The Great Recession 2008 - Term Paper Example

? The Great Recession 2008 Beginning mid-2007, the global financial crisis rapidly changed from the housing bubble burst to one of the worst recessions in US in recent decades (Clungston, 2008). This paper utilizes an in-depth analysis and review of the financial crisis with emphasis on its causes, policy responses, and consequences. In addition, the paper highlights three important points. First, the global economy was unstable contrary to the suggestion that it was stable prior to the crisis. Second, there were interlinked and complex factors that led to the occurrence of the 2007 crisis, including global imbalances, lax financial regulation, loose monetary policy, and misperception of risk. Third, the paper highlights that the impacts of the crisis as diverse beyond the aggregate of the rising levels of unemployment and economic collapse, highlighting the differences in transmission channels, vulnerability of economies, and initial conditions, as well as the role played by government policy in dealing with the crisis. Introduction The 2007 global financial crisis has had serious impacts on the economies of many countries, resulting to what economists call the Great Recession. The downturn began initially as an isolated problem with the sub-prime sector in the US housing market, mutating to a serious and fatal recession by the beginning of 2008. Consequently, other nations especially in the European Union followed the US into the crisis by mid-2008. In essence, 2009 was the first recorded year in history that the global economy was actually in recession since the Second World War (Sherman, 2010). Interestingly, the recession came as a surprise to many economists, investor, academics, policy-makers, and multilateral agencies. For instance, Organization for Economic Co-operation Development’s Jean-Philippe Cotis was quoted as speculating further growth in the global economy because of the buoyancy of emerging economies and favoring financial conditions. After the economy drove into recession, the economics profession was under fire for failure to predict the financial downturn (Baldwin, 2009). As a result, there were few intellectual conversations taking place between scholars of like minds. Therefore, the underestimation of the severity of the global downturn was not surprising. Indeed, some leading financial forecasters like World Bank and International Monetary Funds revised their initial to their growth forecasts in 2008 and 2009. Nonetheless, there were warnings from a few economists of a brewing economical disaster. A portion of the economist predicted a looming recession based on economic models where the accumulation of the private sector was the central cause. However, their cries were not significant enough for the majority of the lulled individuals. Despite all these, the warning signs were blinking red: loose monetary policy especially in the US, lax in financial regulation, misperception of risk and search for yield, and huge current deficits in UK, US, and other super economies that accumulated huge savings of oil exporters and emerging economies. Events of 2008, with emphasis on the collapse and consequent closure of Lehman Brother, reversed the perceptions of risk-taking banks (Clungston, 2008). However, the complexity and nature mortgage-backed securities left most banks in the dark concerning the exact level of liabilities that was linked to the severing housing sector in the US. Thus, liquidity of most banks dried up, literary bringing the global financial system to a halt. Some critiques were quick to question the survival of the American-style capitalism. Governments in developing and advanced countries were quick to react aggressively, injecting obscene credit amounts into their financial markets, reducing interest rates, nationalizing banks, and unveiling stimulus packages to increase discretionary spending. Most policymakers were determined to avoid mistakes from previous crises, and their response was important avoiding disastrous depression in most countries, their effectiveness varied depending on the response and vulnerability levels of domestic economies. Despite these intervening policies, the financial crisis rapidly became a global jobs crisis, as the credit crunch resulting from the crisis literary killed the real economy collapsing the trade flows. Unemployment levels in countries within the OECD block increased; as millions were threaten live in poverty in countries without social security systems (Baldwin, 2009). Many countries became victims to the recession in the US by the fall of 2008. There were several cases of outright recession in some countries, but most experienced a decelerating growth. South Africa, Turkey, Ukraine, Armenia, Baltic States, and Mexico were among the hardest hit nations. However, China and India managed to maintain their economic growth. China’s economic growth in 2009 stood at 8.7%, a performance attributed to the enormous stimulus package that the Chinese government assembled, amounting to around 585 billion dollars (Heng, 2010). India, however, had a relatively small stimulus, but its economy remained resilient because of the strong demand for domestic products. After the recession, the global financial economy progresses with a certain degree of uncertainty. Pre-Crisis Period Interpretation Prior to the financial crisis and the consequent recession, most economic commentators argued that the global economy was in the ‘Great Moderation’, an era of low volatility. Other interpretations highlight the insufficient growth rate in developing countries in the 1980s and 1990s (‘Lost Decades’), and the phenomenon surge in food and oil prices. Furthermore, the 2008 crisis was not the first of its kind, as there are previous crises suggesting a frequent occurrence. However, the impacts of the 2008 crisis make it easy to forget the high growth rate of the pre-crisis period from early 2002 to 2007, particularly in developing countries (Sherman, 2010). There had been a mild economic downturn in 2001 following the burst of the dot com bubble. Nonetheless, there was a synchronized boom for the duration lasting to 2007. Indeed, many countries especially in Africa recorded growth rates similar to those in the golden age between 1960s and 1970s. Actually, some economists referred to this growth as the initial stages of the global platinum era. 2002 to 2007 Global Boom A careful analysis and review of the period indicates that it was actually a period of unsustainable boom. There were a series of surges on external finances such as remittances, private capital flows, and export revenues, which contributed to the boom and a subsequent increase in economic and investment in developing economies. Because of the increase in credit flow, the capital cost declined (Clungston, 2008). The result was a robust sense of optimism concerning the future, particularly to investors with interests in developing economies, resulting to risk underestimation. This optimistic perception led to the overall policymakers’ complacency. During the global boom, economists did not give sufficient attention to the strains and stresses within the labor market. In place of employment quantitative expansions in developing countries and the rest of the world, the labor force became casual, informal economy persistence, sluggish growth of real wages, rising inequality, and declining national output wage shares. Another shortfall of the boom session was failing to translate the economic growth into improved household incomes. Major emerging and developing economies did not exhibit any sustained improvement in real wages. Even economic powerhouses such as the US and the UK experienced stagnant period in income improvement despite their consumption-led economies. However, the situation had different effects in the US as compared to the developing nations. In the US, households increased consumption by taking advantage of the increased household equity resulting from rising prices. Consequently, the US current account deficit became worse, rising to 6% of GDP (803.6 billion dollars) from 3.9% of GDP (398.3billion dollars) between 2001 and 2006 (Sherman, 2010). Fig1: US growth in household consumption during the boom period despite stagnant real wages. Retrieved on March 7, 2012, from Bureau of Economic Administration, www.bea.gov. Moreover, many developing countries were still recovering from energy and price shock that had serious impacts on their current and fiscal balances, leading to protests and riots and pushing millions into poverty. This was a direct result of the global boom, and the consistent increase in demand for goods from India, China and other emerging economies. Actually, some reports indicate that the 2007-2008 energy and food price shock pushed around 100million people into poverty (Baldwin, 2009). In comparison, the World Bank estimates that the Great Recession pushed around 64million to poverty. Thus, the energy and food price shock was more severe and of much concern than middle and low-income economies than the financial crisis. Many observers suggest that the global economy was stable prior to the crisis in 2008. However, perspectives on the years leading to the crisis indicate otherwise. The complex nature of the crisis made it unexpected, leaving commentators, economist, and policymakers puzzled as it first crashed companies and banks, then economies across the world. The sudden real economy collapse had severe impacts on households due to the variance in their initial conditions, including fiscal space, labor market, state of economy, and institutional framework, as well as direct and indirect exposure to impacts of the crisis through trade and credit channels (Heng, 2010). Factors behind the Crisis There were many signs of a probable recession in the years leading to the crisis, though investors and economists ignored them, claiming that it was a new era. This was because the sub-prime crisis in the US had similar characteristics to other banking crises, such as consistent growth of current account deficit, increasing private debt levels, and large surges in equity and housing prices. The securitization level of mortgages obliged by collateral debt complicated the exposure of investors and lenders, creating uncertainty in the markets as the crisis progressed (Nabli, 2010). Consequently, this resulted in a sudden risk perception reversal. Controversy still surrounds the real cause of the crisis, though majority of economists and commentators argue that loose monetary policy and financial regulation, and global imbalances as the result. Previous US administrations in the early years of the twenty-first century have had a significant role in shaping the economy. After the burst of the dot com bubble in 2001, the US authorities significantly reduced policy rates to extremely low levels, fuelling debt debt-financed consumption boom, consequently boosting the aggregate demand. In fact, interest rates were 1% in 2003. This was intentionally set to ensure that the 2001 recession was short-lived and shallow, but it ended up cultivating the financial crisis of 2008. Some economists such as Taylor argue that the Federal Reserve policy between 2001 and 2006 was loose, thus the interest rates were relatively low. Others like Shiller argue that the housing boom began in late 1990s, thus the low interest rates period was longer than the initial suggestion (Clungston, 2008). However, Shiller points out that the loose monetary policy played a significant part in the growth of mortgages fro sub-prime borrowers. The government bonds for the US were significantly low prior to the crisis. This was because of the increasing appetite of export powerhouses and Middle East oil exporters to accumulate US dollar-dominated foreign exchange reserves (Whalen, 2011). Consequently, this led to the ’global imbalances’ with surplus countries such as China having excessive savings and deficit countries like US having excessive consumption. This global imbalance was unsustainable in the end. Fig2: Nominal Federal Funds Rate from 2002 to 2009. Retrieved on March 8, 2012, from http://www.federalreserve.gov/PUBS/FEDS/2009/200949/ The consensus on the connection between the imbalances and the finances is that the capital flow from exporting countries like China contributed to the credit and housing bubble in the US, with significant impacts on the bond yields (Whalen, 2011). As a result, the mortgage rates maintain a low rate even with the intervention of Federal Reserve monetary policy in 2004. Moreover, the foreign borrowing was the main source of funds for mortgage debt instrument and investment, the main recipes of the financial crisis. The low yields from bonds and interest rates made investors to seek other higher-yielding assets. Corporate bonds and yields from emerging economies also went down corresponding to T-bills, thus the option was mortgage-backed securities. The low interest rates encouraged lenders to expand their activities, but the exhaustion of credit-worthy borrowers deflected them to riskier market segment such as non-standard loans, alt-A, and sub-prime. Their efforts were possible because of lax financial regulation that began in 1990a and strengthened by the Gramm-Leach-Bilely Act (Sherman, 2010). This resulted to the emergence of the US sub-prime housing market. Sub-prime borrowers became worthy and profitable targets by yield-seeking investors and lenders. The loose lending standards and aggressive lending propagated the growth of non-prime loans. Forty-eight percent of all mortgages by 2006 were either from Alt-A, home equity, or sub-prime, up from 15% percent in 2001. Poor lending standards resulted in increase of adjustable rate mortgages, at times with 100% loan-value ratio. Consequently, this resulted to low initial repayment. Moreover, the housing bubble received a boost from speculation. The securitization of mortgage bonds meant that the stability of the housing market in the US affected both domestic and international lenders. Investors began selling mortgages to third parties, repackaging them as mortgage-backed securities traded over the counter (Nabli, 2010). Therefore, regulatory measures did not have any significant impact, as the capital requirement was inadequate in products such as collateral debt obligation, as well as inadequate ratings use and risk-taking incentives from arranged structured remunerations. The combination of lax financial regulation, riskless assets low returns, and misperception of risk promoted investment in mortgage-backed securities. Although sub-prime mortgages dominated the centre-stage of the crisis, they did not entirely cause it. The US housing market was the trigger for the crisis. The rise in bad loans and increase in interest rates led to the crush of various mortgage lenders in the US. However, the major problem was that investors around the world and banks were in this situation and did not know the extent of losses and exposure (Whalen, 2011). As a result, majority began hoarding liquidity, setting the pace for the credit crunch. This created a false perception in risk and decreased lending, further propagated by the collapse of Lehman Brother, almost collapsing the financial system. Consequences In the US, the economy shrunk by an estimated 2.7% in 2009 (Whalen, 2011). The G20 countries recorded an average decrease of about 3%. Unemployment rates across the world surged as many businesses collapsed. Other advanced countries followed the US especially through financial and trade channels. However, other countries such as India, Australia, China, Uganda, and Ethiopia evaded major contractions. Fig3: World Economic Growth (real GDP annual change). Source: IMF World Economic Outlook Database October 2009, data accessed February 24, 2010. Fig4: Employment adjustment across different population segments in EU. Source: EUROSTAT Labour Force Survey Database, from http://epp.eurostat.ec.europa.eu/portal/page/portal/employment_unemployment_lfs/data/database Responses The financial crisis prompted governments to roll out certain policies to avoid collapse of real economy and financial markets, in three main intervention: injections and bailouts of money to enhance flow of credit in the financial market, slashing interest rates to promote investment and borrowing and extra fiscal spending to propagate the aggregate demand. The main objective of these measures is to prevent extreme economic deterioration and enable workers to maintain their jobs and create new job opportunities for the unemployed. For instance, the US fiscal stimulus package enacted in February 2009 amounted to 787 billion dollars. About 53% of this amount went to tax cuts, 23% for government purchases, and the rest in form of transfers. Moreover, the US administration projected that around 3.5 million job opportunities by 2010. However, there were only 1.5 million jobs created compared to about 8.4 million jobs lost since 2007 (Nabli, 2010). The paper highlights the economic events of the decade leading to the financial crisis in 2007 and the consequent recession in 2008. It also presents interpretation of the ‘Great Moderation’ and the ‘Lost Decades’ (Nabli, 2010). Additionally, the paper highlights some warning signs that signaled the possible occurrence of the recession. The paper also highlights some of the interlinked and complex factor that led to the crisis, including lax financial regulation, misperception of risk, global imbalances, and loose monetary policies. Moreover, there is a brief analysis of the response policy and consequences on the economy of countries. References Baldwin, R. (2009). The Great Trade Collapse: Causes, Consequences, and Prospects. London: Centre for Economic Policy Research. Clugston, D. (2008). The Great Recession. Gilroy, CA: Bookstand Publishing. Heng, M. (2010). The Great Recession: History, Ideology, Hubris and Nemesis. Singapore: World Scientific Publishing Co. Nabli, M. (2010). The Great Recession and Developing Countries: Economic Impact and Growth Prospects. Washington DC: World Bank Publications. Sherman, H. (2010). The Roller Coaster Economy: Financial Crisis, Great Recession, and the Public Option. New York: M. E. Sharpe Inc. Whalen, C. (2011). Financial Instability and Economic Security after the Great Recession. Cheltenham: Edward Elgar Publishing. Read More