Recession of USA - Research Paper Example

?Introduction Developed world including US is currently passing through a strong economic recession which has crippled the whole economies of these countries. What started as a small subprime mortgage crisis in US soon culminated into a bigger crisis engulfing the whole financial system of US and subsequently its economy. As a result of this, the economic growth slowed down, unemployment level increased and subsequently government has to intervene in order to help financial system and the economy to survive one of the toughest economic recessions in the history of US. There has been lot of discussions on the factors which has actually created the crisis and how they further deepened it. The initial response included the criticism on the subprime mortgage crisis and how financial institutions exploited this market in order to book higher risks in the accounts. Subsequent discussions also included the failure of the regulatory bodies to have an effective check on the financial institutions and their behavior, role of fair value accounting as well as the greed and lust of financial institutions to focus on achieving short term profitability while ignoring the long term impacts of the same on the viability of the system. This paper will attempt to explore and understand as to what factors resulted in these crisis, how the crisis deepened, what was the initial response of the government, did it worked, how the policies of current administration are different from old and finally how does it measure to the short run and long run macroeconomics of the country. What caused the recession in US? A mild recession in US existed in early years of 2000s when US, after witnessing a decade of economic prosperity started to show the signs of economic recession. This recession however could not last longer as it only existed for less than a year. It is also important to note that such type of recession was also experienced by European Union and other developed countries also. This was however, considered as a natural reaction of the economy after reaching its peak in most of the developed countries including US. This was also a period when dot com bubble burst and top level corporate frauds and scandals started to emerge. During the early 2000 NASDAQ crashed due to the dot com bubble and FED also started to increase the interest rates. It is believed that the consistent and gradual increase in the interest rates by FED also contributed towards the creation of recession in the economy during early 2000s. (Ruddy, 2006) This was also a period of 9/11 when terrorist attacks on US resulted into the sharp decline in Dow Jones as well as its impact on different sectors of the economy specially airline industry. Further, US has to divert significant resources towards the war thus increasing the government expenditure. This recession however, was not as damaging as the recession which started to emerge during 2007 as a result of the financial crisis in the country. The current economic recession in the country is therefore a direct result of the financial crisis which started to emerge during 2007. The financial crisis in US started with the subprime mortgage crisis when the subprime mortgage holders started to default on their obligations. Subprime borrowers are those borrowers whose credit history is not good and they could not obtain the credit on normal terms and conditions. Due to their overall situation, they pose a greater risk therefore in order to lend them, it becomes imperative for the banks to charge them higher interest rates. Based on the risk and return criteria banks therefore started to lend to such borrowers in a bid to earn higher profitability while ignoring the risks associated with such borrowers. The issue however, became critical when the banks started to securitize their subprime mortgage portfolio and issued mortgage backed securities offering subprime mortgage portfolio as collateral. (BROOKS & SIMON, 2007). When subprime borrowers started to become delinquent on their obligations banks found themselves short of cash flows. This was due to the fact that securitization process can only work if the cash flows paid out to the holders of the mortgage backed securities are matched with the cash flows received from the subprime mortgage holders. However, with the default of the subprime mortgage borrowers a mismatch between the cash flows arose and banks have to divert their own funds towards the repayment of their obligations against the mortgage backed securities issues against the mortgage portfolio. This therefore created credit crunch in the economy because the funds which should have been lent by the banks were diverted towards the repayment of obligations of the banks. This therefore technically started the credit crunch in the US economy and crisis started to emerge. (Nanto, 2009) How crisis were deepened? The overall crisis started to deepened when banks started the foreclosure of the homes of those borrowers who became delinquent. Another important reason for the deepening of the crisis was the credit crunch which reduced the flow of credit to the private sector and thus reducing the availability of the credit. One of the immediate impacts of the credit crunch was the reduction in the consumer finance which potentially reduced the purchasing power of the consumers to spend. Due to this reduction in the purchasing power, overall demand for goods and services started to reduce and the firms found themselves in difficult situation to generate the revenue and meet their costs. Due to systematic reduction in the demand from the consumers, businesses started to incur losses and therefore in order to further prevent the losses, they started to lay off their employees. This therefore increased the unemployment in the economy and invariably put further pressures on the aggregate demand in the economy. (Ellis, 2008) The foreclosures of the homes also resulted into the sharp decline in the property values thus cooling off the property market at really rapid pace. It is also important to note that due to the reduction in the property values, banks and financial institutions have to make extra provisions in their accounts because of this. Extra provisioning due to reduction in the collateral values therefore resulted into the heavier losses for the banks and other financial institutions also. Thus what started as a subprime mortgage crisis soon started to hurt almost every sector of the economy. Firms like Ford and General Motors were forced to take extra ordinary measures due to the fact that low consumer demand and low consumer finance reduced the demand for new vehicles and thus greatly affecting their profitability. (Baily & Elliott, 2009) The overall crisis became worse due to the integrated nature of the economy and how the different sectors in the economy were linked together. Due to the credit based nature of the US economy, demand for goods and services is largely dependent upon the availability of consumer credit. Once the consumer credit i.e. credit cards, personal loans, auto loans, started to shrink, the demand for goods and services started to suppress and hence economy started to slip into the recession. During this period not only the gross domestic product of the country started to decline but the overall unemployment level also started to increase. Lack of employment therefore further put pressure on the economy as unemployment further reduced the purchasing power of the consumers ultimately resulting into the sharp decline in the growth. (Stewart, 2008) The crisis also spread to other countries due to the overall integrated nature of the global economy and how global banks transact with each other. Firms like Lehman Brothers were true giants with presence in many countries and their failure therefore also started to trigger same chain of events in other countries also. How government responded to the crisis? The initial response of then government of George Bush was the gradual injection of taxpayers’ money into the financial system. The overall objective was to ensure that the liquidity in the market remains at reasonable level and it was because of this reason that the interest rates in the economy were reduced in order to provide necessary stimulus to the financial system. The discount rate offered by FED was gradually reduced to allow banks to borrow at relatively lower interest rates. (Barnanke, 2009) Government also started to inject its own equity into the financial institutions and other firms in order to keep them alive during the difficult times. The equity injection was made in order to ensure that the capital base of the financial institutions is quickly replenished as well as the banks remain solvent. Under the troubled asset reform program, approximately $700 billions were injected into the economy in order to ensure that the institutions remain solvent and liquid during the crisis times. Apart from this, President Bush also signed a stimulus plan of more than $160 billion under which income tax rebates were offered directly to the tax payers. The above actions however, could not proved successful as decrease in the interest rates as well as the income tax rebates resulted into the increases in the prices and therefore nullifying the potential impact of the support provided by the government. New Administration Policy The response from the Obama administration is also considered as a continuation of earlier approach adapted by US government. It is also important to note that the US government along with the banks and financial institutions initiated, on case to case basis, the loan modification process in order to allow the borrowers to avoid their homes being repossessed. During 2009, Obama administration announced the Homeowners affordability and stability program under which approximately 9 million homeowners would be able to avoid the foreclosure with the help of the government. Under this program, US government injected $73 billions into the economy to allow homeowners to avoid the repossession of their homes by the banks and financial institutions. FED has continued to exercise the option of quantitative easing wherein money supply in the system was kept at large level through artificial manner. This policy is being continued by the FED to create the money electronically by expanding the balance sheet of the FED and to ensure liquidity in the market. These measures seem to be focused on achieving the short term stability in the economy. These measures therefore are focused on ensuring that the demand is not suppressed in short run and besides unemployment level is kept within manageable limits. Course of Action Quantitative easing and fiscal stimulus by the government has been successful in achieving stability in the US economy. There are now clear signs indicating that the US economy is slowly recovering from the recession though it has not completely been out of this. Fiscal stimulus has resulted into partly increasing the purchasing power of the consumers in order to revive the aggregate demand in the economy. In order to take a better course of action, it would have been better if FED could stop the process of quantitative easing permanently and allow the financial institutions and banks to meet the challenges on their own. A better regulatory support such as changes in fair value accounting, better corporate reporting, replacement of credit ratings as well as more aggressive fiscal expansion, would have created lasting impression on the economy. It is also important to note that the fiscal expansion has not been direct in the sense that most of the money has been channeled in order to allow the firms to resurrect themselves from the economy. A better approach would therefore have been a decrease in the taxes as well as better and more coordinated open market operations by the FED. In order to successfully negotiate with this, I would have gradually increased the interest rates as well as decrease the money supply in the economy. It is also important to note that actions must also be taken in order to ensure that the surge in prices is minimum and recovery is not hit by the inflation as its being hunting UK now. I would therefore have increased the discount from its current level in order to ensure that the expected changes in inflation can be easily met. Bibliography 1. Baily, M. N., & Elliott, D. J. (2009, June). The US Financial and Economic Crisis:Where Does It Stand and Where Do We Go From Here? Retrieved March 13, 2011, from Brookings: http://econ.tu.ac.th/archan/rangsun/ec%20460/EC%20460%20Readings/Global%20Issues/Sub-Prime%20Financial%20Crisis/Sub-Prime%20Financial%20Crisis-%20Topics/Country%20Studies/USA/US%20Financial%20and%20Econ%20Crisis.pdf 2. Barnanke, B. (2009, January 13). The Crisis and the Policy Response. Retrieved March 13, 2011, from Federal Reserves: http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm 3. BROOKS, R., & SIMON, R. (2007, December 3). Subprime Debacle Traps Even Very Credit-Worthy. Retrieved March 13, 2011, from The Wall Street Journal: http://online.wsj.com/article/SB119662974358911035.html 4. Ellis, L. (2008, September). The housing meltdown: Why did it happen in the United States. Retrieved March 13, 2011, from Bank of International Settlements: http://www.bis.org/publ/work259.pdf?noframes=1 5. Nanto, D. K. (2009, November). The Global Financial Crisis: Analysis and Policy Implications. Retrieved March 13, 2011, from Congressional Research Service: http://www.fas.org/sgp/crs/misc/RL34742.pdf 6. Ruddy, C. (2006, Jan 31). Alan Greenspan's Real Legacy. Retrieved March 13, 2011, from NewsMax: http://archive.newsmax.com/archives/articles/2006/1/31/90119.shtml 7. Stewart, H. (2008, April 9). IMF says US crisis is 'largest financial shock since Great Depression. Retrieved March 13, 2011, from Guardian: http://www.guardian.co.uk/business/2008/apr/09/useconomy.subprimecrisis Read More