Financial Crisis

Why is there a Recession?

By Richard Ryland

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The Banking Crisis

The press would have us believe that the recession and the global financial crisis is caused by a banking crisis. So first let's examine the banking crisis. Banks in the western world simply got greedy and lent more money to individuals than individuals could pay back. Some banks were lending 120% of equity. In other words, banks were lending 20% more than the sale of the property could achieve, if the borrower defaulted. There lies the first problem. Property prices are a market and like most markets prices rise and fall. The banks sought to re-insure their potential losses with other banks. The problem became that most - if not all - banks were playing the same game, to a lesser or greater degree. Some banks also habitually had greater reserves than other banks.

Falling Like Dominoes

A downturn in the economy revealed the weakness of the system. The banking sector fell like a pack of dominoes. Borrowers defaulted and the re-insurance with other banks who were all in a similar position threw more fuel on the fire. In turn the sudden unloading of properties for sale affected the supply and demand in property and so prices of property fell. This meant that even the financial assumptions on which lending was done was exposed and banks could not get, in some cases, most of their money back by selling property. Some countries, such as the USA, let some banks fail. In Europe many banks were bailed out by their governments

The Problem with Democracy

We now consider governments and the economies in the western world. The lessons of history seem to suggest that the best form of government which keeps people happy and preserves human rights most is Democracy. But democracy has its faults.

Governments tend to be voted in for short terms of say 4 or 5 years. In some cases the term can be as short as two years. This can mean that some governments take a short term view, with decisions always taken with an eye to the next election. Many successive governments have borrowed and put the country in debt. This would be true of most western governments and most ruling political parties.

Role of Debt in the Financial Crisis

On top of the banking crisis comes the realization that most countries are carrying too much debt. Countries can simply choose to print more money but that leads to inflation and sets the scene for a national and even global financial crisis. Governments can borrow money from the private sector but must pay interest on borrowed money. Interest on government borrowing tends to increase as more money is borrowed.

So we have the double whammy, banks lending more than people can repay and either shouldering huge losses or becoming part owned by governments. Governments’ excessive borrowing made worse and the costs of borrowing increases.

The banks reaction to the crisis, once they had picked themselves up and dusted themselves off, was to be more cautious with lending. This reaction caused further downward pressure on property prices.

The governments’ reaction to the borrowing crisis is to try and cut government spending. This means reducing the manpower which governments employ and cutting capital schemes, weapons, building hospitals and so on. This in turn adds further downward pressure on property prices. The newly unemployed will tend to default on paying back loans, more properties unloaded on to a bloated market sends property prices still lower.

Confidence is the Key

How does all this doom and gloom end? It may seem strange to say that a third force which is at work needs to be reversed. This third factor is called confidence. All of the above problems do not adversely affect most of the population of any given country but confidence is knocked. People who have the money to buy property and stimulate the market hang back, waiting to see if the market has bottomed out. This in turn means property prices remain stalled or falling. When confidence returns people spend more. Spending means the government collects more taxes. Confidence will see the housing market and, say, the car market starting to recover.

It is time we said to banks that if they fail they will be allowed to close and have their assets stripped and their directors fired. In general if a small business spends beyond its means the directors of a company are liable for prosecution and seizure of their personal wealth. This rule should apply to banks.

For governments the mechanisms of democracy needs adjusting. All countries should have an independent bank which regulates the supply of money. Governments should not be allowed to spend more than the country can afford. Borrowing should become an unavailable option (except in emergencies).

People and Politics

Finally we need people to get more involved in politics. Politics really does affect us all. We need people to look beyond the sound bites and the image and examine policies. Edmund Burke famously said “All that is necessary for evil to triumph is for good men to do nothing” This quote has been attributed to the rise of Nazism.

It is not argued that our politicians are evil, they may be well intentioned but it is sensible in life to not live beyond one’s means. Isn't this ultimately going to lead to a financial crisis? We must support politicians who tell the truth and who are prudent. What we the people must do is to watch the politicians and make them accountable. Lord Acton is often quoted “Power tends to corrupt and absolute power corrupts absolutely”. We must learn the lessons of history. We must watch and question the politicians.

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