American government policies in overcoming the aftermath of the Financial Crisis of 2008 - Assignment Example

?Business Economic analysis 26th April Introduction Since the Great Depression that occurred in1930, 2007-2009 financial crisis is the second negative economic implication that affected majority of the countries in the world. The crisis did not only affect the microeconomic performance but also it affected the macroeconomic aspects such as the employment, government spending, domestic and international borrowing. In addition, the financial crisis resulted to the poor performance of the stock market in many countries, collapse of the local and international financial institutions as well as bailout of the banks by the governments. In terms of the consumer wealth, the crisis led to decline of the investments with most of the local and international investors losing huge amounts of investments caused by the collapse of their companies. According to some economists, the housing bubble that occurred in US was a major trigger that resulted to reduced value of the securities in the US market as well as the prices of the real estates (Ryan, 2009). World economists have come with various theories that attributed to the financial crisis. According to Levin-Coburn Report, a policy paper that was issued by US Senate, the crisis was not as a result of natural forces but it was caused by complex financial products, inadequate credit rating mechanisms and conflict of interests among other factors. This paper seeks to analyze the economic impact of the financial crisis in US as well as the measures that have been taken by the US government to address the implications of the crisis. Financial institutions As a result of the financial crisis, most of the US banks suffered heavy losses due to the unpaid loans. One of the major financial institutions that underwent a financial crisis was the Lehman brothers. For example, this bank had quite an enormous debt burden and unfortunately they had no well curtailed financial frameworks to withhold these defaults and losses. As a result, the bank was forced to be in debt with the government and other international lending institutions. This resulted in the banks being taken over by the government. Major mortgage lending financial institutions suffered a decline in the observance of their underwriting standards as well as the intense defaults in loan repayments. The US directive on the mortgage financial institutions to decentralize their loan facilities to the mid and low income earners increased the risk involved leading to an enormous increase in defaults. High leverage ratios were explicit results of the financial crisis leading to lack of confidence in the financial institution by the investors. Bankruptcy was experienced by a number of mortgages lending institution due to lack of credit worthiness to finance their activities (Braun and Borja, 2004). Failure, economic bailout by the government, mergers, in addition to takeovers of financial institutions for example the Washington mutual, Merrill lynch ,Wachovia and many more was also a major implication of the financial crisis. The insurance companies for instance AIG were not able to offer the necessary insurance on the loans given because they did not have the funds to offer such services. A number of the financial institutions resulted in stringent measures in terms of offering loans leading to few people applying for the loans and the resultants is the decline in profits for the banks, reduced money supply as well as lack of assets acquisition by the people who rely on these loans. Stock markets The decline in the average index was a major result of the crisis. For instance, Dow Jones industrial Average index declined from a high 14,000 points to 6,600 points in a span of two years within the crisis period (Evans-Pritchard and Ambrose, 2007). As a result, Investment turnover declined. Decline in the turnover rate led to lack of investment in the stock markets. Major players in the stock markets that are the New York Stock Exchange, for example Dow Jones and brokers experienced various challenges since their work was minimal thus creating unemployment problems leading to laying off of some of them. Housing This was the major contributor of the crisis and its effects were severe. The drastic growth in the famous US housing bubble led to the frameworks that had been put into place whereby allocation of funds increased thus more people were able to own homes. The pool of funds increased unproportionally to the relative sources of investments projects which could provide the required finance triggered a challenge towards this housing bubble. Most people therefore resulted to becoming homeowners leading to decline in the prices of homes and the mortgage institutions faced an uphill task in repaying their debts inclusive of the high interest rates thereof. Non repayment of debts by the mortgage institutions and non repayment of mortgages by the homeowners were the aftermaths of these financial crises. Unemployment Various companies in the US experienced financial challenges leading to decline in the profit margins. Soros (2008) argues that the resultant decision was to reduce the cost of production. Labor force being one of the essentials of production, reciprocates also as being one of the major considerations in case of reducing the cost of production. Most companies opted for this option in order to realize high profits, leading to laying off of the labor force leading to high level of unemployment (Griffiths and Wall, 2011). The construction industry was also affected in the sense that due to lack of adequate incomes, home builders were not building new homes, thus the laborers had nowhere to go leading to massive unemployment. Massive unemployment challenges were particularly experienced in firms which depended on external borrowing thus the cost of credit drastically increased due to the financial crisis resulting to more people being laid off by the firms. Lack of wealth creation Most investors in US had invested in the stock markets large sums of money with expectations of a 20% rate of return but unfortunately due to economic downturn, they suffered a loss of 25% of their investment (Andrew, 2009). Another example that indicates the effects of the crisis was whereby investors bought apartments with the aim of upgrading these apartments and thus increasing the rents, unfortunately due to the crisis the rent was not enough even to cater for the upgrade leading to great losses to the investors. Distribution of wealth being a consideration in wealth creation was affected in that the rich though they lost significantly the gap between the rich and the poor became wider. Increased of prices for basic commodities Most of the prices of major commodities that are highly demanded by US homesteads increased drastically. The prices of oil for instance almost tripled from $50 to $147 per barrel in the said period (Rajan et al, 1998). Dues to this crisis the cost of production increased thus resulting to the drastic increase in prices of various commodities including foodstuffs. Prices for precious metals for example gold and other metals such as copper, nickel among others drastically increased compared to precedent periods to the financial crisis tenure. As a result, the cost of production in the industries increased causing reduction of the sales and profits for local and international firms. Impact of fiscal policies This entails the government spending and its sources of revenue, the effects were that the government had to increase their spending as compared to previous periods. Due to the collapse of various companies, sources of revenue to the government declined leading to the government of US experiencing deficits and losses in her operations. External borrowing which had an effect on the various companies that depended on it had also a resultant effect on the government. The cost of external borrowing increased drastically leading to the US government incurring heavy debts and high interests thereof. Government bailouts and takeovers were depicted as a result of the crisis leading to budgetary constraints to the government. The gross domestic product decreased as a result leading to a decrease in the national income. Measures adopted by the US Government in addressing the Financial Crisis of 2007-2009 Strategies to address market instability Much of the market instability was attributed to the decline in the housing market aggravated by the recession that began in December 2007. Declines in the value of mortgage-backed securities (MBS) and sub-prime credit market debt precipitated significant portfolio losses across many financial and credit institutions that had invested heavily in these instruments in recent years. These losses led to financial market instability, forced mergers, and bankruptcies (Boorman, 2009). The government introduced open market operations to ensure banks remain liquid. These are effective short-term loans to the banks collateralized by government securities. These were largely reflected in the FY 2009 financial statements, when Housing and Economic Recovery Act (HERA) of 2008 enhanced regulatory authority over the housing GSEs (Ikome, 2008). This included increase in capital of up to $200 billion to Fannie Mae and Freddie Mac. Stock owners Prior to the emergency of financial crisis, open market operations (OMOs) in the US Treasury market were the Fed’s principal policy tools where only banks maintained reserve accounts at the Fed. According to Biekpe (2009), after August 2007, the Fed began to behave differently. It began advancing its own credit against collateral not only to US commercial banks but also to other institutions. Then, in September 2008, it flooded the US financial system with its own zero-interest rate in order to regulate liquidity. Monetary Policies The government lowered the target for the Federal funds rate from 5.25% to 2% and the discount rate from 5.75% to 2.25% with an aim of supporting market liquidity and functioning with anticipation of pursuit of macroeconomic objectives through monetary policy. Shaohua and Martin (2009) argues that these strategies caused a sharp decline in credit availability experienced after banks and financial institutions struggled to maintain solvency in the face of widespread losses. The U.S central bank decided to resort to all monetary policies to contain the financial crisis. The most critical of these policies was lowering the interest rate. The objective was to minimize the cost of borrowing for private businesses and consumers in order to stimulate commercial activities (Kiptoo, 2009). In the long run, the strategy of lowering the interest rates increased investment thus reducing unemployment. Another fundamental monetary strategy that was adopted by Federal Reserve Bank was the temporary cash infusions. It was a part of the year 2008 Economic Stimulus Act that was approved in the month of February the same year. This policy was meant to jumpstart spending and individual consumption in general. A cash of total above $100 billion was granted to various families and individuals in the US (Biekpe, 2009). As a result of this policy, the economy was able to recover considerably although it can’t be considered a solely monetary action since most of the funds were borrowed. Government bailout for major financial institutions In September 2008, the American government arranged, for an 800 Billion US$ rescue plan aiming at saving the most important financial market such as investment banks and insurance companies from bankruptcies to prevent further financial deterioration. As correctly noted by the World Bank (ibid), financial crisis caused many companies and banks to experience bankruptcy including the five largest U.S investment banks as investors pulled funds from them and inability to secure new funding in the credit market. These firms had typically borrowed and invested large sums of money relative to their cash or equity capital, meaning they were highly leveraged and vulnerable to unanticipated credit market disruptions (Biekpe, 2009). In 2008, Government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac had either directly owed or guaranteed nearly $5 trillion in mortgage obligations before being placed under receivership in September 2008. Public stimulus packages The U.S Government launched huge stimulus packages to pull it economies out of recession. As the financial crisis pushed the economies into deep recession, consumer spending declined sharply due to fears and lack of confidence. As a result, industrial output declined and unemployment rose sharply. The stimulus packages aimed at increasing the public spending on infrastructure projects in order to create more jobs and stabilize consumers spending pattern. Financial innovations Major depository banks decided to introduce financial innovation such as structured investment vehicles to address capital ratio regulations. Companies such as Washington Mutual (WaMu) was seized in September 2008 by the USA Office of Thrift Supervision (OTS) which was followed later by the Wells Fargo, Wachovia and Shortgun wedding after it was speculated that without the merger Wachovia was also going to fail. Dozens of U.S. banks received funds as part of the TARP or $700 billion bailout. Home owner assistance Emergency and short-term responses or supported programs were implemented during 2007–2009 to assist homeowners with case-by-case mortgage assistance, to mitigate the foreclosure crisis engulfing the U.S. Such programs included Home now alliance which aimed at helping certain sub prime borrowers. By February 2008, the Alliance reported that during the second half of 2007, it had helped 545,000 sub prime borrowers with shaky credit, or 7.7% of 7.1 million sub prime loans outstanding as of September 2007 (International Monetary Fund (IMF) and the World Bank, 2006). Reforms in the housing market The Obama Administration decided to adopt critical processes in reforming housing finance market. In July 2010 the government enacted The Dodd-Frank Act, which provided vital protections to consumers and investors in ending abusive practices in the mortgage market and improve the stability of the overall housing finance system (Evans-Pritchard, 2007). The reforms included: Paving the way for a robust private mortgage market by reducing government support for housing finance and winding down Fannie Mae and Freddie Mac on a responsible time line, Address fundamental flaws in the mortgage market to protect borrowers, help ensure transparency for investors, and increase the role of private capital and Target the government's vital support for affordable housing in a more effective and transparent manner. In additional the government set certain criteria to access to Mortgage Credit which aimed at attracting additional capital into the housing finance system thus lowering the cost of mortgages and increasing the availability of certain kinds of mortgage products, such as the 30-year, fixed-rate mortgage (Akbar, 2008). Government support increased access to secondary markets for smaller lenders and community banks, promoting a more competitive market and minimizing consolidation. Further, the government introduced Incentive for Investment in Housing that broadened access and lower costs for borrowers and communities. This led to greater long-term growth in housing sector and creation of more jobs which inflated the value of housing assets, leading to larger boom and bust cycles. Other government policies, such as tax incentives like the mortgage interest deduction and other tax credits encouraged investment in housing over other sectors in the economy. Fiscal policies Fiscal policy, including fiscal stimulus were aimed at creating fiscal space to stimulate aggregate demand, expand the productive capacity of an economy and generate employment, reduce poverty and inequalities. In U.S, fiscal policy became instrumental in controlling the financial crisis experienced in 2007-2008. Some of the initiatives that were put in place included, reduced tax rates and increased subsidies for both producers and consumers of goods and services as witnessed in housing sector, steel industry and financial institutions. These further encouraged investments thus increasing employment and protecting the already existing jobs which could have been lost. According to the Romer-Bernstein report (2009), the unemployment rate would have reached as high as 9 percent if strong fiscal strategies were not put in place. Conclusion From the discussion above, it is clear that the even though the economic performance of developed countries significantly resulted to the emergence of the financial crisis, US played a major role in triggering the recession. The Financial crisis of 2007 originated from mortgages market. The financial crisis led to insolvency of many banks and financial institutions in the U.S. The U.S Governments adopted different policies such as; financial saving plans, spending stimulus packages, and aggressive monetary policies to contain the crisis. However, the negative spread affect of the crisis has extended to other sectors and industries such as Motor Industry (Kiptoo, 2009). The financial credit crisis moved the US into deep recession due to bankruptcies and foreclosure of banks and firms that caused huge layoffs and reduced disposable income. As production output declined, factories were forced to lay off more labor. Basically, lack of supervision of regulatory agencies over the financial market, expansion of financial derivatives beyond acceptable norms, imbalance in the world trade and greed of Wall Street has led to the financial and economic crisis. References Andrew R. 2009. Lehman Files for Bankruptcy; Merrill Is Sold. The New York Times. Retrieved March 8, 2009. Biekpe, N. 2009. Effects of Credit Crunch on employment. New York: Macmillan Publishers. Boorman, J. 2009. The Current Financial Crisis: Its Origins, Its Impact, and the Needed Policy Growth Agenda. Vol. 6. April – June 2009 Issue. Braun, M and Borja, L. 2004.Finance and the Business Cycle: International, Inter-Industry Evidence. Journal of Finance, 60(3), pp. 1097-1128. Evans-Pritchard and Ambrose.2007.Dollar tumbles as huge credit crunch looms. London: Telegraph Media Group Limited. Griffiths, A. and Wall, S. 2011. Applied Economics. FT/Prentice Hall. Ikome, F. 2008. The Social and Economic Consequences of the Global Financial Crisis on the USA and Emerging Economies. New York: Macmillan Publishers International Monetary Fund (IMF) and the World Bank. 2006. Fiscal Policy for Growth and Development: An Interim Report. Washington \D.C. Kiptoo, C. 2009. The Lessons learnt from the Global Financial Crisis. London: Sage Rajan, Raghuram G., and Luigi Z. 1998. 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