The Role of Quantitative Easing in Distorting Equity Markets - Research Paper Example

? THE ROLE OF QUANTITATIVE EASING IN DISTORTING EQUITY MARKETS LEADING TO A DISTORTION IN THE LABOUR MARKET Executive summary The US economy has faced severe financial breakdown during 2007 and since then it is suffering from the after effects of recession. The Euro zone is also victim to housing market crash during the same period and is still struggling to recover its economic condition. However, since mid 2009, these economies are showing signs of recovery, although fragile. The problems that are still persistent are high rate of unemployment, low investment, low inflation and income level. According to experts, this economic growth rate is insufficient for bringing high standards of economic performance in these economies. The governments in these countries have been actively taking policy measures, such as quantitative easing and easy monetary policies to boost up the economies and increase level of economic performance. Table of Contents Table of Contents 3 Central Bank Tools Discussion 5 Recent Recession and its effects 8 Equity Markets Bubble in Banking Sector 9 Compare QEs in US, EU and Japan 10 Effects on the Labour Markets 11 Conclusion 12 Works cited 13 Name of the Student Name of the Professor Course Number Date The role of quantitative easing in distorting equity markets leading to a distortion in the labour market Recessionary background The financial crisis that had hit the America and the European Union in the 2008 has come to an end in the 2009, according to economists. However, the effects of crisis have been lingering around for the last four years. The financial crisis had ruptured the financial system and has consequently affected the entire global economy. As the financial drought has neared its end in the year 2009, think tanks consisting of economist and politicians from around the world have been investigating the root cause of global crisis. The actual reason has yet remained a debatable discussion. However, near consensus has been reached on one factor that has led to the financial breakdown; high default rate on the subprime mortgages. In the Europe, high liquidity had led to high level of risky transactions in the real estate market. Loans were provided at low rates of interest and without accepting fair amounts of security. Some of the large financial institutions that were affected the most in this scenario were, Lehman Brothers, Bear Sterns and Northern Rock (Weisberg, “What Caused the Economic Crisis?”). This financial down turn had caused economic activities to slowdown in the Europe and the United States. This has been the primary reason behind the global recession in the first decade of the twenty first century. The effect of the financial crisis has been an elongated one. The extent upto which the effect of recession in the European Union is being experienced is a longer period of time than the actual period of time for which the financial break down had occurred in these countries (Arcega, “European Recession Now Longer than 2008 Financial Crisis”). The countries in Europe are still striving to recover from the after effects of the crisis. Out of the seventeen nations that follow the common currency, Euro, nine countries are in the state of recession in 2013. While in general recession lasts for four quarters in a financial year, this recession is lasting for more than six quarters. Central Bank Tools Discussion In general, the central banks raise lending activity indirectly by cutting the rate of interest. Lower interest rate encourages investors to make higher levels of investment. People are also induced to spend more. But when rates of interest come close to zero, the central bank cannot further lower the interest rate (“What Is Quantitative Easing?”). It has the last option of directly injecting higher amount of money in the economy. The central bank can do this by purchasing assets (usually in the form of government bonds). This raises the level of money supply in the economy. The financial crisis that occurred in the United States and the Europe in the mid-2007 has arouses the concerns of politicians and academicians alike. As the recession deepened, questions were raised about financial instability in these countries. Discussions related to the financial condition in the financially collapsed countries primarily cast their attention on the fundamental role of the Central Banks in these countries, during the period of crisis. The basic role of the central banks is to manage the structure of economic system in the country and prevent chances of aggravating the crisis. The central banks have responded to this state of turmoil by making widespread use of new as well as existing tools, such as, monetary and fiscal policies. The fundamental motive behind these measures is to increase economic activities in the economy so that these activities might support economic growth in these economies. An economy faces recession when it suffers some kind of demand shock or supply shock. These shocks are sometimes deliberately brought in by government actions in order to bring the economy back to equilibrium. However, certain economic shocks lower the economy’s aggregate demand critically and the economic activities slow down thereby further affecting aggregate demand in the economy adversely. Such shocks lead to financial crisis (Mankiw and Ball 49). It involves sharp fall in asset prices in the economy followed by failure of financial institutions in the country (“Aggregate demand”). During the financial crisis of the 2008, the Central Banks in the different countries have taken actions to increase money supply in the economy so as to raise the economy’s aggregate demand. This has created the image of lender-of-last-resort (LOLR) for the banks and the financial institutions operating in the economy. As the economy is submerged in deep financial crunch, the Central Banks assumes the role of lender for the financial institutions to save them from failing. It has remained a question whether the traditional tools followed by the policy makers remain adequate enough to make effective impact on the economy in the stake of current liquidity crisis (Cecchetti and Disyatat 29). Central banks can follow three different tools that they use in order to influence the level of liquidity available in the economic system. The first tool is to act as the lender of last resort (LOLR). While acting as the LOLR, the Central Bank lends or borrows “in the open market” (Cecchetti and Disyatat 32). It implies that these transactions are directed towards the economy as a whole. These operations of liquidity management constitute modifying the repo rate and the reverse repo rate. Although these actions are not made to bring specific impact on some particular institutions in the country, they are designed to alter pressure of liquidity shortage in all the sectors in the entire economy. The second tool refers to the power of the Central bank to buy or sale assets “in the open market” (Cecchetti and Disyatat 32). These operations cast a long lasting influence the level of aggregate supply of money in the economy, which is regulated by the country’s Central Bank. These activities are typically conducted through the sell and purchase of “sovereign bonds denominated in either domestic or foreign currencies” (Cecchetti and Disyatat 32). This tool is comparatively new than the other traditional tools generally used by policy makers. Asset purchase is made by the Federal Reserve of America after the country has been into recession for a long period of time. Prior to this incident of financial crisis, such interventions by the government were rarely found in the asset market. These transactions are made with the aim of affecting the price level in the asset market. Although this purpose of the government has been contested, it is often justified by citing the clause of correcting the fundamental misalignment that has been created in the asset market between demand, supply and prices; and that rise in liquidity would boost up economic activities in the country. This action is a part of monetary policy taken by the government and it is driven by the two fold mandate of “promoting maximum level of employment and achieving stability in prices” (Mayer 184). The third and final tool present at the hands of policy makers is that, the country’s Central Banks are powered with the authority to conduct specific transactions that are directed towards particular institutions in the country, rather than the entire market or economy as a whole. Unlike operations made in the open market, the central banks take these actions according to its own discretion. These transactions involve the channelization of liquidity to some particular institution or from some institution directly, and these transactions can be “either collateralized or uncollateralized” (Cecchetti and Disyatat 32). Instances of such discretionary operations can be found in emergency lending assistance provided by the central banks to the financial institutions traditionally or other standing facilities. Recent Recession and its effects The recession has cast widespread effect on the American and European economies and also the rest of the global economy. These effects have been most vividly visible between the last quarter of 2008 and the second quarter of 2010 (“The Global Impact of the 2008-2009 Recession”). Among the different economic factors that can be used to measure the impact of recession in the economy, are level of unemployment, yields earned on investments made on stocks and equity and overall growth of gross domestic product in the economy. According to results found from recent studies, nearly 39 per cent of the households have been unemployed during this period. Many of these households have had negative yield on equity or had incurred huge amounts of debt. Unemployment has cast significant impact on the economy; in terms of diminution in level of spending by the common households in the country. Price trends in the stock market showed average negative expectations. Pessimistic stock market in turn affected the investment climate in the economy, since expected returns on investment were very low during this period, particularly in the long-run expectations. Since the level of unemployment has been very high and unemployment trend was on the rise, works suffered from insecurity and nurtured high expectations about the loss of job. Therefore, workers were discouraged from joining fruitful work opportunities thereby driving down productivity level in the economy. The overall scenario in these economies slackened (Hurd and Rohwedder, “Effects of the financial crisis and great recession on American households”). In the United States, the Federal government has taken expansionary monetary and fiscal policies in order to improve the economic conditions in the country. This has cast positive impact in the country as a whole and investment activities has increased. This has been able to pull up the level of employment in the economy. Since employment opportunities have increased and workers’ expectations about losing their jobs decreased, although the total rate of unemployment still remained high. This has started happening since the mid 2009. The government has still been on the efforts to bring down level of unemployment. Yet the economy is recovering at snail’s pace and according to reports by researchers, the common households still do not hold much optimistic perception regarding economic futures. Equity Markets Bubble in Banking Sector Deregulation of banking sector, starting with 1980s has exposed the banks fully to the incidences of bubbles occurring in the real estate market. Had the banks been forbidden from getting involved into the functioning of the financial markets, creation of these bubbles and their crashes might have been reduced to a large extent (Senbet and Gande “Financial Crisis and Stock Markets: Issues, Impact, and Policies”). There are evidences of very high correlation between amount of credit provided by banks and the prices of assets. This correlation led to the creation of most bubbles and a very high correlation ultimately leads to their crashes. These are the two variables that are highly dependent on one another. The presence of bubbles loosened “bank credit automatically” (Grauwe, “The Fragility of the Euro zone’s Institutions”). This is because it raises collateral worth of assets used as security in the process of giving credit. Higher amount of credit further intensifies the bubble in the asset market. Due to deregulation, banks were empowered to hold full panoply of the transactions related to financial assets. Also the amount of power led to the misuse of the same and manipulation of balance sheets became very costly. These banks became highly sensitive to asset bubbles. Balance sheets of these banks acted as mirror images for asset bubbles and consequent bubble crashes that occurred in the economy’s financial markets (Grauwe, “The Fragility of the Euro zone’s Institutions”). Compare QEs in US, EU and Japan The quantitative easing policies adopted by the government of the countries such as the United states, the Euro zone countries and Japan have been made with the common aim of boosting up economic activities in these countries. These countries have been suffering from recessionary pressures and their governments have intervened into the economic activities of these courtiers. The most notable government measure is that of quantitative easing (Amadeo, “What Is Quantitative Easing?”). Under this policy the government buys bonds from the banks in the country in the open market in order to increase quantity or level of liquid money in the economy. The Government of Japan, the United States and those of the European Union have taken resort to quantitative easing in order to pull these economies up from the state of depression. This would increase level of spending in the economy and raise the rate of inflation. In the USA, the Federal Reserve has additionally adopted expansionary monetary policy in which it has lowered the rates of interest so as to spur economic growth in the country (Hilsenrath, “Will Fed Act Again? Sizing Up Potential Costs.”). In the UK the European Central Bank started buying corporate debt in mid 2009 as a part of quantitative easing program. During this period the Euro zone economy was engulfed in severe depression and also showed strong deflationary trend. The decision of the government was supported by the need to raise the level of inflation in the economy in order to help the economy recover (Gow, “European Central Bank expected to start quantitative easing”). Effects on the Labour Markets A large amount of economic literature holds the instances of the effects of recession that occurs as a result of financial breakdown. These consequences of this break down are, fall in overall income level in the economy, high rate of unemployment occurring due to reduction in economic activity. The labour market is slack since on one hand there is high unemployment and on the other hand there is insecurity in the minds of the labourers (“United States unemployment rate 201D). These effects can cast lasting influence in the economy. This is because, loss of jobs and fall in income for the households might force these families to make lower level of spending on various spheres. Market for luxury goods faces the strongest downfall. Spending on other commodities and services needed for maintaining good standard of living, like higher education also falls. Spending needs might be delayed or totally forgone due to fall in income. “Frozen credit markets and depressed consumer spending” (Irons, “Economic scarring: The long-term impacts of the recession”) might cast potential impact on both small businesses and large enterprises. Lack of spending would suppress the level of aggregate demand in the economy which hurts the small businesses. Lack of demand affects their performance in the short run and their overall growth prospects in the long run. For larger companies, this affect is recognized in the form of hindrances in the path of fulfilling long run growth objectives. Delayed or reduced spending on Research and Development is a major hindrance (Irons, “Economic scarring: The long-term impacts of the recession”) lack of investment on R&D indicates slow growth which hinders employment opportunities for the labour force. Conclusion The financial crisis that has taken place in the last decade has been followed by recession in the global economy. This has badly affected almost all countries around the world in various degrees. The net effect is the significant fall in economic growth in these nations caused by lack of aggregate demand. The governments and the central banks in all these countries have responded to this situation by formulating better monetary and fiscal policies so as to increase spending in the economy, increase investment and raise the level of income. These policies have intended to improve demand level in the economy and bring stability in the general price level. Government policies are aimed at fulfilling these major objectives. The first positive outcome was the reducing rate of unemployment that was seen in the countries. Improvement of security in the labour market and better overseeing of the transactions in financial institutions would ultimately lead to the creation of stable economic situation in these countries. Works cited “Aggregate Demand.” Economics Online. Economics online, n.d. Web. 15 Jul. 2013. Amadeo, Kimberly. “What Is Quantitative Easing?” About. About.com, 2013. Web. 15 Jul. 2013. Arcega, “European Recession Now Longer Than 2008 Financial Crisis.” VOAnews. Voice of America, 15 May 2013. Web. 15 Jul. 2013. Cecchetti, Stephen G. and Piti Disyatat. “Central Bank Tools and Liquidity Shortages.” FRBNY Economic Policy Review Aug. 2010: 29-32. Print. Gow, “European Central Bank Expected To Start Quantitative Easing.” Guardian. Guardian News and Media Limited or its Affiliated Companies, 2 Apr 2009. Web. 15 Jul. 2013. Grauwe, Paul De. “The Fragility of the Euro zone’s Institutions.” 2009. PDF File. Hilsenrath, Jon. “Will Fed Act Again? Sizing Up Potential Costs.” The Wall Street Journal. The Wall Street Journal. 2013. Web. 16 May 2013. Hurd, Michael D. and Susann Rohwedder. “Effects of The Financial Crisis And Great Recession On American Households.” September 2010. PDF File. Irons, John. “Economic scarring: The Long-Term Impacts of the Recession.” EPI. Economic Policy Institute, 30 Sep 2009. Web. 15 Jul. 2013. Mankiw , Gregory N. and Lawrence Ball. Macroeconomics and the Financial System. New York: Worth Publishers, 2010. Print. Senbet, Lemma W. and Amar Gande. “Financial Crisis and Stock Markets: Issues, Impact, and Policies.” October 2009. PDF File. “The Global Impact of the 2008-2009 Recession.” SJSU. SJSU, n.d. Web. 15 Jul. 2013. “United States Unemployment Rate.” Trading Economics. Trading economics, July 2013. Web. 13 July 2013. “What Is Quantitative Easing?” BBC. BBC, 7 March 2013. Web. 13 July 2013. Weisberg, Jacob. “What Caused the Economic Crisis?” Slate. The Slate Group, LLC, 9 Jan. 2010. Web. 15 Jul. 2013. Read More