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Saturday, 13 September 2014

Guest contribution: Imminent Global Financial Crisis

This blog has always been a free platform for guest contributors to express their views, ideas and argumentation. 

This respective contribution is written by Mr. Mohammed Minhaz Bin Salim, Department of Banking & Insurance (4th year 2nd semester), University of Dhaka

The author can be contacted here: Email-anik626945@gmail.com

Note: The argumentation of the author, does not necessarily reflect the views of this blog. 



Part-I
The present situation

Though US government officials say its recovering, the signs all points to upcoming financial demise, from food price hike, which will ultimately lead to food shortage and riots and retailers closing stores because they are losing revenue. China and Russia among other countries are dumping the use of dollar. Also, the recent news that the US economy has shrunk for the first time (officially) since 2011, it seems economic death  right in the face and most people don’t even know the extent of devastation about to occur.

A quick look on retail apocalypse happening right now:
  • Wal-Mart Profit Plunges by $220 Million as US Store Traffic Declines by 1.4%
  • Target Profit Plunges by $80 Million, 16% Lower Than 2013, as Store Traffic Declines by 2.3%
  • Sears Loses $358 Million in the First Quarter as Comparable Store Sales at Sears Plunge by 7.8% and Sales at Kmart Plunge by 5.1%
  • JC Penney Thrilled With Loss of Only $358 Million For the Quarter
  • Kohl’s Operating Income Plunges by 17% as Comparable Sales Decline by 3.4%
  • Costco Profit Declines by $84 Million as Comp Store Sales Only Increase by 2%
  • Staples Profit Plunges by 44% as Sales Collapse and Closing Hundreds of Stores
  • Gap Income Drops 22% as Same Store Sales Fall
  • American Eagle Profits Tumble 86%, Will Close 150 Stores
  • Aeropostale Losses $77 Million as Sales Collapse by 12%
  • Best Buy Sales Decline by $300 Million as Margins Decline and Comparable Store Sales Decline by 1.3%
  • Macy’s Profit Flat as Comparable Store Sales decline by 1.4%
  • Dollar General Profit Plummets by 40% as Comp Store Sales Decline by 3.8%
  • Urban Outfitters Earnings Collapse by 20% as Sales Stagnate
  • McDonalds Earnings Fall by $66 Million as US Comp Sales Fall by 1.7%
  • Darden Profit Collapses by 30% as Same Restaurant Sales Plunge by 5.6% and Company Selling Red Lobster
  • TJX Misses Earnings Expectations as Sales & Earnings Flat
  • Dick’s Misses Earnings Expectations as Golf Store Sales Plummet
  • Home Depot Misses Earnings Expectations as Customer Traffic Only Rises by 2.2%
  • Lowes Misses Earnings Expectations as Customer Traffic was Flat
Food prices skyrocket
  • Beef: Retail price increased by 22% in the past year.
  • Pork: Retail price increased by 6.8% in the past year.
  • Poultry: Retail price increased by 4.7% in the past year.
  • Milk: Retail price increased by 36%% in the past year.
  • Fruits and vegetables: Retail price increased by 3.4% in the past year.
Could China kill the US dollar?


For the last few years increasing number of commentators,including Max Keiser, have been predicting the collapse of USD, a collapse that could be closer than you think.

America is currently facing a real impeding threat China.

China accounts for more global trade than anyone else on the planet and most of the trade happens in USD keeping demand for dollar high and overseas trade at low costs.

Not only this, but China holds around 1.3 trillion dollars of US debt.

A debt accumulated by China’s stockpile of dollars from International trade, which they lend back to US at ridiculously low interest rates

But what happens if they stop playing this game?

Well, in some respect they already have.These are typical warning signs of economic collapse.

Part-II
The Problem

How do financial panics arise and spread?
  • Financial globalization
  • Great increase in (two-way) capital flows across national borders
  • Net flows from emerging market economies to advanced economies (especially, U.S.)
  • Financial deregulation
  • Blurring of lines between commercial and investment banking
  • Free international capital mobility across as a norm
  • Allowing big banks to use their own risk models in determining leverage
  • The rise of an unregulated “shadow banking system” 
  • Lack of regulation of new financial products
  • “Financial innovation” esp. securitization 
  • Colletarallized debt obligations (CDO), credit-default swaps (CDS)
Greater liquidity and lower returns on traditional investments spur risk-taking and high leverage.Financial globalization: United States


Source: Maurice Obstfeld (2011)

Financial globalization: Iceland and Ireland

Source: Maurice Obstfeld (2011)

The appeal of financial innovation in housing

Who wouldn't want credit markets to serve the cause of home ownership? So:


}  introduce some real competition into the mortgage lending business by allowing non-banks to make home loans
}  let them offer creative, more affordable mortgages to prospective homeowners not well served by conventional lenders. 
}  enable these loans to be pooled and packaged into securities that can be sold to investors
}  reducing risk in the process. 
}  divvy up the stream of payments on these home loans further into tranches of varying risk
}  compensating holders of the riskier kind with higher interest rates
}  call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in
}  just in case anyone is still nervous, create derivatives that allow investors to purchase insurance against default by issuers of those securities. 

The result: a housing “bubble”


Source: Robert Shiller, http://www.irrationalexuberance.com/.

Part-III
Others opinion

Why The Next Financial Crisis Could Be Worse Than 2008

Last year the Federal Reserve celebrated its 100th birthday. Only two days before Christmas in 1913, deep into the night when many legislators had already left for the holidays, Congress passed the Federal Reserve Act, creating a “non-governmental” central bank – a bankers bank if you will – and charged it with the responsibility of controlling the nations monetary system. In all those years, the Fed has never engaged in a monetary explosion like it is today. We are truly in uncharted territory. In this article we’ll discuss the real reason behind the Feds easy money policy and how its could create an economic disaster, even more severe than 2008. First, some background on the Fed.

U.S. Monetary System: The Changing Of The Guard

The Fed was created on December 23, 1913, largely as a result of the Bank Panic of 1907. When Congress amended the Federal Reserve Act in 1977, it created what has come to be known as the Feds dual-mandate. Basically, the Fed is responsible for full employment and stable prices. The tools of the Fed include: adjusting short-term interest rates; regulating the money supply; establishing bank reserve requirements; and a few less-utilized tools. The current “Chair” of the Federal Reserve is Janet Yellen. Note: “Chairman” has been changed to “Chair” due to the first woman appointed to this position. The Fed Chair is appointed by the President to serve a four-year term. Next , we’ll discuss how a specific piece of legislation which emerged during the Great Depression, could have saved us in 2008.

Bank’s Risk Redemption: The Glass-Steagall Act

In the midst of the Great Depression, Congress passed the Glass-Steagall Act, named after Senators Carter Glass (D) and Henry Steagall (D). Glass was a former Treasury Secretary and founder of the Federal Reserve System and Steagall was a member of the House of Representatives and Chairman of the House Banking and Currency Committee. The intent of the Act was to limit commercial banks involvement in securities activities and their affiliation with securities firms. Why? Because when banks engage in risky activities, it places depositors’ money at risk. Hence, the idea was to erect a wall of separation to protect depositors and reduce bank failures. This legislation was enacted in the wake of over 10,000 bank failures which represented about 40% of the banks in existence when the Great Depression began.

During the 1960′s, the interpretation of Glass-Steagall had changed and banks were allowed to engage in an increasing amount of securities activities. Why? Perhaps because the world was becoming a global economy and U.S. banks were at a distinct disadvantage with their foreign counterparts. Although Glass-Steagall was intended to prohibit commercial banks from owning or affiliating with securities firms, in 1998 the Fed, under its own interpretation of the Act, permitted Citibank to affiliate with Solomon Smith Barney. There is a strong consensus that the elimination of Glass-Steagall was a chief contributor to the financial crisis of 2008.

Bank Failures: 2000 to 2013

When Glass-Steagall was abolished, the door was opened for what some like to call, “Capitalism run a muck.” Although I still believe this is the greatest economic system available, like anything else, extremes can occur, especially when greed is rampant. The following chart illustrates the number of bank closings each year from 2000 through 2013, according to the FDIC.


The 2008 Crisis

When the housing bubble burst, banks were so deep in debt that mass failures seemed imminent. In essence, the lubricant of our economy (i.e.; liquidity), suddenly, and with great severity, dried up and the engine froze. This forced Congress to take drastic measures. In fact, Ben Bernanke, former fed chairman relied upon an obscure portion of the Federal Reserve Act which allowed him to lend to “any individual, partnership, or corporation” in “unusual and exigent circumstances.” This was predicated on the fact that “adequate credit accommodations from other banking institutions” was not possible. Basically, the power of the Fed was greatly expanded that day. When Congress passed the Troubled Asset Relief Program (T.A.R.P.), Washington hoped banks would loan this money to stimulate economic activity. However, as I wrote at that time, since banks were so mired in debt, they probably wouldn't use the money for loans, but would use it to mend their wounds. In short, since the crisis was largely due to pressure from the U.S. government to make home loans to sub-prime borrowers, banks were in no mood to go down that path again, at least not so soon. Rather than use more debt to cure a problem which was caused by debt, banks tightened their lending standards and loan activity became temporarily extinct. This greatly increased the severity of the crisis. Even though the financial system didn't actually collapse, the edge of the cliff could easily be seen from where they stood.

The Great Monetary Expansion: The Lethal Brew?

When the crisis began, the Fed had a balance sheet of about $800 billion. Today, after T.A.R.P., QE I; QE II; Operation Twist; and QE III, the Feds balance sheet exceeds $4.1 trillion! Here’s the troubling part. Even though the Fed has done everything possible, the economy continues to struggle. It has reduced short-term interest rates to near zero, drastically expanded the money supply, and lowered bank reserve requirements. On the other hand, prudent fiscal policy (i.e.; tax policy and spending), which is the responsibility of Washington, has been absent. Instead of a prudent fiscal policy, we have had an explosion in national debt, largely due to an increase in entitlements. One dollar borrowed today reduces future revenue since it has to be repaid. With the “official” national debt at $17.3 trillion and rising, we have a scenario where future economic growth will have to be well above average, just to repay what we've borrowed. Hence, the Fed has overshot its target in an attempt to compensate for the lack of fiscal responsibility in Washington. But there may actually be a greater threat looming.

Deflation and Inflation: The Dollar Daze!

Inflation is the general rise in prices whereas deflation is the reverse. The Fed’s goal is modest inflation since deflation can cause great economic hardship. In mid 2011, James Bullard, President of the St. Louis Federal Reserve, appeared on CNBC and discussed the possibility of the U.S. entering a period of deflation. The problem with deflation is that it causes people to restrain from spending as they wait for prices to fall. This can become a self-perpetuating cycle which is difficult to escape. Japan, which has struggled with deflation for over two decades, provides an excellent case study. Former Fed Chairman Bernanke has studied Japan’s problems extensively and wrote a 27 page paper on it in December 1999 while at Princeton. It’s entitled, “Japanese Monetary Policy: A Case of Self-Induced Paralysis?”

Inflation is caused when the supply of dollars exceeds demand. In this case, the value of each dollar is reduced, creating the illusion that prices are rising. Actually, inflation occurs because the dollar loses value and it takes more of them to buy the same goods and services. Why is inflation a goal? If people believe that prices are heading higher, they are more likely to go ahead with that large purchase rather than wait. The Fed has been trying to “entice” consumers to get out and spend by expanding the money supply. When the dollar is weakened, it also helps boost exports.

Operation Twist: Give The Fed An “A” For Creativity!
Just when it seemed it had used up its available tools, in September 2011, the Fed introduced Operation Twist. Here’s how it works. The Fed sells short-term bonds which reduces demand causing prices to fall and yields to rise. At the same time, it buys bonds with longer maturities (i.e.; 7-10 years), which increases demand causing prices to rise and yields to fall. Why would the Fed want bond yields on the 10 year treasury to fall? Because this helps keep mortgage rates low. Lower mortgage rates creates an increase in refinance activity which improves ones cash flow. An improvement in cash flow results in an increase in spending which helps boost the economy. Hence, the Fed was being quite creative. The greater question is why does the Fed continue expanding the money supply despite tepid results?


The Wealth Effect: But It Feels So Good

Another goal of the Fed is to push investors into risk assets (i.e.; stocks). Why? If successful, demand would rise along with prices. Hence, when the stock market rises, people feel wealthier. This is well documented and is known as the Wealth Effect. This also occurs when home prices rise. In short, when people feel wealthier, they tend to spend more. It’s greatly psychological, but again, it’s a well-accepted theory.

The Price Is Right….Or Is It?

Normally, the Fed increases the money supply to keep pace with population growth. Moreover, during periods of economic weakness, the Fed will increase the money supply and lower interest rates to make money more available and cheaper to borrow. However, this time the results have been rather muted. Why? Perhaps people don’t have the same appetite to borrow and banks are more cautious about lending.

In 2006, Congress passed the Financial Services Regulatory Relief Act of 2006, which authorized the Fed to begin paying interest to banks on reserves held against certain types of assets. It was supposed to take effect October 11, 2011. However, when the crisis emerged in 2008, Congress advanced the date by three years. Therefore, beginning in 2009 the Fed began paying interest to banks on the money they held in reserve. This provided a financial incentive to banks to maintain excess reserves rather than lend. In short, if the Fed were to stop paying interest on bank reserves, banks would derive a greater economic benefit by lending this money. Considering the amount of money we’re discussing (in the trillions) if it were to enter the U.S. economy, inflation would be so high that it would make the late 1970′s look like a period of falling prices! According to economist Marc Faber, the U.S. will experience hyperinflation within the next 10 years! If he’s correct, it will be quite ugly. America has never had hyperinflation. Many countries have, but not the U.S. At the present time, several emerging markets are experiencing high inflation and are raising interest rates and reducing their money supply. This activity could put downward pressure on the global economy at a time when we need economic expansion.

Bubble, Bubble, Toil & Trouble?

Much of the Feds money expansion, at least that which is not being held in reserves, has found its way into the U.S. stock market. This has increased demand for risk assets (the Fed got its wish) which is one reason for the meteoric rise in stock prices. Many experts believe that America is in a stock bubble. Is the Wealth Effect working this time? Perhaps, but not to the extent the Fed had hoped. However, for the sake of discussion, let’s assume it’s working. If so, given the fact that the Fed is in the midst of its greatest monetary expansion in U.S. history, GDP is only growing slightly better than 2.0% (year/year). If this is all we can get from such an extreme policy, I shudder to think what would happen if the Fed were to normalize its policy (i.e.; expand the money supply to match population growth). Here’s the harsh reality. At some point, the Fed will have to start removing some of this excess capital from the system. This will be a difficult task. If they sell bonds too fast, it could cause bond prices to plummet. Moreover, any change in the Fed’s “easy money policy” would signal less liquidity for the stock market which would cause stock prices to collapse.  If this were to occur, individuals (which comprise 70% of GDP) would reduce spending and increase savings. Businesses would react to the drop in demand by reducing its workforce and delay any expansion plans. This would cause unemployment to rise and the government would likely increase spending in an attempt to take up the slack. However, as long as the Fed continues to flood the system with dollars, and as long as investors believe the Fed will not make any drastic change in its policy, stocks will have a catalyst to rise and bubble-mania could continue to thrive. At least for a while. I can only speculate on the rest.

Summary

I’m not trying to suggest a “dooms-day” scenario will materialize. However, the longer the Fed continues to pump up the economy, the harder it will be to return to normal. The Fed is paying interest on bank reserves for one reason, to keep the money in reserve and out of the economy. If so, why would the Fed continue adding $55 billion per month? As I said, it is purely psychological. After all, people will spend more if they actually are richer or if they believe they are richer. In this case, it seems to be the latter.

What is the appropriate response? Washington must address its fiscal policy issues (i.e.; spending, entitlements, tax policy, etc). Since consumers comprise 70% of GDP, what do you think would happen if they had more money in their pockets? Of course, some would increase their savings. Others would pay down debt. But many would spend more! However, because the recent crisis was 25 years in the making, it’s likely to take several more years to heal. In the meantime, the Fed will keep interest rates low for several more years, perhaps reduce its monetary expansion ever so slightly over the next year, and we’ll likely be faced with challenging financial markets for quite some time.

Part-IV
My Opinion

It seems the world is going to experience another global financial crisis very soon.World’s giant economic bloc the Εurozone where Crisis is worsening;every problematic economy is trying to provide solution through bailout over and over but in the end it will collapse. This collapse is not inside Εurozone a much larger system,global economic collapse regardless of which country you live in this is going to impact your life. The entire economic bloc is facing debt crisis which is compounded with credit default sawp, derivative and accounting tricks. The solution is bailout of banks with the citizens putting the bills.The bailout are not free money; they are loans. So, Europe is trying to patch up with debt problem with more debt. 

Obviously that is not going to work what would work follow the Iceland example.Iceland charged bankers and now it is recovering.unfortunately,this is not going to work unless enough people wake up.on the other hand,U.S has smashed all its previous debt record and presently its national debt is 16.7 trillion. The US government artificially tried to stimulate the economy after the aftermath of 2008 financial crisis.The government came to the rescue by printing a lot of money,bailing out the banks, propping  up the housing market,dragging out trillions of dollars of additional debts. All they did indeed is delayed the day of reckoning. So,another bigger collapse is waiting. It is uncertain which will go down first. It could be dollar;it could be euro.What is important to realize here if one comes down they will both come down.When they do,they will take down china and the rest of the world with them. A glimpse of the GDP and trading volume between China, EU & US reveal their interdependence.


By GDP China, US and EU are the largest economic bloc in the world. US and China are two top trading partner of Europe. Europe and US are top two trading partner for China. China is in the top three trading partner for US.

So, this is a system of clear interdependence. Any of them go down it will take the other go down. This is why China is continuing to buy US debt though majority of this debt will not be paid off. China has its own problem. Remember housing bubble in US set off a down turn in 2008. China has real estate bubble of its own. It is said that there is around 64 million empty apartments in China. So, one way or another the system is coming down. The reason behind the failure of this system is because modern money is based on debt. The problem mainly lies in fractional reserve banking, which allows banks to loan out multiple of their deposits.The lower the reserve requirement, the higher banks can lend. The person takes out loans for any reason defaults in payment then the bank takes away the asset attach with the loan. If somehow banks get into trouble with this in same financial advantage, the citizens are forced to pay bailout amount. So, in every way banks are playing safe. All these indicate that major financial reforms are needed in our present economic system to deal with this problem. 

References

1. For part-I 
http://www.zerohedge.com/node/488920

2. For part-III by Mike Patton
http://www.forbes.com/sites/mikepatton/2014/02/11/why-the-next-financial-crisis-could-be-worse-than-2008/

3. For part-IV
http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)


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