Federal Reserve and the Great Recession - Research Paper Example

Federal Reserve and the Great Recession Introduction The great recession was a period of economic downturn that was characterized by liquidity-related issues. Despite it affecting the United States in a great way, its impact was felt all across the world. The Great Depression started around August 2007 after the central banks gave their money to the interbank lending market hence resulting to a great decline in liquidity. The lending by the central banks happened after there was a blockage to the withdrawal of money from the hedge funds by the BNP Paribas. The US mortgage crisis as well as the financial crisis of 2007-2008 was the main catalysts of the Great recession. 2008-2009 were the highly hit years through the impact of the recession are still evident today. The Federal Reserve provides the main banking system in the US that is mandated with the role of addressing banking issues and other roles provided by the Federal Reserve Act. This indicates that the Federal Reserve had stake in helping prevent the Great Depression. Therefore, having all that it is required to effectively manage banking crisis, the Federal Reserve failed in their mandate. Research Question What made the Federal Reserve have a poor management of the Great Recession? A General Perspective of Banking System Regulation The monetary system is under the discretion of the Federal Reserve in the United States. This role traverses diverse aspects of the economy that influences the wellbeing of an economy. The institution is required to have control over the supply of money; this means that there should be achieved full employment as well as stability of prices for all the resources within an economy to remain healthy. Some of the other aspects that are under the mandate of the Federal Reserve entail issues relating to the economic performance of the country including lending to the banks in order to shield the financial system from crisis. Such an intervention is meant to prevent aspects such as bank runs as witnessed in the early 20th century. Therefore, being the managers of the monetary system, the Federal Reserve has the mandate to see into the wellbeing of the economy by managing the monetary system effectively. Federal Reserve Failures One of the major causes of the Great recession was the bursting of the housing bubble. Being a regulator of the monetary system, the Federal Reserve could have seen a crisis coming. The major cause of the housing bubble bursting was that the Fed opted to expand their monetary policy; though the regulation was effectively done, this policy was a contributor of the problem. The Federal Reserve might have bowed to the pressure from the government to have the implementation of the housing policy be implemented. It happened that the dot-com crash was followed by a substantial increase in the printing press that resulted to an increase in the monetary base. Additionally there was a great cut in the federal funds by Greenspan (from 5.6% in 2001 to 1% in 2003). These factors contributed to an increase in the housing among other investments that utilize huge amounts of capital. The Fed could have intervened at this point and develop a regulatory mechanism to prevent the situation from escalating to the financial crisis and ultimately the Great Recession. The Federal Reserve failed to develop adequate measures that would deal with the insolvency. Two institutions at the center of the Great Recession, Lehman Brothers, and Washington Mutual became insolvent resulting to their collapse. The Fed made a miscalculated attempt to go ahead and support these institutions instead of giving them a chance to fail, the outcome would have been an increase in the amount of savings as well as investments. It was almost obvious that the resources were misdirected by allowing them to be put in less productive areas that generate less value. It is quite apparent in economics, that a consideration of resource allocation should be prioritized in accordance to the productivity of an institution. This was not the case for the Federal Reserve; they channeled resources to institutions that were expected to generate less value at the expense of saving and investing in high value areas. It is possible to develop a serious economic crisis when the situation is that the resources are directed to areas that are expected to generate less output; this is a misdirection of resources. Therefore, having such a scenario where the resources have been channeled to low-value areas, then there is need to have a fast liquidation strategy of the poorly performing investment and replace them with high-value investments. Though there are some of the resources that cannot be reallocated, the ones that can be allocated should be directed wisely to other alternative uses. The Federal Reserve lacked a mechanism that would ensure that the insolvent organizations are liquidated in order to prevent huge losses especially because resources such as human and physical resources are not easily liquidated. The injection of money in the financial system that resulted to an expansion of the monetary base was a mistake that the Federal Reserve did not foresee its implications. The support accorder to organizations that have turned insolvent as well as the additional of more money to the economy was a bad idea for an economy that was a risk of going down. In addition, they zero-rated the interest rate, which means that the rate of borrowing increased exponentially. Insolvent organizations are usually faced with a myriad of challenges, some of which may be issues relating to bad management. Despite such a view, Federal Reserve has gone ahead to develop the principle of discouraging liquidation of investments that would be termed as bad. Looking keenly at the situations of the insolvent companies, it is clear that the Federal Reserve may be forcing organizations that have failed to operate effectively remain in the market, an aspect that bleeds the economy through the support accorded. The assumption made by Federal Reserve is that the injection of the millions to the organizations is geared towards promoting them, instead a consideration should be made for a change in the management. Therefore, the intervention that was made by Fed was a contributor to the poor management of the Great Recession. Learning from the Great Depression, the Federal Reserve would have made interventions that would facilitate the prevention of the Great Recession. The Financial crisis in the country started to be witnessed around 2007, this was contributed by the increased printing of money in the earlier years. It is quite apparent that there is a great similarity in the causes of the two major economic downturns in the American history; the Great Depression and the Great Recession. No wonder critics have said that the 2007-2009 crisis could have been named the Great Depression 2. There is a great similarity in the fiscal policy adopted by the government in the 1930s and that of the first decade of the 21st Century. With the awareness of the Federal Reserve, they altered the treasury yield curve, an aspect that contributed to the development of the Great Recession. In addition, the alteration resulted in financial crisis. The policies that Federal Reserve enacted resulted to consecutive negative economic implications. Firstly, there occurred a stagnation of the economic growth, an aspect that sent a red signal on the position of the economy. The agency would have developed a fast intervention that would ensure that the situation is contained and the country reverts to normal. However, they went ahead to develop another fiscal policy that resulted to monetary inflation. A combination of these two aspects created a scenario where the economy proved difficult to contain. It is anticipated that an economy that is not growing well coupled with rising cost of living will suffer dire consequences. Such a complicated scenario is what resulted to the Great Recession. In their policy development, the Federal Reserve erred through the inversion of the Treasury yield curve. In the modern context where the economy is dominated by fiat paper money, it is highly likely that the inversion of the Treasury yield curve will have far-reaching economic implications. This came as a result of Fed’s focus on the short term interest rates at the expense of the long-term treasury bond yields. Though this could have addressed the immediate needs, there was the need to have the bigger picture while focusing on the entire wellbeing of the economy. Research has indicated that the inversion of the Treasury yield curve can result to serious problems with financial intermediation. Under normal circumstances, borrowing should be done for the short-term yields so that the trading can have long-term yields that emanates from investments. This scenario results to a yield curve that has an up-ward slope. When this happens, it means that the credit intermediaries will reap good profits on their investments as a result of the positive yield margin (upward sloping). On the other hand, a downward sloping curve results from the trading of short-term rates above the long-term ones, as a result there is a reduction in the profitability or losses that are incurred by the credit intermediaries. The negative yield margin is not the appropriate model that should be considered. Therefore, the Federal Reserve erred in the adoption of this model, hence exposing the economy to the Great Recession. However, it does not seem that the Agency was aware but it seems that there was some level of experimentation or lack of keenness. In 2004, the chairman of Fed, Bernanke in his speech, “what Policy Makers can Learn from Asset Prices”, he alluded to some of these issues and expounded even the more. Therefore, there seems to have been some inconsideration in the adoption of the inversion of the Treasury yield curve. Despite the difficult in the realization of the entire picture of the economy, Fed did not consider all the precautions. While historic data might have shown that the spread of yields can inform on the economic future, they should not be the only consideration. In addition, the capacity of the yields to forecast on the prevailing economic trends are very variant; while some are good predictors, others do not provide any meaningful evidence. In the past, the yield curve has proved to depict some information as regard to the economic scenario in a country. This has made it possible to elucidate the economic trend. However, over reliant on such does not provide the global economic picture, other models are worth giving a consideration. This is because the rest of the strategies provide additional precautions that are significant in aiding in developing a better picture of the economy. As noted by Bernanke, since 1964, there is a negative connotation of economic downturn with the yield curve. However, having the yield curve demonstrate the same behavior before the recession and the intervention was not as swift may mean that the Great Recession may have been stage-managed by Federal Reserve. Fed has the discretion to act appropriately on any alteration in the yield curve hence being able to predict and prevent the prevalence of recessions. The big question is, why did Federal Reserve opt to invert the Treasury yield curve in 2006/ 2007 period? This happened a few months before the start of the Great Recession. The argument presented by Fed’s chairman was that the inversion of the curve was meant to counter the increase in the rate of inflation. However, this seemed to worsen the situation. Probably reading from the Keynesian myth that states that prices are increased by prosperity, Fed developed the strategy in order to reduce economic growth, which was expected to counter the rate of inflation. This decision made by Federal Reserve could not solve the underlying problem, but also went ahead to introduce more problems that created a complex economic scenario that gave birth to the Great Recession of 2007-2009. The exponential reduction of short term rates of interest and the increase in the rate of money printing presented a very unviable way of solving an economic crisis that was looming. The problems created by the agency have continued to haunt the government to date; federal budget deficits have been observed in the American economy in the recent years. This is as a result of miscalculations and inappropriate planning by the Federal reserve. The point was, the money that was printed was meant to increase the issuance of debts by the government, however, the strategy led to increased inflation. Read More