American Debt Crisis Essay
“US AND EU ZONE DEBT PROBLEM AND DOWNGRADE and ITS IMPACT IN GLOBAL FINANCIAL MARKET and GLOBAL ECONOMY”
Contents
Introduction to the Crisis 3
American Debt crisis 3
The EU Zone Debt Crisis 5
Impact on Financial Markets and Economy 7
The U.S. Debt Crisis and its Impact 7
The EU Zone Crisis and its Impact 8
Conclusion 9
Works Cited 10
Answers to Questions based on Passage Reading 11
Works Cited (For The Questions only) 13
Introduction to the Crisis
American Debt crisis
In the U.S., spending more than what the government collects/earns is normal. In the month of August, the U.S. will collect around $170 billion and it will spend around $300 billion. Getting the $130 billion is easy. The government can issue bonds or simply …show more content…
borrow money from others. In U.S. this is the trend. The U.S. government is deeply in debt– more than 14 trillion dollars – and it borrows to meet its debt obligations every month. There are usually more than enough people willing to lend the US government money because it is seen as a very safe investment.
However, everything has a limit, and the U.S. far exceeded its limit a long time back.
The US law states that the Department of Treasury of the U.S. cannot incur debt beyond a debt ceiling set by the Congress. The increase in the debt ceiling is a routine phenomena and the U.S. debt ceiling has been increased many a times in the past. But this time, things changed and a deep tension started in U.S. Let’s see how.
The U.S. Congress has two houses: The House of Representatives (Lower House) and The Senate (Upper House). The House of Representatives in controlled by the Republicans whereas the Senate is controlled by the Democrats. For a proposal or bill to be passed, both houses must ratify it. This time around, when the Obama administration (Democrats) proposed an increase in the debt ceiling, it was met with resistance from the republicans in the House of Representatives. They wanted the government to drastically reduce spending and not increase taxes as a precondition to ratifying the increase in debt-ceiling. The Senate on the other hand insisted an increase on taxes and low reduction in spending.
Now the government started to feel the pressure. A failure to raise the debt ceiling would result in the government being unable to fund the spending which it is by law required to do, and which had been previously authorized by Congress. In addition, the US would enter a sovereign default (failure to pay the interest and principal of US treasury securities on time) creating an international crisis in the markets. This was something that no one had ever imagined.
A complex deal was reached to end the immediate crisis. The U.S. debt ceiling deal negotiated called for an increase in the debt ceiling of $2.5 trillion in exchange for $2.5 trillion in expenditure reductions over the next 10 years with no tax increases.
However, the crisis is much deeper than the immediate crisis that took the world by storm. The problem started quite some time back when the government started spending way beyond its means. Underlying the controversial debate over raising the debt ceiling had been an anxiety, growing since 2008, about the large United States federal budget deficits and the increasing federal debt. "At the end of 2008, that debt equaled 40 percent of the nation 's annual economic output. Since then, the figure has shot upward: By the end of fiscal year 2011, the Congressional Budget Office (CBO) projects federal debt will reach roughly 70 percent of gross domestic product (GDP) — the highest percentage since shortly after World War II. (Congressional Budget office, 2011)".
The American economic model was based on consumer spending, government spending and lots of credit - both private and public. Stagnation in productive industries was ignored as the economy relied on these other sources of growth. A credit fueled economy meant that the crisis would take the form of a financial crash, but all the focus on finance concealed the major issue which was a lack of profitability in productive areas. Hence, the problem began. The U.S. went on accumulating debt to finance its ever increasing expenditure. Moreover, the crisis of 2008 also had a major financial burden on the U.S. government. The practice of sub-prime lending and predatory lending, the expansion of the housing bubble and other such factors had heavily drained the government’s resources requiring it to take more and more debt.
The U.S. received a historical setback on August 5 when, Standard & Poor’s (S&P) downgraded the United States credit rating from AAA to AA+ for the first time in history. For decades United States government debt was deemed the gold standard of credit quality. Textbooks referred to U.S. Treasuries as the “riskless asset” against which all others were compared. However, that era has come to an end. The ever rising debt left S&P with no other option. If the government does not work out something soon to solve the problem, a further downgrade may hit the U.S. government.
Many economists consider the current debt crisis to be the worst financial crisis since the Great Depression of the 1930s. Although many sources have been suggested for the reasons behind, this economic period has often been referred to as "the Great Recession" by leading economists (Background Of American Debt Crisis, 2011).
The EU Zone Debt Crisis Portugal, Italy, Ireland, Greece and Spain nowadays called collectively as PIIGS are the economies which are the main cause of the panic that has gripped Europe and the whole world. The EU Zone crisis is a sovereign debt crisis concerning the PIIGS of Europe. The crisis began in late 2009 and has gained more force with each passing day. The crisis now has been perceived as a major problem for the whole eurozone. This is the first eurozone crisis since its creation in 1999 and shows that the eurozone is not as safe and stable as it was perceived to be.
Greece was the country from where the major problems began to emerge. The role of Greece can be summarized in just a few sentences. Mismanagement and deception by the Greek authorities made the crisis possible. The Greek government now struggles with a huge credibility problem, which makes the resolution of the crisis difficult because nobody “trusts these guys anymore” (Grauwe, 2010).
The Greek economy was one of the fastest growing in the eurozone from 2000 to 2007growing at an annual rate of 4.2% as foreign capital flooded the country. A strong economy and low bond yields allowed the government of Greece to run large public deficits like the U.S. Large public deficits have been a part of the Greece government since their independence. The debt to GDP of Greece has remained above 100% for more than 16 years.
After the introduction of Euro, Greece was able to borrow at low interest rates from the public. However, the crisis of 2007-2008 which shocked the world market made things difficult for Greece too. The government then started to misreport the country’s official economic status to hide its real level of borrowing. This enabled them to borrow more and keep spending. It was later discovered that Greece has paid Goldman Sachs and several other banks hundreds of millions of dollars for arranging transactions that hid the actual level of deficit.
The government went on issuing more and more bonds all the time knowing that they had exceeded the capacity long back.
The Greek bonds were declared as junk bonds by S&P and Fitch and Moody 's in April of 2010 amidst fear of default by the government. A default by the government was very likely and according to S&P, the investors would fail to get 30-50% of their money back.
The government of Greece has since then implemented austerity measures which aim to cut the spending of the government drastically. It has also entered into a loan agreement with the International Monetary Fund and other countries. However, some sort of default or restructuring stills seems eminent.
The biggest fear with the Greece crisis was that it could spread out to the other eurozone countries and this fear soon turned true. The crisis reduced confidence in other European economies. Ireland, Spain, Portugal, and Italy which had high budget deficits, were suddenly under pressure similar to what Greece was facing. Rumors regarding a bailout package for Spain being made were also popular but they proved to be false. All these countries undertook measures to reduce the deficit that they had by one means or the other. They all are now implementing austerity measures to get back the economy in shape. The effect of the crisis can also very easily spill over to Great Britain, Belgium and Switzerland. Grauwe (2010) states that the three major factors which caused this crisis were:
A. The unethical behavior of Greece and its incessant need to keep on spending more and more. Even though other countries were much ahead of Greece and were doing well, the lack of confidence among the investors spread the crisis to the eurozone as a whole.
B. The destabilizing role of financial markets. The markets amplify movements in both directions causing major changes in asset prices. The rating agencies take a central role here. They have been consistently unable to see crises coming. And after the crisis erupts, they systematically overreact, thereby intensifying it.
C. Hesitation by the eurozone authorities to show support to Greece. The eurozone governments failed to give a clear signal indicating their readiness to support Greece. The failure to do so mainly resulted from disagreements among member state governments concerning the appropriate response to the Greek crisis.
Impact on Financial Markets and Economy
The U.S. Debt Crisis and its Impact
The financial market entered a state of nervousness and panic recently due to the debt crisis. The volatility in the market was very high and frenzied selling of the securities was seen for some time bringing the prices down. Banks were hit the hardest bringing their stocks way down. All of this panic caused the price of gold to reach unprecedented heights. Recently, gold hit $1850 at one point. If the current panic continues for an extended period of time, the price of gold may reach up to $ 2500 in some time.
In the United States, much of the focus has been on the losing of the AAA rating of the U.S. government, but possibly the European sovereign debt crisis is probably the biggest cause of the instability in world financial markets right now even when U.S. is also contributing to this crisis. The U.S. will have to go through a period where they risk increasing either the inflation rate which will make everybody suffer or risk creating more unemployment in the economy which will lead to high demands on unemployment benefits and widespread anger. They seem to be in a catch 22 situation. However, whether U.S. will enter into a full-fledged recession soon is yet to be seen.
Coming to the impact on global economy we hear a lot about the American exceptionalism. When it comes to the threat of deteriorating national finances it presents to the world economy, the U.S. is truly exceptional (Schuman, 2011).
As said earlier, U.S. is in a much better position than the European economies like that of Greece and Ireland. The EU zone crisis is quite scary. But, then U.S. stands in a universe of its own when it comes to debt-crisis scenarios. U.S. debt has the risk of crashing the entire operating system of the global economy as it dominates the global monetary system. The foundation of global finance is built upon the U.S. economy. Its capital markets are the most liquid. The dollar is the world 's No. 1 reserve currency and the primary one used in foreign exchange transactions and trade. Countries like China and Japan have their national wealth stored to a great degree in U.S. debt. The U.S. has always been considered as the ultimate safe haven and to a large extent is still considered the same by those with interests in the U.S. economy. If the problem of excessive debt is not solved and the notion of U.S. as a safe haven is lost then the U.S. dollar would weaken rapidly, causing a fall in the value of other countries’ reserves. It will also stop being the premier currency of the world. It would likely mean slower growth in the world 's largest economy, deteriorating living standards for Americans, and thus slower growth and destabilization for the entire world economy. (Schuman, 2011)
The United States has lived well beyond its means for a long time. However, this trend cannot continue into the future. Major changes have to come soon to stabilize the world economy. Otherwise, the world economic scenario can get pretty ugly. “When you build a house of cards on a foundation of sand, you should not be surprised when it comes crashing down.”
The EU Zone Crisis and its Impact
As far as George Soros is concerned "Europe faces almost inevitable recession next year and years of stagnation as policymakers’ response to the euro zone crisis caused a downward spiral". The European Debt-Crisis is largely made up of one thing: PANIC. Greece started it all with its practice of hiding its real deficits and borrowing more and more. However, the crisis spread to a lot of other countries due to what is called the contagion effect. The stock markets in Europe and all around the world have crashed. The European Debt-crisis is much more serious and intense than the American debt-crisis. Infact, the American stock market crash may have been caused more due to the eurozone sovereignty risk. The Euro has lost value as more and more people are shifting to safe haven assets like Gold and Silver boosting its price.
The biggest problem with the current situation is that the crisis has gone from a private sector crisis to being a sovereign crisis. The ability of sovereigns to finance themselves is in question, and there is no one to backstop the governments (Stepek, 2011). It is one thing for one country like Greece to default on its debt, but when major economies like Spain and UK are seen getting into trouble, the global economic environment is bound to be shaky.
The affect of the Eurozone crisis will soon be felt in the developing countries around the world too. The European Union is a huge market for these countries. With a low consumer confidence, the imports will go down leading to a loss of revenue for these countries. Also, the EU is a big investor in the global market. They are more than likely to postpone their investment decisions and hence the countries will be deprived on capital inflows. Moreover, the financial institutions all over Europe have become very conservative and conscious. An environment of distrust is prevalent. A turmoil in the Eurozone financial market will lead to a turmoil in the global financial market.
Conclusion
The debt crisis in Europe is more severe than that in the U.S. but this does not mean that the U.S. is free to run wild. The U.S. crisis is relatively less severe than Europe. The U.S. and the European crisis could have been easily prevented but the required effort was never made. The three most important things for governments to realize from the debt crisis are that:
A. The government must take timely action: If the Greece government had taken some austerity measures some time back and not deflated its deficit, the Euro crisis wouldn’t have ever occurred.
B. The government must take substantive decisions: The decisions taken by the government shouldn’t be half hearted. If the US government had decided to cut the spending substantially, the downgrade it faced could have been avoided.
C. The government must try to do things that are doable: Trying to do things that are almost impossible does not usually help. The government needs to be practical and efficient.
Works Cited
Background Of American Debt Crisis. (2011). Retrieved from www.crisissite.com.
Congressional Budget office. (2011). Retrieved from www.cbo.gov.
Grauwe, P. D. (2010). Crisis in the eurozone and how to deal with it. Center for European Policy Studies.
Greek lessons for America in its debt crisis. (2011). Retrieved from www.csmonitor.com.
Hofmann, T., & Schneider, D. R. (2010). Eurozone debt crisis: Impact on the economy. Allianz.
Schuman, M. (2011). What the U.S. Debt Problem Means for the Global Economy. Retrieved from http://curiouscapitalist.blogs.time.com.
Stepek, J. (2011, August 11). The eurozone crisis won 't go away - that 's bad news . Retrieved 2011, from www.moneyweek.com.
The stock market crash of 2011.
(2011). Retrieved from http://theeconomiccollapseblog.com.
Answers to Questions based on Passage Reading
1. What is the relationship between the returns on stocks and the returns on bonds over the 20th century?
The real return on stocks over the twentieth century averaged 6.45% and the return on bonds averaged 1.57% (Bernstein, 2011) . The higher return on equity occurs due to the fact that stocks are much more risky than bonds as an investment option. The stockholders are residual owners and are compensated only after all other obligations have been fulfilled. But the difference of almost 5% in the real return on equity and bonds can be attributed to two factors:
A) The high growth rates of the corporations after the world war enabled them to pay grand returns to the stockholders who undertook risk.
B) There was an inflationary burst due to the wars and the abandonment of hard money as currency (Bernstein, 2011).The returns on equity adjust to inflation very quickly moving up with the inflation. However, the yield on bond does not change so much and hence the investors in bonds suffer. This is precisely what happened
then.
Overall, returns on stocks have outdone returns on bonds consistently in the twentieth century. This may not have been true in the 19th century where the return was almost equal, but then the conditions were totally different. We can expect the same trend to continue for some time.
2. Why was the decade of 1950s a turning point for investors in the 20th century?
The first half of the twentieth century had been characterized by chaos. The world as a whole went through political and economic instability. There were two world wars in a short period of time. Wars lead to mass destruction and cause inflation in the markets. The great depression of 1929 lasted for a decade and turned investor confidence to zero. Investors in communist countries lost everything due to nationalization of their property. Overall a grim picture could be seen. However, things changed in the 1950s. The Bretton Woods system of monetary management was established in 1940s to establish rules for commercial and financial relations between nations. This system turned out to be successful. The world went into peace mode in the 1950s and the countries tried to provide a stable economic and political environment realizing the losses they had incurred due to years of war and mismanagement. This turned out to be a boon for investors and this period gave some of the best returns to investors all over the world. The change in the overall economic and political conditions in the 1950s changed the second half of the 20th century for good.
3. What two problems do investors in stocks face from inflation?
Inflation represents one of the major threats to stock investors. People get very nervous when the inflation rates start to rise. They expect negative consequences to follow. The two problems investors in stocks face from inflation are:
A) Eating up of the value of the stocks over time:
Theoretically, the prices of stocks go up in proportion to inflation because the companies can pass on the increase in cost to the consumers and hence generate more revenue to offset the increased cost. However, this does not work out in the globalized and ever competitive world where companies from other countries with lower inflation become more competitive. Hence, the value of the stock can go down. Also, the dividends that are reinvested are worth less due to inflation. This inflation, if not controlled can eat up a major portion of the accumulated wealth of the investors.
B) Causing volatility in the markets:
Stock markets are often marked by periodic bouts of volatility, in which prices rise and fall steeply and erratically. This volatility can be seen in the current U.S. market due to the debt-crisis that has rocked investors’ confidence. People end up moving money into and out of stocks in a very haphazard manner. When inflation rises, it becomes difficult to judge whether inflation is normal or very high. Fear causes a lot of investors to shift towards safe haven assets like gold. This causes the prices of the stocks to change frequently.
A comparison between Turkey and Canada proves the point. Turkey has high inflation rates whereas Canada is relatively very stable. The stock market return and variability of Turkey is almost four times higher than that of Canada. High inflation leads to high stock market volatility (Saryal, 2007).
4. According to the author, what must be true for investments in financial assets to be successful?
“Investing in financial assets only works if there are stable economic, political and financial conditions that enable investors to earn consistent returns from their investments.” says the author. This is a time tested and proven fact. Countries that have provided the stable climate have made fortunes for its investors. Whether it is Japan or the U.S., good economic, political and financial conditions make investment successful. The current crisis faced by America and Europe were caused due to poor financial management and the consequences are for all to see. Nepal which has been plagued with political and economic instability is not a great place to invest in for this very reason. Political instability may lead to a more frequent switch of policies, creating volatility and thus, negatively affecting macroeconomic performance. Considering its damaging repercussions on economic performance the extent at which political instability is pervasive across countries and time is quite surprising (Aisen & Veiga, 2010).The same is true for economic conditions. Hence, a politically, economically and financially sound and stable environment is essential for success in investment in financial assets.
Works Cited (For the Questions only)
Aisen, A., & Veiga, F. (2010). How Does Political Instabiltiy Affect Economic Growth.
Bernstein, W. J. (2011). The Efficient Frontier. Retrieved 2011, from www.efficientfrontier.com.
Saryal, F. S. (2007). Does Inflation Have an Impact on Conditional Stock Market Variablility?: Evidence from Turkey and Canada. International Research Journal of Finance and Economics .
Contents
Introduction to the Crisis 3
American Debt crisis 3
The EU Zone Debt Crisis 5
Impact on Financial Markets and Economy 7
The U.S. Debt Crisis and its Impact 7
The EU Zone Crisis and its Impact 8
Conclusion 9
Works Cited 10
Answers to Questions based on Passage Reading 11
Works Cited (For The Questions only) 13
Introduction to the Crisis
American Debt crisis
In the U.S., spending more than what the government collects/earns is normal. In the month of August, the U.S. will collect around $170 billion and it will spend around $300 billion. Getting the $130 billion is easy. The government can issue bonds or simply …show more content…
borrow money from others. In U.S. this is the trend. The U.S. government is deeply in debt– more than 14 trillion dollars – and it borrows to meet its debt obligations every month. There are usually more than enough people willing to lend the US government money because it is seen as a very safe investment.
However, everything has a limit, and the U.S. far exceeded its limit a long time back.
The US law states that the Department of Treasury of the U.S. cannot incur debt beyond a debt ceiling set by the Congress. The increase in the debt ceiling is a routine phenomena and the U.S. debt ceiling has been increased many a times in the past. But this time, things changed and a deep tension started in U.S. Let’s see how.
The U.S. Congress has two houses: The House of Representatives (Lower House) and The Senate (Upper House). The House of Representatives in controlled by the Republicans whereas the Senate is controlled by the Democrats. For a proposal or bill to be passed, both houses must ratify it. This time around, when the Obama administration (Democrats) proposed an increase in the debt ceiling, it was met with resistance from the republicans in the House of Representatives. They wanted the government to drastically reduce spending and not increase taxes as a precondition to ratifying the increase in debt-ceiling. The Senate on the other hand insisted an increase on taxes and low reduction in spending.
Now the government started to feel the pressure. A failure to raise the debt ceiling would result in the government being unable to fund the spending which it is by law required to do, and which had been previously authorized by Congress. In addition, the US would enter a sovereign default (failure to pay the interest and principal of US treasury securities on time) creating an international crisis in the markets. This was something that no one had ever imagined.
A complex deal was reached to end the immediate crisis. The U.S. debt ceiling deal negotiated called for an increase in the debt ceiling of $2.5 trillion in exchange for $2.5 trillion in expenditure reductions over the next 10 years with no tax increases.
However, the crisis is much deeper than the immediate crisis that took the world by storm. The problem started quite some time back when the government started spending way beyond its means. Underlying the controversial debate over raising the debt ceiling had been an anxiety, growing since 2008, about the large United States federal budget deficits and the increasing federal debt. "At the end of 2008, that debt equaled 40 percent of the nation 's annual economic output. Since then, the figure has shot upward: By the end of fiscal year 2011, the Congressional Budget Office (CBO) projects federal debt will reach roughly 70 percent of gross domestic product (GDP) — the highest percentage since shortly after World War II. (Congressional Budget office, 2011)".
The American economic model was based on consumer spending, government spending and lots of credit - both private and public. Stagnation in productive industries was ignored as the economy relied on these other sources of growth. A credit fueled economy meant that the crisis would take the form of a financial crash, but all the focus on finance concealed the major issue which was a lack of profitability in productive areas. Hence, the problem began. The U.S. went on accumulating debt to finance its ever increasing expenditure. Moreover, the crisis of 2008 also had a major financial burden on the U.S. government. The practice of sub-prime lending and predatory lending, the expansion of the housing bubble and other such factors had heavily drained the government’s resources requiring it to take more and more debt.
The U.S. received a historical setback on August 5 when, Standard & Poor’s (S&P) downgraded the United States credit rating from AAA to AA+ for the first time in history. For decades United States government debt was deemed the gold standard of credit quality. Textbooks referred to U.S. Treasuries as the “riskless asset” against which all others were compared. However, that era has come to an end. The ever rising debt left S&P with no other option. If the government does not work out something soon to solve the problem, a further downgrade may hit the U.S. government.
Many economists consider the current debt crisis to be the worst financial crisis since the Great Depression of the 1930s. Although many sources have been suggested for the reasons behind, this economic period has often been referred to as "the Great Recession" by leading economists (Background Of American Debt Crisis, 2011).
The EU Zone Debt Crisis Portugal, Italy, Ireland, Greece and Spain nowadays called collectively as PIIGS are the economies which are the main cause of the panic that has gripped Europe and the whole world. The EU Zone crisis is a sovereign debt crisis concerning the PIIGS of Europe. The crisis began in late 2009 and has gained more force with each passing day. The crisis now has been perceived as a major problem for the whole eurozone. This is the first eurozone crisis since its creation in 1999 and shows that the eurozone is not as safe and stable as it was perceived to be.
Greece was the country from where the major problems began to emerge. The role of Greece can be summarized in just a few sentences. Mismanagement and deception by the Greek authorities made the crisis possible. The Greek government now struggles with a huge credibility problem, which makes the resolution of the crisis difficult because nobody “trusts these guys anymore” (Grauwe, 2010).
The Greek economy was one of the fastest growing in the eurozone from 2000 to 2007growing at an annual rate of 4.2% as foreign capital flooded the country. A strong economy and low bond yields allowed the government of Greece to run large public deficits like the U.S. Large public deficits have been a part of the Greece government since their independence. The debt to GDP of Greece has remained above 100% for more than 16 years.
After the introduction of Euro, Greece was able to borrow at low interest rates from the public. However, the crisis of 2007-2008 which shocked the world market made things difficult for Greece too. The government then started to misreport the country’s official economic status to hide its real level of borrowing. This enabled them to borrow more and keep spending. It was later discovered that Greece has paid Goldman Sachs and several other banks hundreds of millions of dollars for arranging transactions that hid the actual level of deficit.
The government went on issuing more and more bonds all the time knowing that they had exceeded the capacity long back.
The Greek bonds were declared as junk bonds by S&P and Fitch and Moody 's in April of 2010 amidst fear of default by the government. A default by the government was very likely and according to S&P, the investors would fail to get 30-50% of their money back.
The government of Greece has since then implemented austerity measures which aim to cut the spending of the government drastically. It has also entered into a loan agreement with the International Monetary Fund and other countries. However, some sort of default or restructuring stills seems eminent.
The biggest fear with the Greece crisis was that it could spread out to the other eurozone countries and this fear soon turned true. The crisis reduced confidence in other European economies. Ireland, Spain, Portugal, and Italy which had high budget deficits, were suddenly under pressure similar to what Greece was facing. Rumors regarding a bailout package for Spain being made were also popular but they proved to be false. All these countries undertook measures to reduce the deficit that they had by one means or the other. They all are now implementing austerity measures to get back the economy in shape. The effect of the crisis can also very easily spill over to Great Britain, Belgium and Switzerland. Grauwe (2010) states that the three major factors which caused this crisis were:
A. The unethical behavior of Greece and its incessant need to keep on spending more and more. Even though other countries were much ahead of Greece and were doing well, the lack of confidence among the investors spread the crisis to the eurozone as a whole.
B. The destabilizing role of financial markets. The markets amplify movements in both directions causing major changes in asset prices. The rating agencies take a central role here. They have been consistently unable to see crises coming. And after the crisis erupts, they systematically overreact, thereby intensifying it.
C. Hesitation by the eurozone authorities to show support to Greece. The eurozone governments failed to give a clear signal indicating their readiness to support Greece. The failure to do so mainly resulted from disagreements among member state governments concerning the appropriate response to the Greek crisis.
Impact on Financial Markets and Economy
The U.S. Debt Crisis and its Impact
The financial market entered a state of nervousness and panic recently due to the debt crisis. The volatility in the market was very high and frenzied selling of the securities was seen for some time bringing the prices down. Banks were hit the hardest bringing their stocks way down. All of this panic caused the price of gold to reach unprecedented heights. Recently, gold hit $1850 at one point. If the current panic continues for an extended period of time, the price of gold may reach up to $ 2500 in some time.
In the United States, much of the focus has been on the losing of the AAA rating of the U.S. government, but possibly the European sovereign debt crisis is probably the biggest cause of the instability in world financial markets right now even when U.S. is also contributing to this crisis. The U.S. will have to go through a period where they risk increasing either the inflation rate which will make everybody suffer or risk creating more unemployment in the economy which will lead to high demands on unemployment benefits and widespread anger. They seem to be in a catch 22 situation. However, whether U.S. will enter into a full-fledged recession soon is yet to be seen.
Coming to the impact on global economy we hear a lot about the American exceptionalism. When it comes to the threat of deteriorating national finances it presents to the world economy, the U.S. is truly exceptional (Schuman, 2011).
As said earlier, U.S. is in a much better position than the European economies like that of Greece and Ireland. The EU zone crisis is quite scary. But, then U.S. stands in a universe of its own when it comes to debt-crisis scenarios. U.S. debt has the risk of crashing the entire operating system of the global economy as it dominates the global monetary system. The foundation of global finance is built upon the U.S. economy. Its capital markets are the most liquid. The dollar is the world 's No. 1 reserve currency and the primary one used in foreign exchange transactions and trade. Countries like China and Japan have their national wealth stored to a great degree in U.S. debt. The U.S. has always been considered as the ultimate safe haven and to a large extent is still considered the same by those with interests in the U.S. economy. If the problem of excessive debt is not solved and the notion of U.S. as a safe haven is lost then the U.S. dollar would weaken rapidly, causing a fall in the value of other countries’ reserves. It will also stop being the premier currency of the world. It would likely mean slower growth in the world 's largest economy, deteriorating living standards for Americans, and thus slower growth and destabilization for the entire world economy. (Schuman, 2011)
The United States has lived well beyond its means for a long time. However, this trend cannot continue into the future. Major changes have to come soon to stabilize the world economy. Otherwise, the world economic scenario can get pretty ugly. “When you build a house of cards on a foundation of sand, you should not be surprised when it comes crashing down.”
The EU Zone Crisis and its Impact
As far as George Soros is concerned "Europe faces almost inevitable recession next year and years of stagnation as policymakers’ response to the euro zone crisis caused a downward spiral". The European Debt-Crisis is largely made up of one thing: PANIC. Greece started it all with its practice of hiding its real deficits and borrowing more and more. However, the crisis spread to a lot of other countries due to what is called the contagion effect. The stock markets in Europe and all around the world have crashed. The European Debt-crisis is much more serious and intense than the American debt-crisis. Infact, the American stock market crash may have been caused more due to the eurozone sovereignty risk. The Euro has lost value as more and more people are shifting to safe haven assets like Gold and Silver boosting its price.
The biggest problem with the current situation is that the crisis has gone from a private sector crisis to being a sovereign crisis. The ability of sovereigns to finance themselves is in question, and there is no one to backstop the governments (Stepek, 2011). It is one thing for one country like Greece to default on its debt, but when major economies like Spain and UK are seen getting into trouble, the global economic environment is bound to be shaky.
The affect of the Eurozone crisis will soon be felt in the developing countries around the world too. The European Union is a huge market for these countries. With a low consumer confidence, the imports will go down leading to a loss of revenue for these countries. Also, the EU is a big investor in the global market. They are more than likely to postpone their investment decisions and hence the countries will be deprived on capital inflows. Moreover, the financial institutions all over Europe have become very conservative and conscious. An environment of distrust is prevalent. A turmoil in the Eurozone financial market will lead to a turmoil in the global financial market.
Conclusion
The debt crisis in Europe is more severe than that in the U.S. but this does not mean that the U.S. is free to run wild. The U.S. crisis is relatively less severe than Europe. The U.S. and the European crisis could have been easily prevented but the required effort was never made. The three most important things for governments to realize from the debt crisis are that:
A. The government must take timely action: If the Greece government had taken some austerity measures some time back and not deflated its deficit, the Euro crisis wouldn’t have ever occurred.
B. The government must take substantive decisions: The decisions taken by the government shouldn’t be half hearted. If the US government had decided to cut the spending substantially, the downgrade it faced could have been avoided.
C. The government must try to do things that are doable: Trying to do things that are almost impossible does not usually help. The government needs to be practical and efficient.
Works Cited
Background Of American Debt Crisis. (2011). Retrieved from www.crisissite.com.
Congressional Budget office. (2011). Retrieved from www.cbo.gov.
Grauwe, P. D. (2010). Crisis in the eurozone and how to deal with it. Center for European Policy Studies.
Greek lessons for America in its debt crisis. (2011). Retrieved from www.csmonitor.com.
Hofmann, T., & Schneider, D. R. (2010). Eurozone debt crisis: Impact on the economy. Allianz.
Schuman, M. (2011). What the U.S. Debt Problem Means for the Global Economy. Retrieved from http://curiouscapitalist.blogs.time.com.
Stepek, J. (2011, August 11). The eurozone crisis won 't go away - that 's bad news . Retrieved 2011, from www.moneyweek.com.
The stock market crash of 2011.
(2011). Retrieved from http://theeconomiccollapseblog.com.
Answers to Questions based on Passage Reading
1. What is the relationship between the returns on stocks and the returns on bonds over the 20th century?
The real return on stocks over the twentieth century averaged 6.45% and the return on bonds averaged 1.57% (Bernstein, 2011) . The higher return on equity occurs due to the fact that stocks are much more risky than bonds as an investment option. The stockholders are residual owners and are compensated only after all other obligations have been fulfilled. But the difference of almost 5% in the real return on equity and bonds can be attributed to two factors:
A) The high growth rates of the corporations after the world war enabled them to pay grand returns to the stockholders who undertook risk.
B) There was an inflationary burst due to the wars and the abandonment of hard money as currency (Bernstein, 2011).The returns on equity adjust to inflation very quickly moving up with the inflation. However, the yield on bond does not change so much and hence the investors in bonds suffer. This is precisely what happened
then.
Overall, returns on stocks have outdone returns on bonds consistently in the twentieth century. This may not have been true in the 19th century where the return was almost equal, but then the conditions were totally different. We can expect the same trend to continue for some time.
2. Why was the decade of 1950s a turning point for investors in the 20th century?
The first half of the twentieth century had been characterized by chaos. The world as a whole went through political and economic instability. There were two world wars in a short period of time. Wars lead to mass destruction and cause inflation in the markets. The great depression of 1929 lasted for a decade and turned investor confidence to zero. Investors in communist countries lost everything due to nationalization of their property. Overall a grim picture could be seen. However, things changed in the 1950s. The Bretton Woods system of monetary management was established in 1940s to establish rules for commercial and financial relations between nations. This system turned out to be successful. The world went into peace mode in the 1950s and the countries tried to provide a stable economic and political environment realizing the losses they had incurred due to years of war and mismanagement. This turned out to be a boon for investors and this period gave some of the best returns to investors all over the world. The change in the overall economic and political conditions in the 1950s changed the second half of the 20th century for good.
3. What two problems do investors in stocks face from inflation?
Inflation represents one of the major threats to stock investors. People get very nervous when the inflation rates start to rise. They expect negative consequences to follow. The two problems investors in stocks face from inflation are:
A) Eating up of the value of the stocks over time:
Theoretically, the prices of stocks go up in proportion to inflation because the companies can pass on the increase in cost to the consumers and hence generate more revenue to offset the increased cost. However, this does not work out in the globalized and ever competitive world where companies from other countries with lower inflation become more competitive. Hence, the value of the stock can go down. Also, the dividends that are reinvested are worth less due to inflation. This inflation, if not controlled can eat up a major portion of the accumulated wealth of the investors.
B) Causing volatility in the markets:
Stock markets are often marked by periodic bouts of volatility, in which prices rise and fall steeply and erratically. This volatility can be seen in the current U.S. market due to the debt-crisis that has rocked investors’ confidence. People end up moving money into and out of stocks in a very haphazard manner. When inflation rises, it becomes difficult to judge whether inflation is normal or very high. Fear causes a lot of investors to shift towards safe haven assets like gold. This causes the prices of the stocks to change frequently.
A comparison between Turkey and Canada proves the point. Turkey has high inflation rates whereas Canada is relatively very stable. The stock market return and variability of Turkey is almost four times higher than that of Canada. High inflation leads to high stock market volatility (Saryal, 2007).
4. According to the author, what must be true for investments in financial assets to be successful?
“Investing in financial assets only works if there are stable economic, political and financial conditions that enable investors to earn consistent returns from their investments.” says the author. This is a time tested and proven fact. Countries that have provided the stable climate have made fortunes for its investors. Whether it is Japan or the U.S., good economic, political and financial conditions make investment successful. The current crisis faced by America and Europe were caused due to poor financial management and the consequences are for all to see. Nepal which has been plagued with political and economic instability is not a great place to invest in for this very reason. Political instability may lead to a more frequent switch of policies, creating volatility and thus, negatively affecting macroeconomic performance. Considering its damaging repercussions on economic performance the extent at which political instability is pervasive across countries and time is quite surprising (Aisen & Veiga, 2010).The same is true for economic conditions. Hence, a politically, economically and financially sound and stable environment is essential for success in investment in financial assets.
Works Cited (For the Questions only)
Aisen, A., & Veiga, F. (2010). How Does Political Instabiltiy Affect Economic Growth.
Bernstein, W. J. (2011). The Efficient Frontier. Retrieved 2011, from www.efficientfrontier.com.
Saryal, F. S. (2007). Does Inflation Have an Impact on Conditional Stock Market Variablility?: Evidence from Turkey and Canada. International Research Journal of Finance and Economics .