Post 2008 Financial Crisis and Its Impact on the US Economy - Example

Post 2008 Financial Crisis and Its Impact on the US Economy Post 2008 Financial Crisis and Its Impact on the US Economy The US financial markets are highly developed and liquid encompassing numerous products such as equities, their derivatives, currency trading, mutual funds, fixed-income securities and many more. At the outset, the paper provides a general but brief overview of the myriads of financial markets that operate in the US and how efficiently they settle transactions along with the interest rates policy as observed by the Central bank. The paper then attempts to explore the effects of 2008 financial crisis, especially on the US economy that include unemployment rate, GDP growth rate, interest rates, inflation. The paper also looks into the role of the Central Bank and the effectiveness of their monetary policy that they employed to put the economy back on track. Finally, the paper suggests recommendations to avert such financial crisis in future. Financial markets in the US provide numerous financial products for investment and trading. Most of them are also open to private investors. They can be segregated in the following heads (Investopedia). Stock Markets These markets allow investors to buy and sell listed stocks in the specific exchanges. They are extremely liquid and operate 5 days in a week – Monday through Friday except public holidays. The New York Stock Exchange and the NASDAQ are the major stock markets in the US. Bond Markets The US Treasury bonds, corporate bonds, notes and bills, municipal bonds all are parts of the bond markets. They are debt securities also referred as the fixed-income, credit or debt markets. Money Market They are also known as cash investments due to their short-term maturities. It is considered a safe place to park money for short durations. Cash or Spot Market In this market, securities are sold for cash making immediate delivery on daily basis. Derivatives Market They are highly speculative in nature offering numerous derivatives created from the underlying asset. Some of the derivatives are named as futures, forwards, options, swaps. Currency Market Currency pairs, for example, Dollar vs. Euro, or Dollar vs. Yen and others are traded in this market. It is the most liquid market in the world. Anyone from an individual to an institution can participate in this market. The currency market operates 24 hours a day, from Monday to Friday. It is important to note that the US financial markets are governed by numerous laws and regulations through regulatory authorities such as Securities and Exchange Commission (SEC), the Fed (Federal Reserve) and many more. This is to ensure sustainability of these markets. As a whole, the financial markets in the US are the most liquid markets. In a globalized world, they are interconnected with other markets of the world based at London, Paris, Tokyo, or Frankfurt. The US financial markets are considered lead markets for majority of the products that are developed and channelized by them (Murphy, 2014). Efficiency of the Financial Institutions The financial market is one of the significant economic sectors in the US. The US financial sector creates employment in numbers that exceed combined employment generated by automobiles, apparel, steel, and pharmaceutical manufacturing sector together. It is estimated that financial market in the US provide employment to over 5 million people and its contribution to the US GDP has reached to almost 7.9% in 2007 (Greenwood & Scharfstein, 2012). One of the bases to gauge the operational efficiency of financial markets is to check how quickly (period) these markets settle transactions. All currency transactions follow T+2 norm meaning transaction are settled on the second day. While US treasuries are settled next day (T+1), transactions on all other commercial papers are settled on the same day. Similarly, spot stock markets transactions are settled T+3 bases – on the third day (Settlement Period, 2014). Banking institutions in the US has become highly competitive and efficient after the financial deregulation and removal of the Bretton-Woods agreement. After deregulation, banking institutions in numbers have reduced and inefficient small banks are eliminated in this process. In a bid to reduce cost and increase productivity, many institutions have adopted the route of acquisitions and merger. Mergers and acquisitions significantly improve cost efficiency, product-mix efficiency and managerial efficiency. Some of the well known mergers such as Bank of America with MBNA Corporation, Mellon Financial Corporation with Bank of New York, First Union Corporation with Wachovia Corporation, or Banc One with J.P. Morgan Chase & Company were done to rationalise costs through efficient operations and eliminating duplication of work. Mergers provide scale of operation and product mix efficiencies in banking sector. It is also a fact that some of the mergers have made them too big to fail for the government to intervene to prevent widespread economic consequences (Economywatch, 2010). Efficient financial institutions and markets tend to reduce transactions costs in the economy. A well-developed financial market can offer a variety of products to meet needs of lenders as well as borrowers. While embarking on new projects or starting new businesses, the cost of financing can be easily compared due to competition and transparency in the US financial markets. Businesses and individuals get access to the variety of products at most competitive rates and terms. Entrepreneurs can plan their project expansion with more accuracy as the information available to them is full and accurate. That is why the financing cost for the businesses and individuals in the US is one of the lowest in the world (Greenwood and Scharfstein, 2012). Interest Rate Policy of the Federal Reserve Stable prices and liquidity are the two major aspects that help to determine applicable interest rates in the US economy and for that matter in any other country. The Federal Reserve decides interest rates for retail banks to lend and borrow money to them with the objectives of preventing inflation and at the same time maintaining liquidity in the economy. The Federal Open Market Committee - FOMC under the Fed decides about key interest rates that also include discount rate. It takes decisions on increasing or decreasing money supply in the economy to achieve its objectives of inflation. It is the retail banks that are exposed to the consumers and businesses directly and thus, the Fed directs flow of money in the market through retail banking system (FOMC, 2014). Competitiveness of interest rates is important. Gandel (2010) argues that low interest rates are supposed to spur growth by encouraging borrowing, giving people more money to spend and invest. For example, low mortgage interest rates stimulate demand for housing and related sector. Also, when interest rates are low, people spend more as it does not provide any incentive to save. When interest rates are low, stock prices tend to move up as they become important vehicles for higher returns. Lower interest rates help businesses as it brings their costs down. More businesses help to create new job in the economy. Usually, the Fed prefers low interest rates; however, low interest rates prompt people to spend more causing inflation. It is also true that higher interest rates can lead to recession. Interest rates charged by institutions and banks differ greatly on the purpose, and kind such as loans, credit cards, mortgages. A bank will resort to higher interest rate if it assumes lesser safety for the money lent. Similarly, credit cards always charged higher interest rates. When higher risk is involved with the venture undertaken, institutions tend to charge higher interest rate. Interest rates in the US have moved widely in the last 4 decades. Interest rates reached 20 percent – at its highest in March 1980 and were as low as 0.25 percent in December 2008 as is evident from the following chart. The interest rates in 1980s were sky high because inflation was ruling high due to oil crisis during the time, and huge government spending. In order to control inflation, the Fed kept on increasing interest rates in 1980 until it reached 20%. That surely controlled inflation; however, then economy entered into recession (The Economist, 2010). Source: http://www.tradingeconomics.com/united-states/interest-rate The Effect of Financial Crisis The effects of the 2008 financial crisis were widespread not only in the US but across the world. After the days of Great Depression witnessed during 1930s, the post 2008 financial crisis was unique in the sense that the US government had to bail out numerous financial institutions. The US government had to provide almost $200 billion to save Fannie Mae and Freddie Mac, the two largest mortgage institutions, from bankruptcy (Davis, 2014). The US government took over the management of American International Group (AIG), the largest insurance provider by pumping around $85 billion. In 2009 alone, 305 banks were nominated by the Federal Deposit Insurance Corporation as failed banks. Lehman Brothers, the largest non banking financial institutions filed for Chapter 11 bankruptcy on September 15, 2008 as the government refused them to bail out. The US Treasury purchased preferred stocks of nine top banks worth $125 billion in the month of October, 2008 to provide needed liquidity. In November 2008, when other banks got affected, the Fed pumped in another $33.5 billion and bailed them out. Deflation in Crude Oil Price Source: http://inflationdata.com/Inflation/Inflation_Rate/Historical_Oil_Prices_Chart.asp It is important to note that the US consumes almost 40% of the world’s crude output. Impact of the 2008 financial crisis in the US was so huge that crude oil prices came crashing down to $40-45/barrel in March 2009. During its peak, the crude oil prices had touched to $147/barrel so it was a significant drop in the price reflecting overall pessimistic sentiments on the economy (McMahon, 2014). Effect of the US Financial Crisis Spread to Other Areas of the World What initially began with the subprime mortgage crisis in the US soon culminated into a huge financial crisis cutting across most of the banking and financial institutions not only in the US but across other countries such as the UK, Germany, Italy, Greece to name a few. Domino effect was clearly evident as the entire Europe came into the grip of financial crisis that had its origin in the US. Landler (2008) argues, "In a global financial system, national borders are porous". Failure of several financial institutions in the US catapulted into a huge banking crisis in Europe. Belgium, Netherlands, and Luxembourg joined together contributing $16.2 billion to bail out Fortis Bank. Since many large banks in Europe had invested significantly in mortgage securities of US based financial institutions, its impact was felt across Europe (Landler, 2008). Northern Rock (a housing bank) in the UK was taken over by the UK government to safeguard public money. Royal Bank of Scotland (RBS) and Lloyds were bailed out by the UK government to prevent economic fallout within the banking system. The UK then infused almost $100 billion from the exchequer to protect these banks (Thompson, 2013). The worsening financial crisis in the US and Europe catapulted the world economy into a low gear. With the US economy began feeling pinch of the heat, economy of the some of the major exporting countries to the US such as China also nosedived. In the third quarter of 2008, Chinas economic growth slowed down. However, the real impact to Chinese economy came about a year later. In March and April 2009, Chinas exports to the US declined by 17.1 percent and 22.6 percent respectively (Batson, 2009). It will be worthwhile to know how post 2008 US financial crisis macroeconomic indicators such as unemployment rate, GDP growth rates began worsening quarter after quarter providing clear signals that the US economy is getting trapped into recession. Unemployment Rate The unemployment rate in the US began rising from the second quarter of 2008. By October 2009 it touched 10% and remained above 9% throughout 2010 and most part of 2011. Tens of millions of people lost their jobs. The US Economy faced unprecedented employment crisis. Investors stopped investing in new businesses fearing they would not get market for their goods and services. Economists feared that economy might dip into depression. Source: http://data.bls.gov/timeseries/LNS14000000 Impact on the US GDP When millions of people lose their jobs, its impact on the GDP could be catastrophic. Throughout 2009, GDP growth rate trailed in a negative territory; though, it recovered slightly in the first two quarters but again began dipping into either nil or negative growth between mid-2010 to at least first quarter of 2011 (United States GDP growth Rate, 2014). Source: http://www.tradingeconomics.com/united-states/gdp-growth. Housing Sector Severely Affected With the onset of subprime crisis in 2007 and then the financial crisis in 2008, housing prices across the US began sliding significantly putting entire real estate industry in a dire trouble. Those who lost the jobs in the aftermath of financial crisis were unable to pay housing loans they had taken during their employment. Moreover, prices felt to such an extent that a large proportion of homeowners had to let go mortgages due to negative equity in their hands. In these years, the nation had accumulated a large stock of housing units for which there were no takers. The following chart shows how badly the housing index has impacted from its peak of over 205 in 2006-07 receding to around 140 at the beginning of second quarter of 2009 registering almost 30% fall (Leong, 2013). Source: http://www.investmentcontrarians.com/housing-market/ The Role of the Central Bank The Central Bank (Federal Reserve) does an important role of regulating money supply. It does it by either buying or selling government securities. Post financial crisis, the major issue was to enhance the liquidity in the financial market as numerous institutions and banks were short of liquid funds. The Federal Reserve has several mechanisms to regulate money supply such as making changes in reserve requirements, offering discount loans, or may resort to open market operations. Open market operation is an effective tool to regulate money supply on short-term basis. The Federal Reserve began purchasing federal securities in large scale from the market to invigorate economic environment of the country (FOMC, 2014). The steps taken by Central bank along with the US government saved the economy going into depression. The stimulus packages extended between 2008 and 2014 helped in creating 1.6 million jobs every year. Moreover, at least 5.3 million people were saved off from falling under poverty base line. Between 2009 and 2011, the economic output of the country increased by 2-3 percentage points due to Stimulus support provided by the government (What the Stimulus Accomplished, 2014). The Effectiveness of Monetary Policy This was the first time that aggressive monetary measures were employed in the last few decades of the US history to put the economy back on track. As the US financial crisis became intense, the Federal Reserve resorted to aggressive monetary policy reducing the federal funds rate from 5.25 percent in September 2007 to 0.25 percent less by December 2008. Mishkin (2009) argues that monetary policy has been effective as it has injected huge funds in the banking system so as to provide needed liquidity in the market by reducing the funds rate to as low as 25 basis point (0.25%). This greatly reduced the negative impacts triggered due to financial crisis. Most economists agree that large fiscal stimulus packages or more aggressive monetary policy measures are necessary in financial crisis times to maintain buoyancy in the financial markets. However, aggressive monetary policy becomes risky only when it causes to increase the underlying rate of inflation. Monetary policy makers are always alert to revise the interest rates upwards if they find their monetary easing is expected to hike inflation rate (Mishkin, 2009). Monetary Measures and Inflation Rates during Crisis Period It would be appropriate to find whether monetary tools were effective enough to ease the liquidity in the market and simultaneously keeping inflation low during the crisis period. From the chart below, it is clearly evident that in most part of 2009, the inflation was negative; monetary easing did not create any inflation when financial crisis was at its pinnacle. Source: http://www.tradingeconomics.com/united-states/inflation-cpi Even during most part of 2010, inflation remained within targeted rates of 1-2 percent. During second half of 2011, it did cross the targeted rate of 2 percent for some time but then soon it eased in 2012 and onwards to remain around 2 percent until the current times. This certainly shows that monetary easing was not only helpful to keep the economy moving but it was equally successful in checking the inflation rates within the targeted rates between 2009 and 2014. It is also clear that due to monetary measures and stimulus packages provided, the US economy did grow at modest rates between 2009 and 2014 rather than showing negative growth rates. Recommendation Roots of the 2008 financial crisis in the US can be tracked to subprime mortgages that most banking and financial institutions were involved with. Excessive leveraging and inadequate amount of capital were the culprits behind subprime crisis. Lehman was operating at extremely high degree of leveraging. In 2007, its total assets were 31 times of its equity making it extremely prone to defaults (The Collapse of Lehman Brothers, 2014). That was the case with many other institutions too. Proper capital adequacy norms are extremely necessary to prevent financial institutions to operate at such sky-high leveraging. There has to be a strict audit on firms solvency, liquidity position and its profitability. Regulatory authorities such as SEC, the International Financial Reporting Standards, must be extremely vigilant to ensure that good management practices are followed. Ethical business practices and standards should be the usual norm while managing such large organizations. Similarly, for banking institutions, stringent capital adequacy norms are necessary with a clear emphasis on fair ethical governance. Laws need to be enacted to prevent use of public money for speculation. References Batson, A. (2009). Chinas Exports Fall, Threatening Recovery. [Online] Available from http://online.wsj.com/news/articles/SB124209675372909631 [Accessed 14 December, 2014] Bexley, J. B., James, J.F., Haberman, J. (2010). The Financial Crisis and its Issues. [Online] Available from http://www.aabri.com/manuscripts/10500.pdf [Accessed 15 December, 2014] The Collapse of Lehman Brothers (2014). Investopedia. 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