The recent events in the world financial markets are worth reflecting on, as we have been seeing times of extreme riskiness. On May 6th, the S&P500 fell from 1165 to 1065 within one day. The following day it was again back at 1135. Since then, the commodity markets, equity markets, and the currency markets are in high volatility, and investors have become very risk averse.
For the last two years (almost), we have been hearing about economic crisis, financial crisis, banking crisis, current-account crisis; it has become a crisis world. Looking at past crises, we saw the ‘Black Monday’ in 1987 when the Dow Jones plummeted almost 508 points and the S&P 500 declined by 20.4 percent within one day. In 1997, there was the East Asian financial crisis, when currencies of Thailand, Malaysia and Indonesia depreciated significantly within weeks. In 1999 we had the Argentine economic crisis. In 2007, we started hearing about the signs of a major financial crisis, the one we are still experiencing today.
When USA was almost on the verge of economic recovery, the debt problem of Greece led to a sudden panic in the markets, and Euro has fallen to 1.21 against the US Dollar.
Whenever there is an economic or a financial crisis, many people lose their jobs and income, banks fail, and companies go bankrupt, and so crises are definitely bad for societies. I wonder why we get so much of these crises, in the first place.
Well, we all know how the financial crisis started in USA; with the banks lending excessively to the Americans at low interest rates for home ownership. Most of these mortgage loans were made to the ‘sub-prime’ market, a group of people who had the lowest possibility and capability of repaying the loan. These banks and financial institutions then sold these debt to other institutions, and in this way, new financial products were innovated. Bright minds working in fund management firms came up with ideas like the ‘Credit Default Swaps’ (CDS), which are still another form of financial product, that acts as an insurance to those banks that hold mortgage debt. Trading in equity markets have become too much sophisticated, and mostly has become just numbers in computer systems.
In order to address some of the problems of this sophisticated system, on 24th May, Germany has banned naked short-selling of certain sovereign debt instruments and shares of selected German banks. Although some investors are unhappy about this, I guess, the current crisis originated from actions of many investors trying to make gains in the very short run through short-selling of shares and other financial products.
The whole objective of a financial system is intermediation of finance from savers to investments. We buy shares in order to have ownership of a certain company, and when the firm makes a profit, we get a dividend from it. The company gets the benefit of obtaining finance for its needed investments. Whenever we deviate from this basic fundamental objective, and when financial system is dominated by just hypothetical numbers in electronic devices, we will always be prone to crises.
Talking about sovereign debt problems, the one Greece is facing right now, is again a major reason for an economic crisis. Most of the analysts may be talking about the US economic recovery, what they dont talk about is the US debt problem. As at end 2009, the US debt stood at 83 percent of GDP. Hence, in order to prevent yet another crisis, it has to address its debt problem soon in order to avoid America turning into Greece.