Grace from the U.S. Government: The Moral Hazard Problem
: : By Waldo T. Best

In a period of weeks, the U.S. government has taken extraordinary steps to stabilize and reform the financial system. Beginning with the government takeover of troubled mortgage lenders Fannie Mae and Freddie Mac, followed by its takeover of the global insurance giant, AIG, and the proposed $700 billion (USD) plan to buy soured mortgages and mortgage-related securities from financial institutions, the price tag for the stabilization will eventually be in the trillions of U.S. dollars. The U.S. Federal Reserve has allowed the two remaining independent investment banks Morgan Stanley and Goldman Sachs to restructure themselves into bank holding companies, meaning that they will be able take deposits but will be able to take on far less risk. The two key questions now are: who will pay for these extraordinary financial actions and what would have happened if the government had not acted?

The U.S. financial markets are driven by access to credit and risk. Individuals and companies borrow money to buy things and conduct business based on their ability to repay. Banks lend money and charge fees and interest rates that compensate for the amount of risk of the loan. These loans are packaged together into debt securities that are then resold into the financial markets. Insurance companies, like AIG, get involved because they sell insurance policies related to the risk of these debt securities. The insurance policy, called a credit default swap, pays the holder if the debt goes bad.  Read more>>>

A Weakening World Economy Faces a Host of Challenges
: : By Douglas O. Walker, Ph.D.

The year 2008 has been one of financial turmoil and economic slowdown, not only in the United States, but across the globe. The deterioration in performance at home is now being matched by that abroad, and this deterioration is expected to continue and could be severe and long-lasting.

The End of the World Upturn
The global boom preceding the downturn of 2008 was mild by historical standards, but it was widely shared and, until recently, appeared to set the stage for an ongoing and long-lasting expansion of the world economy. For more than half a decade, economic activity had increased at average rates well above five percent annually in the developing countries of Africa, Latin America and the Caribbean, Western Asia, and South and East Asia. Spurred by high prices for commodities such as oil, gas, metals and cotton, growth was even higher in the transition countries of Russia, the Ukraine, and other countries of the Commonwealth of Independent States. Although slower, the pace of growth in the more economically advanced areas of Europe, North America, Japan and Australia/New Zealand had, nonetheless, picked up markedly after the world downturn of 2001 and 2002. The widespread upswing since 2003, was bolstered by a very rapid expansion in the volume of world trade, which increased at rates exceeding 10 percent from 2003 into 2007.

The boom of recent years was brought to an end by accumulating and unsustainable financial imbalances in the United States. A spreading falloff in world growth began in the fourth quarter of 2007, when the U.S. economy weakened markedly due to sub-prime mortgage woes, which greatly damaged its financial sector, and a surge in oil and other commodity prices, which aggravated its already outsized external deficit and lifted inflationary pressures.  As credit criteria became tighter and mortgage rates rose, the U.S. housing sector went into a deep decline, and housing inventories rose substantially while housing prices fell significantly.  High and rising oil prices sapped consumer purchasing power and started an economy-wide adjustment process that negatively affected the auto industry and other energy-dependent sectors of the economy. Read more>>>