Understanding of What Happened in the US Economy over the Last Few Years - Term Paper Example

ECONOMICS UNDERSTANDING OF WHAT HAPPENED IN THE US ECONOMY OVER THE LAST FEW YEARS 20-APR-2009 TABLE OF CONTENTS Introduction Role of the Federal Reserve in managing the Sub-prime crisis 3 Reduction of base rates 3 Open market operations 4 Term auction facility 4 Bail-out of Bear Sterns and other banks 4 How regulation failed to prevent the sub-prime crisis 5 How successful was the Fed in handling the sub-prime crisis 6 Regulatory changes initiated by the Fed 6 Future course of action 7 The Economic Stimulus 7 Conclusion 8 Introduction The US economy has been going through a period of turbulence for the last few years. The economic downturn that began in 2007 and is continuing to this day is a manifestation of the excessive credit policies and bad lending practices coupled with poor regulatory oversight by the authorities. The combination of these factors has ensured that the credit bubble when it burst did really cause the entire global economic system to go into a severe contraction. What makes this crisis different from the periodic cyclical downturns one witnesses during alternating periods of boom and bust is that this crisis has been caused by borrowing and lending practices that were highly questionable and on top of that excessive leveraging of the financial sector meant that the sector’s contribution. As Kevin Philips (2009) notes, “The principal wave of credit card use for debt consolidation and consumption crested in 2005, but industry growth had been enormous. Over the period from 1990 to 2003, the number of card-holding Americans jumped by 75 percent—to 144 million from 82 million. However, the amount that they had charged quadrupled”. Liquidity, debt, and leverage provided the essential structure of the Multi-bubble, and its principal architect, from 1987 to 2006, was Federal Reserve Board Chairman Alan Greenspan. He kept the liquidity flowing and declined to regulate the ultimate excesses, be they rogue derivatives, exotic mortgages, merger mania, margin-loan speculation, or a giddy succession of asset bubbles. Over his nearly two decades at the helm of U.S. monetary policy, total credit market debt in the United States quadrupled from under $11 trillion to a mind-numbing $44 trillion. The principal growth, moreover, came not in government debt but in private borrowing and credit—the unsung, but indispensable oxygen of grand-scale financial leverage and speculation. Role of the Federal Reserve in managing the Sub-prime crisis The role of the Federal Reserve in managing the sub-prime crisis has revolved around a) Reduction in the base rates b) Open market operations c) Auction of Term auction facility d) Bail-out of Wall Street banks. Reduction of base rates The Fed has been cutting the base rates at which it lends to other banks. These are the interest rates as policy instruments that determine the level of credit and the money supply in an economy. The Federal Funds rate (the rate at which the Fed loans money to other banks overnight) was cut from 5.25% to 2% over a period of six months starting from September 2007 through March 2008. Similarly the discount rate (the rate at which commercial banks borrow from the regional offices of the Federal Reserve) was lowered from 5.75% to 2.25% - this is according to the Press release by the Federal Reserve (http://www.federalreserve.gov/newsevents/press/monetary/20070918a.htm) and (http://www.federalreserve.gov/newsevents/press/monetary/20080318a.htm) available on the website of the Federal Reserve. These rates are used by the central banks to rein in inflation or spur growth in the economy. Any reduction of the base rates or the interest rates would mean that the rate at which the commercial banks borrow from the central bank is lower. This means that more credit is available in the economy as a whole and this would spur growth. On the other hand, this would bring in inflationary pressure on the economy because of increased money supply. The real estate market like any other component of the economy depends on the availability of credit and cheaper credit would mean that more and more prospective buyers would find it easier to borrow for buying real estate (Mckinsey Quarterly, Print Edition 2007) Also, the commercial banks (as we have seen above) will lend at cheaper rates. The combined effect of this would be to lower the mortgage rates and this would lead to a boom in the mortgage market. Open market operations The Fed also intervened in the open market providing much needed short term liquidity to the banks. The Guardian (2008) stated that this was the “week that the Fed tried to save the world from Financial Meltdown”. As we see in this section and the succeeding sections, the Fed by intervening in the open market pumped money into the markets and it along with the Bank of England sent a strong message to the markets that it would take all necessary steps to prevent the financial system from collapsing. Term auction facility The Fed increased the Term Auction lending facility – a measure by which the Fed along with other banks provide liquidity to the commercial banks when the other instruments like the Federal funds rate and the discount rate were limited in their impact – from $60 billion in previous months to over $100 billion by the end of March 2008. Bail-out of Bear Sterns and other banks The most visible sign of the Fed’s involvement in the sub-prime crisis was the bail out of the investment bank Bear Sterns by J P Morgan Chase. The Fed let J P Morgan Chase avail of a credit facility to buy Bear Sterns for $2 a share. This prevented the collapse of Bear Sterns and the resultant systemic meltdown that would have happened if Bear Sterns had reneged on its commitments. This action of the Fed was tantamount to nationalising the assets of the bank and was reminiscent of a socialist pattern. However, market analysts justified the action in the larger interests of the economy. Apart from bailing out Bear Stearns, the Federal Reserve along with the government has instituted what is known as the TARP or the Troubled Asset Relief Program that envisages buying up the toxic debt that the banks are carrying by making available federal funds for this purpose. These funds have been given to a large number of Wall Street Banks with the express purpose that they be used to remove the toxic debt from their balance sheets. These bailouts have prompted calls from other sectors, notably Auto and Engineering sectors that have also petitioned the government for more funds. The concluding days of the Bush administration as well as the initial days of the present administration have been occupied with ways and means to fix the ailing economy. While there has been much criticism of the bailing out of the very people who caused the crisis, nonetheless the steps were deemed necessary as a means of saving the financial system from collapsing. How regulation failed to prevent the sub-prime crisis The sub prime crisis was allowed to go out of hand because of poor regulation of the lenders. The fact that the Fed stepped in to buy out Bear Sterns was a case of acting a bit too late. One area where financial guaranty insurers expanded over the years involves Mortgage backed securities relating to loans to borrowers who are classified as sub prime or having a credit history that was less than preferred. These mortgage-backed instruments have fallen in value due to the “sub prime lending crisis,” after an large number of defaults in the housing market occurred involving these mortgages. How successful was the Fed in handling the sub-prime crisis The way in which the Fed acted to manage and “resolve” the crisis arising out of the losses suffered by banks due to under performing sub-prime assets has been praised and criticised at the same time. The praise has been for the way in which the Fed lowered the base rates as well as provided liquidity to the banks that needed it the most. But, as pointed out in the previous sections, there was criticism that the Fed acted a bit late and as the International Herald Tribune pointed out (http://www.iht.com/articles/2007/12/18/business/18subprime.php) the “Fed shrugged as the sub prime crisis spread). Though the crisis seems to have subsided a bit, nonetheless, the disclosures by many banks including HSBC of a write-down of their assets and reporting of losses by Citigroup and the other banks means that the worst is not over yet. The present scenario looks like everyone is bracing for a long haul of uncertainty and weak growth. As the Guardian (2008) notes “the credit crisis has been quite un-predictable and no one is sure when the next problem would appear”. This sums up the prevailing mood of the economy and we have to keep our fingers crossed on the same. Regulatory changes initiated by the Fed The regulatory changes are likely to lead to higher costs and longer loan-processing times, but, these changes should be viewed more as an incentive to improve operations, better innovation on products, and improve the risk-management capabilities. The reduced availability of capital for easy credit, greater compliance costs, and lower profit margins for the medium to small lenders, may prove to be the solution that the industry needs badly. Future course of action It is certain that there is going to be new regulation passed by the Congress to deal with the fallout of the sub prime crisis. But the overall view is that the new regulation is not likely to be crippling. Already, there have been a significant number of self-regulatory actions taken within the industry like for instance stricter underwriting standards and bigger down payments. These may have the potential to take the sting out of the regulatory spirit. The availability of loans to sub prime borrowers has already been reduced significantly because of the market correction. The market system being as it is they are already acting in a self-correcting manner, thereby making the regulators not wish to appear to be denying the sub-prime borrowers a chance to own a home (McKinsey Quarterly, Online Edition, Number 4, and June 2007). The Economic Stimulus While the first of the stimulus packages passed by Senate was for the purpose of bailing out the banks, the second stimulus package passed by the Obama administration was with the purpose of providing much needed funds to the sectors that were affected. According to many observers, this package is being compared to the “New Deal” of FDR. The economic stimulus package passed by senate has the potential to millions of new jobs in the construction and engineering industry. According to the Council on Foreign Relations (2009), the plan envisages a spending “including $30 billion for highways; $31 billion to modernize federal buildings and other public infrastructure; $19 billion for clean water, flood control, and other environmental investments; and $10 billion to improve public transit and rail infrastructure”. This is expected to create stimulate enough demand and make the sectors competitive again. Conclusion This paper has looked at the functions of a Central bank and how it manages the economy with the monetary policy and available instruments at its disposal. The central bank along with the government acts in tandem to steer the economy out of crises as well as to spur growth and control inflation. In this globalised world, the role of the central bank is paramount in managing an integrated economy. Central bankers from Alan Greenspan to Ben Bernanke have been feted and criticised for each of the policy measures they have taken. In the context of the sub-prime crisis, it is more than important for the central banks to keep a “watch” on the economy and ensure that the functioning of the financial system is smooth. The key question that needs to be answered is why the combination of the Federal Reserve and the Government acting in tandem has failed to prevent the current crisis from happening. It is obvious that there has been a failure of oversight and what can be called a dereliction of duty in steering the economy. While my contention is not to go on a spree of blame, it is my firm belief that there should be mechanisms to prevent such crises from happening again. In conclusion, it should be obvious by now that the Federal Reserve and the Government have a great role to play in determining the future of the economy and taking steps to salvage the situation. It is to be seen how far the Obama administration succeeds in putting the economy back on track. Sources 1. Greenspan, Alan (2007) The Age of Turbulence: Adventures in a New World. Allen Lane. London 2. Chubak, David & Connell Sean (2007).Handling the sub-prime crisis (Online). McKinsey Quarterly. Available from: http://www.mckinseyquarterly.com/Survivingand_prevailingin_the_US_subprime-mortgage_market_2014 (Accessed 20 May 2008) 3. Central Bank (2001). The Encyclopaedia Britannica. Deluxe ed. 4. Andrews, Edmund. Fed Shrugged as sub prime crisis spread (Online). The International Herald Tribune (Online). Available from: http://www.iht.com/articles/2007/12/18/business/18subprime.php (Accessed 20 May 2008). 5. Board of Governors of the Federal Reserve System (2008) [Online]. Available from: http://www.federalreserve.gov/newsevents/press/monetary/20080318a.htm (Accessed: 20 May 2008). 6. Elliot, Larry. The week the Fed tried to save the world from financial meltdown (Online). The Guardian Online. Available from: http://www.guardian.co.uk/business/2008/mar/19/useconomy.creditcrunch (Accessed 20 May 2008). 7. Teslik, Hudson-Lee. (2009). The U.S Economic Stimulus Plan. The Council on Foreign Relations. Retrieved Feb 18 2009 from: http://www.cfr.org/publication/18348/ Read More