Crisis (2): 1929

Article written by Xavier Sala Martí (Columbia University) in La Vanguardia, a Catalan newspaper. Translated from Spanish to English using Babel Fish (sorry for the translation mistakes, if you want to suggest any change leave a comment).

The global financial crisis has sown panic about the state of the global economy. Many analysts compare the situation with the Great Depression of 1929. We remind investors episodes of rushing through the windows on Wall Street and queues of hungry Americans begging on the streets of New York. Even my colleague from Columbia, Joe Stiglitz, said that the fall of Wall Street capitalism is what the fall of the Berlin Wall was to communism. Stiglitz's words are a great intellectual contribution to the debate, because it demonstrates once and for all that the prize awarded to Nobel no vaccine against the ability to say nonsense.

Let's see, let us be serious: neither the financial crisis represents the end of capitalism or we face a new Great Depression. The current situation resembles that of the 29 in two essential aspects. The first is that stock markets have fallen. Yes. So what? Many people have lost money and that's sad. But from there to be a looming Great Depression half an abyss. Statistically, short-term movements of stock markets do not reflect the real state of the economy, especially during episodes like the current ones, in which investors have entered the stock market in a state of hysteria that prevents them from seeing things clearly.

That said, there are six major differences between the crisis of 1929 and the present. First: in 1929 the bank deposits were not insured.

When the crisis began, all the families rushed to find their savings to their banks. These, of course, did not have the money because it had provided (that is, precisely, their business), so they could return and were left without resources when the doors closed. Millions of Americans lost their savings. None of this will happen in 2008 because the deposits are insured, precisely, thanks to the lesson of 1929.

Second: in 1929 the monetary system was based on the gold standard, which prevented the Federal Reserve (FED) increased liquidity in the system if not previously increased its reserves of gold. As the gold held by the Fed did not increase, this could not print the money that disappeared because of bank failures. In 2008, central banks around the world are printing money to provide liquidity to the financial system.

Third: in 1929 there was deflation and prices and wages were falling continuously. That meant that the debts were inasumibles family: if one has a debt of 100 and a salary of 300, one can pay.

But if the wage goes down to 100 and the debt remains the same, one ends up not being able to pay. That worsened the financial problems of banks. In 2008 not only there is no deflation but there is inflation.

Fourth: the per capita income of U.S. in 1929 stood at about 6,000 dollars (in current prices). Today exceeds $ 36,000. A fall in income from 25% when you win 6000 poses serious problems of famine. The same drop when you win 36,000 is a problem, but does not generate humanitarian disasters.

Fifth: the U.S. reaction to the crisis of 1929 was to blame foreigners and promote purchases of American products by putting tariffs on imports (the infamous Smooth-Hawley tariff). Naturally, the reaction of foreigners was put tariffs on American products, which triggered a trade war that harmed at all. At present, despite some remaining globófobo haggard (and hairy), there are no documented economists propose protectionism as the solution to the crisis.

And sixth, and most importantly, there is a fact in which almost no one fixed but it is key: the rate of return on investment of non-financial sector. In the year 1929, that rate was 0.5%. That is, in 1929, if one was investing an U.S. dollars outside the banking sector, earning a return close to zero. In 2008, return on investment in non-financial sectors is ... 10%! To become an idea, the rate of return average for the past 50 years has been 7%. This is very, very important, because while economic growth in a country not preceded by increases in the bag, yeah ... has been preceded by high rates of return in the financial sector! To understand: While Wall Street has done its financial follies, Silicon Valley has continued to innovate, and that, ultimately, is what determines the growth of the economy. That means that when the financial regain sanity, capitalism not only not disappear but that the U.S. economy will come out fired toward a new growth path.

Ah! I almost forgot. I said that there were two factors that made the crisis of 1929 and the present were similar. I have one already commented: stock markets plummeted. The second: governments do not learn anything. One is left stunned when the Government approved a plan to purchase 700,000 million toxic assets of banks and a week later decides that the money will be used to buy shares. And one becomes even more petrified when he sees that the explanation given for this change is that ... the stock market has reacted negatively! That journalists will confuse the bag with the economy takes a pass. But the government used the bag to decide its economic policy is crazy that shows that he totally lost. Tan lost as of 1929.

Crisis (1): What has happened

Article written by Xavier Sala Martí (Columbia University) in La Vanguardia, a Catalan newspaper. Translated from Spanish to English using Babel Fish (sorry for the translation mistakes, if you want to suggest any change leave a comment).

The perfect storm continues its inexorable course and we all wonder what is the solution. Before talking about remedies, it is important to know what has happened because, without a proper diagnosis, there is no sensible solutions.

It all began in 2001 when Alan Greenspan wanted to avoid the collapse of the stock market after the fiasco of the dot-reducing interest rates from 6.5% to 2.5% in less than a year. With these guys so low, banks, who live in lending money in exchange for an interest, sought profitability in families with low incomes and with a high probability of being unable to repay the mortgage, calls families have an increased risk subprime.Al, those families pay a higher interest, although the banks thought the risk was mitigated by the fact that the price of their houses were going up: if one day they have problems, they thought, the families will be able to sell the house at a price higher than the mortgage, enabling them to return the money.

But they could charge the margins were so small that in order to obtain profitability, they had to multiply the volume. The problem is that the number of mortgages they could give was limited by regulation to Basel prevents credits granted by a bank exceed a certain proportion of their capital. Curiously, which does allow such regulation is that banks think about parallel investment funds (called under pressure) who buy their receivables. And so they did: the calling given under pressure, buying mortgages to the banks and those recovering the money. Having disappeared from their credit balances (to allow regulation and the Basel accounting of the bank and the conduit was made separately), banks could return to provide the same money, thus expanding the business.

The under pressure, in turn, the Prime Minister took the mortgages, the repackaging (in sophisticated language, title) in ways so complex that get ratings of AAA, which indicated minimal risk and sold to investment banks. To facilitate the operation, even got names pompous as insurance with credit default swaps.Los investment banks, in turn, used these assets as collateral to borrow additional leverage and more financial operations, thus creating a huge snowball of assets , No matter how sophisticated they were, were guaranteed the last of the families subprime mortgages.

And all this was going very well while the price of housing rose. But came a day left to climb. Families who had borrowed 100,000 U.S. dollars saw that his house was worth only 60,000 and had to make a decision: return home or return of 60,000 a mortgage of 100,000. No one should be very ready to see that if the regulation allows to choose, many will return home and not pay the mortgage. And it turns out that the regulation allowed to pick and, therefore, decided not to pay the late payment was fired and all assets secured by those mortgages began to lose its value and to be cataloged tóxicos.El problem is that they had been so many times that retitularizados nobody knew how many active or toxic or who had had. That created a mistrust between banks that made money no longer lend to each other. Interbank interest rates (such as the Euribor) was fired and, with them, the monthly payments of millions of families who stopped to pay their mortgages. Late payments rose, no longer among subprime families, but among the families in the world. Insurers had to pay it insured ... but did not have enough money, so they were the first to break. Their names: Bear Stearns, Freddie Mac, Fannie Mae and AIG. Does it sound like?

And here again to see the regulation of Basel: the investment banks like Merrill Lynch and Lehman Brothers had used such bonds now that were toxic as financial security and the regulation said that when the value of those securities down, banks were required to dispose of other assets and use the money to replenish the lost security. The problem is that this was happening right in the moment that nobody wanted to buy those assets at reasonable prices. But as they were forced to sell, sell. That ... To balance price! That increased their losses, which reduced the market value of its assets, which forced them to sell more, which increased their losses ... and so on in a negative spiral of losses and decreases in trading that led to bankruptcy. The financial panic was served.

Which brings us to the present time: the mistrust, fear and loss of the banks are doing that not only cease to lend to other banks, but will cease to provide a non-financial companies from around the world. Investment in the hospital sector in Germany or the food in Colombia are not carried out due to lack of funding. Economic activity falls, the jobs disappear and what began as a problem in the U.S. mortgage. UU. is getting to the real economy around the world. The public asked their governments to act. The erratic public policies they propose, however, show that they do not know what to do, which raises more distrust and aggravate the situation. That's what we will talk in a future article. For now, this is what happened.