The Root Causes of the 2008-2009 Economic Crisis - Essay Example

THE ROOT CAUSES OF THE 2008-2009 ECONOMIC CRISIS AND THE POLICIES IMPLEMENTED BY KEY FACTORS RESPONSIBLE FOR RESCUING THE U.S. ECONOMY Name/Number Instructor Date Economic crisis Many economists consider the economic crisis of 2008-2009 to be the worst to have ever hit the world since the great depression of the 1930s. The crisis caused large financial institutions to collapse as national governments attempted to bailout banks from the financial crisis. Moreover, stock markets from all over the world collapsed while the housing market was largely affected by the crisis. The effects of the crisis led to numerous evictions and foreclosures in the housing sector and prolonged periods of unemployment for many people. The crisis contributed to the failure of many businesses leading to a massive decline in consumer wealth, a loss which was estimated to be worth trillions of dollars (Simkovic, 255). Generally, there was a significant decline in economic activity all over the world as a result of the recession. This paper will look into how many governments strived to put appropriate measures in place to curb mitigate the crisis; particularly, the United States’ government, through the various policy makers and stakeholders, implemented effective measures to deal with the crisis.  The crisis resulted from a complex interplay of liquidity and valuation problems in the banking system of the United States in 2008. The bursting of the housing bubble in the United State’s mortgage sector in 2007 resulted in a crisis in the subprime mortgage market. Consequently, the values of all securities that were tied to real estate pricing in the United States plummeted significantly leading to the damage of the financial institutions, both in the United States and the world at large. The challenges that resulted from the insolvency in the banking industry led to a decline in the availability of credit. This led to decline in investor confidence that impacted negatively on the stock markets around the globe leading to large losses in the stock markets especially in 2009. Economies from all over the world slowed down significantly during this period as international trade declined and credit tightened (Lahart, 140). While there have been many suggested causes of the crisis by the experts, the senate of the United States issued a report on the same. It ruled out the possibility of the crisis being a natural disaster. Instead, it explained the crisis as having resulted from complex and high-risk financial products; conflicts of interest that had remained undisclosed; failure by credit rating agencies and regulators; and the market which was reported to rein in the Wall Street excesses (Lahart, 142). On the other hand, Ross explains that investors and credit rating agencies failed to do accurate pricing of the risk that was involved with the financial products related to the mortgage sector. They also claimed that the government failed to adjust the regulatory practices that would address the financial markets in the twenty first century appropriately. A repeal done in 1999 on the Glass-Steagall Act of 1993 removed the separation that had existed between depository banks and the investment banks in Wall Street. Both the regulatory solutions and the market-based solutions were considered in response to the crisis and were embedded in the various solution packages. According to Gross, many economic analysts agree that the economic crisis was triggered in 2007 in the subprime mortgage sector as a result of banks in the United States giving high-risk loans to economically unstable people most of whom had poor credit histories. Even then, the root causes of the economic crisis are complex. They include an unregulated or poorly regulated banking industry especially in matters of investment and lending, which led to proliferation of speculative people with unstable income into the mortgage market. The proliferation coupled with highly reduced interest rates for a long period of time created space for overextension of credit and much speculation. Most analysts have chronologically cited excess global liquidity as the primary cause of the economic crisis. Factors that significantly contributed to the liquidity are both internal and external. Such factors include the rapid increase in foreign exchange reserves for emerging economies, especially China; and for countries that export raw materials, especially oil. The increase in the reserves was attributed to high rates of saving and significant trade surpluses in the emerging economies (Simkovic, 260). According to Ross, the global liquidity was also contributed to by the credit expansion mainly because of the reduced interest rates by central banks in the United States and other developed countries. The dotcom boom in the United States in 2000 led to the creation of the European development fund as a counter tactic. The fund allowed cheap and abundant credit and encouraged an increase in the prices of property. This had a positive impact on economic growth and consumption. In America, the authorities in charge of controlling monetary policy did not prevent the continued increase in property prices leading to the development of the housing bubble in 2007. With the excess liquidity, financial innovations were encouraged as banks resorted to giving more mortgage loans. Most of the loans were risky. The federal monetary policy lowered the rates of interest significantly, which encouraged most of the banks in the United States to invest more in the subprime mortgages. This led to deterioration in the quality of loans leading to increased defaults. With this the housing prices fell and the interest rates started rising (Lahart, 144). People were unable to repay the mortgages which led to the economic crisis of 2008-2009. Other analysts claim that the financial crisis was merely a symptom of another crisis that is even deeper, that is, the systemic crisis associated with capitalism. According to Gross, the increased inequality that is occasioned by capitalism has the tendency to produce speculative bubbles that burst to result in the crisis. The economic crunch had far-reaching impacts on the economy of the United States. The total output of services and goods produced by property and labor in the United States declined significantly at an annual rate of about 6 percent leading to negative growth in the real gross domestic product. The unemployment consequently increased to 10 percent by the end of 2009. This was the highest rate since 1983. The average work hours per week reduced to 33, which is the lowest since 1964 when such data began to be collected. Meanwhile, the very rich lost the least compared to the entire demographic structure. The gap between the rich and the poor widened with 1 percent of the richest Americans increasing their ownership of the national wealth from 34.6 percent to 37.1 percent as a result of the economic crisis. To mitigate the effects of the crisis, the treasury, the Federal Reserve and the Securities Exchange Commission took a series of steps. In order to stop the run on the mutual funds in the money market, the secretary of the treasury announced a $50 billion program on September 19, 2008 aimed at insuring the investments, just like the federal deposit insurance corporation program. In the announcement by the secretary of the treasury, temporary exemptions were issued on sections 23A and 23B of the regulation, hence, allowing easy sharing of funds by financial groups within their groups. The exemptions were supposed to expire on January 30, 2009 and could only be extended by the reserve board at the federal level. Meanwhile, the Securities Exchange Commission terminated short selling of financial stocks. This together with taking action against naked short-selling was part of the reaction to the mortgage crisis that had resulted to the financial crisis (Simkovic, 168). Moreover, the secretary to the treasury together with President Bush proposed a legislation that would enable the government to purchase assets related to troubled mortgages, which amounted up to $700 billion, from firms in the financial sector with the hope of increasing the confidence in mortgage-backed securities and encouraging the financial firms to participate in it. The proposal was discussed among legislative leaders. The administration then announced that the proposal would be reviewed significantly before it could be taken to congress for approval. The senate approved the revised version on October 1, 2008. The bill was passed by the house on October 3, 2008 and signed into law. As a result of the review made to the bill, the first half of the money was not used to buy troubled mortgage assets; instead, it was used to buy preference stocks in banks (Lahart, 146). According to Whitehouse.gov, in January 2009, President Barrack Obama made an announcement of a stimulus plan aimed at reviving the United States’ economy by creating or saving about 4 million jobs within a period of two years. The recovery plan was estimated to cost about $825 billion. The package included $365.5 billion that was intended to be spent on the reform the healthcare system through establishment of relevant policy; $275 billion, through tax rebates, would be distributed to firms and households to invest in renewable energy; $94 billion was targeted to social assistance targeting families and the unemployed; $87 billion was to be directed to states to aid in financing health expenditures on Medicaid; and $13 billion was to be spent on improving access to digital technologies throughout the United States. There was an extra $13 billion that was not in the stimulus plan, to be injected to automobile manufacturers such as Chrysler and General Motors. In addition, President Obama and some of his key advisors in government introduced a series of proposals in June 2009 that would regulate the process of economic recovery. The proposals were aimed at executive pay, consumer protection, to cushion banks on finance and capital requirements, expanding the shadow banking system and associated derivatives, and to enhance the authority of the Federal Reserve in order to wind down institutions that are systematically important. Later, in January 2010, the president proposed further regulation to limit the banks against engaging in proprietary trading. In May 2010, the senate passed a reform bill following the regulatory bill passed by the house in 2009. In order to lower the interest rates on federal funds and increase the funds available to commercial banks, the chairman of the United States’ Federal Reserve announced on September 29, 2008 a plan to double the Term Auction facility to about $300 billion. At the time, Europe had recorded a shortage in United States’ dollars. The chairman also announced a plan to increase the swap facilities between the United States and foreign central banks to $620 billion from $290 billion. By December 24, 2008, it was reported that the Federal Reserve had spent $1.2 trillion, using its independent authority, on the purchase of various financial assets and on emergency loans aimed at addressing the financial crisis. This was beyond the $700 billion that was authorized from the federal budget by congress. The money spent included emergency loans to credit card companies, banks, general business, sale of bear Stearns, temporary exchanges of treasury bills for securities that were mortgage backed, and bailouts of companies such as Citigroup, Fannie Mae & Freddie, and the American International Group (Simkovic, 169). In response to the crisis, the United States’ congress passed three legislations between December 2009 and July 2010. The Wall Street Reform and Consumer protection Act of 2009 aimed at implementing regulatory reforms on financial policy following the economic crisis. The bill was sponsored by President Obama’s administration and the 111th congress. The other legislation, the Restoring American Financial Stability Act of 2010 was aimed at enacting monetary and fiscal policies that would ensure the United States attains and maintains financial stability. It also strengthened the ability of the country’s economy to withstand similar economic crises should they occur in the future. The economic crisis that had began in December 2007, together with the recession thereof was over by June 2009 according to reports by National Bureau of Economic Research for the United States. As early as April 2009, the Time Magazine declared the banking crisis over. On January 2010, President Barrack Obama announced that the crisis was over and that the markets had stabilized. He also announced that the government had recovered most of the money it had spent to bail out the banks from the crisis (Lahart, 151). Despite the success made in a bid to recover from the crisis, the aftershocks of the crisis are still on. Moreover, there was no measure taken in the financial and banking sectors which has been a major worry for most of the participants including the International Monetary Fund. The aftershocks continue to hit the United States’ economy quite hard because many tenets in the economy such as textiles, manufacturing and technological development were outsourced to other countries by the time of the recession and the subsequent economic crisis. The public works projects that the Obama administration had outlined in the recovery plan are degraded by the fact they were based on the economic recovery plan of 1930s yet the situation of the infrastructure differs completely from that time. The stimulus plan also lacked sufficient provisions that would establish and maintain market stability and consumer confidence. Even then, the stimulus plans that were put in place were effective enough to pull the country out of the recession and the economic crisis within a considerable period of time. However, there is a looming danger that would see the return of the crisis due to the economic crisis that has been experienced in Euro Zone for the better part of 2011. In addition, the United States no longer has the control it had on the global economy due to the rise of other economies such as China and Brazil. It therefore needs even more economic, financial and fiscal policies if it is to abate such a crisis in the future. References Gross, D. (2009). The Recession Is Over. Newsweek. Retrieved on 17th December 2011, from www.newsweek.com/id/206631?from=rss Lahart, J. (2007). Egg Cracks Differ in Housing, Finance Shells. The Wall Street Journal, vol. 4, Issue 23 whitehouse.gov, (2009). Obama-Regulatory Reform Speech. Retrieved 17th December 2011, from www.whitehouse.gov/the_press_office/Remarks-of-the-President-on-Regulatory-Reform Ross, A. (2008). The Reckoning as Crisis Spiraled: Alarm Led to Action. New York Times. Retrieved17th December 2011, from www.nytimes.com/2008/10/02/business/02crisis.html Simkovic, M. (2009). Secret Liens and the Financial Crisis of 2008. American Bankruptcy Law Journal, Vol. 83, p. 253. Read More