A little about the Financial Crisis

I don't think this paper is that great. It was kinda hastily written and there was way more information I wanted to include than what I had room for. But the things I found out were somewhat interesting. I hope this offers a little bit of insight into some of the causes of the financial crisis. There's more to it also than what I have included, so if you would like to know more, let me know!





The Market Economy vs. The Financial Crisis



Over the past few months, the market economy and the principles that govern it have increasingly come under attack by those who think it inadequate for our complex society. Concepts of the market economy were first put forth by Adam Smith in his 1776 published book entitled “ The Wealth of Nations”. To be brief, his book argues that an economy left alone, is a better economy. And that largely, government involvement can only worsen the economy. In the book, he theorizes that the economy is governed by what he calls, “the invisible hand”; a natural force that through principles such as specialization, competition, and supply and demand, manage a market economy. Furthermore, he stated that the governments only role in a market economy was to promote an environment conducive to fair and free trade. In keeping with the principles of freedom and liberty, including in the economic sector, the United States of America was created. Since the time of the founding, except for few rough spots, the American economy has experienced almost unparalleled prosperity and growth. However, the market system is not perfect; a fact which has become all the more apparent recently. In light of the recent and still current financial crisis America is facing, many have come to question the founding economic principles of our country, and they wonder if the this “invisible hand” and other economic concepts can stand the test of time and remain a force for economic freedom. In order to answer this question, one must understand the weaknesses of the market system as well as the strengths. A short lesson in history will also be beneficial to to help understand why
The “invisible hand”, as mentioned before, is a series of laws and principles that ideally work to create an efficient, free, and basically fair economic system. However, for all the benefits that the market system has, it does not come without weaknesses. Imperfect information is a market weakness pointing to the fact that exchanges are only beneficial to both parties, when both parties are fully aware of the product(s) being exchanged. When imperfect or only partial information is given, it undermines the principle of free trade because at least one party will end up being disappointed. One of the miracles of the market system is that it functions mainly on the self interest of the individuals. For better or worse, as is demonstrated by the weakness of imperfect information, the system also works best with some degree of virtue.
The biggest and most perplexing market weakness, is the problem of economic instability. In other words, economy goes through cycles of growth and recession. Although, the economy on average seems to continually go upwards and get better, there are lulls and even periods of negative economic growth, and although the market will likely return to its normal robust state, that downward cycle can cost millions of dollars as well as misery in the lives of thousands without means and without employment. The causes of recession are as varied as they are often unknown. Many sources now say that the great depression of the 1930's started with a recession. As a result of the great depression, Keynesian economics were implemented to try and reduce the effects of a recession on the economy. Keynesian economics consist of basically two principles – fiscal policy and monetary policy. In fiscal policy, the government tries to stimulate the economy by giving tax cuts to people and/or businesses. The hope is that people will take the extra money they have and spend it on goods, services, or businesses which will create demand, and in turn, create more jobs for the unemployed. Monetary policy involves control of the money supply which to a degree, controls interest rates. The theory in monetary policy is that increasing the cash supply (and thereby lowering interest rates), would also cause people to spend more because goods (especially investments), would then be more affordable. The results of using these methods are mixed – sometimes helping and sometimes making the problem even worse.
History shows these market weaknesses in abundance. The great depression was preceded by the “roaring twenties” - a time of unprecedented growth, but also a time of excessive speculation. Many Americans were gambling on Wall Street with money they didn't have, totally relying on “margin.” This allowed the average American to borrow money and buy a stock for just a fraction of the cost as a down payment. They did not worry about if they would be able to repay the debt because all they had to do was wait and the value of their stock would go up and they could turn around and sell it for a profit. This worked great until the stock market stopped rising. The government then restricted the money supply leading to a recession. Simultaneously it was time for the stockholders to pay for the stock they purchased on borrowed money with a small down payment. Then everyone tried to sell their stocks so they could keep their profit or at least be able to pay for the debt they had incurred. The oversupply of these stocks made the price drop dramatically and the former stockholders could not obtain the funds needed to repay the loans given to them by their banks. Overwhelmed by the vast number of debts that remained unpaid, the banks started to collapse. Concerned by this, people flocked to the banks to pull out their money and caused a run on the banks. A series of unfortunate events led an economic recession into a depression – one of the worst domestic crisis' in American history.
Sixty to seventy years later, the federal government, concerned about an upcoming recession caused by the burst of the “dot-com economic bubble”, lower interest rates to try and stimulate the economy and reduce effects of the recession (Keynesian economics). Tax cuts, especially in the area of capital gains, caused many people to invest their money in real estate. Mortgage companies, sold loans at an alarming rate to those who did not qualify for them due to loosened restrictions, and many packaged these loans provided imperfect or incomplete information causing the buyers to purchase a product they might have otherwise avoided. In 2006, in an effort to control inflation, the government raised interest rates to 4% (again Keynesian economics), but because people were already living on the edge, this was just too much. At the same time, many people's introductory low rates and interest only loans were expiring also causing peoples monthly rates to rise. People began to attempt to sell their homes just as people had suddenly sold their stocks during the time of the great depression. Again there was an oversupply of homes and people just could not (and cannot) sell their homes. The result is they are stuck living in homes they cannot afford and now cannot sell and they end up filing for bankruptcy. Again, the banks issued too many loans to too many people who would never be able to pay them back and usually a bank can sell the home to recover from the loss of repayment, but with the oversupply the banks either cannot sell the home, or sell it for a fraction of the original cost, leaving the bank in debt.
It is important to learn from history so that it does not repeat itself. It is obvious that the market system of economy has many weaknesses, some of which can be somewhat controlled by the government, and some which the government exacerbates. It seems that the biggest problem is a national drift away from morals and virtue. Were every American citizen instilled with these qualities they would not borrow above their means, they would not provide imperfect or incomplete information, and Keynesian economic principles might be more effective because people would spend their money for wisely. The problem therefore in the current financial crisis, lies not in the market economy, but in the citizens of America. According to Washington, “it is substantially true that virtue or morality is a necessary spring of popular government”, and to that I would add that virtue and morality are a necessary spring to a free market system.