Readers Question: Assuming that corporate executives are to blame for the current financial crisis, what would be some of the reasons why they are to blame?
I am not an expert on this. There might be more issues, but some of the areas of blame include:
Mortgage companies ignoring ability to pay and taking unreasonable risks in lending high income multiples to subprime customers. Some examples of subprime mortgage lending was definitely wrong. For example, lending people a mortgage where after 2 years the amount to pay back was greater than their total income (see: dangers of subprime mortgages)
Mortgage brokers even joked about lending to the “ninjas” to whom they lent money – Ninja’s means No Income, No Job, no Assets
Banks hiding or Being Unaware of the risk inherent in their balance sheets. By getting involved in buying collaterised subprime mortgage bundles, banks took great risks with their balance sheets. They were either unaware of the risk involved in their decisions or ignored the risk assuming the boom would continue.
Gambling others Money. The derivatives market was supposed to be a way to help insure the smooth running of financial markets. But, in the hope of making quick profits (and pay bonuses) many dealer took long or short positions on stocks and shares, which magnified their exposure to fluctuations in the market.
It is hard to appreciate how much damage to the global economy by the US Subprime mortgage sector.
Sometimes, people ask - Where has all the money gone? - someone must have been profited.
By looking at what happenned to the US subprime sector, we can understand where most of the initial losses came from. (IMF estimate losses of around £1.3trillion).
These losses from the subprime mortgage sector in the US were then spread throughout the rest of the financial system because other banks bought into these mortgage debt bundles.
Just as important as the initial losses has been the impact on financial confidence which has caused a drastic change in market sentiment.
Readers Question: I want to understand what happens when the exchange rate depreciates and appreciates please can you make me a brief summary based on exchange rates.
Since early this summer the £ sterling has depreciated against the dollar. £1 used to equal $2. Now £1 is only equal $1.75
What does this Depreciation in the value of the £ mean?
Buying goods from America becomes more expensive. If a meal cost $10 it used to require £5 for a British tourist. But, now after the depreciation the $10 meal will cost effectively £5.70
The depreciation in the £ may discourage British tourists to travel to the US.
It makes US imports into the UK more expensive so it may reduce imports
UK Exports will become relatively more competitive. It is cheaper for Americans to buy UK goods, so quantity of exports may increase.
Summary: Depreciation in exchange rate makes exports more competitive and imports more expensive
A depreciation helps UK exporters and improves UK growth prospects
The amount demand changes depends on the elasticity of demand
Effects of Appreciation
The affects of an appreciation in Sterling will be the opposite. A higher value of sterling makes American imports cheaper for British consumers, but, UK exports become more expensive.
An appreciation in the exchange rate will reduce aggregate demand (assuming demand is relatively elastic) Because exports will fall and imports increase
An appreciation is likely to worsen the current account (assuming Marshall Lerner condition and demand is relatively elastic)
An Appreciation is likely to reduce inflation because:
Readers Question: We read of how the the housing market crash in the U S has attributed to the impending world economic recession. Can you discuss the effects, both positive and negative, of this recession on the Property Market of Asian developing economies, notably, China and India.
The recession in US and Europe will contribute to a slowdown in developing economies. For example, China relies on exports to the West, so growth will be lower. With lower rates of economic growth this may reduce the growth of house prices and slowdown property markets in China and India.
However, since growth in China and India has been remarkably high, the slower rates of growth may help to reduce inflationary pressure and prevent an unsustainable economic boom. In this regard more moderate growth could be beneficial for the developing economies and their local property markets.
I’m not quite sure how the global credit crunch will affect mortgages / finance in India and China. I don’t think that Chinese and Indian banks are heavily exposed to the toxic subprime mortgage debt which has been crippling US and European banks. However, the banking problems around the world would probably make it more difficult in developing countries as well. This could lead to a shortage of finance and if this occurs it could cause problems for developing property markets.
The other question worth considering is to what extent are property markets in developing countries overvalued. Certainly places in China suggest a property bubble. A collapse in confidence around the globe would have a negative impact on property market sentiment and could cause the boom turning to bust.
The government has announced a bold move to buy upto £50bn worth of shares in major UK banks. The cost will be borne by the UK taxpayer and averages at around £2,000 per UK taxpayer.
£50bn is a huge sum for the treasury when you consider the annual NHS budget for 07/08 was £89bn. The total for local government spending and Defence was £55bn (Government spending)
At the moment, it is not clear what % of the top 10 banks the government will gain. Also, the government is taking a high % of preference shares (a preference share doesn’t have voting rights, but has priority in any bankruptcy and has a right to dividends even when ordinary share holders don’t)
In theory, the taxpayer has the potential to make a profit. If bank shares rise in the next 5 years, the shares could be sold for a profit. However, this is not a foregone conclusiong and the fact the government has spent so much merely reflects how worried they are with the state of the banking sector.
Furthermore, the Government has agreed to act as a guarantor for up to £250bn to underwrite interbank lending. It is certainly a remarkable decision by the government
Why Part Nationalise the Banks?
The Banks need the liquidity. At least this way the taxpayer gets something in return.
A banking collapse could cause a severe economic depression as investment and spending would fall.
Other schemes have not stemmed the losses banks are facing.
Sounds more attractive than buying worthless mortgage debts like in the US Paulson plane
More on Bank bailout and whether it is a good idea.
Readers Question: WHAT ARE THE PREDICTION FOR THE DOLLAR $ AGAINST THE EURO FOR 2009?
2009, will probably see both EU and US economies enter into recession. So far, the EU has been slow to cut interest rates; it has given greater prominence to the spike in inflation rather than the slowing economy. However, the economic slowdown has been greater than many anticipated in the Eurozone. WIth oil prices and hence inflation falling, you would expect the ECB to finally relent and allow a significant cut in interest rates. As EU interest rates are cut, there will be less demand for Euros and the exchange rate is likely to fall.
The EU is also struggling because of the current high value of the Euro. Using measures of purchasing power, the Euro is overvalued making it difficult for EU exporters. It is hard to see a further appreciation in the Euro because it is already to overvalued.
On the US side, interest rates are already low (2%) therefore, it is hard to see interest rates falling much more (US already has negative real interest rates). On the other hand, the US has so far avoided technical recession but, the ongoing credit crunch means that a deep recession is more likely.
Will Euro replace US dollar as global reserve currency? Because of the weakness in US economy, national debt, current account deficit, people feel the US economy is standing on the precipice and could collapse. However, many of the problems in the US economy are also replicated in the Eurozone. The EU is not immune from the credit crisis as many banks struggle to survive. Housing markets are even more overvalued in Europe and National debt is higher in many EU countries than US.
Having said all that, how can we predict actually predict exchange rates Currently $1= 0.73 Euros. 1 Euros would get you 1.36 US $.
My prediction would be for a rise in the value of the dollar against the Euro, but, only a small unconvincing appreciation.
Readers Question: Should I worry about my UK bank deposits?
No, I think it is fine. The government couldn’t allow a bank to go under. Although they dithered over Northern Rock, the fact they did ultimately nationalise it shows they would not allow savers to lose their money causing a collapse in confidence.
The government currently guarantees all savings upto £50,000. But, because of the response of Germany and Ireland, the UK government is being pressured to raise the limit as well. see: Guaranteeing bank deposits - Game Theory for the Europeans
I would have more concerns if I was a shareholder in a UK bank. It looks pretty bleak on the stockmarket.
Building societies generally have better balance sheets because they didn’t get involved in the securitised mortgage deposits.
Readers Question: how to solve unemployment by tools of monetary policy?
Monetary policy effectively means changing interest rates to influence aggregate demand, economic growth and therefore demand for workers.
The UK is heading into recession and unemployment is rising. It is argued a cut in interest rates would help reduce unemployment.
Lower interest rates reduce the cost of borrowing encouraging spending and investment.
Lower interest rates reduce the cost of mortgage payments giving homeowners more disposable income and therefore spending increases.
Therefore, lower interest rates should help increase consumer spending and investment. Therefore, aggregate demand will rise. If there is spare capacity in the economy, there will be an increase in economic growth and therefore firms will demand more workers. This will help reduce demand deficient unemployment.
However:
Lower interest rates may not increase consumer spending if confidence is very low. (e.g. in a recession, people may not want to borrow to invest, even if interest rates are very low)
Cutting interest rates will only solve demand deficient unemployment. It will not reduce supply side unemployment - the natural rate
Readers Question: Why does a firm prefer to remain small??
In recent times, the tendency is for product markets to be dominated by large multinational corporations who can benefit from various economies of scale. However, despite this general trend, there are still advantages to being a small firm.
Concentrate on niche Markets. Small niche markets may have less competition and therefore be more profitable. Moving into a mass market may make competition more intense.
Small Can Be A Selling Points. In some goods like clothers, there could be an advantage from small firms selling top end clothes ranges. A big firm like Primark and M&S may be able to sell clothes cheaper, but, small firms can target the customer who wants an exclusive deal - somebody who wants to stand out from the crowd. Some people prefer a local small coffee shop, rather than visiting a ‘bland’ multinational like Starbucks.
Economies of scale limited in some industries. In the car industry there are a small number of relatively big firms as economies of scale are large. But, in some industries like coffee shops, economies of scale is less. There may be diseconomies of scale in expanding production.
Not all Firms Aim at profit maximisation and sales maximisation. Some owners may want a business that is manageable and easy to retain control. Expansion may involve listing on stock exchange which makes you liable to shareholders.
