Federal Reserve System and Credit Crunch 2008

Fed or the Federal Reserve System is the fundamental banking system of the United States. It is the central banking system of the country. Federal Reserve System was established in 1913. It was formulated and implemented by the enforcement of the Federal Reserve Act. It is a partly public and partly private establishment, and it is often referred to as a banking system of quasi-public mode. It is made up of Washington, D. C’s Board of Governors of the Federal Reserve System. The Governors are appointed by the President. In this appointment, other significant associates are the member banks of the US, advisory councils, US Treasury agents, Federal Reserve Banks of 12 regions, and the Federal Open Market Committee. (Epstein, 2003).

It should be stated that as per policy, the basic purpose of the Fed is multifold. It moderates long-termed interest rates, it is helpful in stabling prices, it maximizes employment, and it implements monitory policies and controls the money supply of the country. It also stabilizes financial risks, and the consumers are protected in the context of credit rights. Fed is also instrumental in banking institutions’ regulation and supervision. The Federal Reserve System also acts as a balancing mode in the context of government centralized responsibility and banks’ private interests. (Fletcher, 2008) Investment banker Allen Waugh’s insight would be interesting in this context.

Interview 1: Allen Waugh. Investment Banker. Contact: 1-213-233-7724

How do you assess this current crisis?

This time around, the crisis is likely to prove very costly. The present crisis has snowballed due to the imprudent handling of rating agencies who are supposed to protect the average investor, financial innovation that has gone all wrong, and inept market regulation.

What do you think about the consumers?

Consumers are now threatened by many negative shocks: falling home values and equity, rising debt servicing ratios, a credit crunch in housing and consumer credit, rising oil and gasoline prices, weakened labor markets, and, inevitably enough, a falling stock market.

Waugh’s concern is highly justified. Next was the increased use of collateralized debt obligations, which allowed AAA ratings to be obtained by a large section of the subprime mortgage loan pools. This validated the loans, they began to attract pension and insurance funds, and soon these loans expanded their presence here. As loans over dollars 1000 billion were rapidly shot into the system, the Federal Reserve, state, and federal regulators, strangely somnambulated through the whole thing. Had this not been so, the equivalent of about 10% of America’s GDP would not have been loaned out. (Squires, 2004) However, this act by the Federal Reserve has proved to be sustainable until this date. Andrew Peterson indicates some truly valuable points.

Interview 2: Andrew Peterson. Investment Banker. Contact: 1-213-233-2893

What is the best learning aspect of this crisis?

To learn vital lessons from this period, one only has to look at official estimates concerning the crisis at the time to see how reality always bites hard. As the dust settled after the S & L crisis, the official figure, quoted far lower, rose to $150 billion. US government officials, however, reveals that the actual wipeout could be close to $100 billion. This looked like rising even further if the amount accruing as write-offs were to be factored in. The write-off figures on just alternate and subprime loans would heave up the loss figure to about $250 billion, assuming a write-off rate of 10%. (Fletcher, 2008)

Why was there such a misconception in the initial stages?

In October 2008, we find that the total gross outflow from the developing economies was about $1.2 trillion, which was slightly more than thrice the amount recorded in 1996. Thus, we see that unlike what might have been led to believe in the earlier part that capital provided by the policies of the Federal Reserve has not stopped streaming from the industrial economies to the developing economies. The amount of capital moving from the industrial economy to the developing economy has increased phenomenally. What has brought about the change in the movement of the capital is, therefore, the sudden growth of the amount of money the developing countries are now putting in into the industrial countries. (Robert, 2008).

Thus, as per Peterson, it can be stated that a number of theories have been propounded in order to explain this sudden growth of global capital. A range of them concentrates on the conflicting configuration of growth and investment. One such bailout theory suggests that the increase in US productivity expansion during the 90’s improved the perceived return rate on American assets and thereby drew more capital, and this should be repeated, and helpful policies should be put forward as bailout plan. Thanks to the anticipation of higher return rates and increased earnings USA’s investment and regular expenditure increased as well. Yet another bailout theory, proposed by no less than the Chairman of the Federal Reserve, rested on the idea of a ‘global saving glut.’ According to this theory, the reduction in investment-related expenditure beyond the USA (partly due to the rising market crises) was the primary reason behind the excess money saved due to the lack of investment. This extra capital, the theory explains, is what is now being directed towards the US economy. The saving glut theory, of course, implies that the developing companies have been profiting from the way in which global capital seems to be flowing at present. (Fletcher, 2008) William Lamb looks into this aspect.

Interview 3: William Lamb. Financial Analyst. Contact: 1-213-233-8891

How else would they be earning both demands for their items as well as guaranteed profits on their assets, especially at a juncture when an investment drop had been threatening to reduce domestic activities and the return rates?

It’s not easy to understand what the theory intends to suggest with its story about US productivity. However, there is no denying that developing countries, such as those in Asia especially, have been making a reasonable amount of profit out of the increase in the investment and production prospects brought forth by the IT booming the USA.

So, what is the outcome?

The fact that this flow of capital from the developing to the industrial economies cannot possibly prove to be beneficial for the developing countries in the long run. In order to eradicate poverty and develop their economy at a faster rate, developing economies must take initiatives to augment their productivity. With the large labor force they have at hand, such an improvement should not be particularly difficult for them. However, to boost the labor force, all developing countries will be in dire need of capital. If this capital is instead shipped off to the industrial economies, the developing economies will be bidding a final goodbye to their chances at productivity.

What can be used as redemption?

We must keep in mind that the present pattern adopted by the capital flow is not by any means the natural norm that should be encouraged and continued; rather, it is a deviation, an error that must be corrected as soon as possible. There are a number of ways in which the flow of the net capital may be inverted. Some of these methods are better than others. Not long ago, large budget deficits and unsuitable exchange rate systems caused current account deficits in the market economies that were still emerging. Returning to policies that hark back to such economic disasters is, of course, not the best way to deal with the current situation.

What is the alternative?

Instead, an inversion in the present direction of the capital flows would best be attained by means of policies that will help increase the formation of capital and thereby assist economic growth in the developing economy. These policies will not only develop the environment and make it ready for business investment but also help toughen up the country’s feeble financial system, thereby ensuring that the capital the developing economies require in order to prosper continues to remain within the country and does not have to travel abroad in search of better investment opportunities.

As per the views of the financial analyst, it can be formulated that this had a major impact on many businesses as they had to restructure and speculate their monetary policies. The increase in the prices of products and taxes had a big influence on both the economic and social life of the Americans since the unemployment rates increased, and thus the Federal Reserve acquired the authority to control inflation at the expense of unemployment as a bailout policy. (Fletcher, 2008) It would be interesting to look at the current position as per the current illustration:

Structural adjustment policies are entrenched in neoclassical economic theory. They envisage that macroeconomic problems like the balance of payments deficits, high inflation, and budget deficits characteristic of many developing countries are caused largely by inept domestic policies and unnecessary interventions in the market. The resolution of these problems is viewed as possible through concretionary demand policies, which include fiscal austerity, exchange rate devaluation, and market liberalization. Liberalization is aimed at attaining the right prices operating in the economy by allowing the operation of market forces to attain efficiency. It is argued that governments meddle too much in economic activities and cause inefficiencies. Thus, governments should reduce their involvement, implying they have no business in business, but in making laws and regulations that make business transactions flow smoothly, hence improved efficiency. In the labor market, this efficiency is achievable by allowing employment and wage flexibility so that the demand for labor responds to changing economic conditions. This adds a relevant problem to the aspects of the Credit crunch. (Henry, 2008).

In this context, it would be relevant to report that “New York State’s private sector employment decreased over the month by 1,600, or less than 0.1 percent, to 7,254,300 (seasonally adjusted) in September 2008, the State Labor Department reported today. The September 2008 state unemployment rate, after seasonal adjustment, was 5.8 percent, which was unchanged from August. The rate for New York City also held steady at 5.8 percent between August and September 2008. The rate in the balance of the state outside of New York City increased from 5.7 percent in August to 5.8 percent in September 2008.“ (LSNU, 2008).

The trend of the international investment position of the US could be termed as a problematic situation because with the balance of payment being negative, there lies a subtle chance of a market crash and even a probability of deflation. The example of East Asia could be enumerated in this situation where it was found that the credit volumes of the economy of those countries lead to the massive market crash.

It would be relevant to mention that the current account is an extremely important tool that can determine the entire business cycle of a country as the current account can be determined according to trade balance as the difference of import and export of tangible goods and services like consulting and legal. The current account is also instrumental in determining the overseas factor incomes like dividend and income along with the net overseas Unilateral Transfers like gifts, grants, and aids. (GORTON, 2008) Robert Prior lightens up the issue.

Interview 4: Robert Prior. Financial Analyst. Contact: 1-213-233-0267

What are the possible bailout plans?

In the US, five of the leading banks of the world, including the Federal Reserve Bank of the USA, came together to invest huge amounts of fresh money into the global market to combat the international credit crunch failing economy with about one trillion dollars. (Grynbaum, 2008) This move is largely stimulated by the concern of leading economists who were predicting a recession in US markets as a slowing down or decline of US and British housing markets. In an emergency set of solution-seeking procedures, the Federal Reserve Bank drastically diminished interest rates, splurged out innovative lending programs, sought to modify the poor condition of Bear Stearns, and provide loans to boost the nearly crippled mortgage agencies of Fannie Mae and Freddie Mac. It was, however, not as if the Federal Reserve Bank was taking over every financial proposition in the US, but had to do so because it was big enough to stem the crisis. (Fletcher, 2008)

What is the Federal Reserve doing on the issue?

To avert the crisis, the Federal Reserve Bank is lending out money to small and big borrowers on an unprecedented level and, as such, has been thoroughly criticized by politicians for interfering with the fiscal policy. (Macey, 2008).

In addition, keeping in mind the feedback received from the interviewed, it can be well indicated that at present, the Federal Reserve Bank has already provided money for AIG and Bear Stearns, amounting to $217 billion. It has also agreed to gear up the amount to $277 billion as a bailout plan. (Meltzer, 2008) Marsh states that the bailout plan includes Ford and M’s recovery of $25 billion and indicates that the bailout plan is actually an “infusion of credit versus direct cash payment.” (Marsh, 2008) As it is, the income and expenditure balance of the US is at a deficit of $407 billion as of 30 September 2008. At the same time, the offshore deals help foreigners to avoid at least a tax amount of $100 billion each year. (Robert, 2008) Thus, it is obvious that steps are necessary and should be taken soon. Though, the validity and the reliability, along with the sustainability of the steps already taken, are yet to be tested.

References

Epstein, Lita & Martin, Preston; (2003); The Complete Idiot’s Guide to the Federal Reserve. NY: Alpha Books.

Fletcher, R; 2008; Credit Industry: Beliefs and Knowledge; Believing and Knowing; Mangalore: Howard & Price pp 188.

GORTON, G. B. PING HE; 2008; Bank Credit Cycles; Review of Economic Studies; 75: 4; 1181-1214; The Wharton School University of Pennsylvania and NBER; School of Economics & Management, Tsinghua University.

Grynbaum, Michael M. 2008. Persistent Anxiety Over Tight Credit Sends Stocks Plunging. NYTimes. Web.

Henry, Elaine, Oscar J. Holzmann, Ya-wen Yang; 2008; The recent credit crunch and GAAP; Journal of Corporate Accounting & Finance; 19: 5; 89-94; Wiley Periodicals, Inc.

LSNU; (2008); Small Loss in Jobs, Unemployment Rate Unchanged; Economy Continued to Slow, Though Still Stronger than Nation; Labor State New York US. Web.

Macey, Jonathan R, Geoffrey P. Miller, Richard Scott Carnell; 2008; Banking Law and Regulation 2007, Aspen Pub; pp 143.

Meltzer, Allen H; 2008; Congressional Budget office (Spending); Office of Management and Budget; pp 41.

Marsh, Bill; 2008; A Tally of Federal Rescues; The New York Times.

Robert & Utan; 2008; Where in Federal Budget This year….; NY Times.

Squires, Gregory D; (2004); Why The Poor Pay More: How To Stop Predatory Lending; LA: Procter Sons.