The Economic Crisis of 2008 - Research Paper Example

In 2008, a string of insurance company and bank failures sparked off a financial crisis that was so severe that it brought global credit markets to an abrupt halt and required extraordinary government interventions. The crisis began as a result of greed on the part of mortgage lenders. Over the years, they lent money to people who could not afford their mortgages, charging higher interest rates and thus making more money on sub-prime loans.  If the borrowers defaulted, they simply got hold of the house and put it back on the market. Everything was great when the houses were selling and their values were sky-rocketing. This prompted lenders to lend out even bigger mortgages as they now had more protection against possible foreclosures. An economic crisis arose when the mortgages accumulated and a whole host of homeowners were not able to pay their mortgages. There was subsequently a shortage of liquidity among the lenders who had to bear more and more foreclosures. Major financial markets went into a free fall when the government of US decided to take over both Freddie Mac and Freddie Mae. The crisis was further aggravated when Lehmann Brothers, failing to find a buyer, declared bankruptcy. American International Group had to be bailed out by the federal government of US with the help of $85 billion capital injection, while another failing company, Merrill Lynch, was rescued from deep waters by the Bank of America. This series of failures triggered a nerve-wracking chain reaction of further failures that plunged whole of America into chaos (Chari et al 2008). The assets of Washington Manual were purchased by JP Morgan Chase in order to limit the damage done as a result of the biggest bank failure in the history of America. These failures resulted in a crisis of trust and confidence that made banks unenthusiastic to lend money among themselves or to anyone else. Consequently, the whole economy was brought to a complete standstill as there was not much money in the economy to spend. In order to understand the measures taken by the governments in the wake of the economics crisis we need to understand the mechanisms of monetary and fiscal policies. We also need to be clear about what role the government has to play in such situations. Should the government follow a hands-off policy or should it play a more active role. A government can aim to improve the economy through either a fiscal policy or a monetary policy. The two together are the main macroeconomic policies available to the government if it wants to adjust the level of employment, inflation or output in the economy in times of recession or a boom. Fiscal policy refers to the measures taken by the government to increase or decrease aggregate demand by either changing its spending or the level of taxation. When the government decides to increase the level of spending or reduce taxes, the policy is known as an expansionary fiscal policy as it, according to the Keynesians, leads to increased aggregate demand in the economy which in turn generally causes prices and output to rise. On the other hand, when the government increases taxes or reduces its expenditure, then it is said to be following a contractionary fiscal policy. Keynesian economists argue that when the government decreases the taxes, say in times of recession in order to kick start the economy; people have more income to spend which drives up the demand of goods and services in the economy. In order to match this increased demand, the producers strive to increase their output as well. This is achieved through adding more and more people to the workforce pushing down the level of unemployment in the economy. However, demand and supply can only match each other up to the point of full employment. Beyond this point, the increase in demand is failed to be satisfied by an increase in output as adding further workers may result in a loss for the firm. When such a gap between demand and supply occurs, the price level in the economy tends to rise. This is because demand is more than the supply and producers exploit this scenario to raise the prices of goods and services. The complete reverse of the above process takes place i.e. aggregate demand is gradually pushed downwards till the point where equilibrium is again achieved. According to the Keynesians, prices and wages are sticky, that is they take time to adjust to new conditions and that is why there are issues of unemployment and inflation in the economy. Therefore, a Keynesian would say that fiscal policy has an impact on macroeconomic variables in the short run but no effect in the long run. A similar effect is induced if the government expenditures are increased as that simulates aggregate demand. Government pursues an expansionary policy in times of recession when the employment and output are low. Also, the government is compensated for the possible increases in budget deficit as a result of increased expenditure by the expectation of periods of boom afterwards (Bartolotti 2006). On the contrary, classical economists believe that the prices and wages are not sticky and adjust quickly to the changes in aggregate demand. In short, money is neutral in both the short and the long run. Moreover, they argue that the government in reality covers for the budget deficits by borrowing from local and foreign institutions or through the printing of money. As a result, interest rates go up because there is now higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, a process known as crowding out as people are now reluctant to borrow and thus spending declines (Hansen 2009). Now I would discuss the second macroeconomic policy available to the government i.e. the monetary policy. Central Bank, in times of recession, may seek to increase the level of output and employment in the economy. This is achieved through either increasing the money supply or reducing the interest rate. This is termed as an expansionary monetary policy. Increasing the money supply through simply printing more money causes an increase in aggregate demand in the economy as people want to spend more. This is the point of view of the Keynesians. They believe that money is not neutral in the short run but has no effect on aggregate demand in the long run. When the Central Bank reduces the interest rate, people find it more attractive to spend their money in contrast to saving it as banks offer little interest in return. This shifts the aggregate demand curve upwards leading towards a similar process to the fiscal one. Thus if the Central Bank wishes to control inflation, it would increase the interest rate, decreasing the aggregate demand and increasing saving in the economy (Fredric 2007). Reserve requirements to be met by the banks can also be increased to achieve the purpose of contractionary monetary policy. By increasing the reserve requirement, the Central Bank forces the banks to lend out less. This ensures that a credit crunch does not arise, especially in event of a foreclosure or an expected foreclosure. In other words, banks keep a certain amount in deposits which helps them to avoid problems of liquidity in trying times. Since lesser money is lent out, aggregate spending in the economy goes down as well as the aggregate demand. Since supply is greater than demand, the prices go down as well. This in turn results in lower output being produced and hence unemployment. A Central Bank may influence the money supply through open market operations i.e. the managing of quantity of money through the buying and selling of various financial instruments like treasury bonds, company bonds, or foreign currencies. When the Central Bank wishes to push down inflation or want to finance government expenditures, it issues government bonds or treasury bills with a pledge to return back the money of the buyers of the t bills and bonds. On the contrary, when Central bank wants to stimulate aggregate demand, then it buys bonds of companies. In this way it injects money in the economy, simulating aggregate demand (Sinclair and Lavan 2005). Coming towards exchange rates theory, when the interest rates are high, demand for local currency increases as foreign people value the local currency highly. This is because they are expecting a higher return to their savings in local banks. This in turn appreciates the local currency driving drown aggregate demand. A simple monetary rule is followed by most governments: when they expect inflation to rise and they want to curtail it they raise the interest rates or start printing less money; when they expect unemployment to increase, they lower down the interest rates or start printing more money (Taylor 2008). The argument against public sector intervention is that it hampers a free market economy and is against the principles of perfect competition. Deadweight losses occur because of government intervention in the form of increased taxation or printing of more money resulting in a loss of efficiency. According to advocates of perfect competition, the market is best left untouched by the government as any attempts by the government to regulate the variables distorts the equilibrium and creates problems both in the long run and the short run. Also, it is argued that public sector does not have the same incentive to spend on research and development or innovation of goods and services. The advocates of government intervention, on the other hand, argue that some level of intervention is necessary to regulate the market, to set up the rules of the game, and to ensure that the transgressors are rightly punished. Also, some goods can not be provided by the market and therefore should be provided by at least someone. These goods are termed as public goods i.e. the goods whose provision is the responsibility of the government who in turn finances it through levying of taxes. While education and health care can be provided by the market, there are serious equity concerns to ponder at which the market conveniently ignores in its insatiable pursuit of efficiency. Equity arguments can further be used to justify imposing of taxes and subsidies, and also that of keeping the greed of lenders and borrowers alike in check. The paramount importance of a Central Bank is highlighted as someone needs to set the rules of financial transactions and monitor the market, and possibly intervene if need arises. For instance, it is Central Bank that sets up the reserve requirement that all banks must meet so that they do not face a situation like today’s credit crunch. In order to limit the damage done by the economic crisis, policy makers in US made five cuts in the target federal funds rate totaling 225 basis points as well as dropped the premium on primary (discount) lending from 100 to 50 and then to 25 basis points, above the federal funds rate target in order to encourage spending in the economy so that aggregate demand could be simulated. Moreover, the Fed extended $24 billion in credit to the European Central bank and the Swiss National Bank which was later raised to $36 billion. Credit was also extended to primary dealers through the creation of “Primary Dealer Credit Facility”. In addition, the Fed authorized lending to support the JP Morgan purchase of Bear Streams (Cecchetti 2008). These actions of the fed indicate a willingness to increase credit in the economy to induce spending in the economy in order to create more jobs and to generate economic activity, which are in line with the monetary and fiscal policy theories. This was what John Taylor (2008) mentioned in his article entitled “The Financial Crisis and the Policy Responses: An Empirical Analysis of what went wrong”. Theoretically speaking, these steps should have given banks access to short-term funding at lower interest rates than they had been facing, while reducing the demand for inter-bank loans, thus enabling funding markets to return to normal. Also, these steps should have given banks access to the liquidity that they desperately needed to carry on their day-to-day operations. This was essential as otherwise the whole economy would have been at a standstill and people would have gone in their shells, reluctant to lend money hence further aggravating the credit crunch. On the contrary, the mere fact that there was no return to sanity, and that through the late fall and early winter of 2008 the situation only worsened, indicate that these policies were not able to achieve their intended objectives. One of the reasons behind this anomaly was that all this time the federal funds rate was extremely volatile. It seemed that the stigma attached to borrowing was the main factor behind this unexpected volatility as people continue to abstain from borrowing. In accordance with Cecchetti (2008), seeing traditional interest rate instruments proving ineffective, policymakers introduced several unorthodox measures. Starting in mid-December 2007, the way in which Fed lent money to commercial banks was changed, and a new Term Auction Facility was announced. Then, in March 2008, large amounts of Treasury securities were offered in exchange for lesser-grade instruments as well as lending of loans directly to investment banks. Along the way, the Fed increased the size and term of the repurchase agreements they engaged in substantially and swapped dollars for euros with the ECB and Swiss francs with the Swiss National Bank. Similarly, France, Italy, Germany and twelve other European countries took comprehensive steps to salvage their banking systems from potentially disastrous implications of the credit crunch emanating from US. They drafted a 13-point draft according to which The European Central Bank was to intervene in the financial turmoil to boost liquidity. Likewise, the Euro zone governments committed to underwrite bank debt till the end of the following year and pledged to take appropriate steps including recapitalization to prevent the collapse of “systematically relevant institutions”. The announced European model was based on Gordon Brown’s model that focused on three elements – liquidity support, recapitalization of distressed banks and inter-bank lending guarantees. Moreover, EU finance ministers tried to improve the confidence in the battered banking system by raising the minimum level of guarantee on bank savings across member states from 20,000 euros to 50,000 euros for one year. It was also promised by them to support bigger financial institutions that might have caused systematic failure if allowed to fall apart. Apart from these measures, the ECB lowered the interest rate as well as offered unlimited liquidity at weekly auctions. All these measures validate the argument of monetary theorists as they seek to improve the liquidity and make more credit available to the borrowers. Harvey et al (2009) surveyed 1050 Chief Financial Officers in the US, Europe, and Asia in order to clearly assess whether their firms were credit constrained at the time of financial crisis 2008. What they found out is that constrained firms were forced to plan deeper cuts in tech spending, employment, and capital spending than unconstrained firms. They were also compelled to draw more heavily on lines of credit for fear banks would not allow access in the future, burn through more cash, and sold more assets to finance their operations. Many of these firms had to simply bypass attractive investment opportunities because of their inability to borrow externally. These results were shown to hold in Europe and Asia as well. Viewed in this context, we get the better picture why policymakers took unprecedented measures to unfreeze credit markets. It is important for the both the constrained company and the policy makers to work towards relaxing the financial constraints faced by the troubled company in order to produce long-term growth opportunities in the economy. Ivashina and Scharfstein (2008) discuss bank lending trends during the financial crisis of 2008. According to them, new loans to large borrowers went down by 47% during the pinnacle of financial crisis (fourth quarter of 2008) relative to the quarter before that and by 79% relative to the peak of the credit boom (second quarter of 2007). They also proved that banks that had access to deposit financing cut their lending less than banks with lesser access to deposit financing. Furthermore, a large overhang of revolving credit facilities was observed that might have led to curtailed lending. An increase in drawdowns undertaken by low credit quality firms concerned about their access to funding was also witnessed. Although, such drawdowns might have been helpful to the borrowers, they restricted the ability of banks to make other loans. Ivashina and Scharfstein (2008) found out that “banks with more revolving lines outstanding relative to deposits reduced their lending more than those with less revolving line exposure” (Ivashina and Scharfstein, 2008. p.1) . Austin Murphy (2008) in an analysis of the financial crisis of 2008 presented some workable solutions to the crisis other than the option of a massive bailout of the markets. According to him the real estate and mortgage crisis can be resolved by letting the defaulting mortgagors to refinance with shared appreciation mortgages that would prompt lowering of their payments in return for a share in the future appreciation on the home for the lending institution. Another policy suggested by Murphy to improve the situation is to have cases of defaults on secured consumer loans such as for autos be renegotiated of both the loan terms and the collateral in a unique way. He goes on to explain his point by giving an example of the action of repossession of cars held by defaulting auto loan borrowers being replaced by an exchange of a cheaper car for the existing collateral, worth more in value, which could result in more manageable payments for the borrower. Moreover, Murphy suggested that depository institutions of the failed corporate holding companies be nationalized while letting the holding companies along with all the failed institutions to go bankrupt and default on their credit default swaps. References: Mishkin, Frederic S. Monetary Policy Strategy. Cambridge, Mass.: MIT, 2007. Print. Mahadeva, Lavan, and Peter Sinclair. How Monetary Policy Works. London: Routledge, 2005. Print. Bartolotti, Leo N. Inflation, Fiscal Policy and Central Banks. New York: Nova Science, 2006. Print. Hansen, Bent. The Economic Theory of Fiscal Policy. London: Routledge, 2009. Print. Chari, V.V. et al. Facts and Myths about the Financial Crisis of 2008. Working Paper 666. 2008. Cecchetti, S. G. Monetary Policy and the Financial Crisis of 2007-2008. 2008. Taylor, J. B. The Financial Crisis and the Policy Responses: An Empirical Analysis of what went wrong. 2008. Ivashina, V. and Scharfstein, D. Bank Lending During The Financial Crisis of 2008. 2008. Murphy, A. An Analysis of the Financial Crisis of 2008: Causes and Solutions. 2008 Harvey, C. R. et al. The real effects of financial constraints: evidence from a financial crisis. 2009. Read More