Friday, December 19, 2008

Cascading Economic Problems

Source: "Sustainable Developments: Blackouts and Cascading Failures;" January 2009; Scientific American Magazine; by Jeffrey D. Sachs.

Jeffrey Sachs uses the metaphor of power outages cascading through the grid to explain the current financial crisis. Borrowers defaulting on sub-prime mortgages cause banks to lose capital, which causes them to reduce new lending (with a multiplier effect since banks lend more than they hold in capital), which led to a failure in short term lending to banks, which led to banks selling mortgage backed securities, which led to a reduction in their value, which became cyclical. With the problems in banking, lending drying up, companies cut back in manufacturing and sales, laying off employees, which led to consumer fears and cutbacks, which had a cyclical effect on demand and business. In these processes, international financial markets participated, and eventually imports fell. Thus the contagion spread to other nations.

I have not read the suggestion, but I wonder whether the spike in oil prices was not involved. (Certainly the precipitous drop in those prices was a result.) But the energy crisis earlier this year resulted in increases in prices of everything that uses energy in its production or distribution, and thus hit the poor in the pocketbook. Did that trigger the mortgage defaults that triggered everything else? I am not suggesting that we would not have had the overall crisis eventually had the oil prices not shot up, but the timing seems suspicious.

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