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Problems and Crisis in the Economy

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 Abstract

The economy fluctuates in some studied cycles and it is normal that it revolves around long-term trends showing its productive capacity. It is therefore normal to see a crisis in some countries cyclically and the authorities must intervene so that crises do not become persistent. But there have been crises of great magnitude such as the crisis of the 1920s, 2000s and 2007. The latter was a financial crisis that had its causes in the measures taken by the central bank and the government to solve the stock market crisis in the United States in 2000. But it was a crisis that spread to most countries in the world due to globalization in investment, so people in all countries saw the crisis originated in the United States.


 

Throughout history in the economy, there have been several global crises that have emerged in different countries and each has a different explanation. This article will mention some problems that have arisen in the economies and that can still be presented in the future. The first issue to be discussed is the crisis that occurred in 2007, which originated in the United States.

The starting point to understand why occurred one of the biggest crises in history we should analyze the historical price of housing in the United States. There have only been two periods in the recent history of a drastic increase in the price of housing in the United States. The first period was in the 1940s during the Second World War and was due to the low construction activity in this period and an increase in demand when the war was over.

The second episode of a drastic price increase was the first decade of the 21st century, but this second episode cannot be compared to the phenomenon of the Second World War. Construction costs were declining, and demand grew, but not of great magnitude. In the following graph, you can see the magnitude of the increase in the prices of new homes in the United States.

Graph 19. (2011, January 22). Median and Average Sales Prices of New Homes Sold in the US 1963-2010 Monthly. Retrieved November 8, 2017, from https://commons.wikimedia.org/wiki/File:Median_and_Average_Sales_Prices_of_New_Homes_Sold_in_the_US_1963-2010_Monthly.png.

As the price growth was so fast, the prices could not sustain this trend and ended up decreasing close to 30% which led to the entire US economy collapsing along with other countries that also saw as the housing market was in imbalance. The effect on the economies was magnified because part of the income of the families came from this market since they had these investment instruments, so the price reduction ended up affecting household consumption.

To explain this crisis, we must first analyze the reason for the volatility in the price of housing. The prices increased drastically first because of very low interest rates that gave liquidity to the market, making the loans more affordable and second, due to the total euphoria of the consumers who had the belief that real estate prices would never fall. again. The nominal interest rates were low since inflation was low, so the central bank had no incentive to increase these rates and since the housing price did not directly enter the inflation indicator, it did not generate inflationary pressure.

A fact that would have prevented this housing bubble would have been to include the sale prices in the consumer price indicator and thus the FED would have had to increase the rates to control inflation since the only thing considered in the indicator of prices is the value of the leases, but these did not rise proportionally to the sale prices. Another element that fueled the bubble was the regulatory change made by banks to approve the granting of mortgage loans. The following graphs show inflation and the real interest rate of the United States during the crisis.

Graph 20. Inflation, consumer prices. Data taken from the World Bank

Graph 21. Real interest rate. Data taken from the World Bank

This regulatory change made easier to access a mortgage loan, which encouraged consumers to take loans and increased bank profits. Consequently, loans were granted to people who were likely to default on their loans. But the banks did this knowing the possible consequences because with the creation of financial instruments recently banks were able to take out new and risky loans from their balance sheets and passed them on to investors who did not know the type of mortgages they had within these financial products.

This is a problem of moral hazard since the banks were less careful in the loans they granted since in principle the risk of nonpayment was no longer theirs. When the market stopped rising, some households saw that the market price of their homes was lower than what they owed to the bank, so they stopped paying their loans and the banks began to seize the real estate, but going into loss due to the decrease in prices and the costs of having to keep a property for sale. In addition, many banks leveraged lending that is to borrowed money that was not theirs since they were indebted to other financial institutions so when people stopped paying and investors who had financial instruments some banks were insolvent.

The banks that survived the crisis remained in a weak position, so they had to take some measures such as lending less and increasing the requirements or selling liquid assets such as bonds and stocks, thus incurring losses. The result of this was the significant decrease in the loans granted which ended up having repercussions on private consumption which is the main compound of most of the economies in the world, expanding what started as a financial crisis and affected the price of the shares as panic was generated after the sale of shares by financial institutions what ballasted the values of the stock market.

The financial crisis that began in the United States spread and ended up affecting most advanced economies and emerging market countries due to trade. This is the main problem of globalization because with the opening of the markets of goods consumers spend part of their income on foreign goods and as consumption in the United States was depressed, also the demand for foreign goods was affected which ended for affecting production in the other economies, especially those that depend most on international trade. In addition, as mentioned above the financial instruments created were obtained by investors around the world, which is why it also affected the purchasing power of investors around the world.

Central banks used monetary policy to lower interest rates while government entities used fiscal policy to encourage consumption and replace private demand with public demand while consumption and investment recovered. But in some countries, the nominal interest rate was close to zero, so the banks did not have maneuver margin, so they had to wait until the fiscal policy stimulated the economy almost by itself. The only thing the central bank could do was to buy assets from banks that were weak so that the cost of lending would not rise, and they could continue giving loans for investment and consumption.

Once the crisis of 2007 is analyzed, another problem will be analyzed, such as the high debt of the countries. To understand why high and growing debts are generated, one can start from the assumption of an economy with a balanced budget. At a given time, the government decides to lower taxes by keeping public spending constant generating a budget deficit.

When a government faces a budget deficit, it can ask the central bank to finance it. In this specific case, what the government does is sell bonds to the central bank or private investors. If the government decides to reduce taxes for a certain period, to rebalance state accounts, the public sector must create a primary surplus, which can be achieved by raising taxes or reducing spending. The longer the government waits to raise taxes or the higher the real interest rate at the time of paying off debts, the higher the tax increase will have to be in the year to prevent the debt from increasing further.

Also, to pay interest on the bonds in each year that continues to have a deficit every year should have a primary surplus and thus not alter the level of existing debt. The longer a government waits to raise its taxes and create a surplus in its accounts, the stabilization will be more difficult because the tax increase will have to be much greater over time as the debt will increase. If this problem is not solved in the short term the debt will have high levels as a percentage of GDP and a debt crisis will be unleashed as interest rates increase and so will the government’s main debt, which will be a vicious cycle.

It is at this point that the idea of failing to pay the doubt to lower taxes or to increase public spending begins to seem attractive. But if this happens the government will have difficulties to finance itself in the future since the investors will not have credibility in the government and will ask for higher risk premiums within the interest rates of the bonds, so it will be a problem in the long term. In addition, this measure can affect the consumption of households by affecting their wealth as some will be holders of bonds that the government does not pay.

Many times, the correction in the debt does not arrive in time since the governments are reluctant to accept that the debt is becoming a serious problem or because there is political interest in maintaining certain policies such as tax reduction to win elections and not affect economic groups. important in the voting. In summary, governments can take three measures to correct deficits, the first is to increase taxes or reduce costs, the second is to finance through the central bank or stop paying the debt, but all these measures have their negative effects on both the balance of the government as in the consumers.

The last problem of the current economy that will be dealt with in the article will be high inflation. In the past, when the authorities could determine the monetary policy of central banks, this authority was used to print money to finance their spending. When the authorities did this, higher inflations were generated that ended up affecting consumers and investors through very high inflation rates. Currently what the rulers can do is request cooperation with the central bank so that the government issues bonds and the bank buy them with new money, that is, printing banknotes by the central bank which will have the same effect as if the government issue new money.

The phenomenon explained above is called monetizing the debt and it is not the main policy used by the government and the central bank, but there is a possibility that can occur. If this type of financing is used, hyperinflations that are large increases in inflation could be generated and become a repetitive one since inflation is indexed in certain goods of the economy, so if inflation is very high in a period, is likely to be in the next period very high

Hyperinflation would be generated if the nominal amount of money increased and is maintained indefinitely causing an increase in effective and expected inflation. When inflation overflows the fiscal deficit will also be affected since the purchasing power of people will be reduced and the collection of taxes from the government will take more time. In addition, taxes are collected on past nominal income and their real value decreases with inflation over time.

To curb hyperinflation governments must have a stabilization program that contains a fiscal reform and carries out a credible reduction of the budget deficit. Also, show and promise that the central bank will not monetize more the public debt of the state. If the problem of inflation is very large, a drastic measure that some countries have taken is to take the dollar as the national currency to reflect the fact that it does not have control over monetary policy.

©Forex.Academy

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