Sougata Basu is the Founder of DaulatGuru.com. He has an MBA in Finance from Boston University and has done Electrical Engineering from BIT, Mesra, India.
August 2010: Almost 2 years after the financial crisis of 2008, we still do not see a real recovery in the US economy. The data on unemployment and debt levels in US do not indicate any significant improvement. The economic crisis of 2008 was not a sudden disaster like an earthquake or a tsunami that happened without sufficient warning signals. It was building up as the consequence of serious economic problems that started many years ago. Some economists and finance experts had predicted it accurately. However the Government agencies, media and financial services firms didnâ€™t pay attention to these experts. So what should we learn from the 2008 experience?
First, we must do an independent analysis and shield ourselves from the noise in the media. Second, whatever the politicians, CEOs or FED Chairman say may be completely wrong. Third, if something has not happened in the past doesnâ€™t mean it cannot happen in the future.
Please take a look at the video below:
Let us consider the story of my neighbourâ€™s son. He didnâ€™t learn how to properly speak or write in English. However, he somehow managed to get an admission to a low-ranked engineering college in India. He took a loan of INR 10 Lacs for the course. After the course he didnâ€™t find a job because of his poor communication skills. Instead of taking a course to improve his English, he decided to pursue a Masters degree from Australia. So the problem of not finding a job was postponed for 2 years. But this solution didnâ€™t solve his real problem and instead increased his loans by another INR 30 lacs. After his Masters degree, he still couldnâ€™t find a job. The problem was worse this time because he had much more debt.
This is exactly what US is doing now. It is taking on more debt to postpone its current problems. This may work temporarily. But in the long run, it can be disastrous. Though it is not possible to exactly predict the date and time of the next economic collapse, it is possible to predict the direction.
We all understand that easy availability of cheap debt was one of the main reasons for the crisis. However the steps take n after the crisis have only increased the debt. So a problem caused by high debt has been solved by taking on higher debt. Debt is good only if the return on the investment is greater than the cost of borrowing. If someone takes debt at 6% to build a factory and sells the goods to get a net profit of 10%, then thatâ€™s a â€œgoodâ€ debt. If someone takes a huge debt and simply consumes it, then thatâ€™s generally not a good use of debt. So a consumption driven society mainly financed by debt is not sustainable in the long run.
Politicians and Government officials in US may say that things are moving in the right direction. However it becomes difficult to understand how such a solution can ever work. If we study the history of economic problems in various countries, it is evident that such a solution has never worked. Countries had to take tough measures of austerity and cut down Government spending to reduce budget deficits. Otherwise the country is left with only two options: default on the debt or print money to cause very high inflation.
The US Government has taken many steps after the crisis to solve the problems. Iâ€™ll briefly describe two steps that tell me that they are not solving, but only postponing, the problems. The â€œCash for Clunkersâ€ programstarted after the crisis gave tax incentives to consumers who would sell their old cars and buy new fuel-efficient cars. This program was marketed as aâ€œclean, green and sustainableâ€ initiative. However the real intention was to artificially increase demand in the automobile industry. The poor consumer who had a decent car would now get a new car (which was not required), and his personal debt would increase sharply.
The video below describes that program:
Another important change that happened after the crisis was an accounting rule called â€œMark-to-Marketâ€. Itâ€™s difficult to calculate the exact value of complicated and illiquid securities (e.g Level 3 assets). Prior to the crisis, these securities were valued at their market price. As the value of these securities started declining dramatically, banks had to write-off these assets and that resulted in a huge loss. It was hurting the banks and some senior executives of finance firms blamed this rule for the financial crisis. Thatâ€™s like blaming the X-ray machine for a fracture!
The US Congress agreed that the rule was a problem and pressurized the Financial Accounting Standards Board (FASB) to change this rule. Now banks can use â€œMark-to-Modelâ€ to value those securities. Ever since this change has taken place, all banks have started showing good profit numbers. Guess why? Itâ€™s because the banks are allowed to create their own financial models to value these securities. If all these financial models were perfect, then the crisis wouldnâ€™t have occurred in the first place.
Why is this information important if you are not investing in US? Whether you are a student or a working professional, it is good to understand the global macroeconomic trends. US has considerable power and influence, and is the largest economy in the world. So if it has economic problems, then we will definitely experience some adverse effects - whether we are working in the Finance industry or planning to study abroad.
Sedatives can reduce pain but not really cure the root cause of the pain. Bailouts and stimulus packages in an economy are similar to sedatives. Weâ€™ll have to wait for 3 - 5 years to see the actual impact.