The US Financial Crisis | Economics

As we know, the U.S. had faced with economic crisis since the Great Depression. The U.S. financial crisis or we know as the ‘Hamburger crisis,’ started in the home mortgage market, especially the market for ‘subprime’ mortgages, which is one type of loan that are suit for low-income borrowers (Hamburger, 2009). The home mortgage market spread beyond subprime to prime mortgages, commercial real estate, corporate junk bonds, and other forms of debt. Additionally, the U.S. banks had gained capital loss at the high rate. The crisis had reached to a sharp reduction in bank lending. As a result, it caused a severe recession in the U.S. economy. This paper will analyze the fundamental causes of the current crisis from the falling rate of profit and various strategies to fix it, from showing how bad the crisis was, and ending up with the government policies by both the Federal Reserve and Congress who dealt with the crisis.

The falling rate of profit

What is the rate of profit? It is the key variable in explaining the current crisis. If we want to understand the basic causes of the current crisis, we have to look back over the postwar period. From 1950 to the mid-1970s, the rate of profit in the U.S. economy declined almost 50 percent, from around 22 percent to around 12 percent. An important factor in the 1970s was that many governments responded to the higher unemployment by adopting expansionary fiscal and monetary policies (more government spending, lower taxes and lower interest rates). However, these policies generally resulted in higher rates of inflation, as capitalist firms responded to the government stimulation of demand by rapidly raising prices in order to restore the rate of profit, rather than by increasing output and employment. Financial capitalists revolted against these higher rates of inflation in the 1980s, and it forced governments to adopt restrictive policies (less government spending and higher interest rates). The result was less inflation and return to higher unemployment. Consequently, these facts show that government policies affect the combination of unemployment and inflation (Moseley, 2005).

Strategies to restore of the rate of profit

There are various ways to restore the rate of profits. Firstly, the strategy of inflation, for example of increasing price at a faster rate, which reduce real wages. Therefore, all the benefits of increasing productivity have reached to higher profits. Moreover, many companies have reduced money wages since the great depression. As a result, lots of workers suffered a lot because they have faced with the choice of either accepting lower wages or losing their jobs. Secondly, it is the common strategy that needs to cut down on health insurance and retirement pension benefits. As we know, there are a lot of workers that have to pay higher premiums for their health insurance. In addition, they think that they will have a comfortable retirement are in for a rude awakening. For example, they have to work at an older age and leaving fewer jobs for younger workers. Another strategy to increase the rate of profit has been to make workers work harder and faster on the jobs. It is like a speedup in the intensity of labor increases the value produced by workers. As a result, it will increase profit and the rate of profit. Moreover, workers are forced to compete with each other for the limited jobs available by working harder. Another significant strategy used by capitalists to reduce wage cost had been to move their production operations to low-wage areas around the world. It is the globalization strategy, which a worldwide search for lower wages in order to increase the rate of profit. This strategy also puts more downward pressure on wages in the U.S. because of the much greater threat of outsourcing jobs to other countries. Additionally, NAFTA and CAFTA are very significant parts of globalization strategy to reduce wages and increase the rate of profit. Finally, the strategy used by capitalist enterprises to increase their rates of profits caused great suffering for a lot of workers recently, such as higher unemployment and higher inflation, lower living standards and increased insecurity and stress on the jobs. As we know, most American workers today work harder and longer for less pay and lower benefits than they did several decades ago (Economic crisis,2009).

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Structure of home mortgage market

The structure of the U.S. home mortgage market in recent decades also contributed to expansion of mortgages to low-income workers. Commercial banks used to make mortgages and own them for their entire thirty-year term, and also had a strong financial incentive to try to make sure that the borrowers were credit-worthy and likely to be able to keep up with their mortgage payments. There is the securitization, which in turn pooled together hundreds and even thousands of mortgages as “mortgaged-based securities”. The outcome of the securitization of mortgages was the ‘originators’ of mortgages (commercial banks and mortgages companies). The originators have to perverse financial incentives to lower credit standards and to ignore possible problems with creditworthiness because they will soon sell the mortgage to other investors and also they earn their income from ‘origination fees’, not from the monthly mortgage payments. Therefore, the more mortgages-based securities sold, the more fees and income for investment banks whether or not the borrowers can make their payment down the road (Moseley, 2008).

The current crisis

The housing bubble started to burst in 2006, and the decline accelerated in 2007 and 2008. Housing prices stopped increasing in 2006, started to decrease in 2007, and have fallen about 25 percent from the peak so far. The decline in prices meant that homeowners could no longer refinance when their mortgage rates were reset, which caused the default of mortgages to increase sharply, especially among subprime borrowers. From the first quarter of 2006 to the third quarter of 2008, the percentage of mortgages in foreclosure tripled, from 1 percent to 3 percent, and the percentage of mortgages in foreclosure or at least thirty days delinquent more than doubled, from 4.5 percent to 10 percent. These foreclosure and delinquency rates are the highest since the Great Depression; the previous peak for the delinquency rate was 6.8 percent in 1984 and 2002. And the worst is yet to come. Early estimates of the total number of foreclosure that will result from this crisis in the year to come ranged from 3 million to 8 million. So far, there have already been almost 3 million mortgage foreclosures. Another 1 million mortgages are ninety days delinquent, and 2 million were thirty day delinquent. Therefore, a total of about 6 million mortgages either have already been foreclosed, are in foreclosure, or are close to foreclosure. Six million mortgages are about 12 percent of all the mortgages in the United States. The situation could get a lot worse in the month ahead, due to the worsening recession and loss jobs and income, unless the government adopted stronger policies to reduce foreclosures. Defaults and foreclosures on mortgages mean losses for lenders. Estimate of losses on mortgages keep increasing, and many are now predicting losses of $1 trillion or more. The future estimates that banks will suffer about half of the total losses of the financial sector. The rest of the losses will be borne by non-bank financial institutions (hedge funds and pension funds). Therefore, dividing the total losses for the financial sector, the losses for the banking sector could be as high as $1 trillion. Since the total bank capital in the U.S. is approximately $1.5 trillion, losses of this magnitude would wipe out two-thirds of the total capital in U.S. banks. This would be a severe blow, not just to the banks, but also to the U.S. economy as a whole. The blow to the rest of the economy would happen because the rest of the economy is dependent on banks for loans. Bank losses result in reduction in bank capital, which in turn requires a reduction in bank lending (a credit crunch). For the credit crunch, consumer spending will be further depressed in the months ahead due to the following factors: decreasing household wealth; the end of mortgages equality withdrawals and declining jobs and incomes. All in all, it is shaping up to be a very severe recession (Current financial crisis, 2008).

Government policies

Federal Reserve

The Federal Reserve adopted lower short-term interest rates in order for commercial banks to increase loans to businesses and households. This policy was not effective because banks do not want to increase their lending since they do not trust borrower’s credits and they suffer capital loss. Moreover, banks reduced their lending to maintain acceptable loan to capital ratios. The policy that they initiate failed. The Federal Reserve extended loan to investment banks. However, investment banks are not regulated by the Federal Reserve. As a result, the Fed thought that they have no responsibility to act as a lender to investment banks when they are in trouble. For example, JPMorgan Chase had taken over Bear Stearns. Since Bear Stearns was heavily indebted to so many different financial institutions, its bankruptcy would have caused very widespread losses and could have resulted in a complete meltdown of the U.S. According to Fed Chief Ben Bernanke, the financial system of the U.S. was at risk. Additionally, AIG was the largest insurance company in the world. It was in such financial trouble that the Fed feared the company would not be able to pay off all the insurance policies. Therefore, the Fed decided that it had to bail out AIG in order to save the financial system. The policy was somewhat successful but is not a complete success. It boosts investors confident due to the Fed commitment to avoid financial disaster (Government policy, 2010).

Congress

Congress gives out an economic stimulus which means ‘free money’ for citizen. Households and businesses get tax-cut or tax-rebates. These tax cuts had some positive effect on the economy, but their effect was small and temporary. Also, tax rebates boost consumer spending for a short period, however not all consumers spend it, they save it. Moreover, Obama Administration and Democrats in Congress are working on a second stimulus, which is more effective than the first, mainly because it is so much bigger and also because more of the total money is for increased spending rather than lower taxes. Therefore, this stimulus will make the recession somewhat less severe than it would otherwise have been (Teslik, 2009). Furthermore, the government took over Fannie Mae and Freddie Mac and guaranteed to pay all their debts. However, this will cost taxpayers hundreds of billions of dollars. As the crisis worsened, Treasury Secretary Paulson requested and Congress approved $700 billion to purchase high-risk, mortgage-based securities. He used the $700 billion to inject capital into banks instead of purchase their high-risk, mortgage-based securities. So far, the first half of the $700 billion has been spent, as a bailout of the banks and their bondholders, but banks have still not been willing to increase their lending (Bank Bailout Bill, 2011).

In conclusion, the subprime mortgage crisis or the current crisis put the U.S. economy into the worst recession since the Great Depression. As I mentioned above, there are the falling rate of profit, various strategies to restore the rate of profit, structure of home mortgage market, the current crisis and government policies. After I read about the U.S. economic crisis, I have learned that to understand the fundamental causes of the current crisis, we have to look back over the entire postwar period. Moreover, when the U.S, economic crisis exist, all banks in the world also suffered from the crisis. Although this crisis happened between 2007 and 2008, the U.S economy still faces with its impacts. Therefore, I think fixing and solving this big economic crisis in the U.S., it needs to have good strategies and it require more time.