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There is a feeling that in extending a last-minute $85-billion lifeline to American International Group (AIG), the troubled insurer, and now with the proposed $700 billion in new money to be pumped into the system to prevent more ailing banks and other financial intermediaries from sinking, the US has now changed in course away from the path of the free market to that of a government aided economic system. Well, who says the market could not fail?
In the classical economics scheme of things, the free market economy is set to correct itself when it verges away from full employment. This was proven to be untrue in the 1930s with the Great Depression when up to a fourth of the workers in the US were out of work. The Great Depression had for its solution the New Deal that required the US government to intervene in many aspects of the economy. The US government's role in the economy is said to decline with the return of the free market ideology in Reagan's time that we also copied in some way on the advice of the World Bank and the International Monetary Fund to where we run for help when in trouble. Think of deregulations for example that former presidents Cory Aquino and Fidel Ramos bannered in their time.
Now the financial meltdown in the US that started with the collapse of its subprime loan market has reached a point that many believe already require a drastic action of the New Deal type to contain it. This is supposed to be coming now with the proposed $700-billion rescue plan that the US Treasury and the Fed submitted to Congress for approval.
News of the rescue plan immediately reversed the worldwide stock market fall but doubts of its efficacy and its implication to the fiscal health of the US government is now troubling the market again. The US Congress, which vowed to cooperate with the Treasury and the Fed, is still discussing the final form and details of the $700-billion rescue plan. How it would finally look may not matter much anymore if the people in the market still believe that more are still needed to clean up the mess in which the US financial market is in now.
Why is the US financial market mess here now? In his blog and New York Times column, US economist Paul Krugman summed what happened as follows:
1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities - assets whose value ultimately comes from mortgage payments.
2. These financial losses have left many financial institutions with too little capital - too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.
3. Because financial institutions have too little capital relative to their debt, they haven't been able or willing to provide the credit the economy needs.
4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”
We are told by the BSP that the Philippines has very limited exposure to Lehman that folded up after failing to get cash injections and the just bailed-out AIG. Still, when the US stocks goes down, the Philippines stocks also goes the same way. This proves that there is more between the Philippines and the rest of the world than just the level of our exposure to Lehman and AIG that makes us vulnerable to what happens outside or in the US.
Many of us also tend to think that because ownership of stocks is not common in the country, the impact of the US financial crisis will not be felt much by our people. In the surface and for now, that may be true but not when the US will finally succumb to the much feared recession that is expected to follow with the deepening of its financial trouble. That is why the success of the $700 billion rescue plan also matters much to us. For although we are no longer dependent on the US market for much of our exports as before, when the US economy goes into a recession so does many other countries in the world in which we have significant economic ties, like Japan and the rest of Asia and some countries in Europe.
So it pays to prepare like ensuring that local demand which had been the caused for much of our growth in the past is not unnecessarily curtailed through such moves as limiting the budget deficit to look good to foreign investors who are not coming anyway for many other reasons or in raising the local cost of money or interest rates to fight inflation when this only constricts domestic business activities, leading to lower number of new jobs created.
