Economic Crisis 2008-2009 in the US - Causes, and Policies - Literature review Example

Economic Crisis in the United s POL 201 Janice Hodge Dovie Dawson March 19, Analysis of the 2008-2009 Economic Crisis in the US: The Root Causes and the Policies Implemented The magnitude of the US economic crisis in 2008-2009, having affected millions of peoples’ lives not only within and outside the nation, is comparable to 1930’s ‘Great Depression’; thus it is dubbed the ‘Great Recession’ (Katkov, 2011, p. 898). Various explanations as to the root causes of the crisis have been given, essentially blaming it either on market failure (i.e. corporate mismanagement, Wall Street’s risky undertakings, and banks’ fraudulent practices and toxic instruments) or government failure (i.e. widespread failure in regulatory oversight) (Barclift, 2011, p. 450). However, deeper analysis of the crisis shows that though the crisis is financial in nature, the culprit is not financial as many have explained but structural; it is caused by the faulty macroeconomic strategies of US – the reliance on bubble economy and dependency on international credits and imports. I. Understanding the Crisis Experts, policymakers and observers (BBC, 2007; Zaman, 2009, p. 64; Katkov, 2011, p. 898) perceive the crisis in contending ways, depending on which spectrum one aligns. But as the events unfold, everyone seems to agree that the crisis has started to manifest itself in the burst of the housing bubble in 2007 followed by the financial market crash. How did this happen? This question must have been asked with the shocking realization that this actually happens in the US – the seat of world power and the home of distinguished economists, financial analysts, and bankers. But after understanding the events, one would probably say that this kind of crisis would be most highly probable in the US. Why? The answer to this would come later. Going back to the first question, to answer this requires one to understand the mortgage lending in the US. One good simple explanation on this is to understand the effects of the changes made on the traditional model of mortgage lending to the sub-prime model as illustrated below. The differences between the two models rest on three important factors: First, the reliance on real assets for banks to lend; second, the guarantee on the capacity of borrowers to pay; and third, the transparency in the conditions of loans – i.e. that sub-prime loans are usually adjustable rate mortgages (ARM); toxic instruments, like the collateralized debt obligations (CDO) that the biggest investment banks of the world pump out (BBC, 2007, p. 1). In short, there are solid bases by which banks and borrowers conduct business, giving both parties clear indicators by which to act. Unfortunately, these three important factors on which banks traditionally operate are disregarded in the new sub-prime model. Though it is true that selling on the mortgages to the bond markets has given banks additional leverage to fund more borrowings, however, it has resulted to fraudulent practices, which banks no longer have the incentive to check (BBC, 2007, p. 1) – i.e., falsifying credit histories or income of borrowers by mortgage brokers to qualify borrowers so that brokers can earn fees and commission (Zaman, 2009, p. 65). Truly, the sub-prime model has succeeded in raising the demand for housing, which caused the housing bubble, but in the end caused the financial crisis. Freeman (2002) explained that the housing bubble created a hyperinflationary spiral, fuelling speculative investments in real estate. Consequently, this sent prices, assessments, real estate and mortgage credit volume also spiraling upwards. Such was actually the objective of the City of London-Wall Street financier and Fannie Mae. On the contrary, the productive economy that would have given debtors the capacity to pay and that would have given resilience to the US economy was staggering downward. (pp. 12, 17) Expectantly, as BBC (2007) reported, sub-prime borrowers, which make-up 22% ($1.3 trillion) of the $6 trillion mortgage bond market, defaulted in their payments. This resulted to wave of repossessions, causing the decline in housing prices. (pp. 2-3) Worse, since the US financial system has been largely dependent on the housing bubble, its burst has also caused the financial market to crash (Freeman, 2002, p, 12; Katkov 2011, p. 901). What made these unfortunate events possible is the loosened monetary policy of the US Federal Reserve System. In his paper, Zaman (2009) explained that under the leadership of Alan Greenspan – a staunch proponent of deregulating the US financial system (Chan, 2011, p. 2) – backed by his Republican gurus in the White House and in Congress, the US Federal Reserve System deregulated its monetary policy in favor of Wall Street through the enactment of the Financial Services Modernization Act of 1999 (FSMA). This Act lifted former restrictions (i.e. integration of banking, insurance and stock trading) under the Glass-Steagall Act of 1933 that would have curbed possible power accumulation and abuses by banks and other financial institutions. In effect, Zaman (2009) furthered that the FSMA allowed banks to engage in all types of financial markets (from investing to speculating), essentially leaving the US financial markets in the claws of financial conglomerates (p. 64). However, the FSMA is not enough to create the housing bubble that Greenspan has been developing since 1995. According to Freeman (2002), keys to this are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Loan Corporation (Freddie Mac), which pumped in huge sums of liquidity through their secondary home real estate market. To them, Greenspan had depended. (p. 12) In short, it happened because the government allowed it. The reason is political. Katkov (2011) explained that in 1990’s the US government is compelled to achieve its political goal of making homes accessible to the marginalized lower-income groups. The easiest strategy seen was the easing of banking standards in approving mortgages. (p. 898) Henceforth, banks, financial institutions and Wall Street took advantage of the situation to gain more through profitable securities – e.g. CDO, mortgage backed securities (MBS), collateralized mortgage obligations (CMO). As Ilie, Colibăşanu, Sârbu and Dumitriu (2009) described: “The subprime crisis is based on the securitization – the ‘packaging’ and selling of risk, based on ratings” (p. 53). But, why American borrowers do not have the capacity to pay? The answer to this leads to the macro-economic root causes of the crisis. Simple logic tells that one should only spend according to one’s capacity. Meaning, do not borrow nor consume more than you can pay; live only within your means. Such belief is anti-market, because restrained buying will not spur market growth. So to invigorate the market, consumers must be lured to buy and must be given purchasing power. Traditionally, American consumers’ purchasing power is wage-based. Meaning, with paid jobs, they can buy; without paid jobs, they cannot buy. But aside from the problem of unemployment, Tabb (2008) explained that real wages have declined for decades, forcing Americans to borrow more (p. 7). And the financial market is too happy to lend Americans money to finance their consumerism. To finance American borrowings, the federal state has to borrow abroad to finance its lending institutions. And being now the super consumer of imports with lesser exports, the US always ends-up with increasing trade deficit that further increases its current account deficit. Also, to fan consumerism in the absence of a strong manufacturing industry, US engaged in unregulated speculative real estate investment, which left the financial market free to hyper-inflate prices. This created a highly-risky bubble economy. Therefore, the periodical growth of the US economy is unreal growth because it is not based on real investment. What made matters worse is the problem of high unemployment. Employment is vital to sustain consumerism, but it remains at 25-year low (Brown & Lundblad, 2009, p. 43). Jacob (2011) cited in the International Business Times five primary reasons for unemployment: “fewer new openings,” “lack of real growth,” “government sector layoffs,” “Chinese job grab,” and “high taxes” (p. 2). However, these are only effects of the altered world economic role of US from being the super producer to super consumer. Katkov (2011) explained that a capitalist economic system is inherently characterized by a boom and bane business cycle. So to have a national economy with fewer manufacturers but more distributors would surely confront problems during economic contraction; the contraction of production means fewer products to be distributed, which means lesser need for sales persons. He furthered that even when the computer revolution has raised productivity and employment, the traditional link between these growths and consumption has been problematic because there are fewer new products being created. In other words, business has to create something that would fan consumerism to keep the economy going. But currently, the US lacks the needed productivity; so to fan consumerism, the best product to sell was housing because many desire to own homes. To enable the low-income group, the sub-prime mortgaged was introduced. It immediately became a blockbuster. (pp. 901-902) II. Policies to Revitalize the US Economy To reverse the economic downtrend, the Federal Government swiftly took the lead role by installing both fiscal and monetary mechanisms. Immediately, the Bush administration bailed out Bear Stearns, but left the Lehman Brothers to collapse, sending wrong signals to and adding more uncertainty in the financial market (Chan, 2011, p. 2). To Katkov’s (2011) account, through the 110th US Congress, Bush passed into law the Emergency Economic Stabilization Act on October 2008. This Act is a palliative measure meant to prevent the financial recession into becoming a depression by creating the Troubled Asset Relief Program (TARP). Through the TARP, a $700 billion relief package is entrusted to the US Treasury to buy mortgages and some other financial instruments in the hope of stabilizing the financial system. (p. 903) TARP essentially gave US Treasury Secretary Henry Paulson the discretion to save which he thought deemed to be saved (Holcombe, 2009, p. 3). Unfortunately, TARP failed. Bush left the presidency without resolving the crisis. What can be lauded in Bush’s response to the crisis is the immediacy. But his administration failed to stop the crisis which was unsurprising. In the first place, his policy response simply repeated the problem. Despite knowing that the financial crisis was due to the deregulation of the financial market, it did not bother to address this problem; instead it doled out billions of dollars to its favorite but troubled FIs and again the Federal Reserve System loosened the monetary policy and handed troubled FIs large amount of cheap loans. Though it may be argued that FIs have to be helped to prevent depression, Holcombe’s (2009) comment is also worth noting that this policy response undermines the market-based economic system (p. 1). Furthermore, the TARP is not enough to bail out the FIs. Having inherited the crisis, Obama started his presidency briefed on the gravity of the crisis by a team of economic advisers, who unfortunately were criticized to be the same people responsible for the economic policies being blamed to have caused the crisis – Suskind described US Treasury Secretary Timothy Geithner, who formerly served the Bush administration, as Wall Street’s man; while US National Economic Council Director Larry Summers, who formerly served the Clinton administration is described as a market fundamentalist (as cited in Siegel, 2011, p. 3). As such, it is not surprising to see them craft the same monetary and fiscal policy response made during Bush – stimulus package. Perhaps, the differences between Bush and Obama’s stimulus package are the breadth and amount. Bush’s TARP was meant only to bail out banks, whereas Obama’s Recovery Act of 2009 is not only $87 billion larger but also broader, as it also addresses the creation of jobs, stimulation of investment and encouragement of consumer spending (Katkov, 2011, p. 903). Aside from the stimulus package, Obama’s Dodd-Frank Act of 2010 further expanded the role of the federal government in regulating the financial market to prevent banks from going again into abusive and fraudulent practices and to protect American taxpayers and consumers. But the Republican-dominated Congress in cohort with the financial industry seeks to dismantle essential parts of this Act. (The New York Times, 2011, p. 1)On the other hand, the Treasury Secretary Tim Geithner and Federal Reserve System Chairman Ben S. Bernanke simply continued the monetary and fiscal policies in 2008 – providing soft loans to banks and buying bank securities. The only difference is the inclusion in Bernanke’s additional $2.2 trillion money supply to finance student and automotive loans and credit cards that may default in payment (Katkov, 2011, p. 903). Essentially so, Obama’s policy responses to the crisis do not differ from those of Bush; worse their scope and influence are greater. To Cordato’s (2010) description: If Bush brought America to this crisis; Obama further stagnated the economy and increased unemployment (p. 1). But to Scheiber’s (2012) analysis, unlike Bush, Obama’s team at least helped prevent the recession be dipped into depression; though it failed to achieve economic recovery as it promised (as cited in Kakutani, 2012, p. 3). Obama’s failure of economic recovery is unsurprising because he just continued Bush’s failed policies. It would have been different if Obama had taken a route different from that of Bush. Yet, Obama is really in a tougher situation – He is dealing not only with a great economic problem that requires immediate yet strategic policy responses but also with an uncooperative Republican congress, which judgments are based more on political expediency rather than economic reality; with a pro-market economic leaders who are far aggressive than Obama – e.g. Geithner prevailed in bailing out the nation’s banks over Obama’s political adviser’s call for tighter restrictions on aid recipients (Labaton & Andrews, 2009, p. 1); and with an American people not willing to make sacrifices for the economy. III. Conclusion: The ‘Great Recession’ in the U.S. is inherent in the flawed economic strategy of the US. What resilience can be expected in a bubble growth-dependent and import and credit-dependent economy? As such, the remedies advised by economic advisers, passed by the US Congress and signed into law by the US Presidents are mere stop-gap measures that hope to prevent the worsening of the recession into a depression. But since the main problem is the flawed economic strategy of the US, what is needed is not simply stimulating then regulating the financial market, but getting back the economy to the right track by reclaiming its traditional superiority in producing goods. This will not only resolve unemployment, but will also result to real capital growth and solid investments. Unless the US government learns to recognize that the problem is its flawed economic strategy of dependency on bubble economy (speculative investments) and international credits (debt-dependency) and imports (high consumerism), the crisis will recur and probably it will be more destructive. References Barclift, Z. J. (2011). 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The causes and ramifications of the 2008-2009 meltdowns of the financial markets on the global economy. Eurasian Journal of Business and Economics, 2 (4), 63-76. Read More