History of economy would suggest that once every couple of generations there is a complete prosperity-depression cycle that occurs within the financial market, and economy as a whole. The last time this happened was in the 1920’s, and 30’s. It started with the Wall Street Crash of 1929, and then it moved through to the Great Depression and ended beyond World War II. The current global financial and economic situation resulting from crisis caused by the U.S. sub-prime market appears to be the start of one of these historic cycles at this point in the maturation of the human race. Despite the fact that U.S. economy is in recession, there are many contradictory opinions about another financial and economical crisis. The purpose of this blog is to clarify similarities and differences between the economical events in 1920's, and 30's with current global financial and economic situation.
The twenties in America were a very good time. Production and employment were high and rising. Wages were not going up much, but prices were stable. Although poverty was very evident, new technology, like the radio and the car coupled with real estate speculation, especially in Florida, created an economic atmosphere of “get rich quick.” Stock prices were run up to excessively high levels, which everyone knew were unsustainable. For the first time in investing history the masses of investors were allowed to borrow on the margin in order to buy stocks. Industrial production was rising, and this fueled the speculation. However, production and GDP were rising at a much slower rate than the stock market.
Then all of a sudden, in October 1929, everything went differently. The masses lost faith in the value of stocks and opted to sell -all at the same time ! This caused a panic. Stocks started to decline sharply, leading to more selling. Investors couldn’t pay the interest on their margin accounts causing the small and mid-size banks that had loaned the money to go out of business. Between December 1929 and March 1930 the stock market regained three-quarters of what it had lost since the beginning of the crash, but the slow economy sent the stock market into another plunge and did not hit the bottom until July 1932. Unemployment, which has started to increase since October 1929, rose to 25%, Consumer confidence and expenditure declined. Federal reserved increased the interest rate. Moral hazard and adverse selection problems worsen the situation for businesses to fund their investment opportunities. Economic activities declined, and America went to The Great Depression.
However, current global financial and economic situation has many similarities to 1920’s and thirties, but today’s crisis triggered by real estate market bubble and wrong banking systems. Once again in the history of human being, GREED played its role and won the best actress prize. She seduced human to invent sub-prime mortgage to earn more, unaware of his invention’s consequences. And so, traditional way of lending has given its place to the new model of borrowing, so called sub-prime mortgage.
In this model, banks sell on the mortgages to the bond markets. This has made it much easier to fund additional borrowing. The business proved extremely profitable for the banks, which earned a fee for each mortgage they sold on. They urged mortgage brokers to sell more and more, mostly to un-informed poor, worker class people, and recent immigrants. Just as people were treated back in 1920s, brokers told them that they could get cash by refinancing their homes, but often neglected to properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate.
Sub-prime mortgage led to abuses as banks no longer have the incentive to check carefully the mortgages they issue. The result was a wave of repossessions across the cities, and crisis went nationwide by 2006. By then, one in five mortgages was sub-prime. But these mortgages had a much higher rate of repossession than conventional mortgages because they were adjustable rate mortgages, and totally dependent on the level of Fed interest rates, which also rose substantially.
The wave of repossessions is having a dramatic effect on the economy; sold and unsold house prices is decreasing 4.5% annually, and it expected to decline by at least 10% by 2009, building industry expected to cut its output by half with the loss of between one and two million jobs, many small firms in construction and related industries such as durable goods will go out of business, Consumer confidence and expenditure is decreasing every quarter, inflation is rising, and lenders are cutting back on how much credit they will make available. The banking industry is facing huge losses as a result of the sub-prime crisis too. It is estimated that ultimately losses suffered by banks and bondholder, such as pension funds, could be between $220bn and $450bn. Financial institutions losses and increase in uncertainty resulting from that, could worsen the current bearish stock market and lead it to another depression.
To be Continued ...
P.S. To get more info, You may read chapter 8 of "The Economics of Money, Banking, and Financial Markets (7th ed)"