Saturday, October 11, 2008
"Economics is, at root, the study of incentives."Indeed, with that opening quote I shall now do an intelligent post on an analysis of the current economic crisis which I'm sure many of you have heard about. Readers of this blog, if you haven't, you probably live in Burma or North Korea, or are mugging for what you see as the more important end-of-year examinations. But since many of my friends have actually asked me about what are the origins of this economic crisis and what's the big deal anyway, I shall endeavor, in this post, to use my scant 2 years of JC economics knowledge to explain it simply to all of you why your dads and mums are quivering now and are complaining about the conditions.
To examine the crisis now, we must of course start at its foundational factors. The foundation for such a crisis indeed was the surge in oil prices of 2007-08. Now, most of you have probably heard about the complaints about high oil prices. Quite simply, this is because of the rapid industrialization of developing countries like China and India. It doesn't take a genius to figure out that with new factories you need more oil to make machines work, and therefore demand for oil has increased. However, oil supply has largely remained the same, which drives prices up, as people are willing to pay more as they desperately need it. Oil doesn't have many substitutes after all. I doubt if any major factory can operate solely on HEP or wind turbines. This surge in price is made worse by speculators. And of course, the oil crisis aggravates the food crisis, which is our second factor.
Food prices rose dramatically in tandem with oil prices, which is also a cause of several reasons. The primary reason being oil is needed to operate tractors, etc, so with increased oil prices it costs more to produce food. Also, owing to countries developing rapidly, people who grow richer also demand more food like meat and beef etc. Furthermore, droughts and certain foods being burnt for biofuel instead of well food leads to decreased supply. Once again, increased demand plus decreased supply=increased costs of food.
Of course, that was just a crisis in the commodity sector. Now, we go on to the subprime crisis. Many have asked me just what the hell does this mean. Well basically, it refers to the property crisis in the USA. In 2005-8, banks in the USA got hell lot of foreign funds and money, as a result of investors being confident in the country's economy, thus investing to make a quick buck. The increase in funds meant banks could lend out money more easily, as they had more funds. Banks make money by lending money with interest rates, so of course they were motivated to lend more easily. As a result, they practiced subprime lending, which is basically lending to people who fall below security level. For example, previously I may not have been able to qualify for a loan of let say 10k cause i have no income, etc. But now, due to the increase in funds, banks are willing to lend it to me, and are not afraid of me not paying back in time, cause hell they have alot of cash. The result: People start borrowing like crazy to buy houses and property, desparate to own a home. This led to increased building etc in the property sector. More and more and more houses were built, until there was over-supply, leading to fall in property prices and decrease in value of homes. Eg, there could possibly only be 1 bungalow worth 450k but due to more bungalows being built its now worth only 200k. This significant decline in worth of housing led to increasing rates of foreclousre, which basically means banks can't get their money back. The fear of foreclousre and inability to get cash back led to almost a liquidity crisis in banks which leads into the next section. But first, decline in housing prices meant consumers (that's us) have less wealth as well, since we're not sure our houses are worth so much anymore. Therefore, we consume less, and consumption is part of AD, which i will explain later.
On to liquidity first, which is what many of you probably heard about. Basically, liquidity is the ease of buying and selling an asset. In banks, which we will be focusing on here, it means how easily the bank can well, provide currency to borrowers or to pay for its operations. Now, we heard about how people bought their houses, prices decreased and were unable to pay back loans as a result of foreclosure. Well, as a a result, this er.."bankrupted" banks, they were unable to get their money back and this led to liquidity crisis. They were unable to pay for stuff, etc, which led to er Lehmann Brothers, Fannie Mae and Freddie Mac, etc all going under. The USA Federal Reserve and Warren Buffet though, were able to save some other big banks like Goldman Sachs by giving them cash.
Now why is this important? Well banks reflect a country's economic health, and if major banks are having liquidity problems, it means businessmen probably can't borrow cash to invest, to build up their businesses and create jobs. They can't even borrow to cover cost etc. Remember, the banks have no money owing to the property bubble bursting. As a result, businessmen will probably start to cut operating costs by shutting down stuff and laying off people, leading to increased unemployement. In the USA, that's a problem. The USA's people love to buy and import. Bags from Gucci, LV, Cars from Honda, Mitsubishi, etc. The USA's demand for these imports form a huge part of the national income of countries like Italy(Gucci) and Japan(Honda). Not to mention the manufacturing plants of these firms in countries like Singapore and China. So, if USA's people, as a result of unemployment and lack of cash, demand less of this, it means loss in income for like 2/3 of the world's countries as well. This is a more practical loss. Meanwhile, seeing banks like Freddie Mae, with such stability intially collasping, has probably sparked fears in investors in other countries as well. They think: If even FreddieMae can collaspe, my shares and stuff are in trouble. Speculating the prices will slide, all of them sell, causing a even bigger crisis in the stock market.
So, besides the financial crisis, I shall use a more simple economic model to explain why other countries economies slide as well. All economies are basically made up of C, I, G, (X-M). C refers to consumption by consumers, which are us, the common people. For example, when I buy a bike, I'm consuming. I stands for investment. This occurs when businessmen build like factories and offices, etc. This is an investment. G is government spending. For example, when the goverment builds new schools and MRT lines etc. X-M is net exports, which is basically how much we earn from exporting our goods. For example, milk bottles made in Singapore sold to India. Using Singapore as an example, we can already see why the economic crisis affects us. Clearly, we are a small market and we depend highly on exporting to other countries. E.g if we sell milk bottles to everyone in China we would clearly make more than if we sell it to only our own people. Our net exports thus form a huge part of our economy. The USA is the biggest swallower of our exports. Now that they demand less, our exports decrease and boom! we get less money, affecting our economy severly. Furthermore, we look at the worldwide crisis and being a kiasee lot, we say: better not spend too much, must save for a rainy day. BOOM! our consumption, C decreases and our economy gets worse. Thus, by using these two examples we can see how our economy is already suffering from the crisis.
Of course, this crisis is only quite temporary but will only abate if a few things occur. Speculators stop causing crisises to fall. Greater regulation on banks and lending. More government spending and consumption. Prices of oil start to fall. Only such drastic actions will help reboot the global economy. Yea. Any questions, feel free to ask on the tagboard. I know that was a long post, and I probably didn't cover all aspects, but hey I had to make it simple.
To examine the crisis now, we must of course start at its foundational factors. The foundation for such a crisis indeed was the surge in oil prices of 2007-08. Now, most of you have probably heard about the complaints about high oil prices. Quite simply, this is because of the rapid industrialization of developing countries like China and India. It doesn't take a genius to figure out that with new factories you need more oil to make machines work, and therefore demand for oil has increased. However, oil supply has largely remained the same, which drives prices up, as people are willing to pay more as they desperately need it. Oil doesn't have many substitutes after all. I doubt if any major factory can operate solely on HEP or wind turbines. This surge in price is made worse by speculators. And of course, the oil crisis aggravates the food crisis, which is our second factor.
Food prices rose dramatically in tandem with oil prices, which is also a cause of several reasons. The primary reason being oil is needed to operate tractors, etc, so with increased oil prices it costs more to produce food. Also, owing to countries developing rapidly, people who grow richer also demand more food like meat and beef etc. Furthermore, droughts and certain foods being burnt for biofuel instead of well food leads to decreased supply. Once again, increased demand plus decreased supply=increased costs of food.
Of course, that was just a crisis in the commodity sector. Now, we go on to the subprime crisis. Many have asked me just what the hell does this mean. Well basically, it refers to the property crisis in the USA. In 2005-8, banks in the USA got hell lot of foreign funds and money, as a result of investors being confident in the country's economy, thus investing to make a quick buck. The increase in funds meant banks could lend out money more easily, as they had more funds. Banks make money by lending money with interest rates, so of course they were motivated to lend more easily. As a result, they practiced subprime lending, which is basically lending to people who fall below security level. For example, previously I may not have been able to qualify for a loan of let say 10k cause i have no income, etc. But now, due to the increase in funds, banks are willing to lend it to me, and are not afraid of me not paying back in time, cause hell they have alot of cash. The result: People start borrowing like crazy to buy houses and property, desparate to own a home. This led to increased building etc in the property sector. More and more and more houses were built, until there was over-supply, leading to fall in property prices and decrease in value of homes. Eg, there could possibly only be 1 bungalow worth 450k but due to more bungalows being built its now worth only 200k. This significant decline in worth of housing led to increasing rates of foreclousre, which basically means banks can't get their money back. The fear of foreclousre and inability to get cash back led to almost a liquidity crisis in banks which leads into the next section. But first, decline in housing prices meant consumers (that's us) have less wealth as well, since we're not sure our houses are worth so much anymore. Therefore, we consume less, and consumption is part of AD, which i will explain later.
On to liquidity first, which is what many of you probably heard about. Basically, liquidity is the ease of buying and selling an asset. In banks, which we will be focusing on here, it means how easily the bank can well, provide currency to borrowers or to pay for its operations. Now, we heard about how people bought their houses, prices decreased and were unable to pay back loans as a result of foreclosure. Well, as a a result, this er.."bankrupted" banks, they were unable to get their money back and this led to liquidity crisis. They were unable to pay for stuff, etc, which led to er Lehmann Brothers, Fannie Mae and Freddie Mac, etc all going under. The USA Federal Reserve and Warren Buffet though, were able to save some other big banks like Goldman Sachs by giving them cash.
Now why is this important? Well banks reflect a country's economic health, and if major banks are having liquidity problems, it means businessmen probably can't borrow cash to invest, to build up their businesses and create jobs. They can't even borrow to cover cost etc. Remember, the banks have no money owing to the property bubble bursting. As a result, businessmen will probably start to cut operating costs by shutting down stuff and laying off people, leading to increased unemployement. In the USA, that's a problem. The USA's people love to buy and import. Bags from Gucci, LV, Cars from Honda, Mitsubishi, etc. The USA's demand for these imports form a huge part of the national income of countries like Italy(Gucci) and Japan(Honda). Not to mention the manufacturing plants of these firms in countries like Singapore and China. So, if USA's people, as a result of unemployment and lack of cash, demand less of this, it means loss in income for like 2/3 of the world's countries as well. This is a more practical loss. Meanwhile, seeing banks like Freddie Mae, with such stability intially collasping, has probably sparked fears in investors in other countries as well. They think: If even FreddieMae can collaspe, my shares and stuff are in trouble. Speculating the prices will slide, all of them sell, causing a even bigger crisis in the stock market.
So, besides the financial crisis, I shall use a more simple economic model to explain why other countries economies slide as well. All economies are basically made up of C, I, G, (X-M). C refers to consumption by consumers, which are us, the common people. For example, when I buy a bike, I'm consuming. I stands for investment. This occurs when businessmen build like factories and offices, etc. This is an investment. G is government spending. For example, when the goverment builds new schools and MRT lines etc. X-M is net exports, which is basically how much we earn from exporting our goods. For example, milk bottles made in Singapore sold to India. Using Singapore as an example, we can already see why the economic crisis affects us. Clearly, we are a small market and we depend highly on exporting to other countries. E.g if we sell milk bottles to everyone in China we would clearly make more than if we sell it to only our own people. Our net exports thus form a huge part of our economy. The USA is the biggest swallower of our exports. Now that they demand less, our exports decrease and boom! we get less money, affecting our economy severly. Furthermore, we look at the worldwide crisis and being a kiasee lot, we say: better not spend too much, must save for a rainy day. BOOM! our consumption, C decreases and our economy gets worse. Thus, by using these two examples we can see how our economy is already suffering from the crisis.
Of course, this crisis is only quite temporary but will only abate if a few things occur. Speculators stop causing crisises to fall. Greater regulation on banks and lending. More government spending and consumption. Prices of oil start to fall. Only such drastic actions will help reboot the global economy. Yea. Any questions, feel free to ask on the tagboard. I know that was a long post, and I probably didn't cover all aspects, but hey I had to make it simple.
i want this to last 8:50 PM