The Recession And Its Impact On The Economic - Essay Example

The Recession And Its Impact On The Economic Introduction According to the National Bureau of Economic Research, the US recession began in December 2007 and extended for 18 months, ending in June 2009. The years preceding the recession were characterized by increases in asset prices and thus resulting in a boom in economic demand. Moreover, the US non-depository financial institutions such as the investment banks grew and rivalled depository banks. These institutions were not subjected to regulatory oversight and they made it vulnerable to run banks (Cecchetti, 2008). The US mortgage-backed securities that were difficult to assess gained global demand because they offered higher returns. The securities later lost value following the US house bubble and mortgagers began to default in payment in 2007. The subprime losses that emerged began the crisis, which exposed other risky loans and overpriced assets. An increase in loan losses and the collapse of the Lehman Brothers in September 2008 brought a big panic in the inter-bank loan market. The shadow banking system caused major banks and financial institutions in Europe and US to go bankrupt and suffer huge losses. The crisis was majorly caused by the emergency of shadow banking system that included investment banks and non-depository financial institutions. The systems rivalled the depository system yet they weren’t subjected to regulatory safeguards (Tett & Gillian 2008). The housing bubble burst leading t major losses and default in mortgage payment. The accumulation of household debt prior to the crisis resulted in balance sheet recession. Consumers started to pay down debts which reduced their disposable income, thus slowing down the economy further. US government policies encouraged home ownership even to people who couldn’t afford it, resulting in lax lending standards, unsustainable increases in house prices and debts. Analysing the viewpoint’s Strength I support the approach which proposes for a simpler and smaller financial sector in which the size, power and complexity of the financial system are limited in important ways. A smaller financial sector has the strengths of providing more benefits to the economy. These benefits include a more effective monetary and fiscal policy, increased corporate financing, reduction in market risks and greater integration. A smaller financial sector has the strength and the advantage of influencing the government to develop sound and efficient monetary and fiscal policies. A sound monetary policy is a tool that regulates demand and supply for money by influencing changes in interest rates, open market operations and adjustments in commercial bank reserves (Barberis, 2011). In a smaller financial sector, the size of the financial markets enables the government to make sound monetary policies that address deficits and excesses of money supply in the economy as soon as they appear. This maintains the money supply in an equilibrium balance to avoid future financial crises. A fiscal policy is a tool that the governments use to manipulate taxes, government spending and transfer payments to regulate the demand of money in the economy. Fiscal policies ensure that demand of money doesn’t exceed the supply so that interest rates are kept in check to avoid inflation that may increase lending rates. An increase in the lending rate will increase the rate of default of payment for loans and other mortgage-backed securities, resulting in major losses and risk of bankruptcy for commercial banks (French, Leyshon & Thrift, 2009). This result in a financial crisis and in more serious cases, an economic depression that is difficult to overcome. A smaller financial sector increases the government’s efficiency and ability to form credible and quality fiscal policies that are able to restore the economic balance of interest rates before they cause a panic in the financial markets. This facilitates the government’s efforts to achieve macroeconomic growth in all sectors of its economy. Another key strength of a smaller financial sector is an increase in corporate financing. The concept of corporate financing is critical in financing of businesses by depository system such as banks and other regulated financial institutions. The small size of a smaller financial sector ensures that borrowers maintain a close relationship with financial institutions. This facilitates the credit rating process and risk assessment. These functions are important because they reduce the chances of default in payment, a factor that rendered many banks bankrupt during the 2007-2008 recession. Understanding the financial strength of the borrower is facilitated in a smaller financial sector because of the close relationships between market players (Ivashina & Scharfstein, 2010). The lenders understand their clients’ financial positions and refrain from lending to businesses that can’t afford to service loan obligations. The government also finds it easy to regulate corporate borrowing and lending in a smaller economy to prevent shadow banking systems from affecting how depository system work since the shadow systems are not subjected to regulatory standards. A smaller financial sector poses the strength of lowering the market financial risks. The financial market becomes concentrated and it is easier for information to penetrate the market. Financial information is easily diffused and absorbed in a smaller financial sector. As a result, market players make sound and rational decisions having considered all the effects and consequences of their investment decision (Cecchetti 2008). Availing the information hedges the risk of investors acting with limited information in purchasing investments that later fall in prices, making them panic and default in loan payments. It hedges the investment bubbles that always burst later and result in adverse financial consequences. Another strength of a smaller financial sector is that it allows for integration of major sectors that influence the soundness of the financial systems. For example, government functions in regulating the demand and supply of money through monetary and fiscal policies integrates well with the needs for money in a smaller financial sector. The government is able to monitor changes and integrate the needs of financial institutions while making financial policies (Erkens, Hung & Matos, 2012). The integration of financial policies with the needs of financial institutions creates a harmony that increases the soundness of financial institutions and public confidence in the financial systems. Investors are confident that their money safe, which reduces panic in the financial market and allow the financial system to be self-regulatory, thereby, eliminating influences of economic crises. Responding to the Criticism of the View Point A major criticism of smaller financial sector economies is the smallness of financial markets. A small financial market provides narrower range of services compared to a wider more democratic financial sector. For example, the foreign exchange markets in smaller financial sectors have lower turnover compared to that of wider and more democratic financial sectors. The money markets are thin and mostly dominated by overnight interbank cash borrowing (Reinhart & Rogoff, 2008). The small financial sector has less developed stock exchange with low trading of stock in the stock markets resulting in low economic impact of the stock exchange. The regional integration has limited impact in deepening the markets. In addition, the critics argue that there are few small financial sector economies that are successful except for Croatia and Jordan. To respond to the criticism, a smaller financial sector addresses the above problems by increasing the efficiency of financial market operations to cater for shortcomings such as the lower turnover rate of foreign exchange. A narrower range of financial services allows the financial sector to specialize and offer services of superior quality, ensuring quality differentiation and attainment of a competitive advantage against wider and democratic financial sectors (Volcker & Paul, 2002). Concentrating the exchange market on a narrower scale ensures that the regulation of foreign exchange is urgently carried out to maintain the stability of a country’s currency. In the more elaborate and democratic financial sectors, foreign exchange fluctuations are common. They offset the balance of trade and in some extreme cases, continuous fluctuations of foreign exchange results in financial crisis because a country may be unable to participate in global market trade if its currency keeps on fluctuating against others. As a result, a country may find itself in an economic crisis like it was experienced in the US during the 2007-2008 recession. Critics also argue that financial markets in smaller economies are underdeveloped. This result in small economies that face intrinsic obstacles which are large and go beyond the control of policy makers. For example banks in smaller financial sector economies are underdeveloped and uncompetitive. Since banks are the lending agents, the small number translates to less growth in the economy since companies lack funds to start, grow and expand businesses to boost the economy. A smaller financial sector had undiversified real economy that limits chances of transferring risks. To overcome the challenges of market development, smaller financial sectors use policies. For example, the development of sound policies to address the problem of excess liquidity in the banking sector. Excess liquidity put banks on the sale side of money markets (Taylor & John 2008). Policies hedge against dollarization that reduces the scale of local currency financial transactions. A smaller financial sector eliminates policy rigidity that hinders the efficiency of market operations and inability of markets to adopt to changes and absorb new information quickly in order to make sound and rational financial decisions. Why the Alternative View Point Doesn’t Represent the Best Way Forward The alternative view point argues that the problem is not that the financial sector is too large but that it has been directed towards the wrong kinds of goals and only promotes the interests of large corporations and wealthy households rather than society as a whole. Supporters of this second viewpoint often argue that a larger, but more democratic, financial sector is needed. I disagree with this viewpoint because a larger and more democratic financial sector has its own limitations that affect the effectiveness of financial policies. For example, it is very difficult to effect monetary and fiscal policies aimed at regulating the demand and supply for money in a wider financial sector economy. A wider financial sector has numerous financial institutions and financial systems that are affected differently by changes in interest rates, open market operation, central bank adjustments, taxes, and government spending (Tett & Gillian 2008). The diversity of financial institutions makes it difficult for the government to develop standard policies that cut across the wide financial sector. It is taxing and time consuming to make policies that are only specific to a certain financial institution. Lack of standard policies creates inefficiencies in the financial markets, resulting in poor crises management and thus economic recessions. In a wider and more democratic financial sector economy, market development policies are at times unrealistic and not tailored to the specific needs of the financial markets. The market development policies may be unrealistic because it is difficult to develop a single set of policies that work for the diverse range of financial institutions offering a wide range of differentiated financial services (McAndrews, 2008). This makes the effective implementation of market policies difficult and can cause chaos and confusion, especially if financial institutions are forced to implement policies that are ill suited for them. In addition, the opportunity cost of using public resources to make ineffective market development policies is very high in wider financial sectors that the smaller financial sectors. Regional integrating has the potential to address the problems of market development policies but attaining the integration is challenging for a wider financial sector economy. Instead of complementing local markets, regional integration replaces local markets, exposing the financial sector to higher risk of foreign exchange fluctuations and inflation. Furthermore, government intervention is only effective in attaining regional integration when individual institution’s interests conflict with market integration interests (Lowenstein & Roger, 2001) References Barberis, N. 2011. “Psychology and the Financial Crisis of 2007-2008”. Available at SSRN 1742463. Bordo, M. D. 2008. “An historical perspective on the crisis of 2007-2008 (No. w14569)”. National Bureau of Economic Research. Cecchetti, S. G. 2008. “Crisis and responses: the Federal Reserve and the financial crisis of 2007-2008 (No. w14134)”. National Bureau of Economic Research. Cecchetti, S. G. 2008. “Monetary policy and the financial crisis of 2007-2008”. CEPR Policy Insight, 21. Erkens, D. H., Hung, M., & Matos, P. 2012. “Corporate governance in the 2007–2008 financial crisis: Evidence from financial institutions worldwide”. Journal of Corporate Finance, 18(2), 389-411. 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M., & Rogoff, K. S. 2008. “Is the 2007 US sub-prime financial crisis so different? An international historical comparison (No. w13761)”. National Bureau of Economic Research. Taylor, John B. and John C. Williams, 2008. “A Black Swan in the Money Market,” unpublished manuscript, Department of Economics, Stanford University. Tett, Gillian, 2008. “US banks quietly borrow $50bn from Fed via new credit facility” Financial Times, 19 February, pg. 1. Volcker, Paul A. 2002. “Monetary Policy Transmission: Past and Future Challenges,” Federal Reserve Bank of New York Economic Policy Review, pg. 7-11. Read More