Causes of Economic Growth and Crashes

Causes of Economic Growth and Crashes Amy Zhi â€Å"How an Economy Grows and Why it Crashes,† â€Å"Too Big to Fail† and the 2008 Recession The film â€Å"Too Big to Fail† takes viewers down the 2008 financial meltdown, also known as the â€Å"Great Recession of 2008,† and emphasizes its impact on the economy. The crisis was avoidable and caused by â€Å"widespread failures in financial regulation (Fed’s failure to stem the tide of toxic mortgages); dramatic breakdowns in corporate governance including too many financial firms acting recklessly by taking on too much risk; an explosive mix of excessive borrowing and risk by household and Wall Street that put the financial system on a collision course with crisis; and simply lacking a full understanding of the financial system they oversaw.† ( University of North Carolina). The book â€Å"How an Economy Grows and Why it Crashes,† by Peter Schiff, comically interprets the effects of inflation, deficit spending, central banking, foreign trade, and the housing bubble and credit crunch of 2008. The U.S. economy boomed during the 2000-2007 period, as the global pool of fixed-income securities increased greatly from $36 trillion in 2000 to $80 trillion by 2007. In â€Å"How an Economy Grows and Why it Crashes,† the Usonian economy starts with production and trade soon follows. Usonia now had savings and credit, an increase in savings decreases real interest rates and an increase in credits increases demand, hence, there was expansion in the Usonian economy. As the economy prospered, it created a paper currency backed by fish, similar to currency backed by full gold reserves in the U.S. However, fractional reserve banking develops and only a fraction of bank deposits were backed by actual fish for withdrawal. The government decided to delink the paper currency from the fish. Usonia degraded the value of the fish by creating more fish out of the value of one. This process of â€Å"shrinking fish† eventually leads to â€Å"fishflation.† As people start spend ing more and producing less, the economy stops blooming and crashes. A king from Sinopia, an island that still had no savings, bank credit, or business, observed Usonia and saw their luxurious lifestyle of credit and commerce. The king thought that the possession of Fish Reserve Notes was the key to advancement. Notes were then used as money across the entire ocean, and the economy was saved as Sinopia traded their fish for Usonia’s fish reserves. Thus, Usonia was again piled with savings and credit, causing a spending binge atmosphere in Usonia. This is similar to when China supplies the essential items for U.S. fiat currency. Usonia largely consumed and Sinopia produced, hence, the trade relationship was skewed. However, as Goodbank said, â€Å"The people will get wise. They will worry about their savings and withdraw their deposits,† which is exactly what happened next. Foreign islanders realized that the fish reserve was worthless with no backing at all. Therefore, islanders started to withdraw fishes with their fish reserves all at once. In truth, there really were not enough fish in the economy, so Usonia had no choice but to close the fish reserves window. It is fiat currency and worthless, backed by nothing but the faith in the government. Producers were harmed by the expansion of the money supply because resources were more expensive and workers would soon demand higher real wages. Production decreased further and the Usonian bank loan officials targeted the islands â€Å"hut loan market.† As lenders and borrowers in the U.S. put their immense amount of savings to use, the â€Å"Giant Pool of Money† â€Å"overwhelmed the policy and regulatory control mechanisms in the country.† (Abir) Citizens jumped to buy houses all at the same time, either for greed, fear, or stupidity. There were risky investors and individuals who thought there was no ceiling price on real estates. There were individuals jumping into the housing market because they were concerned if they didn’t, they would lose out on easy profit. Mortgage regulators were not paying close enough attention to the market and business practices, commodity mortgage buyers were not researching the loans they were taking out, and speculators /builders were pricing homes entirely too high in the first place. All of which lead to the housing bubble of 2008. Senator Cliff Cod of Usonia created Finnie Mae and Fishy Mac to buy hut loans from the market. â€Å"The hut lending program was a massive hit amongst banks as they were earning risk-free profits. These agencies created a big industry where hut building, hut selling and hut decorating industries took off.† (Krishna) All of production and advancement occurred while no actual fish were being generated, so, nothing productive was actually happening. Although loans were not the best use of savings, political officials â€Å"encouraged hut ownership and education.† (Krishna) There were tax breaks on hut loans, which caused even more people to invest on these huts. Sinpoian fish were being imported to Usonia like rapid waves, credit levels were high and risk was ignored. Huts started becoming more luxurious and unreasonably expensive. Eventually, â€Å"the â€Å"hut market† took a down turn and every associated industry felt the pain.† (Krishna) As U.S. home pri ces declined steeply after peaking in mid-2006, it became more difficult for borrowers to refinance their loans. In addition, â€Å"assets dramatically plummeted, while the liabilities owed to global investors remained at full price.† (Abir) One of the primary causes of the recession was government intervention in the housing market. This intervention, primarily through Fannie Mae and Freddie Mac, helped inflate the housing bubble that triggered the crisis. Due to the lack of regulation, banks and credit card companies were freely lending out money to people. Even those who could not afford expensive houses took out loans that they seemingly couldn’t pay back to buy the expensive houses. During the 2008 recession, struggling banks and lenders cut back lending and created a sudden sharp reduction in availability, causing a credit crunch. Consumers were no longer able to borrow and spend, while businesses also cut back their investments as demand decreased. In â€Å"Too Big to Fail,† Dick Fuld, CEO of Lehman Brothers, a large investment bank, is seeking investment, but investors are hesitant because Lehman is exposed to toxic housing assets from the housing bubble. The Lehman’s counterparty risk, risk that a counterparty will not pay as obligated on a transaction, is impacting the entire financial market, while the stock market is in a free fall. The government could only do one thing, urge consumers to spend more. They wanted to keep spending though the crisis and borrow more, however, this would eventually lead to a depression. In the film, Henry Paulson, U.S. Treasury Secretary, plans to buy the toxic assets from the banks, so they wouldn’t go bankrupt and could lend out money again. Paulson later then decides to inject capital into the banks, for it was easier and could boost lending more quickly. By injecting the capital, he expected that the banks will have the money now to lend out to citizens and credit will flow again. The banks agreed, markets stabilized, and the banks repaid their Troubled Asset Relief Program (TARP) funds. However, Paulson’s expectations were wrong, banks didn’t lend out the money from the injections. As the epilogue of â€Å"Too Big to Fail† stated, â€Å"credit standards continued to tighten resulting in rising unemployment and foreclosures. As bank mergers continued in the wake of the crisis, these banks became even larger and ten financial institutions held 77% of all U.S. banking assets and have been declared â€Å"too big to fail.†Ã¢â‚¬  (Gould) Congress created â€Å"TARP in October 2008, part of which was used by the Treasury to inject much needed capital into the nation’s banks. The Fed aggressively lowered interest rates during 2008, adopting a zero interest rate policy by the end of the year. It engaged in massive quantitative easing in 2009 and early 2010, purchasing Treasury bonds and Fannie Mae and Freddie Mac mortgage-backed securities to bring down long term interest rates.† (Blinder and Zandi) â€Å"The Troubled Asset Relief Program of 2008 rescued our financial system from almost certain meltdown, saving the U.S. financial system at the brink of disaster.† (Weller) Shortly after TARP enacted, loan tightening and interest rates eased. The Recovery Act spending helped decrease unemployment and personal disposable incomes increased. â€Å"Industrial production turned around with infrastructure spending spurred by the Recovery Act. After-tax income grew more quickly following the payroll tax cut , followed by job growth accelerating and decrease in household debt. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 â€Å"strengthened the fledgling economic recovery by cutting the payroll tax and continuing extended unemployment insurance benefits.† (Weller) In the end, Usonia was completely out of fish. They borrowed more and more to the point where most of their debt was funded by more debt. Citizens don’t save more since borrowing is a simple and easy process. Most people just walk in wanting more money, and walk out with more money and debt. Although higher taxes create more jobs and government revenue, it discourages work and investment. Plus, individuals and private businesses use money more efficiently than the government. In today’s society, spending is almost the route to happiness. That is, people spend to make themselves and others happy. We can’t spend less, but perhaps we can spend smarter. The book’s message itself is very clear. If the U.S. keeps spending and borrowing freely, it will soon meet with hyperinflation and an even more severe economic devastation. Bibliography University of North Carolina. Subprime mortgage crisis. 13 January 2008. 25 April 2014 http://www.stat.unc.edu/faculty/cji/fys/2012/Subprime mortgage crisis.pdf>. Abir, Zaber. THE Global Financial Crisis: Above Beyond. 6 December 2012. academia.edu. 25 April 2014 http://www.academia.edu/2344211/THE_Global_Financial_Crisis_Above_and_Beyond>. Blinder, Alan and Mark Zandi. How the Great Recession Was Bought to an End. 27 July 2010. economy.com. 25 April 2014 https://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf>. Romer, Christina. Treatment and Prevention: Ending the Great Recession and Ensuring that It Doesn’t Happen Again. City Club of Cleveland. Cleveland: whitehouse.gov, 2010. 16. Krishna, Radha. 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