You know what they say: Whoever does not know history is doomed to repeat it. While it is true that history is not perfectly cyclical, nor, of course, perfectly linear (rather, an intermediate point, let us say, as a perpetual spiral,) to know the problems of the past is vital for systems to evolve. We all know very well the sad bankruptcy stories of 2007 and 2008. The number of companies that had to restructure, to refinance their debts, and to file for bankruptcy, was tremendous. We are now on the verge of another great crisis: What lessons have we learned from the previous ones, and how can we avoid not falling into the same mistakes?
Read also: The Big Crash: No longer a hypothesis, by Suzzanne Uhland
The first thing that we should analyze here are the causes of the crisis of 2007. How did everything start? In the first place, the main problem was the big speculative bubble related to the real estate business, linked to very low-interest rates (which had never been seen, really.) What was the consequence? It began to inflate a bubble. People borrowed, bought, and sold at a fast pace, so prices began to rise.
Actually, people spent more than they earned, and inflation levels naturally grew, so, in 2004, the Federal Reserve had to take action on interest rates and raised them as a measure of control. What caused this in consequence? That the interest rate increased from 1 to 5%, and this, in turn, made the price of housing to fall downhill during the first five years of the last decade. Then, in the second half of the current one, the role of the banks was crucial for the crisis to worsen.
Banks began offering mortgages, as well as the financing of a considerable portion of the people’s loan portfolio. They did so by contracting the debts with short-term maturity. At the same time, the Government’s expansive monetary policy did not consider the asset of prices and credit as a priority amid the flood of financial problems that emerged then, and this gradually weakened the whole system.
To this extent, the real problem could have been a poor valuation of the risks, especially by the Government, in addition to the automation of the stock market. People no longer had direct control over the processes of the stock market: The automation of many processes was delegated to computer programs.
Well, what followed was a domino effect. In 2008, eight big players of the financial world fell sharply; and, although the US government did everything possible to rescue three major mortgages, the bankruptcy of one of them was imminent and this complicated things even more. Worst of all, the crisis did not remain in our country but spread to the United Kingdom, the European Union, and Latin America. Some of the more developed countries of the First World had to adjust their belts and experienced the same problems as in the United States. We had not seen such a crisis since World War II.
The way out of the crisis was not very effective either. Although there was a joint action by several institutions, the United States Congress did not agree with a series of recovery plans that could definitively end the leverage, and, for this reason, during the first two years of the current decade, the recovery was just halted. This, among other things, is one of the causes of the next economic crisis that threatens our country and a big part of the world.
It is important to consider two lessons from that experience. On the one hand, the impact of the crisis was long-lasting mainly due to the constant increase of debt, followed by an expenditure of similar proportions. The same patron of all bubbles: Some people promote a high investment, it seems the perfect opportunity to make money and to put the economy in motion, but when the States take measures, like the one of the Federal Reserve, the crisis begins, diminishes the debt, everybody is cool, but the investment also begins to decline as well as the stock of physical capital … and then, crash; and hence, a chain reaction. The companies that support this level of excessive consumption fall back, no longer grant the same loans and rather ask for the money people that own them money. At some point, no one can pay anyone because all are debtors of somebody else. Even lawyers and bankers lose.
On the other hand, there is a huge ignorance about the way crises originate and operate. Indeed, few people know what an interest rate depends on, very few know how to explain the basic phenomenon of inflation, and many, sadly, believe that boom situations are enduring (if not eternal,) and even believe that it is a responsibility of Governments to keep them that way. Then, they never learn from mistakes: They do not save money, they ask for loans that they can never pay, and even encourage this attitude in other people.
Recommended: The 2007-08 Financial Crisis In Review
* Featured Image courtesy of Jeffrey Zeldman at Flickr.com