Macroeconomic Policies Regulation - Report Example

Introduction Macroeconomic policies consist of two basic tools for managing an economy – fiscal and monetary policies. While taxation and government expenditure are the primary devices of fiscal policies; monetary policies pertains to managing the nation’s money supply. When the government regulates economic activities through controlling the tax receipts and government expenditures, they can stimulate or decrease economic activities. Interest rates are an instrument of monetary policies and by increasing or decreasing the same; the Federal Reserve can stimulate or depress the economy (Gilpin, Robert). The US economy’s success in the past with their macroeconomic policies is reflected in the Federal Reserve’s successful management of the economy during the economic meltdown in 2000 and 2001. The dot.com meltdown along with the subsequent recession brought down the US economy in early 2001 with high levels of unemployment and plunging equity markets. But with the government’s repeated tax cuts and Federal Reserve’s interest rate reductions, the economy was back on its feet in a short span of time. The Subprime crisis The economy grew steadily post that through the end of 2007, with real GDP expanding at an annual rate of 2.6% during this period. Productivity rose at a 3% rate, equity markets soared, unemployment rate fell to 4.4%, inflation remained low and consumer spending grew by 5.5% year-on-year (Rattner, Steven). With capital readily available, the cost of borrowing fell to record lows and lending grew at a rapid pace. With the soaring economy, the level of corporate bond defaults reached its all time lows. With record liquidity in the credit market, the economy went all out and volumes of leveraged buyouts soared. Leveraged buyouts are a sign of an ambitious take-over as the financing in such a case is mobilized principally through risky bonds that carry high interest rates. Such low rated debts swelled to 35% of the total high yield issuances in the US (Rattner, Steven). “The US mortgage default rates hit an all time high in the first quarter of 2007 and the percentage of mortgages in default rose to a record high of 2.87%” (Whitney, Mike). In 1994, less than 5% of the total mortgages were subprime in the US; in 2005, the figure was up to 20%. The rates of interest began to increase in 2005 after years of stable and decreasing trend (EconomyWatch.com). This led to fall in demand for houses, which brought down the house prices as well. A number of house owners who were highly leveraged on subprime mortgages found themselves neither being able to combat the increase in payment nor sell of their houses. The origin of Subprime crisis - Macroeconomic policies of the American government and the Fed Reserve “According to a National Bureau of Economic Research study published in 2003, the cross-sectional variation in wages and disposable earnings has grown significantly in the US since 1970, though income inequality has been moderated by the higher hours worked by the low-wage populace” (Karmakar, Suparna). In retrospect, the federal government policies encouraged the co-existence of high wage inequality with low consumption inequality. This led to increased use of the credit market to smooth out short-term fluctuations in income. These inequalities and the government’s inadequacy to counter such problems, led to creation of incentive structures that later accentuated the housing bubble. In response to the tech bubble and the terrorist attack in 2001, the Federal Reserve began to cut interest rates dramatically and the rates were at 1% in 2003. The goal of low rates is to expand the money supply and encourage borrowing, which would in turn spur spending and savings (Barnes, Ryan). The loose monetary policies of the Fed encouraged financial institutions to create innovative debt schemes and derivatives to maximize short term and volume driven gains. With dollar being the international reserve currency, the Fed was able to pursue the policy of keeping the interest rates really low for a long time (Karmakar, Suparna). The Real Estate Boom With the lower interest rates, also came the real estate boom. Mortgage rates were at the lowest in 40 years and people saw this as an opportunity to gain access into the cheapest financing available. New financial products sprung on Wall Street and these products spread into pension funds, hedge funds and international governments (Barnes, Ryan). Asset backed securities with real estate as the underlying asset emerged prominent in the market. Credit rating agencies such as Moody’s and S&P put their AAA ratings on many of these securities, thereby qualifying them as relatively safe investments. The government has also joined the race, selling ABS mortgages and investors gained a higher yield on them than on treasuries. The companies selling the securities were thereby able to use the funding to offer more mortgages in the market. The real estate boom led to a lot of subprime mortgages also entering the ABS system. The subprime loans, even with their high default risks, were classified under AAA and lower ratings depending on the risk classes. This led to the subprime lenders marketing their debts more aggressively and Wall Street continued to package them along with other mortgage securities and sell them in the market. In the meanwhile, Fed’s record low interest rates and the flexible lending standards pushed the real estate prices to record heights all over the US. With the high liquidity in the market, investment bankers were able to borrow more and create additional investment products with subprime loans as assets. The ability to borrow more prompted banks to create collateralized debt obligations (CDOs), and these along with residential mortgage backed securities (RMBS) created a drift in communication between the lenders and the borrowers. Thus the mortgage lenders were successful in exporting their risks in subprime lending to investors. They packaged the products with teaser rates, by which special low rates were offered for the initial years of the mortgage after which the payments would skyrocket (Barnes, Ryan). As the real estate market pushed to its peak in 2005 and 2006, more and more people were lured by the prospect of being able to refinance, at a huge profit, in a few years. Over a span of five years, home prices had doubled in many areas in the US. The bubble bursts By the middle of 2006, the trend started to change. With rising inflation, the Federal Reserve started increasing interest rates. Sales of new houses stalled and default rates on mortgages started to rise (Barnes, Ryan). There was a dramatic upsurge in defaults by subprime borrowers and this was followed closely by stall in the high yield market, “where rising supply overwhelmed demand.” These developments swept its way into the “real” economy, which saw job losses occur in the housing and financial sectors. Consumer spending reduced as a result of falling house prices and investors being unable to meet high payments. Economic forecasters began predicting a recession in the economy (Rattner, Steven). Mortgage lenders, with no willing secondary markets and investment banks to turn to, were left high and dry and were forced to close operations. The CDOs floating in the market “went from illiquid to unmarketable” (Barnes, Ryan). In this fall, investors became risk averse and frayed away from risky assets such as subprime mortgage backed securities. Three-month treasury bills and other government backed bonds became the most sought after investment avenues and this led to the closing of numerous hedge funds. There were increased selling pressures on banks to raise capital and this affected the stock markets worldwide. There were sharp declines in a matter of weeks and this stalled the Dow Jones Industrial Average that had been on its all time highs in mid 2007. The subprime crisis also brought out disturbing aspects of the US economy. Some of them being: the mushrooming balance of payment crisis, approximately $1 trillion per year; the record-high national debt, approaching $10 trillion; the growing budget deficit, approaching $1 trillion annually; the slowdown in basic manufacturing industries; decreasing profit rates of major companies; dismal job picture; unprecedented oil prices; dollar declining against all major currencies; near bankruptcy of the U.S.-backed World Bank and the International Monetary Fund; and finally, the slowing down of the major economic driver of the country, consumer spending (Mackler, Jeff). The central banks around the world sprang into action to rescue the major banks in their country. Several billion dollars were injected into various banks to help them with liquidity issues and to stabilize the financial markets. “The Federal Reserve cut the discount window rates which made it cheaper for financial institutions to borrow from the Fed, add liquidity to their operations and help struggling assets” (Barnes, Ryan). Conclusion The initial impact of the crisis was felt in March 2008, when the investment bank, Bear Sterns was acquired by J.P. Morgan Chase, for $1.2 billion. September 2008 witnessed major shakeouts in the US financial sector. US Fed Reserve provided emergency loan of $85 billion to insurance major, AIG. They also gave approvals to investment banks, Goldman Sachs and Morgan Stanley to convert themselves into commercial banks. With continuing financial measures the Federal Reserve and the US government are working on bringing the economy back on its feet. In response to the rising crisis, the US Federal Reserve increased money supply, decreased interest rates and thereby eased the conditions for raising funds (Nadareishvili, Giorgi, Gabatashvili Giorgi, Shvangiradze Guram & Ilia Imerlishvili). With strong inflation and an even stronger US Dollar, the outlook of the economy, although still gloomy and pessimistic, might be far better than expectations. References Nadareishvili, Giorgi, Gabatashvili Giorgi, Shvangiradze Guram & Ilia Imerlishvili. “US Credit Crisis and Fed’s Response Presentation”. http://www.slideshare.net/okili/us-credit-crisis-and-feds-response-presentation [viewed on 23 April, 2009] Mackler, Jeff. “U.S. Economy in Doldrums as Credit Crisis Deepens”. Socialist Action, December 2007. http://www.socialistaction.org/mackler20.htm [viewed on 23 April, 2009] Gilpin, Robert. “Global Political Economy: Understanding the International Economic Order”. Published in 2003. Pg 369-370. Rattner, Steven. “The Credit Crunch and the U.S. Economy”. March 27, 2008. http://www.lse.ac.uk/collections/LSEPublicLecturesAndEvents/pdf/20080327_RattnerSlides.pdf [viewed on 23 April, 2009] Barnes, Ryan. “The Fuel that Fed the Subprime Meltdown”. Investopedia.com. http://www.investopedia.com/articles/07/subprime-overview.asp [viewed on 23 April, 2009] Karmakar, Suparna. “US policies and the housing bubble”. The Hindu Business Line. March 27, 2009. http://www.thehindubusinessline.com/2009/03/27/stories/2009032750740900.htm [viewed on 23 April, 2009] EconomyWatch.com. “US Subprime Mortgage Crisis”. http://www.economywatch.com/us-subprime/crisis.html [viewed on 23 April, 2009] Whitney, Mike. “US Housing Bubble Meltdown: “Is it too late to get out”?”. April 28, 2007. http://www.marketoracle.co.uk/Article882.html [viewed on 23 April, 2009] Read More