General Studies ( ECO SV) Supplementary notes of class no 8 (ALL BATCHES 2012-13) US CRISIS 2008 & 2011

The largest economy of the world went through two major crises in the recent time and the worst since the great depression 1929-33. The crisis of 2008 was a financial sector crisis, the genesis which was sowed in the inverted financial system, highly over leveraged, as an inverted pyramid. The mechanism of the overleveraging was through complex financial derivative products (products deriving value from an underlying financial assets) which had excessive risk. Globalization of the financial system had happened even earlier to the economic globalization, resulting in a broad global financial architecture covering banks, investment banks, pension and insurance funds, housing finance companies, hedge funds all finely inter meshed with each other difficult to differentiate the financial products and the holders of such products. These products were traded over the counter, outside the stock exchanges resulting in their being unregulated or any kind of supervision on their trading. It was also driven by consumption led growth especially through housing loans making it relatively easy for people to get mortgage backed loans which were then sliced and diced as multiple risky derivative products. In 2008 the total outstanding of mortgage loans was around USD 15 trillion, more than the GDP of US and the financial derivatives market was of over USD 600 trillion. A default in the mortgaged loans brought down the financial system, resulting in an overnight shut down of around 140 banks, financial institutions, crashed the stock market resulting in the crisis also known as the Global meltdown and also as subprime crisis. The US crisis of 2011 was a fiscal crisis, arising out of reckless fiscal spending over the past decade with deficit to GDP climbing to double digit in less than a decade. This was due to compulsions of the US of mounting expenditure of social security and the crisis of 2008 only making matters worse, in terms of recession and also rising unemployment of one of the highest in the history of US, requiring increased spending besides monetary easing. At the same time, taxes were never reviewed with tax rates virtually unchanged and on the contrary, as a response to the crisis in 2008, tax rates were lowered for boosting consumption in an attempt to revive growth. The fiscal crisis occurred when the US hit the ceiling of the overall level of debt of USD 16.4 trillion, which meant that deficit could not be sustained through increased borrowing as done in the past. Further with fears of breaching the cap, there also arose the likelihood of a default as bonds due for payment could not be done through more borrowing, unless the cap was raised. This resulted in the first ever down grade of the US rating by Standard & Poor in 2010. The Senate realizing the gravity of the problem passed a resolution of suspending the cap but with strict austerity measures in government spending and roll back of tax concessions given effective December 2012, resulting in a fiscal cliff, of the relative inability of the government to reduce spending and also raise taxes , in the wake of the growing un employment rates and marginal growth of the US economy. The US govt has to cut expenditure by USD 1.2 trillion over a 9 year period beginning December 2012. In view of the fiscal cliff, US congress has further extended suspension of the debt ceiling till May 19, 2013. The fiscal crisis of the US has not been resolved but only postponed and the fiscal cliff would resurface in May 2013.

EURO ZONE CRISIS

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Earlier European Union represented one economic market as an economic union with free trade with each other. The Euro Zone came into existence with the signing of Maastricht treaty signed in 1992, of a monetary union, one Central bank and single currency, replacing country specific currencies in the European Union. As a result The Euro as common currency came into existence in 2002, but of the 27 member countries only, 17 members of the EU accepted Euro as the common currency and became part of Euro Zone. Some of the members not opting for Euro (10) especially Sweden, UK, Switzerland which while accepted Euro, also had their own respective currency and not part of the Euro zone even though part of European Union. There are 6 other countries which have Euro as their currency but are not part of the Euro zone resulting in 23 countries in the world having Euro as their currency with 17 as part of Euro Zone. The Euro zone had structural problems ever since it came into existence: a) Of a union of dissimilar economies, difference in sizes, economic activities, resources, technology, levels of development and incomes. On the one hand the stronger economies of Germany, France and Italy and the other peripheral economies like Greece, Portugal, Spain etc. b) Some of the Euro Zone member had strong currency before Euro came into existence like Deutsche Marks (Germany), French Francs and the Italian Lira, while other had a weak currency like Greece (Drachma), Portugal (Escudo) and Spain (Peseta). Thus monetary union was not across similar monetary strengths of economies. c) The larger economies especially Germany had a current account surplus while others had a current account deficit largely with Germany. d) There was a Growth with Stability Pact amongst Euro zone members which was more of an understanding rather than a fiscal union of debt to GDP not exceeding 60% and deficit to GDP of not exceeding 3%, which was never adhered to by the member countries resulting in fiscal excesses, high levels of deficits resulting in large borrowings especially by what is referred as PIGS economies, comprising of Portugal, Ireland, Greece and Spain. (please refer to slides already distributed) The Euro Zone crisis is a Soverign debt crisis as it is government debt outside the country.

CYPRUS CRISIS
The Crisis Cyprus is a banking sector crisis, with volume of business m any multiple of its GDP, unregulated, high exposure to Greek bonds almost resulting in collapse of the second largest bank necessitating a bail out by European Central Bank.

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