Economic Collapse Overview, Executive Summary
James Li, June 2006
With financial giants such as Warren Buffet forecasting economic doom, one has to wonder why. This paper essentially serves to illustrate some of the most pressing economic issues, including the ballooning American debt, the aftermaths of the housing bubble burst, and the unpredictable impact the derivative market currently has on the financial sector.
Government deficits are at an all-time high: the United States currently has an $8.8 trillion federal budget deficit, while also incurring an $862.3 billion annual current account deficit. Recent United States fiscal policies have not helped, as 2001-2003 saw some of the largest tax cuts in recent history coupled with extraordinarily large sums in spending. The issue of American health care reform and social security also looms in the nearby future. Estimates of projected costs and funding for the two programs combined for the next several decades amount to be a staggering gap of $33 trillion. The choice may well be described as one between the young and the elder, since either spending will have to be cut or taxes must be raised. The US trade deficit is also becoming an increasingly critical issue, with large sums of capital inflow directed towards the production of consumption goods rather than more productive capital goods. Capital inflow, warn many experts, is bound to stop when economic and investment opportunities outside the United States begin to look more attractive. The issue of personal debt also looms in the prospect of American economy, with consumer bankruptcy filings increasing dramatically from 300,000 in 1980 to around 2 million in 2005.
The collapse of the subprime mortgage market, the effects of which are still reverberating throughout the economy, can have dramatic effects on the consumer market and pension funds as well as on GDP growth in the US. On top of the wealth effect, the housing market has become intricately tied to the consumer market after consumers begin to back up their purchases using their mortgages and property values. Thus, a decline in the housing market, in theory, will inevitably lead to a broader decline in the consumer market, which is essentially driving the US economy. Furthermore, the eruption of mortgage-backed security purchases that accompanied the rapid growth of the housing market is now leaving many investors—particularly those in China and US pension funds—holding securities that are worth much less and that face possible downgrades in credit ratings. Many such financial institutions have invested heavily in this area, and with a projected 25 – 30% increase in expected downgrades, many such institutions are in danger of becoming financially insolvent.
Perhaps more emphasis should be placed on the $415 trillion derivative trading market, having grown 60% from just 4 years ago. The over-the-counter nature of most derivative trading contributes to its lack of transparency and central regulation, while events such as the collapse of the Barings Brothers in 2000 and financial crunch of Bear Stearn’s in 2007 demonstrate just how immediate and pervasive the effect of derivative trading has on the rest of the financial sector. With over 99% of derivative trading based on monetary movements rather than the real economy (i.e. tangible assets), derivative trading itself depends upon volatility to thrive. Even Warren Buffet, the successful investor from Berkshire Hathaway, warns about the fickle nature of derivatives, calling them “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
The American economy is heading into a time of volatility and uncertainty. While systems of rescue and balance exist to counteract negative impacts of influential factors, the need for greater awareness and less complacency is imminent. Unsustainability in governmental finance and the flaws in our financial system must be acknowledged and addressed in a timely manner.
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