Since hitting a peak almost exactly a year ago, the Dow Jones has fallen almost 4,800 points, from 14,800 to about 9,450 as of Tuesday. This, coupled with failing mortgage and banking institutions, have led some to dub this America’s worst financial crisis since the Great Depression.
Most people did not see the crisis coming, as the market drop was a shock to investors and the general public. Those with little interest in economics became involved when their banks were sold or their student loans affected.
However, economists have predicted the market crisis for a while, as the economy follows regular cycles of peaks and depressions. “The cause was known for a very long time and shouldn’t have surprised anyone; the only surprise is how quickly this was happening,” said Dan Breznitz, assistant professor in the School of Public Policy and the School of International Affairs.
Economics is a complex subject to understand, with many factors affecting the market. ‘Market’ is a term used to describe different interactions between people and how items are moved. “Markets work only if people have information; preferably, full information,” Breznitz said. Though the U.S. market has been growing, market fluctuations are a part of the cycle; even during long-term growth patterns, markets will go up and down.
“As long as people are willing to bet [or ‘gamble’], the financial market is going to have booms and busts,” Breznitz said. Buying and selling stocks keeps the market moving, but speculation is what causes large changes in the economy. Since no market is perfect, all economies will go through the boom and bust cycle (“boom and bust” refers to the high and fast changes in the economy due to factors that “perfect” models do not take into account).
Multiple problems combined to lead to this crisis. First, there was no main “clearing house” for financial institutions, so there was a lack of information about ownership. The lack of information between banks and investors destroyed trust. According to Breznitz, the real problem is not that there is not enough money, but that no one trusts anyone. With no trust between investors and institutions, the market is shaky.
Now, banks are having trouble staying afloat. Wachovia is in the process of being sold, and Washington Mutual was bought out by JP Morgan. Though Bank of America has held out so far, it is reporting profit losses.
“The problem started with the question about moral hazards: will mortgage banks now calculate risk in the same way they did when the risk stays on with them? Add to that the problem with that derivative, you have no central clearinghouse; when things go bad, no one knows who owns which part,” Breznitz said.
People often panic when the economy starts going downhill. “The most rational thing to do when you think the bank is going to fail is to take the money out…it becomes a self-fulfilling prophecy because banks’ business models rely on not having to pay all the customers at the same time,” Breznitz said.
The Federal Deposit Insurance Corporation (FDIC) was created by the Glass-Steagall Act of 1933 after the panic of 1933 to insure people against such bank failures. Over 4,000 banks were closed this year while the government oversaw mergers that created stronger banks. Currently, as of Oct. 3, 2008, the FDIC insures up to $250,000 per person per bank, protecting more money during this economic crisis. This policy will continue until Dec. 31, 2009, when the insured limit will go back down to $100,000.
Since the beginning of the Information Age, when something occurs in one nation, it affects other nations. “It is no longer possible for one nation to regulate global economy or to save it,” Breznitz said. “We should hope that…the U.S., Europe and China will do something.” According to Breznitz, the global network must shift to deal with the changes not only in their own nation, but also in others.
“What will be interesting is to see if the financial crisis…will force or teach policy makers to cooperate more closely internationally,” Breznitz said. In Breznitz’s opinion, while focusing on our own economy, other nations’ financial well-being cannot be ignored.
The debate over inflation versus the crisis is ongoing. “[The] greatest fear, I think, is long-term high inflation…[which] will probably be much more damaging than a crisis,” Breznitz said. “If the choice of policymakers will be a crisis for two or three years, or high inflation for a decade, the shorter crisis will probably be less damaging.”
With student loans to pay off, soon-to-be graduates and recent alumni have valid concerns about finding a job. Breznitz believes the American economy will not recover before the second half of 2009. “[If] you’re a computer scientist, two or three years ago you could have found a good job doing models for investment banking; now, I’m not so sure,” Breznitz said.