Was the Federal Reserve Effective in Its Management of the Great Recession - Essay Example

Lecturer: Due The Federal Reserve was not effective in its management of the “Great Recession” From early 2007to June 2009, the world economy faced the greatest economic recession after the great depression of 19. The recession was characterized by many huge financial institutions seeking funds from the Federal Reserve as a lender of last resort, huge firms like the Lehman brothers collapsed, the recession led to difficult times to the citizens with soaring unemployment and rising inequality. This paper examines the role that the Federal Reserve played in response to the great recession and whether or not that was the right way to handle it. There were a lot of actions that the Federal Reserve took in its wisdom to handle the recession including the purchase of long term credit, bailing out Bear Stearns, accepting low quality assets. These actions as the paper discusses were ill advised. It also accesses the alternative decisions and whether or not there is need of oversight of the Federal Reserve and or whether it is even important to have a Central Bank to prevent such lapses in decision making. The “Great Recession” can be said to be the decline in international economy as observed in world markets during the first decade of this century. In the USA the recession began in early 2007 and extended to mid 2009. The recession was caused by mainly by the burst of the housing bubble in mid 2007 leading to a housing market correction and subprime mortgage crisis. Other reasons included failures in financial regulation including the Federal Reserve’s ineffectiveness in toxic mortgages stemming. Many financial firms also took large risks. The recession led to a loss of close to 8.7 million jobs from February 2008 to February 2010 and reduced the US GDP by 5.1%. Unemployment reached a peak of 10% in October 2009. Today the economy is yet to recover from the effects of the recession that is the worst since the great depression. There is still high unemployment, with job growth being uneven. There had been signs of a recession in early 2008. According to Alan Greenspan, the recession was to be the worst after the end of the Second World War(Alan 8). The trough was attained during the second quarter of 2009; this marked in technical terms the end of the recession. To handle the recession, the USA announced an economic stimulus plan. First, the Treasury announced a $50 billion program that would insure investments. There would also be temporal exemptions on section 23A and 23B to allow easier sharing of funds by financial groups within their groups. 799 of short selling financial stocks were terminated by the Securities and Exchange Commission to respond to the mortgage crisis. This would according to the government help curb the recession. The Federal Reserve refers to America’s central Bank. It plays a critical role on the economy especially during recession. Among what it is charged with is the sale or buying of government debt. It can also give cash or credit to businesses. The Federal Reserve can also raise or lower the interest rates dependent on the prevailing economic circumstances. During the economic recession the Federal Reserve had already exhausted all these options. It reduced long term interest rates to make borrowing cheaper for both businesses and consumers. It also bought off mortgages in order to raise cash to buy mortgage and government bonds. It also provided lines of credit to financial institutions in order to provide money for consumer loans and buying. The Federal Reserve also loaned money to J.P Morgan Chase to enable the firm to take over Bear Stearns. The Federal Reserve later established financing and a credit line for the government acquisition of American International Group (AIG) a global insurance firm. One of the initial actions that the Federal Reserve took in response to the economic crisis was the purchase of financial assets and the issuing of emergency loans to various financial institutions and the sale of Bair Stearns and consequent bailout of Fannie Mae, Citigroup, Freddie Mac and the American International Group. This was a wrong move. The Federal Reserve would have let these institutions fail and encourage a huge de-leveraging of the economy at the time so as to increase both investments and savings. It is critical to realize that an economic crisis is representative of misallocation of productive resources. During this time, the best action would be to allow market participants to direct their resources to higher valued uses from the lower valued ones. This means that the market should liquidate bad investments in order to make them present for other uses once investments are realized to be mistakes. Despite the fact that both human and physical resource cannot be reallocated in a costless and instant manner, contracting parties should negotiate without the central bank’s intervention. The Federal Reserve acted in a completely antagonistic manner by bailing out financial institutions that were insolvent at the time hence preventing in all ways possible, investors from liquidating any bad investments. Rather than them going through both bankruptcy and reorganization, leading to the replacement of poorly performing executives, they have received a lot of money and the executives remain at the top. This bailing out of financial institutions reminded financial institutions that-too-big-to-fail was part of the operating policy that now included non-banks and medium sized financial institutions. This bailout policy kept in place and there was an extension for support on banks and other financial institutions earning high returns on assets that were risky but many of these losses were shifted to the taxpayer. There was a shift in policy by the Federal Reserve; the change of too-big-to-fail policy that allowed the Lehman Brothers to fail and days later the bailing out of the American International Group (AIG) by investing $180 Billion is a perfect scenario. Some economists argue that. The Federal Reserve’s policy that let the Lehman Brothers collapse was a mistake that worsened the recession (Meltzer 17) .These policy shifts led to uncertainties over what would follow. Financial institutions and other firms responded by increasing in high percentages the demand for cash. The Federal Reserve in return acted as the lender of last resort to the financial markets both in the USA and abroad by the increment of cash assets. The Federal Reserve had indicated that this increment of cash assets was only on short-term assets that would decline over time and be withdrawn. When this did not happen, the Federal Reserve replaced the short term assets with longer term assets and consequently allocated credit to stimulate the housing market by the buying, as earlier indicated of mortgage related securities. This was given an explanation that the holdings would reduce with time as borrowers paid both interest and an amount of principal. When this did not happen, the Federal Reserve had to buy long term treasury securities to avert a shrinking balance sheet. The Federal Reserve also in response to the recession purchased more than $1 trillion long term mortgages to be sold later when the inflation rises. This purchase is credit allocation and it is virtually impossible to sell these mortgage related securities while the housing market remains troubled. The sale of Treasury securities to finance mortgage is a fiscal operation. The fact is that money does not change, and these purchases lead to a reduction of the interest related payments to the treasury. The sale of two year treasuries in a bid to finance the buying of long term bonds does not in any way alter the money or reserves. It is an act of debt management, a role of the treasury. During the 2010 summer, the Federal Reserve adopted a QE2 bond purchasing program; this was in response to financial markets commentary, warning of a likely deflation and recession. Market speculators benefited by purchasing long-term bonds ahead of the program. The predictions of the financial markets commentary were wrong. The Federal Reserve’s actions too did not prevent the prediction. This is so because soon after the Federal Reserve announced the buying of $600 billion of treasury debt that was long term, the excessive reserve rose to $500 billion. In return the US dollar fell against most currencies and some countries bought the dollar in order to slow down the exchange rate appreciation, hence taking up a huge chunk of the remaining $100 billion. The exchange rate depreciation in return raised the prices of imports. Later on after the end of the QE2, the Federal Reserve announced of its intention to keep a near zero rate for federal rates for the next two years. This was so as to avoid the rise of future interest rates. This in return is proof that markets think that inflation is not likely for the Federal Reserve. However the exchange rates and prices painted a completely different picture. The US dollar actually depreciated by 15% against weaker currencies, market commentaries does not focus on the dollar because the Federal Reserve does not check the exchange rate. The “Twist the Yield Curve” that failed during the early 1960s has being recently employed by the Federal Reserve. This has being through the purchase of long term debt and the consequent sale of short term debt. This however is not a monetary action because both money and reserves do not change. The Federal Reserve had again responded to market commentaries and in advance the market reduced its bond yields leading to the gaining of some speculators. Actions such as these do not help the unemployed. The reason the Twist the Yield Curve failed mainly because traders sell what the Treasury purchases hence leading to a reverse of the change in yields that the Federal Reserve attempts to achieve. Unlike the thinking many share that the burst of the housing bubble was not due to irrational exuberance neither was it due to corporate greed or failure of regulation. What caused the burst was the highly expansionist monetary policy of the Federal Reserve under the then Chairmen Greenspan and Bernanke. Soon after the crash of the dot-com the Federal Reserve turned into printing press, in 2001. They increased the monetary base by 5.6% to 8.7% in 2002 and 6.7% in 2003 while the MZM rose by 15.7%, 13.0% and 7.3% in those years. Chairman Greenspan later reduced the federal funds rate from 6.5% in 2001 January to 1% in the June of 2003 and kept the level at a constant 1% to late 2004. This credit infusion led to the overinvestment in the housing sector and many other industries in the economy that are capital intensive. This was aided by Federal Government policies that aimed at reducing the home ownership rate by softening the standards of underwriting. Although the Federal Reserve and other leading financial institutions can claim to have handled the recession well. There were massive public losses resulting from ill advised decisions and the failure of the system particularly the Federal Reserve to foresee the coming of the recession. The recession led to the loss of 8 million jobs in the United States, and unemployment falling 6percent from its peak and in a major departure from other post 1945 recessions. Johnson (2011) A lot of questions arise today on the ability of the Federal Reserve to singlehandedly deal with an economic crisis. Attempts by the congress to increase its oversight and governance over the Federal Reserve faced a lot of criticism with some economists stating that ‘the Federal Reserve must not be audited, governed or supervised in a serious manner’ Klein(2012). If the Federal Reserve has the congress as its oversight, there would be the advantage of a more solid and stronger governance and also greater transparency. Exposure of the Federal Reserve’s monetary policy for instance to the scrutiny of the congress would exert pressure on the Federal Reserve to be more concerned about achieving short term political goals. There have also been arguments about whether there really is need for the existence of Central Bank. Money just like any other commodity, milk, vegetables has the ability to regulate itself in the market. This is because, money is a commodity that is selected and governed by the choices of the business people and the consumers. The modern world trade involves paper currency and electronic payments opposed to the then payments of gold and silver. According to the Austrian School, the government attempts to regulate the money supply by in order to create distortions in the economy by warping of the capital structure, interference of relative prices of commodities and in overall encouraging poor investments that in the long run are manifested in the cycle of business. Money value should be determined by the market during the day to day exchange between money and goods and services. Despite the Federal Reserve’s ability to look ahead where today’s policy becomes the futures reality, enhanced by the Rule-like behavior it excises, there is need for more in order to improve stability( Johnson 24) . The dollar has significantly depreciated against the Franc, Yen and some other currencies. There is need for the United States, the Bank of Japan and the European Central Bank to agree on a common inflation target. A country that pegs its currency to one of these three would have a fixed exchange rate and low inflation. Meltzer (2009), the exchange rates of all the three currencies would gain against those that peg. In return, markets would check the commitment to decreased inflation. However, the recession presents great lessons to the financial sector and the Federal Reserve. There is need to be more cautious in predictions and the mistakes made should be averted incase another recession hits the global economy. Works Cited. AH Meltzer (2009). Federal Reserve Policy in the Great Depression. Retrieved from www.hoover.org/.../meltzer_federal_reserve.com on 28th Nov Greenspan, Allan. “We Will Never Have a Prefect Model of Risk” Financial Times. 22nd Sept 2008. Meltzer, Allan. A History of the Federal Reserve: Volume 1, 1913 to 1951. Chicago: University of Chicago Press, 2003. Peter G. Klein (2012). Federal Reserve Folly and the Great Recession. Testimony before the U.S House Committee on Financial Services. Retrieved from www.independent.org/issues/article.com on 28th Nov 2014 Simon Johnson (2011)Great Recession: The Federal Reserve Shouldn’t Brag About its Response. Read More