How Overvaluing Assets Causes Financial Crisis

Overvaluing Assets Is The Most Harmful Cause Of Financial Crisis

There are a number of causes behind financial crisis, and arguably the worst is the overvaluing of assets.

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Hundreds of years ago, financial crises were insulated. It was a problem that a country would face on its own. If one country plummeted, others would face little to no struggles in relation.

Today's economy has been globalized. Investment banks are global. Oil companies are global. Free trade is encouraged, and the exchange of goods and prices have high interconnectivity. As a result, a financial crisis in either the United States, China, or the United Kingdom can have a rippling effect on the rest of the world.

There are a variety of things that can cause a financial crisis. One of the most harmful is the overvaluing of assets. Overvaluing assets caused both The Great Depression and the 2008 Financial Crisis. What is overvaluing assets, and how does it really harm the economy?

The overvaluing of assets typically originates in the stock market. That's how it started both in 2008 and 1929. To better understand overvaluing assets, we can study the 2008 financial crisis.

Banks were engaging in risky lending practices in 2008 like sub-prime loans and mortgage-backed securities.

Subprime Lending: Typically banks don't lend to individuals with low credit or little collateral. In the '90s however, banks began to engage in this sort of lending. This made it easier for people, in general terms, to purchase homes. As a result, the demand for homes rose quickly.

Mortgage-backed Securities: Banks also started to trade mortgage-backed securities. These were essentially bundles of a hundred mortgages, packed together. These securities were categorized by risk and being sold and bought by different banks. But banks knew little to nothing about the ability of these borrowers to pay back their mortgages. Despite that, the securities were being traded.

Eventually, low credit borrowers began to default on the loans. The sub-prime loan business began to tank, recouping little to nothing on their loans. Even further, the mortgage-backed securities were valued significantly higher than what they were worth.

A simple example follows. Banks had originally believed they may get 70% of the borrowed money back. They reported such numbers as assets in their books. But since they didn't really know much about the mortgage-backed security they purchased, they were surprised to find out high rates of borrowers were defaulting. They were making pennies on the dollar. The public began to notice and as a result, lowered stock investments into these banks. The stock market began to decline, and financial institutions were losing tons of money.

In situations where banks are closing and need money, there are two options:

1) get a loan from another bank, or

2) get a loan from the Federal Reserve.

But banks were afraid to make loans to each other because they didn't know the real value of the banks who were borrowing. Would they be paid back or not? So loans from banks to save other banks declined. Interbank lending dried up.

This led to a credit crunch. Banks were afraid to loan to everyone. If you weren't a top of the shelf creditor, you weren't getting a loan from the banks in 2008. Because of this, saving increased and spending declined. Banks weren't making investments in firms or households. Capital decreased dramatically. Without a loan, how can a business buy all the new equipment they need? How can they finance some of their more costly processes? Businesses closed.

In the end, the decrease in capital led to lower levels of productivity, creating a vicious cycle of crisis.

There are a few things that can be done to fix it. In this situation, the Federal Reserve did its best to preserve financial institutions. They "bailed out" the banks. The economy took years to recover, even after the necessary measures were taken. This sort of financial crisis can be dangerous for an inept economy. But at times it can be difficult to avoid such situations. There is little that can be done to anticipate this sort of situation. Questionable bank practices are difficult to monitor, let alone their impact on the economy.

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Why Money Isn't Everything

What really matters in life are family, friends, and happiness.
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Everybody wants to be successful in life. People want to be rich, have a lot of friends, and become famous. However, what if instead of being rich with money, you were rich with family and people who cared about you? What if instead of having a lot of friends, you had a lot of happiness and health in your life?

Many people forget that money and fame do not lead you to the top. Having friends and family who truly care about you and obtaining a raw happiness from just living life are really what matters in my opinion. It all depends on people's values and morals.

Some people will say that money is what makes the world 'round. This is true. Unfortunately, money is a big factor in how we live our lives in today's day in age. However, money is not everything. While money can buy you a mansion, it cannot buy you a family to live in it.

When we think about success, we tend to think about these material items, but how sad would it be not not have anyone to enjoy them with? Life is supposed to be spent with the ones you love and care about. If money gets in the way of that, then maybe it is time to reassess your priorities in life.

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Politics And Economics Are As Important As STEM

Why you should care about politics and economics.

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It's common for people to come to the conclusion that politics, economics, and the humanities are questionable fields. Not useful. Not productive. Jobless. Nonsense.

I concede none of those points. In fact, I frequently find that politics and economics are extremely important to well-being and prosperity.

The stigma against political science is far stronger than that against economics. This opinion is likely because of the scientific and mathematical elements contained within economics as a discipline. Moreover, the economy is an important part of society. It affects our daily lives. It discusses our wealth, our country's performance, and the country's overall state of affairs. But most would argue that economics can't stand beside chemistry, biology, or engineering. That perspective demonstrates two things:

1) lack of critical thought, and

2) mob mentality.

The intersection of political science and economics determines everything. The world spins on the market. The market is undoubtedly influenced by government actors, politicians, politics. Don't believe me? Let's consider an example.

The stock market had expanded rapidly in the 1920s, but stocks were being overvalued. Companies were not actually worth their stock market value in the real world. People really wanted stocks, so demand was high — but this wasn't an accurate representation of how companies were performing. Investors began to realize this and started to sell overpriced stocks left and right.

Eventually, it became clear that investors were uncertain. Trades were being made at rapid rates, but the investors were selling stocks for cheaper than they had been purchased. Sixteen million shares were traded in one day. Everyone was losing money.

So naturally, consumer confidence declined. People stopped spending. They were afraid of losing money. This dramatic decrease in spending and investment led to companies producing less. Spending and demand went down, and subsequently supply went down as well. Companies stopped producing as much as they had been because they weren't selling as much as they had been. As a result, people were laid off. Households were losing jobs -- they were losing cash, causing spending to decline even further. So more people were laid off. You can see the vicious cycle. At one point, half of the United States' banks failed. Fifteen million Americans were unemployed. The world was in the midst of an economic disaster.

This situation is commonly referred to as the Great Depression. It went on for 15 years.

This is what economics studies. It analyzes, attempts to anticipate and hopefully, prevents these situations. Where does politics fit in?

Obviously, the government tried to respond to the Great Depression. Franklin D. Roosevelt was the president at the time. He passed a variety of policies to stimulate the economy. Yet the Great Depression continued until WWII. In fact, two UCLA economists concluded that FDR's policies prolonged the Depression by several years.

It's unimportant whether they are right or not. What is important is that the economic policy by Roosevelt (and Congress) certainly had an impact on the country's economy. In fact, it was the reason some people may or may not have had enough money to eat. It was the reason that people may or may not have had jobs. It was the reason people could or could not afford homes.

To argue that the intersection of politics and economics is a useless study would be out of touch. Economics and politics create or destroy the world we live in. The next time you're told that they don't, ask the person what would happen if the demand for STEM labor fell.

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