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a- what were the causes f global recession f last year.
Real Causes For US Financial Meltdown and Global Recession
By Jonathan Wang, Ph.D. Contact Author
Current economic recession in the United States and all around the world is seen as the worst downturn since the great depression. There is little doubt that this global recession was caused by the financial meltdown in the United States and quick spread out to touch almost every corner of the world. It appears to be a commonly accepted theory among economists that this episode of US recession was a direct result of sudden busting of house bubble, and the house bubble was created by rapid growing yet unregulated subprime mortgages.
These are all true. But the real questions are, as shown in Fig 1, the house bubble, if any, started to emerge in the closing years of 20th century, why has it not been busted until year 2007? and during that over a decade long period, were there any indications that had signaled this crisis might happen eventually? With these unanswered questions, we must think deeper and much deeper so to make sure this type of sad economic drama will not recur.
It is the reduced affordability of average consumers that has busted the bubble in house market.
I am not an economist, but it does not take a economist to understand one simple plain word, affordability. It is a common sense that the economy of a nation is supported by domestic spending of average consumers. It is equally clear that growth of the house market can not be sustained without synchronized growth in household incomes. When the growth in household incomes under pace that of the house market, the affordability becomes an issue. With the gap between two growth rates trending wider, affordability problem is inevitably escalated and will result in a collapse of the house market eventually.
That was exactly how the house market in the US was collapsed.
Let's divide the recent history into two periods, Clinton era and Bush era. A division timeline lies right in year 2001 when Bush took the office. Apparently as shown in Figure 1, chart of S&P home price indices, shift of power did not cause the growing pattern of the house market to change. Moreover, the indices even kept its climbing pace during 2001-2002 recession. I recall many economists and economic commentators even used this fact to argue validity of the recession. Unfortunately, Figure 2, chart of real median household income for the same period paints a completely different picture.
According to S&P, between 1995 and 2000, the Home Price Indices increased 24.29%. During the same period, the data from US Census Bureau show the adjusted real median household Income were up nearly 10% from $46034 to $50557. An 15% offset between two sets of the growth rates still appears to be in healthy range although arguably a small house bubble might have been rooted. However, the Home Price Indices jumped strikingly over 122% between 2000 and 2006 while the real median household income inched 2% lower from $50557 to $49568. A huge bubble was formed as a result. After that, affordability became a non-existence; mortgage delinquencies and foreclosures continued its journey of rapid rise; banks and financial markets started to fall and consequently, the entire financial market collapsed and global recession was officially commenced in 2008.
What has caused house price and household income to run in opposite directions?
Many argued that house market always delays its reaction to the overall economy. This argument seems difficult to withstand scrutiny. Consumer's confidence is a key factor in any marketplaces. House market is supposed to be as sensitive to consumer's confidence as the overall economy.
It is reasonable to believe that multiple Fed interest cuts during 2001 to 2003 period, as seen in Figure 3, in attempt to pull out the nation out of recession had in part contributed to the uninterrupted rise of house prices. I must challenge the necessity of the interest cuts of that scale, particularly in 2002 and 2003, considering a severe house bubble had clearly come to sight. The 2001 recession was relatively mild, which was predominantly determined by contractions of the gross domestic products. It is arguable that GDP is one of important macro economic indicators, its significance, however, should not be overlooked.
What is GDP? I learned a great story from by a real MBA student.
Once upon a time, there were two business school students, A and B, walking in campus. They suddenly discovered a pile of dog shit sitting on the street. A joked with B by saying I will give a million dollars if you swallow the pile. B pandered for a moment and determined it is a great deal. So he moved the entire pile into his stomach. He asked student B for one million dollars. A shook his head and replied, "put it on my account". Several days later, they discovered the same thing while walking together again in the campus. B said to A, if you do what I did last time, your account will be cleared. A swallowed it immediately with a relief as he felt he wouldn't have to carry the debts for life. They then went to see their professor and told professor the story. The professor jumped from his chair and shouted, "that great, congratulations, you two have contributed two million dollars to our nation's GDP!"
Now come back to the topic. It is conceivable that the interest cuts during 2001 to 2003 had escalated house bubble, however, they are not the fundamental causes for the financial meltdown and severe global recession we are now facing.
Human history tends to repeat itself. The capital market is of no exception. When comparing patterns of certain economic data, it is not difficult to find out that this economic down turn and the great depression took place in the 20's have surprising similarities. Comparison studies often can reveal facts and solve mysteries.
Although causes for the great depression are still uncertain, one thing is clear that house market did crash during that period. Specific data measuring house industry did not become available until 1950's, but an over 90% drop in homebuilding between 1925 and 1932 was well documented.
There must be a single troubled issue that could cause a system to collapse "overnight". Combined causes would have damaged the system in a much slower and possibly manageable pace. Considering house market is the only capital market that touches vast majority of consumers, it is logical to infer it was financial difficulties in house market that triggered the great depression.
As a long term Republican, I have always believed in non-compromised free market; believed that capital market could always work its way out any crisis without government interventions and, inequality is a blessing baby that free market has naturally delivered. Nearly disastrous outcome of the recent financial crisis, however, has greatly shaken my ideology. After searching for dynamic reasoning for this sudden change of the world, I am sadly convinced that blessing baby had dropped a huge bomb directly onto the body of its beloved mother.
It is the extreme inequality that has resulted in the great depression in 1929 and again caused the global recession today
Figures 3 and 4 charted the shares of total income going to top one percent and top ten groups in the history of nearly one century. These are the best indicators of capital inequalities. There are two peak points appearing on each chart, precisely pointing to the years when the great depression and recent recession took place.
These graphs are striking. When the share of total income going to top 10% was quickly approaching 50%, the great depression officially started without sending out any warning signal. The history repeated today. When the same parameter was once again sprinting towards the 50% mark, a swirl of financial tornado suddenly raided the "booming" capital market
Two episodes of extreme inequalities led to two episodes of economic disasters. This is no coincidence. There is mechanism in it. The mechanism is still pertaining to the house market.
As being discussed earlier, the house bubble was created when house prices rose rapidly while average household income stood still. What had driven house prices up when average consumers did not gain any more spending power? Many believe that excessive liquidity and unregulated lending in the financial market had promoted the continuing expansion of the house market. That means "reckless spending" by average consumers and "reckless lending" by financial institutions are the ones to blame. I don't think that is very accurate. The causal relationship seems to have been reversed in this theory. In fact, it was rapid rise of house prices that had prompted financial institutions to excise "reckless" lending practices as they had plenty of reasons to view houses as appreciating assets. There is another fact. The financial market was already tightened up in 2005 and 2006. As I recall, many lending agents were forced to close door due to sharp decline in lending business. Why house prices did not reverse their jumping course during that period? Actually, my marble business enjoyed the best time in 2006 and early 2007. Why? Because luxury homes had dominated the house market. Perhaps, average households never even dreamed of those types of prestige.
Figure 6 Top Bracket
Federal Tax Rates
1914-2009
Recent reports suggested that severe house crash only occurred in handful cities such as Los Angeles, Las Vegas, Miami and Phoenix. Let's not forget these were the major areas favored by extremely wealthy people and birthplaces of booming celebrity-style home markets several years ago.
It is evident that the extreme inequality was an "invisible hand" that had constantly pulled up house prices until average households could not afford average homes.
Let's compare Figure 2 and Figure 4. There was virtually a "recession" in the real median household income between 2001 and 2007. However, the share of total income going to top 10% group jumped from 45% to nearly 50% during the same period. Especially since 2003, such inequality expanded in a incredible pace resembling the episode right before the great depression.
There is no doubt that the spending power in house market from top 10% group has been on constant rise. This group of people might not have bought many homes but many of them have built their mansions that occupied huge pieces of land. Land occupations certainly drove up land prices. Moreover, most of those luxury homes were built in the newly developed areas. Infrastructure development added significant amount of dollars to price tags of the houses. When seeing house prices rose on a daily basis, it was really difficult for the average households to sit back. Motivated by basic consumer psychology, the middle class had to participate in the market actively. All these factors combined constituted strong power to drive the average home prices up continuously. When the average home price reached a point that the average households could no longer afford, house market started to collapse.
Therefore, the extreme inequality is the real cause for today's financial meltdown. Presumably, such inequality was also a triggering factor that eventually evolved into the great depression in 1929.
We have so far discussed the real cause for the current recession and for the great depression. Next question is,
Did government play any roles in the recession or depression?
Absolutely.
There is no such thing called real free market. Government intervention has always been there. Government's key leverage on the capital market is taxation. Good tax policies would help healthy expansions of economy. But on the same token, any bad decisions or abrupt changes in policies by government could take the economy to a wrong direction. I believe government made a same mistake that had escalated today's recession and the great depression in the 1920's.
Figure 6 included two comparison charts, exhibiting the top bracket federal tax rates from 1913 to 1931 and from 1992 to 2009. These two charts show a rather interesting similarity that certainly calls for our attention. There was a large tax cut for the richest group in 1925. Four years later, the great depression began. There was also a tax cut for the richest group, five years before the economy started to collapse.
Is it reasonable to deduce that government had cut taxes in wrong times and for wrong groups of people ?
Yes, they did. Just like pouring a barrel of gasoline into a raging fire, those two episodes of tax cuts for the top bracket group, as shown in Figure 6, had clearly accelerated expansions of the extreme inequalities in terms of real spending power, which consequently pushed the house market into a "no way out" position.
In theory, economic expansions are essential to maintain social prosperity. Certain level of inequality is infallible outcome of any economic expansion and is a positive element in the entire system of capitalism. However, when the inequality becomes extreme, government must step in and take all necessary means to pull it back to a sustainable level. Otherwise an ultimate consequence would be what we are facing today and what we had gone through in late 90's. It only takes one catastrophic economic downturn to wipe out entire wealth accumulated from decades of expansions. We are yet to know where current crisis is heading towards, but the great depression should have given us a great lesson on this. If government were able to determine as early as in 2002 that the inequality had reached a level that took economy into the depression in 1929, certain effective regulatory interventions could have been planted to prevent this ugly recession from happening.
Considering the extreme inequality had already been in place in the beginning of this century, it is my opinion that government had chosen a series of improper approaches to stimulate economy in 2001-2003 period.
In order to put a stop on the emerged recession while avoiding escalations of the rapidly growing inequality and house bubble, right government interventions should be treasury, not monetary. To be specific, instead of cutting taxes on the top 10% group, government should have raised them to strengthen the abilities of direct government investments. It is redistribution. But redistribution can be a life saver of the broad economy in many cases and can be a great recipe even for the long term financial well being of the richest group.
In terms of monetary policies, government should have left interest rates alone instead of lowering them. In an economic down turn, what we need most is orderly stabilization, not unpredictable expansion. History has repeatedly taught us that government investing is the most effective way to stabilize economy no matter it is in a socialist system or in a capitalist market. Any attempts to speed up free market expansion in a recession will like create new bubbles or enlarge the bubbles that have already existed.
I would like to end this article with a call. Let's abandon all ideological believes, political stands and take the approaches best for a quick economic recovery and for the sustained prosperity of our society in the future.
Conclusion:
1. Two major economic expansions led to two episodes of extreme inequalities in the United States. Both ended in severe economic crisis.
2. When the share of total income going to top 10% group approached 50% in 1929 and again 2007, the capital market crashed in the United States. Does this suggest 50% is a threshold separating expansion and turmoil? Should we develop an inequality index as an key indicator measuring health of the capital market? Please debate.
3. It is the extreme inequality that had led house market to crash in 2007 and most likely in 1920's.
4. Government's improper interventions in the capital market before both episodes of crisis had accelerated the extreme inequalities and ultimately intensified the crisis.
5. It is author's opinion that government must focus on stabilization rather than expansion in any economic crisis. The most effective measure to stabilize a down turning capital market is direct investment. In order to do so, raising taxes on top income groups becomes necessary. Such tax increases can also reduce inequalities so to prevent bubbling economy from happening.