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Tuesday, April 08, 2008

Financial crises and Recession risks

The current financial crises problem is a problem of capital destruction leading to recessionary risks.

The destruction of capital is happening at financial institution level and individual level. At the financial institutional (FI) level - where brokers who have guranteed capital (i.e. deals etc) are finding it diffficult to fund these commitments. At the individual level wherein individuals are finding it difficult to repay their debt.

The government and quasi- government institutions are targeting relief efforts at the first level. This is primarily to avoid a systemic default and thereby keep a channel open for aid to reach the second level. It is also logistically difficult to address the individuals directly. The recessionary risk, consequently, also attacks two levels - firms (broader than FIs) and individuals. The capital destruction puts a lot of strain on spending plans of firms making them costly. This also puts strain on individuals' spending plans. A slowdown in the consumer spending is catastrophic for an economy like US.

Now given the eminent slowdown in consumer spending, the FIs go into a mode of self preservation. They push the risks down the chain - through higher interest rates, higher equity contribution for same level of spending. This prevents the government aid from reaching to the individual (where it should actually flow). In fact even if now government were to push aid to individuals - institutions will nullify the effect by cornering higher share of the pocket from individuals for repayment.

This is primarily (and simplistically) why no recession-avoiding efffort will be of any use. The only beneficiaries will be share holders of financial institutions. Even those can realise the value in the longer term. In fact this aggravates the probability of recession by pressurising the marginal borrowers (who were good but just so) because of higher interest cost. The situation parallels that shown in movie Titanic where the people on rescue boats refused lower class passengers letting them drown to protect themselves. Fed has given the boat to the FIs and most likely FIs wont allow anyone (individuals) to get on board. The individuals will either drown sooner or later in the sea of debt! Here comes the iceberg - all hands to the bridge!

The best the regulator can do is to efficiently catalyze the process - i.e. lessen the pain on the down swing and push the economy back on to growth track.