Interesting read... About US Debt crisis etc

The last week was action-packed. First the US debt ceiling was raised,
which was considered good news (at least compared to what could have
happened).
But a couple of days later, the US stock markets plunged 500 points in a
single day, the biggest single day fall since the 2008 financial and
credit crisis. The week ended with rating agency S&P downgrading the US
debt rating from the highest AAA to AA+; the first rating downgrade for
the US in its entire history. Now there are reports on the US going into
another recession, called a 'double-dip' recession.
Meanwhile, in Europe, countries like Italy, Greece and Spain are seeing
severe debt crisis.

Common questions people may have:
- Is this recession related to the 2008 crisis or another one?
- Are the crises in US and Europe related?
- Why is the downgrade such a big deal?
- Why is the dollar depreciating?
- Why should I care?

Let's try to understand all of this.

Is this recession related to the 2008 crisis or another one?
Let's revisit history.

2001 to 2008
We all know what happened in 2008. But here's a quick recap anyway.
Between 2001 and 2005, a bubble was being formed in the US housing
market with real estate prices going up rapidly.

Banks too started lending aggressively to the housing market and in
doing that they created, what is now famous as the 'sub-prime' industry.
Sub-prime lending refers to lending to people who may not be eligible
for a loan under normal circumstances. Maybe they don't have a regular
job or income, or have defaulted in the past. Banks traditionally did
not lend to such people due to high risk of default. But since these
loans were mortgaged against property and property prices were rising
continuously, banks started doing so. If customers defaulted, they could
sell the mortgaged property.

But banks did not factor in the possibility of a fall in property
prices.
When the Federal Bank (the US equivalent of RBI) started increasing
interest rates, the sub-prime borrowers who couldn't afford higher EMIs
started defaulting and banks started selling off the mortgaged
properties. The more properties that got sold, the faster property rates
started falling.

Now these banks were faced with another problem, another animal. During
the same time between 2001 and 2005, the US financial markets had
developed a new product - a bond securitised against the mortgages. In
simple terms it means that the mortgage banks borrowed money against the
mortgages on the condition that they would repay to lenders as soon as
they recovered their mortgages. The lenders in this case were financial
institutions (like Bear Sterns, Lehman and Merril Lynch) who in turn
sold retail bonds to individuals.

Sadly, the repayment never happened. And institutions like Bear Sterns,
Lehman, Merrill Lynch and AIG were the casualties. Since the mortgages
were not honoured, the banks could not repay these financial
institutions who in turn could not repay retail investors. The same
thing was happening across Europe too who were holding these bad bonds.

This is what caused the crisis of 2008. Banks are the financial backbone
of an economy and a run on a bank is like a run on an economy. And we
are talking hundreds of banks here.

2008-2010
In order to prevent a run on the large banks, the US Government started
to bail out the failed financial institutions so that they didn't go
bankrupt.
They decided to dole out funds to these banks (the large ones) to the
extent of loss they faced. The important question: Where did they get
the money from?

As it is, the people in the country were in bad shape. People were
sitting on houses worth far less than their mortgages. They had
accumulated huge debts with little savings. People stopped spending and
unfortunately in the US, when people stopped spending, the companies
(dominated by processed and fast food, car makers and petrol companies,
retail) stop making money and send the economy into recession. Jobs were
starting to go. At this point, the Government could not raise money from
taxes. In fact, it had to cut taxes. Moreover, the country had fought
two expensive wars which had dipped heavily into Government surplus. The
amount for bailout required was so huge that borrowing from other
countries would have been expensive.

So the Fed decided to 'print' money to dole out in fiscal packages,
called stimulus packages; trillions of US dollars. Failing companies
were given money to survive; people were given money to spend. (There is
a fear that printing money causes inflation but that didn't happen
because firstly demand was low and secondly costs were kept low in the
US by cheap purchases from countries like China) For the time being, the
crisis was controlled.

During this time, smaller countries in Europe started facing trouble as
their banks held a lot of the bad mortgage backed securities. Iceland
went bankrupt. Ireland and Greece were running out of money.

2011
But the doling out of money was just a temporary solution. It only
prevented a further fall. It only prevented the loss of more jobs. In
the long-term, in order to keep the economy sustainable, in order to
reduce the deficit (the gap between Government spending and earning) the
US had to do something to create jobs within the country, to promote
sectors that created these jobs. And that of course is something that
will take time, especially with emerging countries like China and India
becoming strong hubs of manufacturing, service and job creation.

The fiscal stimulus did not help promote industry, did not help create
jobs.
All this while, while the US Government did not earn much by way of
income, it still had the same level of spending to do to keep up the
people's standard of living. This led to a widening deficit.

So in reality, the US never recovered from the blow of 2008. A double
dip recession is explained as follows: A double dip recession occurs
when the economy has a recession, emerges from the recession with a
short period of growth, but quickly falls back into recession.This is
what everyone fears will happen in the US now.

Are the crises in Europe and US related?
Yes. As we saw earlier, the credit crisis of 2008 had spread to Europe
where many banks were holding the bad assets of US banks. As a result,
many smaller European countries starting going down.

Now, even the bigger economies like Portugal, Italy and Spain are
feeling the heat. The problem across is universal: too much Government
spending compared to too little Government earnings.

If the European countries and people start spending less, this will
impact the US economy. The US exports a lot of things like software,
video games and all kinds of intellectual property to Europe.

In this global world, it's all related.

Why is the US debt downgrade such a big issue?
How did the US Government fund the widening deficit? It borrowed more.
It borrowed so much that it hit the debt ceiling. The debt ceiling is a
self imposed limit for US Government borrowing. Increasing the debt
ceiling was not by itself a difficult task because it was up to the
Government to decide. But increasing the debt ceiling would send a
signal to the rest of the world about a weakening US economy. So far,
the US economy and therefore the US dollar was the single strongest
currency in the world. The US Government had a great credit rating (AAA)
so it could raise money from other countries at very low interest rates.
Raising the debt ceiling would hamper its credit worthiness.

And that's exactly what happened. On Friday, the S&P downgraded the US
long-term debt to AA+. This would mean higher borrowing costs for the US
which in turn will affect the deficit or slow growth.

Why is the dollar depreciating?
The currency is a reflection of the strength of an economy. It shows the
credit worthiness of the country. If I hold dollars, it means that I
believe I will always be able to sell it at a certain price. There will
always be a buyer for my dollar. I will invest in US treasury bonds
because I believe the US will never default. I will always get my money
back. The dollar has been, for the longest time, the single strongest
currency in the world.

But the crisis over the last few years has shaken that confidence.
People have been selling dollars that they hold and buying gold (that is
why gold prices are going up). People believe they will no longer get
what they expect from the dollar. When people, institutions, countries
start selling dollars in the open market, there is an excess supply of
dollars. This brings down the value of the dollar.

Why should I care?
It's important to understand all these things, not only to improve
knowledge but also to be prepared. A US crisis will likely impact India
too; our IT exports will be affected. Foreign investments that we need
for our infrastructure development will reduce. While our domestic
economy is strong and has a large consumption base, we will still see
some slowdown in growth.

This is just a broad overview of the current crisis, put as simply as
possible.

http://blogs.economictimes.indiatimes.com/moneyhappyreturns/entry/explained-the-us-downgrade-double-dip-and-other-related-concepts

Thanks Lot good simple article got lot

Thanks a lot. It in simple terms and hence a lot can understand, Nice attempt and thanks again.