisis was not an isolated event and will eventually take a toll on theeconomy and whose ultimate impact will be on the impaired prices of homes.Subprime and Alt-A (including "stated income" or "liars loans" which are basically loans madeto home buyers without the verification of borrowers incomes; home buyers tend to overstatetheir incomes in order to get the loan amounts they desire to purchase their dream homes, thuscalled the "liars loans") loans account for about 21 percent of loans outstanding and 39 percentof mortgages made in 2006. In April 2007, financial problems similar to the subprime mortgagesbegan to appear with Alt-A loans made to homeowners who were thought to be less risky.American Home Mortgage said that it would earn less and pay out a smaller dividend to itsshareholders because it was being asked to buy back and write down the value of Alt-A loansmade to borrowers with decent credit; causing company stocks to tumble 15.2 percent. Thedelinquency rate for Alt-A mortgages has been rising in 2007. In June 2007, Standard & Poorswarned that U.S. homeowners with good credit are increasingly falling behind on mortgage© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 19
  • 20. GLOBAL MELTDOWN: ROAD AHEADpayments, an indication that lenders have been offering higher risk loans outside the subprimemarket; they said that rising late payments and defaults on Alt-A mortgages made in 2006 are"disconcerting" and delinquent borrowers appear to be "finding it increasingly difficult torefinance" or catch up on their payments. Late payments of at least 90 days and defaults on 2006Alt-A mortgages have increased to 4.21 percent, up from 1.59 percent for 2005 mortgages and0.81 percent for 2004, indicating that "subprime carnage is now spreading to near primemortgages."The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, withover 7.5 million first-lien subprime mortgages outstanding. In the third quarter of 2007, subprimeARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of theforeclosures begun during that quarter. By October 2007, approximately 16% of subprimeadjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begunforeclosure proceedings, roughly triple the rate of 2005. By January 2008, the delinquency ratehad risen to 21%. and by May 2008 it was 25%.The value of all outstanding residential mortgages, owed by USA households to purchaseresidences housing at most 4 families, was US$9.9 trillion as of yearend 2006, and US$10.6trillion as of midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly1.3 million properties, a 79% increase over 2006. As of August 2008, 9.2% of all mortgagesoutstanding were either delinquent or in foreclosure. 936,439 USA residences completedforeclosure between August 2007 and October 2008.Credit risk arises because a borrower has the option of defaulting on the loan he owes.Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages theyissued. Over the past 60 years, a variety of financial innovations have gradually made it possiblefor lenders to sell the right to receive the payments on the mortgages they issue, through aprocess called securitization. The resulting securities are called mortgage backed securities(MBS) and collateralized debt obligations (CDO). Most American mortgages are now held bymortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residentialmortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4trillion by traditional depository institutions.When homeowners default, the payments received by MBS and CDO investors decline and theperceived credit risk rises. This has had a significant adverse effect on investors and the entiremortgage industry. The effect is magnified by the high debt levels (financial leverage)households and businesses have incurred in recent years. Finally, the risks associated withAmerican mortgage lending have global impacts, because a major consequence of MBS andCDOs is a closer integration of the USA housing and mortgage markets with global financialmarkets.Investors in MBS and CDOs can insure against credit risk by buying credit defaults swaps(CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 20
  • 21. GLOBAL MELTDOWN: ROAD AHEADcounterparties increased. This created uncertainty across the system, as investors wondered ifCDS issuers would honor their commitments.In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15November 2008, leaders of the Group of 20 cited the following causes:"During a period of strong global growth, growing capital flows, and prolonged stability earlierthis decade, market participants sought higher yields without an adequate appreciation of therisks and failed to exercise proper due diligence. At the same time, weak underwriting standards,unsound risk management practices, increasingly complex and opaque financial products, andconsequent excessive leverage combined to create vulnerabilities in the system. Policy-makers,regulators and supervisors, in some advanced countries, did not adequately appreciate andaddress the risks building up in financial markets, keep pace with financial innovation, or takeinto account the systemic ramifications of domestic regulatory actions."Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to$7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposablepersonal income. During 2008, the typical USA household owned 13 credit cards, with 40% ofhouseholds carrying a balance, up from 6% in 1970.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 21
  • 22. GLOBAL MELTDOWN: ROAD AHEAD BAILOUT PACKAGES AND WAY OUTThe Federal governments efforts to support the global financial system have resulted insignificant new financial commitments, totaling $7 trillion by November, 2008 and by midFebruary 2009 the total bailout figure is estimated to be approximately US$ 8.5 trillion. Thesecommitments can be characterized as investments, loans, and loan guarantees, rather than directexpenditures. In many cases, the government purchased financial assets such as commercialpaper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity infrozen markets. As the crisis has progressed, the Fed has expanded the collateral against which itis willing to lend to include higher-risk assets.Government of China has also announced a financial package of US$ 585 billion to pump primethe economy by making huge public investment and by providing subsidies to protect domesticeconomy which is otherwise exposed to external market and is likely to be severely affectedbecause of the cuts in imports by all the major importing countries.Economic Stimulus Act of 2008It was passed by the US Congress on 13 February 2008, authorizing Bush administration for aneconomic stimulus package costing $152 billion, mainly taking the form of income tax rebatesfor the year 2008.Housing and Economic Recovery Act of 2008The Housing and Economic Recovery Act of 2008 included six separate major Acts intended torestore confidence in the American mortgage industry. These measures speak about creation of anew Federal regulator to ensure the safe and sound operation of the GSEs (Fannie Mae andFreddie Mac) and Federal Home Loan Banks. This Act authorities Federal Housing.Administration to generate upto $ 300 billion in new 30 year fixed rate mortgage for subprmebrokers.Emergency Economic Stabilization Act of 2008The Act was passed on October 3, 2008, creating a $ 700 billion bailout package for the troubledasset relief programme to purchase the toxic assets on the bad loans of the failing banks. Theeffect of this bailout on the US fiscal deficit for the year 2009 is to increase it to a level beyond $1 trillion and the federal debt to $ 11.2 trillion from the present level of $10.6 trillion.Financial Package announced by Obama AdministrationBarak Omama seems to be in a fix or in a sea as his financial stimulus packages of US$ 789brillion has failed to bring any thrill in the economy as most of his announcements are backloaded to 2010 and beyond as evident from the blue print of February 10th released by histreasury secretary Mr. Tim Geithner. It has failed to show any tangible aggressive plan whichcould break the spiral of uncertainty and gloom that has gripped the investors and the consumers.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 22
  • 23. GLOBAL MELTDOWN: ROAD AHEADThe stimulus package has thus failed to boost the confidence of investors, leading Dow Joneindex to dip by 297 points crusting to 7553, close to November low, on 17th February 2009.Penny Pinching and lukewarm approach at a time when the entire financial system is brokendown, may end up paying more price than the aggressive and more rational approach withinnovative solutions that could tread boldly and salvage the devastating economy.‘Buy American Debate’The financial stimulus of US$ 789 billion as approved by US Congress contains a rigorousprovision containing a condition of “Buy-American.” There was an odd debate on the issue andfew compared it with Smoot Hawley Act of 1930 to haunt Americans and there has been samewatering down by requiring only that stimulus fund which spends in a way does not violate UStrade agreements under various FTAs including NAFTA. However, same controversy remainswith the members of the WTO, who may retaliate to this negative approach of protection.This is not the first occasion that US has included such provision in the stimulus package as UShas already passed The Buy American Act in 1933 to prefer US made products in its purchases.As of June 30, 2008, residential mortgages owed by USA households totaled US$10.6 trillion.As of August 2008, 9.2% of these mortgages were either seriously delinquent or in foreclosure.Bailout A Bombshell ?The present financial bailout package of US Government amounts to US $ 8.5 trillion and is farin excess of the aggregate of the several bailout packages announced or dolled out in the past, asmay be evident from the following figures. US$ billionInvarsion of Iraq 597Life Time Budget of NASA 851S & L Bailouts of 1980s 256Louisiance Purchase 217Korean War 454© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 23
  • 24. GLOBAL MELTDOWN: ROAD AHEADA study conducted by the San Francisco Chronicle brings the total bailout package to $8.5trillion (including the $ 700 billion Wall Street bailout; $ 600 billion to Fannie Mae and FreddieMac; 168 billion in stimulus cheque and the present stimulus package announced by ObamaAdministrations amounting to $ 789 billion). According to Hepburn, the President of HepburnCapital Management in Prescott, AZ, “Everyone is going to lose something. The winners will bethose who end up losing the least.”The source of the bailout package of US$ 8.5 trillion is not known exactly as to how much iscoming from fresh borrowings and how much is in the form of minting money. It is also to beestablished as to how much of it is in the form of fiscal incentives and how much is in the formof financial pay outs. However even if part of the aggregate bailout package of US $ 8.5 trillionis in the form of cash, it will amount to glut of dollar in the global market and may turn out to bea “Bombshell” wiping out huge wealth of those holding dollar or dollar reserves.It is a matter for evaluation and research for several sovereign wealth Funds and for centralbanks of various countries who have invested in US treasures as the panic button for a crash invalue of US dollar may be pushed anytime from now.Way-out of the Present CrisisPoliticians and academicians across the World from Beijing to Berlin to Brasilia are looking atthe present economic crisis as the outcome of a scrambled global financial infrastructuredominated by the United States. They may ask for big changes in the present economic systemin the forth coming second G-20 meeting in April at London whether US like them or not.The global thinking and debate about the financial crisis is quite different from the one in theU.S., over the issue as to whether the present mess is the result of too much governmentinterference in the housing market or too little government regulation of financial markets. In therest of the world, it is due to inadequate and inconsistent financial regulation. A consensus seemsto have emerged among the world‟s finance ministers and central-bank chiefs that the underlyingcause of the crisis was an unbalanced and out-of-control system of global capital flows in whichdisproportionate consumption in U.S. ran up huge debts while big savers like China and otherAsian Countries had huge surpluses and reserves.The political head of the People‟s Republic of China, Mr. Wen Jaibao has made a very criticalremark on what had gone wrong in the US financial market, when he was in Davos recently, Hesaid, “The crisis is attributable to a variety of factors and the major ones are: inappropriatemacroeconomic policies of some economies and their unsustainable model of developmentcharacterized by prolonged low savings and high consumption; excessive expansion of financialinstitutions in the blind pursuit of profit; lack of self-discipline among financial institutions andrating agencies and the ensuring distortion of risk information and asset pricing; and the failureof financial supervision and regulation to keep up with financial innovations, which allowed therisks of financial derivatives to build and spread.”© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 24
  • 25. GLOBAL MELTDOWN: ROAD AHEADAngela Merkel, the German Chancellor, has advocated a sort of United Nations EconomicCouncil, much like the Security Council. Brown and others have urged reform andrecapitalization of the Bretton Woods international financial institutions (IFIs), with a muchgreater role handed to the International Monetary Fund, to which Japan, quietly re-establishingthe credibility in international financial debates it had in the 1980s, has pledged $100 billion.The crisis has two sides. The narrower one is a consequence of the collapse of the U.S. housingmarket. This put pressure on bankers, both in the U.S. and elsewhere, who held toxic assetssupposedly backed by real estate and it squeezed U.S. consumers, who for a generation had beenthe spendthrift engine of the global economy. The broader one is a function of massive globalimbalances between debtor and creditor nations that have developed over the last few decadesand imbalances will have to be unwound, preferably by fundamental changes to domestic policythat encourage saving in the U.S. and spending in China. In the developed world, as the creditcrunch bites, economies are heading for the worst recession and a demand contraction in thewestern world is likely to severally affect the export-oriented economies, especially in East Asia.The overall impact of the financial crisis has been felt as a tsunami throughout the world cuttingacross all theories of decoupling to insulated economies in some part of the world. The wholeworld is reeling through the pains of global crisis with decline in the growth rate and loss ofemployment apart from erosion in the value of wealth which is as high as US$ 15 trillion andmay increase further. The economic problems are escalating and the economic thinkers need todevelop an alternate economic order for the future so that there is revival and rehabilitation of thedevastated world economy.The blessing in disguise could be a new world economic order devoid of extremes ofcommunism and capitalism and which would be based on integral humanism. A new world orderwould be created devoid of poverty and environment pollution based upon sustainableconsumption where people can feel a harmony between the social issues, the political issues andthe economic issues a new world where competition is accompanied with compassion and peoplecan live without the fear of terrorism, a different world where peace and prosperity can co-existfor the well being of the whole universe. Let us awake and look for a holistic solution to thepresent global crisis.The temporary bailout process of the present financial crisis which began prior and subsequent toG-8 meeting in Washington was followed by G-20 meetings of the Heads of States includingIndia and China on 15th November 2008 but could not arrive at any concrete long term solutions.The G-20‟s is scheduled to meet on 2nd April 2009 under newly elected U.S. President BarrackObama who has already formed his economic team with a vision to bring a long term solution tothe Wall Street and the Main Street. However the crisis is deep and any bailout or way-outpackage will take at least minimum period of 18 to 24 months to restore confidence in the mindsof the consumer, the banks and the Investors. The distinguished features of the present crisis withthat of several other crisis in the past few decades is that the contagion effect in earlier crisis was© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 25
  • 26. GLOBAL MELTDOWN: ROAD AHEADlocal or regional whereas the tremor of the Tsunami type of present crisis has touched the shoresof all the countries, big or small, rich or poor, developing or developed.G-20 Meeting: The first meeting of the G-20 leaders on financial markets and the worldeconomy was held in Washington, D.C. on November 14-15, 2008. The Summit resulted froman initiative by French and European Union President Nicolas Sarkozy and United KingdomPrime Minister Gordon Brown. Since many economists and politicians called for a new BrettonWoods system (a monetary management which was instituted after World War II) to overhaulthe world‟s financial structure, the meeting has sometimes been described by the media asBretton Woods II. The G-20 comprises countries considered to be systemically important, butomits over 170 governments (192 governments are members of the United Nations).The outcome of the summit came out in the form of a declaration stating inter-alia about the rootcauses of the global crisis, common principles for reforms in financial markets, reaffirmation ofthe commitment to free market principles and to have a follow up meeting by April 30, 2009.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 26
  • 27. GLOBAL MELTDOWN: ROAD AHEAD Conclusions and Summary The Challenges arising out of Global crisis and the need for International CurrencyThe history and analysis of the global crisis indicate that the trade cycles are the natural way ofcorrections in the irrational economic behavior. The irrationality may be manifested either byexcessive consumption, or excessesive inequality or the imbalances or in the speculation in realestate or in capital market. It may also resemble in the form of macroeconomic indicators byhigh current account deficit, high amount of fiscal deficit and the debt service ratios. Theartificial bubble is bound to bust. The global crisis prior to Bretton Wood and before the secondWorld war had a different character than what we notice in the post Bretton wood era. The pre-war crisis was confined to US and few developed countries in Europe. There is no instance of apre war crisis in a poor or a developing countries except sufferings due to famine or other naturalcalamities. However the post war crisis has been resembled from debt crisis of Latin America in1980s to currency crisis of East Asia in 1997.The post war crisis in the post Bretton wood era or to say in post colonial era of the present formof globalization has been identified to be the result of some speculative attack either in thecurrency market or in the stock market. The boom and bust has been the result of speculation andthe financial innovation and not the demand supply factor in the commodity. Therefore there isthe need to understand the underlying root causes of the crisis and to remove them by thoroughdeliberation by participation of all research organizations and the political system. Though thereis need to revise the entire system of the present financial architecture but there is an immediateneed to place a capping on the borrowings of a sovereign state as certain percentage of its GDPwith certain coefficients of population and or the poverty and unemployment. There is also aneed to reformulate the exchange rate system which should have some basis similar to the goldstandard so that there is some credibility and capping on the money in circulation and formaintaining the foreign currency reserve.The present global crisis has taken the shape of the Great depression of 1929 at least in US andJapan. The biggest losers will be US, Japan and China. The biggest gainers may be India, Braziland few other developing countries with their own domestic savings and domestic market. Theworld will have to undergo the impact in different forms, somewhere it will be economicslowdown, somewhere recession and somewhere depression. However the correction wasoverdue and would result in removing toxicity and fallacies from the present global economicsystem. Let us wait for a better change and a better tomorrow.© Copyright, Dr. Dhanpat Ram Agarwal, 2009 Page 27