Understanding the financial crisis
Troy Media – By Livio Di Matteo
The current mayhem on world stock markets and the threat of another recession invariably generate questions as to what is happening and why.
Today’s turmoil is linked to the mortgage loan and financial crisis of 2008 and the ensuing global recession. In essence, prior to 2008, the world economy had a big party, which involved a lot of debt financing. Not everyone was invited to the party but those who were had a great time. Of course, the party had to end, and now everyone – whether they attended or not – has to help clean the mess up. In simple terms, this is the crux of the matter.
Stimulus programs bought time only
The government stimulus programs introduced in the wake of the financial crisis and recession bought time but with the result that, after three years, mountains of public debt have been added to the mountains of private debt. Worse, the world economy has still not started growing in a manner that would assist in dealing with the debts.
The U.S. economy is still mired in slower economic growth and Europe is still facing debt problems not only in Greece but also in the larger economies of Italy and Spain. Once you add in the reluctance of politicians to face their debts – as most recently illustrated in the U.S. debt ceiling debate – and it is no wonder that world stock markets have decided that things are not so good.
There is a lot of debt to unwind and it basically means that there is going to be a lot less consumption in the immediate future both publicly and privately. This was apparent before Standard and Poor’s downgraded the U.S. debt which, at best, was the match that lit the highly combustible world financial situation.
Debt is a tool that enables individuals and government to deal with large capital purchases or short-term fluctuations in purchasing power. Used responsibly, it allows people to buy a house, companies to finance expansions, and governments to build infrastructure. Used irresponsibly, it becomes a way to fuel current consumption and short-term growth and postpone the day of reckoning which, when it arrives, can be quite brutal if the economy has slowed or interest rates are rising.
Part of the solution to the current situation will require that governments and individuals take responsibility for their current debts, with the introduction of institutional mechanisms to prevent the future irresponsible accumulation of both private and public debt. In many respects, there is a crisis of confidence in world economic leadership and that confidence needs to be restored before progress can be made in dealing with debt and world economic growth.
The leaders of the G-20 will need to create a new global sovereign debt stabilization fund (a global bailout package for lack of a better term) that, in essence, safeguards debt issues either through the World Bank or the International Monetary Fund (IMF) or as part of a new institutional arrangement. Countries will also have to implement credible plans to restructure their finances and deal with their fiscal deficits over a three to five year period, as well as make available transition payments (in essence a form of global equalization grant program) from the new global fund to deal with the shock of adjustment.
The current situation is a crisis in confidence and the current ad hoc approach needs to be replaced with a more formal mechanism that will generate the confidence the world financial system needs to restore stability in world markets.
What about Canada?
Canada is in comparatively good shape but the indicators do suggest we should be concerned. We have high levels of private debt and public sector debt has grown but not to the extent that it has in Europe or the United States. However, watch out for the value of our dollar. Oddly enough, while the United States received the debt downgrade, the value of its dollar rose relative to ours.
The U.S. problem is not the debt ceiling debate, the risk of a default or the Standard and Poor’s downgrade but its lack of a credible long-term plan to resolve its debt issues and a very anemic economy. Its debt instruments – treasury bills – are still seen as a safe store of value. A weak United States economy means a drop in demand for Canadian exports and a slower economy – hence a drop in our dollar’s value.
Livio Di Matteo is Professor of Economics at Lakehead University. Visit his Northern Economist Blog
Category: Opinion
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