USA: Credit crisis - full text
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The Federal Reserve (the US central bank) on Sept. 18 reduced its benchmark federal funds interest rate by a half percentage point (from 5.25 to 4.75 per cent), in a move designed to combat some of the adverse affects on the US economy of a credit crisis in the global financial markets and a sharp downturn in the value of US house prices.
Immediate context
The credit crisis first emerged in early August after repayment problems in the US “sub-prime” mortgage sector--which catered to borrowers who had poor credit histories--created widespread uncertainty and panic in the global financial markets, leading to a virtual freezing of the availability of credit. The “sub-prime” mortgages had typically been sold on by the lending institutions to investment banks, which had repackaged them into mortgage-backed securities, which were then sold to global investors. These securities were then usually repackaged with other types of debt and sold as collateralised debt obligations (CDOs), which frequently commanded credit ratings that were much higher than those of the underlying debt. Many CDO securities were infrequently traded and so their value was determined through artificial assessment rather than by the market process. The revelation in July of large losses by hedge funds that possessed sub-prime-related CDOs led to a widespread questioning of CDO values. Panic selling led to the collapse of the CDO market with the result that access to global credit by companies was severely restricted.
The credit crisis was widely regarded as a serious threat to the US economy, principally because the availability of credit had fuelled much of the country’s recent economic growth. The crisis also threatened to increase the pace of the downturn in US house prices as mortgage lenders restricted access to borrowing and raised interest rates, whilst some economists believed that the crisis could precipitate an economic recession.
The threat of an economic recession was widely regarded as a major political issue for the administration of President George W. Bush. In his annual State of the Union address in January, Bush said that “a future of hope and opportunity begins with a growing economy”, adding that the US economy was “on the move”. However, opponents of the Bush administration frequently criticised the administration's handling of the US economy and claimed that the government’s high public expenditure and low rates of taxation were unsustainable.
The US trade deficit reached a record US$763.3 billion in 2006, an increase of 6.5 per cent over the previous year, according to statistics released in February by the US Census Bureau, whilst the USA’s trade deficit with China reached US$232.5 billion in 2006 and was the source of an ongoing trade dispute between the two countries.
The US-led military operations in Afghanistan and Iraq had also had a major impact on the US economy. The House of Representatives (the lower house of Congress, the bicameral US federal legislature) in April enacted a bill authorising military expenditure of US$95.5 billion, whilst the US$2,900 billion US federal budget for the fiscal year 2008, presented in February, made provision for the highest level of military spending since the Korean War (1950-53).
Reaction and Outlook
The US rate cut was “intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time”, the Federal Reserve announced in a press release published on Sept. 18.
Alan Greenspan, the former Federal Reserve chairman, on Sept. 28 in an interview with the BBC, said that the risk of an economic slump in the USA had “obviously risen” as a result of the credit crisis, but predicted a less than 50 per cent chance of a recession. In a report published by the Reuters news agency on Sept. 28, Greenspan acknowledged that overinflated asset markets, such as the housing markets of many developed nations, would “probably burst” if they were allowed to “expand long enough”. Greenspan also believed that the emergence of the credit crisis had marked the end of a protracted period of low inflation and low interest rates.
In the UK, Alistair Darling, the chancellor of the exchequer, on Sept. 14 authorised the Bank of England (the UK central bank) to provide emergency financial support to the UK’s fifth largest mortgage lending company, Northern Rock plc, which was highly dependent on the availability of short-term loans from the financial markets.
On Oct. 1, Reuters reported that a major Swiss bank (UBS AG) and financial corporation Citigroup (the world's largest bank by market value) were facing losses as the effects of the crisis in the USA were felt around the world.
Historical Context
Despite currently having the largest economy of any country in the world (as measured by GDP), the US market had never been immune to economic crisis and government intervention had often been required to stimulate growth and prevent--or contain--the detrimental effects of decline.
The first major economic crisis in the USA to trigger government intervention was the “great depression” of 1929-40, which was triggered by the US stock market crash of 1929. The “depression” was the most serious economic crisis in have occurred in US history and prompted President Franklin D. Roosevelt (1933-1945) to launch the “New Deal”, a series of emergency economic measures designed to combat the widespread unemployment, hunger, and homelessness that ensued after the slump took hold. The 1930s “depression”, which spread rapidly throughout the industrialised world, was an early indicator of the global impact of an economic slump in the USA. It was also thought to have contributed to the popularity of fascism in countries such as Nazi Germany, and to have hastened the outbreak of World War II.
The public spending that funded World War II, however, provided the global economy with a massive boost. In July 1944, just prior to the end of World War II, the UN monetary and financial conference was hosted at Bretton Woods (in the US state of New Hampshire), at which agreements were signed to establish the International Bank for Reconstruction and Development (IBRD) (now part of the World Bank), the General Agreement on Tariffs and Trade (GATT--the functions of which were superseded by the WTO), and the IMF.
The 1950-60s witnessed significant global economic growth, whilst international financial markets became increasingly integrated. By 1971, however, dwindling US gold reserves, principally caused by the costs of the Vietnam War (1959-75), effectively forced the US government to suspend the convertibility of the US dollar to the value of an ounce of gold. The ensuing “dollar crisis” reduced the value of the US currency and led to massive increases in the price of oil as the Organisation of Petroleum Exporting Countries (OPEC) readjusted it prices to reflect the dollar's depreciation.
In the 1980s, President Ronald Reagan (1981-89) pursued a series of aggressive free market policies (often referred to as “Reaganomics”), in which the government planned to reduce public spending, taxes, regulation, and inflation.
During the administration of President Bill Clinton (1993-2001), the US economy suffered the “dot com” stock market crash, in which there was a sharp reduction in the value of technology-based stocks, spurred by concerns that they were overvalued when assessed by traditional criteria, such as profitability and company asset holdings. The “dot com” crisis led to mass bankruptcies amongst the business community and the loss of tens of thousands of jobs.
In October 2001, the House of Representatives approved a US$100 billion economic stimulus plan designed to boost the economy after terrorists linked to the al-Qaida network launched a series of suicide attacks against targets in New York City and Washington DC (the capital) in September 2001.
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