Introduction
After years of rapid growth, the economy of the globe is slowing rapidly, and the worldwide economy is being pounded by an extraordinary financial outrage and by inflation in energy and other commodity prices. The financial outrage has put pecuniary-policy makers “between a rock and a hard place,” the IMF said, requiring working on two borders: stabilizing the financial sector and using monetary and fiscal policies to support growth. The coordinated rate cuts announced Wednesday by the major central banks, including the Federal Reserve and the European Central Bank, was “clearly a step in the right direction,” said Olivier Blanchard, director of research for the IMF.
Financial Crisis
The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems.
On the one hand many people are concerned that those responsible for the financial problems are the ones being bailed out, while on the other hand, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided, if ideologues supporting the current economics models weren’t so vocal, influential and inconsiderate of others’ viewpoints and concerns.
Effects On Financial System
A collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail. Banks borrowed even more money to lend out so they could create more securitization. Some banks didn’t need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities.
Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on. Some banks loaned even more to have an excuse to securitize those loans. Running out of whom to loan to, banks turned to the poor; the sub-prime, the riskier loans. Rising house prices led lenders to think it wasn’t too risky; bad loans meant repossessing high-valued property. Sub-prime and “self-certified” loans (sometimes dubbed “liar’s loans”) became popular, especially in the US. Some banks evens started to buy securities from others. Collateralized Debt Obligations, or CDOs, (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. While things were good, no-one wanted bad news.
Crisis And The Bailouts
The extent of the problems has been so severe that some of the world’s largest financial institutions have collapsed. Others have been bought out by their competition at low prices and in other cases, the governments of the wealthiest nations in the world have resorted to extensive bail-out and rescue packages for the remaining large banks and financial institutions. The effect of this, the United Nation’s Conference on Trade and Development says in its Trade and Development Report 2008 is, as summarized by the Third World Network that the global economy is teetering on the brink of recession.
The downturn after four years of relatively fast growth is due to a number of factors: the global fallout from the financial crisis in the United States, the bursting of the housing bubbles in the US and in other large economies, soaring commodity prices, increasingly restrictive monetary policies in a number of countries, and stock market volatility. The fallout from the collapse of the US mortgage market and the reversal of the housing boom in various important countries has turned out to be more profound and persistent than expected in 2007 and beginning of 2008. As more and more evidence is gathered and as the lag effects are showing up, we are seeing more and more countries around the world being affected by these rather profound and persistent negative effects from the reversal of housing booms in various countries.
Construction Industry
Globally, work has been halted on construction projects, including 29 of 301 U.S. projects, according to Emporis GmbH, a German company that tracks development. Work is stalled on the five tallest buildings on five continents, including the Spire — Emporis refers to these landmark buildings as “Babel” projects. Work was stopped on the kilometer-tall (.6 mile) Nakheel Tower in Dubai, one of scores of construction projects idled in the former Gulf Arab boom town. A January HSBC report said $75 billion worth of projects in the United Arab Emirates were suspended or canceled. Contractors complain of not being paid. Other tall towers on hold are Moscow’s Russia Tower and the Gran Torre Costanera office building in Santiago, Chile.
Massive Job Losses
The U.S. economic downturn has probably been felt most acutely in the construction industry. Some 2 million American construction workers are unemployed and the industry’s 21.4 percent jobless rate is the highest of any sector. “Every month we see massive job loss in the construction industry and every month it gets worse. The construction industry is in a near depression. The recently passed U.S. economic stimulus bill was expected to funnel $150 billion into building and repairing infrastructure, which the union said would employ 700,000 workers, for a while.
The stimulus funding is viewed as only a down payment on the $2.2 trillion engineers say is needed to rebuild the nation’s infrastructure. Fewer workers are needed to perform maintenance than build from scratch, laborers say. If there are no buildings going up, what do you do? Prepare yourself because it’s going to get worse before it gets better. Construction workers are accustomed to boom-and-bust cycles but this downturn appears deeper and longer. The impact of lost wages of $35 to $40 an hour ripples through the economy. People out of work, people lose their homes, people lose their hospitalization, people lose all their benefits,” said Tom Villanova, president of the Chicago and Cook County Building Trades, which covers 100,000 construction workers.
Dublin-based Shelburne Development Group has so far failed to get financing for the $1 billion Chicago Spire. Now, construction unions are negotiating to invest their pension funds to kick-tart the project. The Spire would provide 1 million paydays for ironworkers, carpenters and others. But construction loans are hard to come by. Delinquency rates in Chicago on such loans have risen for 10 consecutive quarters to 15 percent in the fourth quarter of 2008. Many projects never got off the ground, while other developers have scaled back or suspended work altogether. The residential market has a glut of unsold and foreclosed homes. In downtown Chicago, canceled contracts on condominiums in the latest quarter outnumbered meager sales, which were off sharply from nearly 3,800 sales in all of 2007, according to Appraisal Research Counselors, a real estate firm. Prospective buyers surrendered down-payments of $10,000 or more, scared off by falling prices and the bleak job market.
Inflation
The macroeconomic effects of a financial and banking crisis of such scale are not trivial. Economic forecasters frequently underestimate the importance of credit and financial channels. What saved the US economy during the 2001 recession was a booming housing market and the availability of cheap consumer credit. This time many of those mechanisms work in reverse. The housing markets in the US and several other economies are headed for a severe downturn. In fact, it is a testimony to the innate strength of the US economy that it has produced positive growth rates until recently.
The second risk is inflation – for two reasons. First, persistent high inflation could destabilize global government bond markets, a rare pillar of stability in an uncertain financial environment. Second, high inflation places constraints on monetary policy. This in turn could make the downturn harder and longer, and the banking crisis more severe. The problem for central banks is not the rise in headline inflation rates, but the rise in inflationary expectations. A sharp economic downturn would almost inevitably reduce headline inflation rates, owing to lower oil and food prices. But it would not necessarily reduce expectations of future inflation.
Inflationary expectations went up worldwide during 2007, partly because of rising headline inflation, but possibly also because central banks may have lost a part of their credibility as they appeared torn between conflicting objectives of price and financial stability. In the Euro zone, for example, five-year inflation futures show that the financial markets expect medium- term inflation to be about 2.5 per cent. Markets obviously distrust the European Central Bank’s medium- term inflation target of close to 2 per cent. In the US, the markets have little faith in the US Federal Reserve’s comfort zone for core inflation, either.
But this also means central banks will be cautious. In the US, some market participants may be disappointed when they discover that the Fed may not be in a position to cut the Fed funds rate to much below 4 per cent, unless and until the economy contracts sharply. A fall in short-term nominal rates to 1 per cent, as happened in 2003, is very unlikely. The third risk is a disorderly unwinding of global imbalances, in particular a collapse in the exchange rate of the dollar against the euro and the yen. That could occur if central banks in Asia, Russia and the Middle East were to shift reserve assets out of dollars on a large scale. On this score, I am more optimistic.
Conclusion
The bottom line is that this year marks the start of an asymmetric global economic downturn that is likely to persist for some time and will probably be quite unpleasant, but which will be well short of catastrophic. People may find their mortgages harder to pay, or re-mortgaging could become expensive. For any recent home buyers, the values of their homes are likely to fall in value leaving them in negative equity. In the wider economy, many sectors may find the credit crunch and higher costs of borrowing will lead to job cuts. As people will cut back on consumption to try and weather this economic storm, yet other businesses will struggle to survive leading to further fears of job losses.
References
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