The Present Global Recession - Assignment Example

a) 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 triggered in turn 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 bursting of the bubble and the ensuing financial crisis is a potent reflection of the failure of American Macroeconomic policies which essentially targeted to restrain the recession that loomed large on the economy after the bursting of the dot com bubble in the early parts of the first decade of the present millennium. In fact it is debatable whether the turmoil would have reached its epic present day proportions if the demand stimulation targeting policies which in essence were affected through high leverage proportions were not introduced and the recession was allowed to do its bit. Thus, it emerges that the government and the Federal Reserve have failed in playing a role that could prevent the crisis. However, the failure is even more strongly reflected in certain policies that targeted to recover the economy from the crisis but were evidently misdirected since the economy, understood to have faced a crisis since 2007 is still on a downward trajectory, and the persistent spread of the crisis is yet to be checked anywhere. The remainder of this section shall explain the phenomenon of a recession in theoretical terms to facilitate enhanced perception of the Government and the Federal Reserve’s roles in the ongoing crisis. To understand the present global recession and how it was a failure on the part of the government and the Federal Reserve in not being able to prevent it, it is imperative to first understand the phenomenon of any recession. 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 the following section, 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 unsteady and thus unsustainable bubble and thus lead to the financial meltdown. b) This section will discuss the major macroeconomic policies adopted over the course of the last three years in context of the crisis. It will be shown how certain policies first created the unsteady environment that nurtured the crisis and we shall also point out certain misdirected others which thereby failed to engender a recovery thus far. The trigger to the financial meltdown 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 admittedly bad credit histories received loans. The effects of the bust were actually amplified due to the excessive risk taking fuelled by sub-prime as well as adjustable rate mortgages. The excessively lowered interest rates by the Fed also motivated high risk ignorance. Further, allowing the adjustable rate and sub-prime rate mortgages to be packed alongside with other mortgages into mortgage backed securities created a very complicated framework from and the resulting opacity led to risk assessment extremely complex and gross underestimations followed. (Taylor, 2009) Fannie Mae and Freddie Mac, which are government sponsored, were persuaded to buy securities backed by mortgages including risky sub-prime mortgage backed ones in pursuit of expansion. (Tatom, 2009) Improper assessment on the part of the Government and the Fed actually contributed to the crisis being aggravated as well as prolonged. On 9th and 10th of August the fact that the crisis had become acute was announced in the form of interest rate surges in the money market and unprecedentedly steep jumps in interest rate spreads such as the overnight and three month interbank rates. The situation was misdiagnosed by the Fed as one reflecting the effects of liquidity constraints while the possibility that counterparty risks could be at the root of the problem was ignored and thus attempts to inject more liquidity followed. If the problem had been indeed caused by constrained liquidity, steps like easing borrowing conditions would have proved effective. However, to treat the problem if counterparty risk had any significant role as a root, the proper steps would have been to directly concentrate and turn focus onto quality of and reducing opacity of, the banks’ balance sheets. However, misdiagnosing the situation the Fed adopted the policy of creating the Term Auction Facility in December 2007 to enhance liquidity. The objective was to bring down the interest rate spreads and this policy response had very little success which only reflects more prominently the possibility of the situation being caused by counterparty risk. (Taylor, 2009) Another policy response to the continually deteriorating situation was the introduction of the Economic Stimulus Act of 2008. The policy, which in its major role disbursed about 100 billion dollars of cash to individuals as well as families to kick-start the consumption demand spiral, also failed to stimulate any recoveries. The cause of the failure of this policy can be identified in the logic of Milton Friedman’s permanent income hypothesis. People who received the cash recognized it as a temporary boost to their incomes and not permanent. Thus, as the theory predicts, consumption was not inspired to any significant levels. (Tatom, 2009) The third policy response germane to the present discussion was that of lowering the federal funds rate from a previous 5.25 percent in august of 2007 to 2 percent in April of 2008. This sharp reduction culminated to a strong depreciation of the Dollar which thereby led to considerably increased oil prices. Though the oil prices fell eventually with lowered expectations regarding global economic growth, the initial surge inflicted considerable damage on the economy which was already reeling. (Tatom, 2009) A year of misdirected policies finally led to the crisis being much more aggravated with the aforementioned severe credit crunch around September 2008 primarily triggered by the collapse of the Mortgage Backed Security. Notably, if the Fed had not resisted regulations, the collapse could have been prevented. The credit crunch on top of the oil price shock and the bust of the housing bubble made the US economy face its worst days since the depression of the 1930s. (Taylor, 2009) Thus, what emerges is that the present global economic crisis if not caused has been significantly aggravated by impotent and often noxious macroeconomic policies. 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. 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. Gandhi, J. (2008, October 19). Global Recession - Causes. Retrieved April 12, 2009, from http://ezinearticles.com/?Global-Recession---Causes&id=1597698 Froyen, R.T., (1996) “Macroeconomics: Theory and Policy”, Tata-McGraw-Hill 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