Government Intervention in an Economy

Early America Let's look at history for a guide. In the beginning of America's history, America had a predominantly Laissez-Faire economy, besides the National bank, tariffs, and the government arming the military with private sector weapons. [1] Keynesian Theory With government intervention in an economy, the government can smoothen out the bumbs in the business cycle that are inevitable. The government can use government spending and/ or tax cuts to stimulate the economy, reducing unemployment. The government can also buy/ sell bonds to lower or raise interest rates (respectably). Later, when inflation threatens, the government can raise interest rates and/ or raise taxes moderately to curb inflation. [2] [3] Plus, government spending creates a multiplier effect, which is when funds are directed to consumers with a high propensity to consume, the $1 spent by the government results in $1.50 in economic activity. [4] Now let's take a look at an example in which government intervention didn't exist but then came in. The Panic of 1907 is an example. The stock market fell about 50% in about a year. Many local businesses entered bankruptcy. The crash was caused by less liquidty and more unregulated derivatives. [5] Private banker J.P. Morgan organized a swift response to the crisis, and the Treasury also injected cash to shore up the banking system. A national crisis was averted. Now, if there was no response from the government, the crisis would of gotten worse, despite the efforts from J.P. Morgan. Still, the cooperation worked the best. [6] The Great Recession: The Case for Federal Regulation -----------Background---------- The Great Recession resulted from a lack of regulation and subprime mortgages, which could of been limited from federal regulation. Subprime loans are risky loans are have usually variable rates. The beginning of the massive use of Subprime mortgages made it more likely that more homeowners would default. However, subprime mortgage usage was regulated well before 1980. Strict laws controlled who could get mortgages, and if you couldn't get a mortgage, you don't get one. [6] When deregulation occurred, although more citizens got homes, risk was high. When these people failed to pay for their homes because of the variable rates, the mortgage went bad. This information will be important soon. When DEREGULATION occurred in the 1980s and 1990s, it sometimes had pretty bad consequences. When the Gramm–Leach–Bliley Act was passed in 1999, larger banks were allowed to merge, creating less competition, and more risk if one was to fail. [7] Between the mid 1980s and 1999 increased securitization laws were passed. These extremely complex laws encouraged the usage of subprime loans. These devices are called derivatives. With derivatives, investors couldn't accurately assess what the risks of their investments were. These were basically bets, bets that betted on people's ability to pay back questionable loans. When many Americans defaulted in 2006-2009 (subprime mortgage crisis), the values of these derivatives dropped hugely, and sending the FEW LARGE banks in a tailspin. [6] These derivatives also allowed investors to bet on other things as well, such as the weather. An investor could also bet on, well, just about anything, including a person putting an insurance policy on your house. [9] Also, the banks got much of their income from buying and selling these derivatives and CDO's, which resulted in massive bank failures as seen in 2008. [6], [10] When CDO's went bad, so did some derivatives, which was huge for Wall Street. CDO: Collateralized Debt Obligation; a security that is a combination of several unpaid loans such as student debts, credit card debts, mortgages, etc. However, people who wanted investments on Wall Street such as us couldn't assess the risk of these CDO securities. We would look towards what ratings given by the ratings agencies such as Standard and Poor's, Moodys, etc. However, because OF A LACK OF FEDERAL REGULATIONS, the big banks paid the ratings agencies to change the rating to AAA, the highest rating possible. So, in affect, they gave these risky debts a HIGHER CREDIT RATING THAN THE U.S.A. [10] That is totally absurd, and a great case for regulation. Also, all of these deregulations complicated the banking system in the U.S. because instead of local banks controlling the mortgage payments, loans, etc., they sold them to one of the top big financial sector businesses, which sold them around the world, complicating the process. Also, the people who took out the risky loans were usually enticed by the banks through Predatory Lending. With federal regulation, these consumers (who some were gullible) would not of been taken advantage of. [6] Conclusions As you can see, federal regulations could of made sure that derivatives were transparent and rated accurately for consumers. Predatory lending could of been made illegal. Plus, less bank merges would allow less threat to the economy. With less government regulation in the economy, the process can very well happen again and be MUCH WORSE. Why is that? Well, the total derivatives market is over $700 TRILLION dollars in value. [8] However, many don't complain about that and instead complain of government food stamps. Other businesses have to be regulated as well to make sure their employees get safe working conditions and such. However, the most MASSIVE case for federal regulation is on Wall Street. True, the S.E.C. and a few other institutions regulate Wall Street already, but many have been very lenient on this task, and let the banks get away and just charge fines and then the case is settled. Sources: [1] http://economics.about.com... [2] http://www.wisegeek.com... [3] http://www.investopedia.com... [4] http://www.investopedia.com...[5] Yale M. Braunstein, "The Role of Information Failures in the Financial Meltdown", School of Information, UC Berkeley, Summer 2009[6] "What You Should Know About Politics... But Don't" By Jessamyn Conrad --A Nonpartisan Guide to the Issues [7] http://www.symtrex.com... [8] http://seekingalpha.com...[9] Capitalism: A Love Story (movie 2009) : documentary[10] Inside Job: documentary