What Caused the Present Economic Recession - Case Study Example

What do you think caused the present economic recession? An economic recession is a phase in the business cycle where a slowdown of the economic activity occurs. Every economy experiences the peaks and bottoms of a business cycle that brings about wide fluctuations in the various macroeconomic indicators. Since all the economies follow a business cycle, there are periods of different growth namely, high growth, low growth and no growth. The RBC (Real Business Cycle) theory remarkably explains the economic fluctuations and shows how the economic variables change while the economy moves along the crests and troughs of the Business Cycle. During a recession an economy hits the rock bottom of the business cycle; all the major macroeconomic variables suffer from a decline. Economists agree that this downfall is due to decreased aggregate demand, which leads to cyclical events of low production, low income, and low savings. This vicious cycle continues to operate, often spirally, until some corrective measures in form of investments get injected into the system. The picture of the economic recession is portrayed by a series of negative values of the GDP. But a deep search into the cause of recession will lead to ultimately rest on several quarters of positive GDP growth (growing slowly) seen in the economy much before the economic recession actually started off. There are various hypotheses that suggest that an economic recession is supposed to last for consecutive two quarters but practically there is no such defined time period for economic recession. (What is Recession? Economic Definition of Recession, n.d.) Present Economic Recession: Source and Origin The current global economic recession rests on the major economic fluctuation in U.S. economy. Being the largest economy of the world, with GDP of $13.84 trillion in 2007, US market leads the rest of the nations. In today’s world of trade liberalization, USA shares trade relations with almost all the nations of the world. Hence, any shock experienced in USA is transmitted immediately to other economies resulting in a greater shock for the global economy. (USA Economy, American Economic Profile, Economy of the United States of America, n.d.) The latest global economic recession is also a result of the major bubble that occurred in USA’s housing market. Bubbles are often noticed in the financial markets, especially when the investors strive for innovations without agreeing on the asset prices.(Tomilson B., April 2009) The major failure of the USA’s credit and housing market has resulted in slogging down its growth. This is well manifested by the growth rate of GDP in the years 2007 and 2008. In 2007 the country showed a GDP growth of 2.2% while in 2008 it was a meager 0.9%. (USA Economy, American Economic Profile, Economy of the United States of America, n.d.) USA Housing Bubble The exceptional appreciation in house prices of USA produced several effects on the economy. There was a rapid increase in constructing housing projects. The price rise in housing market was followed with the exceptionally low interest rates issued by Federal Reserve. The cut in short-term interest rate by Federal Reserve Board was a corrective measure for the economic recession of USA in 2001. This low interest rate was followed by the sub prime lending by US banks as individuals found the mortgage lucrative than before. Such subprime lending led to extremely easy home loans which ultimately resulted in NINA (No Income No Asset Loans). According to NINA, loans were granted people without any strict verification of the official documents of income. The mortgage lenders were driven by the optimistic view that the lenders will rarely default. The perceived return from the stock market was thus low and caused the crash in the stock market in 2000. The slump in the share market led to a change in the perceptions of the investors. Investors were encouraged by the high returns on assets and switched to holdings of assets, favoring the housing in US. This further boosted the housing market and caused appreciation in house prices. (Bursting of the US housing bubble, n.d.) Investment Banker’s Role As huge loans were granted, the mortgage backed securities attracted the global investment community. (Bursting of the US housing bubble, n.d.) Due to the involvement of the global investment community in the US housing market, there was a formation of speculative bubble. With the increase in easy loans the homeownership rate rose and the following factors were noticed: Dramatically low nominal interest rates. Elimination of the wealth constraint from the US mortgage securities market. Development of ‘Sub-prime mortgage market”. Development of the home equity loans market.( Goodman A.C. and Thibodeau T.G.) The speculation, by the investment bankers regarding the loan holding and mortgage securities, led to the exceptional rise in house prices. The soaring prices of the houses made lender confident to cover up the debts of the defaulting borrowers. This wrong speculation ended in enormous foreclosures. (Could Risky Mortgage Lending Practices Prick the Housing Bubble?, September 2005) The house price appreciation affected the individual consumption significantly. There was a huge chunk of loan seekers who were unable to repay the loans. The volume of defaulters soared high and consequently brought about the crash in the home equity loans market and sub-prime mortgage market. Government’s Role The housing bubble was further boosted by the credit bubble formed from the Federal Reserve’s policy of lowering down short-term interests. This policy made the loans considerably cheaper than before. ARMs or Adjustable Rate Mortgages, based on 1 year interest rate became cheap compared to 30 year fixed mortgages. In this kind of loans borrowers enjoy a low interest rate for the first twelve months which is then followed by annual rate changes governed by the market conditions. Naturally the payments can thus be adjusted every one year. (Could Risky Mortgage Lending Practices Prick the Housing Bubble?, September 2005) By the year 2004, ARM rates were 194 basis points cheaper than the fixed mortgage rate of 30 years. Borrowers were noticed to rely on the Federal Reserve’s lowering of the interest rates for as long as they kept their mortgages. The market value of real estate is thoroughly boosted by low interest rate since real estates are long-lived assets. The exceptionally loose monetary policy of Federal Reserve allegedly caused the price boom to occur in US. (White L.H., November 2008) All these above factors caused a demand bubble to form in the US market. Buyer borrowed huge amount of money and were unable to pay the interest. Consequently there are enormous foreclosures. The high expectation created in the home equity loan market and mortgage securities market were affected adversely leading the giant investment banks like Lehman Brothers to massive lay off. The booming housing market of USA halted abruptly form 2005-2006 reflecting reduction in sale of houses and falling prices. (Slowdown in US Housing Market and its Impact, n.d.) The decline in the house prices were largely attributed by two distinct forces- the loose monetary policy and the fading speculative enthusiasm of the investor. The upshot of the housing bubble consequently led to the recession in US economy. Comparative Study of Nations Presently, not only USA but several other financially robust countries are also facing the heat of the US recession. The biggest European economy, Germany has also countered the recession. Its GDP is falling by 0.5% for the year 2009. The picture of the Germany recession is expected to worsen with the rise in unemployment and fall in the consumer sentiment. (How Long Will Germanys Recession Last?, November 2008) Japan which is world’s second largest economy is also on the verge of recession as its GDP has declined by 0.1% in 2008. The sharp drop in trade volume in 2009 has also sown signs of recession in Japan and it is expected by the government that the problem can amount to an alarming situation. (Japanese Recession Hits Hard as 2009 Exports Plummet, April 2009) However Asian countries like China and India has been lest affected by the US economic recession. The prime reason is the strict trade relations the governments of these countries maintained with US. The strict macroeconomic framework of these nations, with reference to the commodity exports has helped them to suffer lest from the heat of the economic crisis. Today, government around the world are cutting interest rates and increasing the supply of money to the economy in order to try to counter the fall in economic activity and well being. In the 1930’s during The Great Depression governments did little and hoped that markets would take care of themselves. Which do you think is the right approach to solving such crises and why? The major economic catastrophe that occurred in USA in 1929 was named the Great Depression. The economic disaster of 1929 was a result of a series of events that took place in the country. The first and foremost event to notice was the sharp fall in the employment rate. A quick glance on the various macro economic variables will produce a clear picture that shows how the economy faced a downfall. According to the US statistics, the unemployment rate in the country was 3.2% in 1929 which increased massively reaching an alarming figure of 25% in 1933. The reason of this high unemployment was the lack of aggregate demand in the nation. This caused the economy to produce less than what it can produce with its high rate of employment. There was a sharp fall in the GDP of the country which was mainly attributed by the decline in consumption (this was a result of mass unemployment) and reduction in the investment purchases. The sharp fall in the investment purchases was the prime cause of pulling down the GDP volume. The reason to pit forward this fall in investment purchases is the real interest rate. Due to the dramatic inflation during that period the real interest rate was high which affected the investment purchases of the country. (Watkins T., n.d.) Prior to the Great Depression in 1929 the US government followed a lassiez faire economy, where the economy was left on itself to get stabilized. The then economists followed the idea of Adam Smith who believed in the mechanism of invisible hand in the market. But the disturbance created in the US market during 1929 could not be fixed with the theory of Adam Smith. Excess supply of labor and goods need an alternative method for its correction. It is during the 1929 that the alternative theory of Keynes came into the economic forefront. Government intervention shaped the theory of Keynes. According to Keynes’s view government played a crucial role in the remedial measures of Great Depression which was a contrast the prevailing economic theories. Keynes proposed expansionary fiscal policy which aimed at greater government spending. The idea behind the suggestion was that if government starts spending for the infrastructure more jobs will emerge in the market wiping the severe unemployment problem. Then with the chain effect of multipliers the GDP will also rise. (Roy U., n.d.) The present global economic recession which first hit the US economy, was caused due to the collapse of two noted institutions namely, Federal National Mortgage Association and Federal Home Loan Mortgage Corporation. These institutions went bankrupt creating a huge turmoil in the US economy. (Watkins T., n.d.). The fundamental cause of the current recession is the surplus formed in the financial market. Unlike the depression in 1929 thus time USA noticed a dramatic rise in the consumption levels. The consumption especially in UK and USA observed a rise more than the rise in their GDP. The factor that led to such exceptional rise in consumption is the low interest rates. The sudden collapse of the Lehman Brothers caused the worldwide freezing of the commodity and credit markets. The result was the dramatic fall in the equity prices. Consequently the US GDP is expected to fall by 2% between the mid 2008 and mid 2009. The unemployment rate is also observed to rise from 7.5% to 8%. (Mussa M., December 2008) One of the largest insurers of US, AIG sought the government bailout to survive in time of recession. The US government provided a hefty $85 billion for rescuing AIG. Presently the financial backing of the US government on AIG is a prime issue. The issue of AIG stands at the center of the global economic crisis and the present US government is planning to bail out more funds to this insurer. (AIG bailout benefits European banks, raises questions, March 2009) The greatest casualty of the economic recession is Merrill Lynch. The bank had written down assets worth $40 billion in the last year. And the recession has put it on the knife’s edge with bad mortgage debt. The bank has sold itself to Bank of America in order to survive in this tough time. The Bank of America made the deal which is worth $50 billion and is expecting to become the next financial giant. (Lehman Bros files for bankruptcy, September 2008) Due to the globalization the heat of the US recession has dissipated into the global economy and has been reflected by the poor trade volume figures. It is expected that in 2009 the global trade volume will fall by 2.8%. The world trade volume experienced a sharp fall in the last few months of 2008. The repercussion of the financial crisis has also shown a major thrust in the global growth rate. The world growth rate has slowed down form 4.9% in 2007 to 4.1% in 2008. (IMF Sees World Growth Slowing, With U.S. Marked Down , January 2009) The growth rates in the most advanced economies of the world are facing a slump. A look into the countries like Japan, Germany and UK displays the global slowdown very clearly. Japan which is world’s second largest economy is also on the verge of recession as its GDP has declined by 0.1% in 2008. It faced the automobile crisis due to the pricy automobile fuels. This caused the automobile customers to turn away from the huge sport vehicles. The country is also suffering from the heat of the global credit crunch. The falling GDP of Germany also manifests the country’s recession. The GDP of Germany is expected to fall by 0.5% for the year 2009. However, the developing countries of Asia have shown promising results despite the global economic crisis. The Asian countries especially China and India has expanded strongly due to the effective and disciplined macroeconomic policies followed within these countries. The policy framework in these nations is more disciplined in regard to the commodity exports. It is expected that strict trade relations of China and India with US is the reason of getting least affected by the economic crisis. In the aforesaid circumstances of the global economic crisis the macroeconomic framework should be oriented in a way to restore the previous conditions in the credit market. This can be done by offering correct stimulus which can assure quick recovery form the recession. The freezing of the global credit market from September 2008 brought about an awful threat to the world economy. Unlike the previous global financial crisis, this time the policy authorities have instantly reacted to the crisis. Federal Reserve has expanded its net credit from nil, 15 months back, to $1.5 trillion presently. Central bank in US has also introduced trillions of dollars into the short term credit market and interbank. There has also been a massive expansion in the insurance coverage deposits for the interbank. Government has taken the instant initiative to assure the financial institutions by providing financial solvency through large capital introduction. With all the enormous efforts of government intervention to control the economic crisis, it is expected that financial crisis can calm down quickly. The idea behind this forecast is that the constant policy aid of the government can help waive the severe situation of the credit market which occurred in September-October 2008. In the present condition the fiscal incentives taken by the government is expected to improve national purchases and produce a modest increase in the local and state government purchases. (Mussa M., December 2008) The upshot of the above analysis shows that government intervention is necessary in the present context of global economic recession. A proper and disciplined macroeconomic framework that boosts liquidity in the economy is essential to stabilize the present condition. 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Economic Definition of Recession, No Date, Kush Media, [Online] Available: http://recession.org/definition [April 17, 2009] White L.H., November 2008, Federal Reserve Policy and the Housing Bubble , Cato Institute conference “Lessons from the Subprime Crisis,”, [Online] Available: (http://72.14.235.132/search?q=cache:eWxaEEQa5c4J:pages.towson.edu/baetjer/PolEconProj/White%2520Cato%252008%2520Federal Reserveeral Reserve%2520Bubbles.doc+US+housing+bubble+investment+bankers+site:edu&cd=2&hl=en&ct=clnk&gl=in [April 17, 2009] Read More