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Wednesday, February 20, 2013

Cause of the GFC explained in less than 2 minutes

Over dinner recently, one of my friends asked how the sub-prime mortgage crisis in the United States caused the Global Financial Crisis (GFC). I explained that although the sub-prime mortgage debacle received all the publicity, it was more a symptom of the cause rather than the cause itself.

So then my friend posed a challenge to me. He wanted me to explain to everyone at the table exactly what did cause the GFC, but I had less than two minutes because he didn’t want me boring them all!

So here is my two minute explanation as to how the GFC occurred:

Pretty much from the 1970s attitudes started changing about the economy, and the role of government in commerce. By the late 80s, we were well and truly living in what was referred to as a “free market” economy where consumers and store owners (supply and demand) controlled the market with little government control. This is what lead to the privatisation of services such as utilities and transport.

The logic behind the “free market” economy was that with no trade restrictions to act as barriers to their creativity, entrepreneurs would be encouraged to generate wealth.  Then, as people became wealthier, it was expected that the wealth would subsequently cascade down so that everyone would benefit. Basically, the world would be saved by free economics.

In actual fact the above scenario didn’t achieve a cascade of wealth, it lead to “crony capitalism” whereby private companies were free to influence the market with little regulation. This fostered the perfect breeding ground for collusion, corruption, and concealment (as an extreme example, think Enron). Transparency was a thing of the past…

So all this meant that financial institutions, including banks were not answerable to anybody, and in the spirit of the “free market” economy, took the entire world down the drain a la GFC.

How did I go for less than two minutes? Obviously I could write pages on the topic, but that’s my absolute really simple explanation, and let’s face it, life’s complicated enough without complicated financial definitions...

So what does it mean for us now? Well the authoririties are working double time to compensate for their error in judgement by bringing control back into the equation. While trying to control terrorism, they also want some control over the media, financial industry, electronic media etc. I guess they want to kinda nip that “law unto themselves” idea in the bud.

The problem is, and history suggests this was always bound to happen, they are swinging the pendulum too far the other way - from no restrictions to major restrictions. This of course has an impact on how much risk people will take and how much people will buy/invest because the future is so uncertain.

History also suggests that a happy medium will be reached eventually. In the meantime, we need to accept that volatility will be an integral part of our investing lives until the dust settles. For more information on how to best deal with this, refer back to my birthday musings program and blog of 7 February.
Talk soon,

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