Causes of the Global Recession - Assignment Example

1. A fall in the total output of any economy over any significant interval of time is identified as a recession. The practice in the USA is to recognize a phenomenon of falling GDP as a recession if the situation continues for two consecutive quarters (three month periods) (Foldvary, 2007). This essay shall argue that the present global recession, often cited as the worst since the great depression of the 1930s with unemployment rates soaring the world across, was triggered in the US a by a financial meltdown in turn triggered by bursting of an unsustainable housing market bubble on top of the difficulties being faced by most major economies due to rising oil prices and commodity prices. The boom in the housing market preceding the crisis was created through offering and promoting unregulated subprime mortgages in pursuit of stimulating demands to combat the slowing down in the aftermath of the busting of the dotcom bubble which led to a growth in the housing market that exceeded incomes finally culminating to the collapse. To understand the present global recession and its causes, it is pertinent to first understand any economic recession theoretically. According to Keynesian effective demand framework, a fall in real aggregate national income is triggered by a reduction in the effective aggregate demand (AD) which is composed of planned real aggregate consumption expenditure (C), a function of real aggregate national income itself, planned real aggregate investment expenditure (I), a function of the rate of returns on investment (r), Government Expenditure (G) which is usually taken to be autonomously determined and finally net export demand (defined as the difference between export demand and import demand, i.e., X - M). Now, in the Keynesian framework, there is sufficiently excess capacity to ensure prices and wages are sticky in the short run and thus a fall in aggregate demands leads to a fall in output. This fall again dampens demand for consumption expenditure which in turn leads to reduced aggregate demand and in turn reduced real aggregate output. This mechanism continues and the real aggregate income goes on falling which is tantamount to a recession. Thus it emerges that a recession must be triggered by a fall in any of the components of effective aggregate demand. (Mankiw, 2002) In fact a recession is a part of a business cycle that the economic growth of all advanced economies experiences. The idea of the business cycle is that the growth path of real aggregate output follows an oscillatory trend with the rise gradually moving onto a peak where after a reduction or contraction follows until it reaches a bottom and begins to move up once more. The movement towards the peak from the bottom or the trough is the period of expansion while the movement down from the peak to the trough is the period of recession. A period of recession is identified to be a depression if the real aggregate national income falls below the long run average trend. (McConnell & Brue, 2005) The expansion of the economy is supported and sometimes facilitated by monetary expansion on part of the monetary authority. This includes measures such as reducing the rate of interest to induce higher investment demand. This boosts the aggregate demand thereby leading to an upward spiral of rising real aggregate income. However, as the demand for investment rises there is a rise in interest rates which increase the cost of production. Further the rise in incomes which motivates greater consumer spending, thereby lead to higher commodity prices. Increased demand to invest in financial assets leads to risen asset prices. All these factors combined lead to a fall in real aggregate demand and thus a slowing down of the economy thereby triggering the downward movement (Foldvary, 2007). Often, to prevent or to restrict this downward movement, governments resort to expansionary monetary and fiscal policies to stimulate demands and motivate increased investment and consumer spending. As will be showed in what follows, the present crisis was in essence an outcome of such a monetary stimulus that targeted enhancement of induced investment primarily in housing markets without considering the associated risks of imbalances that could create an unsustainable and unsteady bubble. The trigger to the crisis in the USA was the collapse of the mortgage-backed security, a particular derivative type in 2008 which has been strongly attributed to lack of regulations on the financial markets and particularly on derivatives. Particularly the expansionary policies adopted by Alan Greenspan, the former chairman of the US Federal Reserve like federal funds rates being reduced to 1 percent along with resisting suggestions of implementing regulations on the financial markets (Faiola, Nakashima & Drew, 2008). However, as mentioned earlier, these were expansionary steps taken in 2002-2004 that targeted stimulation of demand to move the economy out of the recession that had been looming large over the American Economy since the bust of the dot.com bubble in the early 2000s (Pettifor, 2008). The causes of the failure of these expansionary monetary policies lies in the boom and bust trajectory of the US housing market with the market reaching its peak in the period 2005-2006. Driven by the combined effect of lowered interest rate induced demand boosts and strong inflows of foreign funds made conditions congenial for relaxing credit conditions which motivated increasingly larger numbers of people to take home loans which thereby led to increased home prices and fuelled the growth of the housing sector further. With sufficient liquidity loan agencies in an attempt to increase consumer bases increased disbursement of loans and relaxed conditions substantially. Increasingly larger numbers of people were induced to take home loans and risks of default were overlooked. Loans were forwarded to people without ensuring repayment capacity properly and sometimes people with bad credit histories received loans. Loans forwarded to people with doubtful repayment capacities are recognized as sub-prime lending. However, this stimulated an initial surge in the growth of the housing market but the expansionary policies fuelled by monetary excesses spurred a housing boom which was inevitably trailed by a severe slump. This led to large scale defaults, disintegrating mortgages and thus collapsing mortgage backed securities and thus finally culminating to the crisis on a global scale with a large number of the largest and most trusted banks, investment houses and insurance companies either declaring bankruptcy or requiring financial rescues. 2. The 1930s are marked as years of great significance for economic theory as they invalidated the classical notion known as Say's Law. It was postulated that "supply creates its own demand" and thus a laissez faire or non-interventionist policy of governance was optimal for the economy. However, the era of the great depression were characterized by situations of massive piling up of unsold stocks in the form of inventories and gradually mounting numbers of unemployment. These were the years that saw the birth of Keynesian economics. Neoclassical economics that was the basis of economic governance prior to the depression assumed wage-price flexibility and predicted that any excess supply problem would be resolved automatically through price adjustments in the related markets. However, the importance of effective demand emerged through its absence as it was the primary cause for the depression. Pointing out the downward rigidity of wages and prices in the short run Keynes showed that it was effective demand that would eventually determine the level of equilibrium output and consequently, employment. And that a depression was in essence a situation of a lack of aggregate effective demand that manifested in the form of falling level of real incomes and employment thus cyclically aggravating the predicament. The resulting lack of consumer and investors confidence would gradually act as strong deterrents and compound the problem. (Krugman, 2009) Therefore, government interventions were essential to kindle demand. The money market and the commodity market were two alternative channels through which demand stimulation could be targeted. The commodity market operations would involve stimulating effective demand through directly increasing planned government expenditure or reducing taxes to increase disposable income. This is known as an expansionary fiscal policy and is typically envisaged as an outward shift in the IS curve. Money market operations would typically involve constraining or expanding the money supply in the economy which were expected to stimulate demand through affecting the rate of interest and thus investment demand. Expansionary Monetary policy is in effect tantamount to a rightward shift in the LM curve. (McConnell & Brue, 2005) It was also exhibited that during severe depression, monetary policies may be ineffective and fiscal policies would be the only way out. This was termed as a case of a liquidity trap. The idea was that in a severe depression the rate of interest may hit a floor beyond which it did not move and thus render stimulation of investment through monetary policy untenable. In essence if the rate of interest became so low that every one believed that it would not fall further and would rise soon such that a fall in bond prices was impending, then no one would hold bonds and everyone would hold cash. As a consequence the demand for bonds would not rise and thus nor would bond prices thus preventing any reductions in the rate of interest rate (note that bond prices are inversely proportional to the rate of interest). This situation is represented in the diagram below. However, in the case of liquidity trap, expansionary fiscal policy can be effective. Since it stimulates demand directly by increasing government expenses, there is a rise in equilibrium output for every rate of interest and thus manifests in the form of a rightward shift in the IS curve. Note that in the diagram above, if instead there was a rightward shift in the IS curve, there would be a rise in equilibrium output as well. Thus, what emerges is that the depression of the 1930s proved that macroeconomic problems are not necessarily best left to the market system itself. Active intervention in the form of monetary and fiscal stimulants is crucial to rescue the economy from difficulties like depressions. However, in light of the preceding discussion it also emerges that the successive failures of many monetary expansion attempts to enhance effective demand do reflect the necessity of a large fiscal stimulus in the lines argued above. References: Faiola, A, Nakashima, E & Drew, J (2008) "What Went Wrong", The Washington Post, 2008-10-15 http://www.washingtonpost.com/wp-dyn/content/article/2008/10/14/AR2008101403343.html'hpid=topnews&sid=ST2008101403344&s_pos= Retrieved on April 15, 2009. Froyen, R.T., (1996) "Macroeconomics: Theory and Policy", Tata-McGraw-Hill Gandhi, J. (2008, October 19). Global Recession - Causes. Retrieved April 12, 2009, from http://ezinearticles.com/'Global-Recession---Causes&id=1597698 Krugman, Paul (2009) "The Return of Depression Economics and the Crisis of 2008", W.W. Norton Company Limited, New York Lindbeck, A. (1993) Unemployment and Macroeconomics, MIT press Mankiw, H.G (2002) macroeconomics 5th ed, Worth McConnell, C.R, & Brue, S.L., (2005) "Macroeconomics (16th Ed)", McGraw-Hill, NY Pettifor, A (2008) "America's financial meltdown: lessons and prospects", openDemocracy.net, http://www.opendemocracy.net/article/america-s-financial-meltdown-lessons-and-prospects, Retrieved on 2009-05-04. Tatom, J (2009), The Superlative Recession and economic policies, MPRA Paper No. 13115 Taylor, J (2009) "How Government created the Financial Crisis", Wall Street Journal, Monday February 9th Read More