Essay on Economic Climate
Analysis of the Current Economic Climate
The autumn of 2008 is without a doubt a significant economic event, whose course and implications are yet to be known. It is already possible, however, to indicate most of its causes and to identify some recent economic trends and occurrences involved in it.
Background
The US economy is still considered as a benchmark and a leader of global economy. Following the recession of 2001 and the weak economic performance during 200-3003, the US macro environment began to grow steadily, booming in 2005 and showing good results also in 2006. One of the main growth factors was the housing market, which was considered as sound investment with fairly good returns. However, this market is characterized by high leverage and a long-term investment horizon. Thus, financial institutions became very involved in this market, raising funds in the (mostly domestic) money markets and providing loans to both suppliers and buyers of houses. Easy access to finance has led to overbuilding and speculations in this quite traditional market. What seems now as excess supply of homes has led to declining prices and eased credit policies; the financial sector started to provide loans to borrowers with bad credit reputation (“sub-prime mortgages”). Throughout the second half of 2006 and especially during 2007 the US macroeconomic environment started to change. As happens often in times of high growth rates, the US market showed growing inflation rates, boosted by soaring energy and commodity prices. Additionally, the US Dollar depreciated fast during these years, partially due to the Federal Reserve’s policy of low interest rates, mainly targeting to keep economic activity and access to finance and to help the domestic market’s competitiveness; it helped indeed, as exports were a key engine that supported GDP growth during these years. Nevertheless, these factors caused to a decline in household income. Many borrowers (in particular in this “sub-prime” market) began to default, which has led to losses and collapses in the banking and insurance sector during 2008, increased risk and a direct liquidity crunch of businesses and, of course, extreme drop in stocks, energy and commodities markets. When discussing financial markets, it is clear that people worry not only because of the falling value of their direct investments, but also about the state of their pension funds, as these bodies (institutional investors) are still the most dominant player in the financial markets and thus suffer most of the losses.
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US government’s fiscal policy and actions
The American fiscal policy is traditionally quite expansionary and based on national debt. The Bush administration’s policy prior to the peak of the crises in the summer of 2008 refrained from material involvement in the market. Some critics will say that the administration’s approach, characterized by tax cuts and weak regulations is one of the sources of the crises, although it is not clear to what extent the government could get involved before bank started to collapse, considering the general approach of American governments before (mainly Republican aspiration for small government) and the administration’s focus on security issues. Either way, it is clear that the underlying market (in terms of microeconomic measurements regarding the behaviour of firms and consumers prior to the events of last summer) suffered from lowering disposable incomes and unemployment.
The turning point of this policy occurred in October 2008, when the Federal Housing Finance Agency took over Fannie Mae and Freddie Mac, two publicly owned mortgage corporations which dominated about half of the American mortgage market. Later this month another low point was reached, when the collapse of the investment bank Lehman Brother caused a riot in the market. The result was a significant event in the history of American fiscal policy, with a federal takeover of AIG and the House of Representatives’ approval for more than a $700 billion government spending on purchasing bad debts from the financial sector. The main question which arises here is extent to which these events (and possibly others in the near future) will influence the relations between the Federal Government and the private sector, both in the regulatory level as well as when considering that the government now owns a significant portion of the domestic financial sector.
Effects on the global macro environment
Economic slowdown in the US and financial turbulences have profound effects on most of the world’s economies. This has several reasons.
First, the US market is still the world’s biggest consumer for domestic and international goods and services. Hence, a slowdown in this market means that less money will go from the US to other economies in terms of US-targeted exports (in particular key exports such as oil), American investments and the US government support for developing countries; as their market is weakening and overall risk increases, Americans also pull their money back from other countries.
Second, the US is the world’s second target for FDIs (after China). Decreased cash flows from current investments in the US are a major threat that already shows signs on many economies.
Third, every financial crisis has a significant psychological effect. The American media, an influential force on global trends of economic behaviour boosts the role of American events as foreigners perceive it.
All of these, led by the international contribution to the government and public debts, push this snowball ahead to other countries and sectors. Although some countries are more exposed than others, it is clear the globalization is not a set of bilateral relations between the US and another economy, but a complicated set of relations where macroeconomic factors became much more influential than ever before.
Foreign exchange issues
The trends in foreign exchange rates are perhaps the most complicated issue here, due to the fact that they are directly influenced from all other factors and play a key role in international trade.
The US Dollar has been devaluated in recent years, a fact that helped US producers in their domestic markets. Lately we see the opposite trend, although not so drastically yet. Growing demand for Dollars is influenced from several factors and can serve as a key issue in this situation.
The two main initiators of the USD exchange rates are the Federal Reserve’s monetary policy (i.e., opportunity cost in the markets) and the global trade situation; as Americans draw their investments out of foreign markets they increase the demand for Dollars, whereas the monetary policy will try to keep discount rates low to ease credit policies.
Monetary policies of other central banks, in particular the ECB, and their correlation with the Federal Reserves’ actions will set the course for future FX trends. A weak Dollar means lower returns from export transactions with the US and China (whose currency is pegged to the USD). Some countries may wish to see a stronger Dollar to help their exporters. On the other hand, most non-US Western markets (and also many developing markets, such as in Eastern Europe) are based much more on private consumption than on exports. If the current devaluation of the main currencies against the USD will continue, it is highly possible that the trend will bring about soaring prices in the markets for goods and services, possibly causing stagflation in some weak markets. It is warning sign in front of decision makers; many tend to underestimate trends in the underlying markets, as they did in their policies prior to the event during the summer of 2007.
Where are we heading from here?
So far it seems that the Federal bailout program does not affect the behaviour of investors and, businesses and consumers. All the economic indicators, in particular job creation, spending and borrowing show that recession is unavoidable. Heavy losses in financial markets mean that investors will be reluctant or are already unable to push economic activity up. A recessionary Tsunami is on its way to Europe and Asia, leading to the same behaviour of investors and players. As consumption markets (demand) are going low, the business players (supply) adjust themselves, reducing costs (in particular slashing their workforce) and avoiding investments in new projects. A typical pattern of recession is seen here, perhaps one of the greatest recessions we have ever experienced.
Macroeconomic patterns tend to be wide in effect. A secondary wave may arise from the other retail credits, in particular credit card companies. If this will occur, we are at fatal risk of cutting the credit line for consumers. Not only that it will paralyse consumption, but it will join unemployment to bring about extreme poverty and desperation, which will jeopardise any attempt to get the economy out of recession.
Macroeconomics and behaviour of individuals and nations go hand by hand. A great political risk is underlying here. Developing economies which are based on Western consumption such as oil producing countries (many of them, such as Russia and Iran, are very responsive to macroeconomic factors) may channel this desperation to increased nationalism or religious radicalism. We have seen such examples in the past and should be extremely worried about the implications of this process on world peace and political stability.
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