The State of the US Economy and the Current Recession - Essay Example

USA Economy: A Review April 2009 s The purpose of this study is to bring to light the of the US economy and the current recession US is going through at this juncture. The study will also mention how the crisis started, how it got spread to all the economies and what was is role and responsibility of a Fed in dealing with such a crisis. The study also suggests ways to improve the situation. There is also a mention of the recent shut down and take-over of Lehman Brothers and also the problems faced by AIG to borrow money, which have only made the whole crisis worse than before. One of the most important responsibilities of the Fed is to ensure monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Fed comes out with monetary policy in order to ensure a certain key objectives like delivering price stability with a low inflation level coupled with an objective to support the Government’s economic objectives of growth and employment. To understand how the Fed monitors price related regulations to keep a check on inflation, we may consider a small example of the regulation of house and property prices. To take any decisions related to interest rates keeping in mind the ongoing inflation rate, the Fed must be thorough with the booming property prices and must take steps to ensure that the prices are not artificial. Government intervenes through its central bank to regulate the prices of many commodities, similarly it also regulates the prices of houses like any other important commodity. Fed has the responsibility to keep a check on asset prices including the prices of houses. There can be a number of reasons why the prices of houses may shoot up, like the simple rule of demand and supply has a definite impact. (Demand and Supply for Housing). The central bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. This step is of indispensable importance to the economy, as this is very widely used to contain inflation. The only purpose behind such a step is just to contain undue inflationary levels prevailing in an economy. The point to be noted here is that, this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices throughout the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is note that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and similarly high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in US will yield better returns to the investors compared to their overseas ventures. This phenomenon usually makes US dollar assets attractive, which pushes up the value of the currency vis a vis other currencies, and a stronger US dollar would mean less money would be shed on imports and less quantity of exports will take place as there will a lesser demand for products made in US because of the currency being strong. It is interesting to understand the process of how the bank sets interest rates. Current Recession and Subprime Crisis The subprime crisis started with the subprime lenders lending at higher rates than usual to the borrowers with bad economic history and lesser ability to pay back. The subprime lending functions on the principle of no collateral and higher interests. There debt instruments are then traded and are passed on to other banks or institutions which are ready to take them for the higher interest they get out of them. Effects on the US and the State of Current Economy The high liquidity crunch faced by the US because of the subprime crisis has made the Fed cut key interest rates several times over the last one year. The liquidity crunch that the US has witnessed had also done bad to the commodity prices and the willingness of the banks and financial institutions to lend each other or even to the consumers. The Bank of England has also cut rates to 4.5 percent in its latest monetary policy. This would also result in the housing prices falling as the buyers will not be able to raise mortgage finance and sellers will be forced to cut down their asking prices. The collapse of Bear Sterns has affected their London operations with over 2,000 jobs in London. (Q&A: How will the financial crisis hit us?) Another unfortunate incident that took place a few days back was of the 158 year old firm Lehman Brothers filing for chapter 11 bankruptcy due to the credit crunch. Financial institutions around the world have recorded $ 500 billion credit losses and write-downs due to the subprime crisis. At the end of August, the company is believed to have had assets worth $ 600 billion funded with equity of just $ 30 billion. (Lehman Is In Advanced Talks To Sell Key Business) AIG also faced the liquidity crunch due to the crisis and approached the Fed for funds as a temporary measure. American International Group was hit to the tune of $ 18 billion in losses over the last 3 quarters due to the guarantees they wrote on mortgage derivatives. (AIG, Facing Liquidity Crunch, Reaches Out to Regulator). The problem has also had a very deep impact on the equity markets across the globe, that have tumbled down to their lowest levels in as many as 6 years. Dow Jones had plunged to below 8,000 levels for the first time after 2003. The latest story on the crisis is that it has had a very deep impact on the automakers of the US, besides impacting banks and financial institutions. GM, Ford and Chrysler are expecting a $14 billion bailout from the government. The bill is supposed to provide money to the troubled auto industry as they are cash strapped and contemplate bankruptcy. Auto industry in the US supports 3 million jobs and it is very important for the government to do something to save the industry so that matters don’t go from bad to worse. With unemployment in the US already crossing 6.5 percent and the economic activity not indicating improvement, it would be suicidal not to save the auto industry. Earlier the government had made available $750 billion to bail out distressed institutions that have been reporting abysmal earnings quarter on quarter due to write downs they have faced in the property market. The Fed seems determined to stem the subprime problem and is prepared not to stand down until the crisis is fully resolved, but it remains to be seen whether the rescue measures will have any impact on the economy in the medium term, for the short term though, it seems like the crisis will take at-least a couple of years to clear itself. Conclusion Having discussed the issues related to central banking and the evident economic slowdown, there are very limited options to boost growth. The Fed has cut rates and brought them down to 0-0.25 percent currently. Fed has been consistently cutting rates ever since the beginning of 2007. Not only the Fed, but central banks across the world can now cut rates more swiftly as inflation seems to be slowing down as commodities have corrected steeply and many companies are about to report abysmal earnings due to the slowdown. Lower rates, is a sure shot way to boost growth and liquidity in the economy and the effects are beginning to show, as the liquidity situation has become better over the weeks. Banks have slowly started lending and the liquidity position has certainly become better. Low rate of interest is supposed to boost corporate earnings thereby boosting the overall economy. However, the Fed will have to keep an eye on recovery and liquidity because if liquidity is not controlled even when the economies starts picking up, it will result in inflation and the same cycle might get repeated for different reasons. Works cited “AIG, Facing Liquidity Crunch, Reaches Out to Regulator” CNBC.1 April. 2009. http://www.cnbc.com/id/26710104 “Demand and Supply for Housing” tutor2u. 24 March. 2009. tutor2u. http://www.tutor2u.net/economics/content/topics/housing/housing_demand_supply.htm “How Monetary Policy Works” bankofengland. 24 March.2009. Bank of England. http://www.bankofengland.co.uk/monetarypolicy/how.htm “Lehman Is In Advanced Talks To Sell Key Business”. CNBC. 24 March. 2009. http://www.cnbc.com/id/26708143 Read More