Help! Still trying to get my head around it

I'm going to put this simply:

Lets say in the world there existed at the height of the boom, €100

Now we're in a recession,.....a worldwide recession.......nobody has money

WHERE HAS THE €100 GONE???

Surely in the world today, there exists the same amount of money as always.

My take on it is that the banks created "virtual" money which they gave out as mortgages and loans. This was essentially money that didnt exist.

Buildings didnt sell and now lie idle.

Banks want their repayment which the property developers cant afford.

Anyone agree?

The current financial crisis has its roots in the rise of neo conservatism in America and globalisation. Under conservative policies markets are deregulated and allowed to find their own balance (this is known as free market capitalism). Conservatism also advocates classical economics- classical economics argues that the future can be predicted through probabilty and mathematical calculations. This has led to financial institutions believing they can predict the future values of products, markets etc- this practice is know as hedging, derivatives etc- basically the speculation on the future value of stocks, commodities, bonds etc

America is the finacial hub of the world which explains why the effects of the American sub prime scandal effect the rest of the world. The sub prime market was fueled by massive debt- essentially financial institutions were borrowing heavily from each other and lending at higher rates to consumers in the belief that they could pay it back. Sub prime lenders tend to lend to high risk borrowers (people with below standard credit ratings) This is fairly common as a higher interest rate is used as incentive for the lender who should also be spreadint their risk by hedging in low risk investments(again, borrowers). They didnt spread their risk- instead they focussed heavily on lending to high risk borrowers, or they thought they spread their risk but hedged on over inflated derivatives. Why did they do this? Hard to say but I beleive it was down to inflated confidence in the market and the belief that the high interest rates would offset any losses. The got a very basic lesson - high risk people couldnt pay back and defaulted, this knocked confidence which exposed their overinflated hedges which quickly nose dived leaving them unable to pay back the banks- causing wide spread panic and wiping billions off the exchanges in lost confidence which basically made all the lenders stop in their tracks in a frantic bid to limit damage and survive.

Globalisation again played an important role here as American industried began to be outsourced to Asia and America was cought in a situation where it was borrowing billions from China while sending all of its industries there- this might work if you had a global economy but because China was saving dollars and lending instead of trading it essentially sucked both the industries and the capital out of the American economy. American consumers were borrowing billions from China while also sending their jobs (their primary means of repaying debt) to Asia aswell. China deliberately undervalued the Yuen against the dollar, which basically allowed them to hoard dollars while giving out little in return (comparitively)- the rest of Asia also refused to float its currencies (this is known as dirty floating)

This lead to global finacial companies treating American consumers as global consumers- but because American consumers lost their manufacturing jobs to outsourcing they were unable to repay their loans- this sent shockwaves through the finacial sector as each sub prime lender defaulted.

Essentially "confidence" was lost in the lending market- ie banks did not trust that people would pay them back and so cut back on credit (credit crunch) in order to survive and mitigate their losses- unfortunately this led to good businesses losing liquidity and folding even though their liquidity ratios were good which again knocked market confidence.

Governments have been trying to restore confidence by gauranteeing loans and this is what Obama is trying to do with his stimulus package.

Fingers crossed

(PS I know my spelling sux before anyone comments)

Its basic enough to say that deregulation leads to finacial scandals (we've had these problems many times in history) and on the flip side liberal policies can also lead to economic problems such as stagflation. Obviosuly the issue is the unregulated lending but personally I believe the problem lies in the fact that technololgy has allowed the finacial market to become much more gloablised than the "real" markets and politics. Finacial institutions are not in touch with local economic forces- instead seeing finacial growth as the ultimate goal and pressuring indurstries to locate geographically in places which apresent very different social and political levels of global interaction- primarily China (which is set for 7.5% economic growth while the rest of the wrold contracts at an average of 4% this year). We need a level playing field in globalisation and financial institutions need to help their commercial customers offset the problems in maintaining competitive advantage, instead of pressuring them to adjust to unsustainable market forces for short term gains.

We need to dig up Keyens, clone his DNA and get him going again!!:D

read this

http://cynicuseconomicus.blogspot.com/2008/07/root-of-problem.html


the whole blog does a great job at explaining where we are and why in easy to understand examples, highly recommended read for anyone interested in subject

The Economist wrote: »

It's amazing how your Keynesian views have distorted your perspective on this, my good man.

http://gregmankiw.blogspot.com/2008/09/distorting-history.html

It's a bad thing when I agree with Greg Mankiw.



It's amazing how your Keynesian views have distorted your perspective on this, my good man.



The situation is far more complex than it is being made out to be. Casually associating deregulation with neo-liberalism is at best a half-truth. Ignoring the blame of intervention (by Clinton, by the Fed in LTMC, by establishing Fannie and Freddie...) in causing this crisis is foolish. Blaming globalisation without casting an eye on Iceland is intellectually dishonest. Finally, citing early Keynes without acceptance of his later work, and the great insights that macroeconomics has provided since, can only be justified by idealogy -- and as I'm sure Bill Clinton can now appreciate -- that is never a good basis for policy creation.

Modern liberalism in the American context is associated more with interventionism (regulation) than deregulation- which accords perfectly with Keynes "The General theory..".

If we are simply going to trade other peoples blogs then we should just post up a list of web links: so here's one from Robert Skidelsky: http://www.skidelskyr.com/site/article/where-do-we-go-from-here

The question was asked how we came to this- but it is not enough to simply say banks loaned too much- we must ask the question why people were'nt able to pay back their loans. To simply assume that millions of people were dumb enough to take out loans they knew they couldnt pay back is being the most intellectually dishonest (not to mention downright insulting) and to then assume that finacial institutions, who supposedly make a living off predicting the future (another thing Keyens said was impossible) could not have the most basic foresight to spread their risk properly is pure naivity.

The fact is that on paper the numbers added up (in a gloabl context) but once the flow of dollars was not able to go back into the US economy to repay the American conumer debts we immediately saw defaulting- this was both a government and market system failure

Important note: While I am a supporter of a more Keyensian approach it makes little difference whay I think- the fact is fiscal policies are being adopted by governemnts right now as we speak- most notably America- which is in line with what the original poster asked- what went wrong (corruption through deregulation) and what is the current situation (government intervention/stimulus) - these are the present day facts

nesf wrote: »

Remember the penalties for defaulting on a mortgage in the United States are very low. You only take a hit to your credit rating, you do not owe any money to the bank even if the sale of the property did not cover the whole mortgage amount. If people already have a low credit rating then they do not have anything to lose by taking a chance on buying a home and hoping to resell it later on for a profit. It's not a case of them being dumb enough not to realise they mightn't be able to pay it back, it's that the cost of not being able to pay it back was very small for Sub-Prime borrowers.

Also, remember that there were some very dodgy lending practices going on with "teaser rates" for the first year or two suddenly turning into very high interest rates which arguably a lot of buyers might not have been aware of.

I take your point about the borrowers and indeed my sentiment was that borrowers knew the personal risk was worth it but the lenders either drastically underestimated their risk of lending or most likely hedged on over inflated derivatives which were over-valued by over confident institutions relying on flawed neo classical economic views of probablity calculations-

Basically the traders advised clients (sub prime lenders included) that hedging was worth way more than it was- the true values only came to light once the borrowers, who through the most basic logic as high risk, proved why they were indeed high risk- by not being able to repay their loans.

This is the most basic and scandalous problem; High risk people were encouraged to take out loans not only by lenders but also by the cost/benefit scenario of the loans to themselves- but why? Why did lenders push loans which their own probability calculators told them would not be repaid- I dont want to give a simple explanation but the notion that high interest returns clouded their judgement (ie greed) is very tempting

Greed is natural and a flaw of the competitive market but deregualtion is the space in which greed is allowed to operate and this is a flaw of the government

Deleted User wrote: »

No, not really a glib response.

I take a little bit of an issue with the way you package everything up so neatly. You have nice little causes for events and you have nice little effects for the schools of liberalism etc.

However, I don't think you simply just take a out a school of thought and apply it to the market like that; its too complicated. To say that 'x' school of thought would lead to a solution is itself glib.

Please actually contribute something to the discussion. If anything your responses are packaged up in the most neatly. If you want to actually logically critique/analyse what i said or even (and i dont hold out much hope for this) contribute your own view then please do. Responses such as "you packaged everything up neatly" are the very definition of glib

nesf wrote: »

You have to look at the structure of CDOs and how insanely difficult it would be for buyers (or creators) of these CDOs to work out what the actual risk of the CDO was to grasp why this turned into the crisis that it did. The market can't work if the market can't "accurately" value the product as was the case here.


The problem wasn't down to neo-classical views of probability. It's far more complex than that and the quantitative views of risk used were a long way from neo-classical economic theory. How much do you know about derivative markets, option pricing and quantitative methods of risk analysis? (I'm asking so that I know what I need to explain and what I don't before I launch into a long complicated answer on the problems of risk analysis that led to the whole Sub-Prime crisis, I don't want to be patronising and start explaining what the Black-Scholes model is to someone who understands it (and its limitations) already)

I see, I need to provide academic qualification before I can enter into a discussion now?

Please feel free to lecture on the reliability of probability models (in the face of the economic disintegration of the worlds largest hedge fund and derivative advisors)

Of course we all know that these models only work when markets are "well behaved" and crumble when unpredictability enters the arena. Remember "Long-Term Capital Management". The fact is that quant theories-while mathmatically provable do not gaurantee success, the main problem is that over inflated share values who's only justifaction relies on a baynesian or Black Scholes probabaility calculation go to pot once a variable deemed too unlikely enters the equation

Probabailty calculations are the realm of mathematics and physics (as someone said) and from a technicsl point of view are independant or "atheoretical" however the very belief that the future can be accurately predicted is fundamentally classical see Ricardo-Malthaus, Keyensian is very much on the side of the here and now and the uncertainty of the future with really the only certainty being "in the long run we're all dead"

But I can se im being drawn into an argument on semantics- which while legitimate is is pretty inane and only loosly related to the OP's question