Economic Crisis 2008-2009

harshsingrodia By harshsingrodia, 10th Nov 2013 | Follow this author | RSS Feed
Posted in Wikinut>Business>Analysis

Starting in mid-2007, the global financial crisis quickly metamorphosed from the bursting of the housing bubble in the US to the worst recession the world has witnessed over six decades. The global financial crisis of 2007 has cast its long shadow on the economic fortunes of many countries, resulting in what has been often called the “Great Recession”.

Economic Crisis

The economic conditions in the early 2000’s were characterized by the end of dot-com bubble which peaked in March 2000 before bursting until the end of 2002. The reaction of the Federal Reserve to this stock market decline has been to ease economic conditions using declining interest rates. Over the years leading up to the global financial crisis of 2002 and the ensuing recession, leading academics proclaimed that the economy had entered a new era of low volatility. Also, reasons like insufficient rates of growth in developing countries in the 1980’s and 1990’s to tackle poverty and then more recently, the devastating impact of the surge in oil and food prices on the poor are considered responsible for the global recession. A second characteristic of the world economy in the early 2000’s was massive inflows of capital on international financial markets. Between 1995 and 2000, it increased from 1.54% to 4.25% of GDP and continued to raise in the first half of the 2000’s to peak at 6.10% of GDP in 2006. The US economic conditions in the first half of the 2000’s was characterized by rapid economic recovery with low interest rates, increasing financial inflows and a high degree of risk-aversion in stock markets, following the tech bubble burst.
Also, in their search for new places of investment, many economic agents saw property as safer and more profitable. The conditions were consequently slowly put in place for a housing bubble. In four years, between 2001 and 2005, the number of houses sold increased by 41.3% and the average price rose by 39.3%. In addition to economic conditions, several regulatory measures have also led to incentives towards home-ownership. Traumatic external events have the potential to engender turning points in the evolution of the global economy. In this respect, the second oil price shock (1979) was followed by a prolonged global growth slowdown that lasted throughout the 1980’s and well into the 1990’s. The development rate per capita of the developing world between 1980 and 1998 was effectively zero. The global and historical circumstances surrounding the emergence of the crisis of 2008-2009 are subject to alternative interpretations. This in turn, reflects dualism in the global economy: countries which were gaining from globalization versus the losers such as poorly integrated low-income countries.
Given the historical evidence, insufficient attention was paid to the costs associated with low frequency, high impact events. This inadequate perception of risk stands in contrast to the fact that between 1970 and 2008, there were: 24 systemic banking crises; 208 currency crises; 63 sovereign debt crises; 10 triple crises; a global economic downturn about every ten years, and several price shocks. Amid the doom and gloom of 2008 and 2009, it was easy to forget that the pre-crisis period between 2002 and 2007 was one of historically high rates of growth, especially for developing countries. There was a relatively mild global downturn in 2001 after the bursting of the dotcom bubble. This was followed by a synchronized boom that lasted until 2007. However in hindsight, the 2002-2007 period stands out as a case of unsustainable boom. There was a surge in various forms, of external finance that fed a consumption boom in advanced economies and a surge in investment and exports in the developing world led by China and other emerging countries. One legacy of the global boom of 2002 and 2007 was that insufficient attention was given to the stresses and strains that afflicted labor markets across the world even during the high growth era. Quantitative expansion in employment in many parts of the world, particularly in developing countries, were juxtaposed with sluggish real wage growth, persistence of the informal economy, declining wage shares in national output and rising inequality. One key shortcoming of the boom period was the failure for increases in economic growth to translate into improvements in household incomes.
The politicians desired to expand home-ownership, especially for poorer families. In the US, two institutions played a particular role in this policy: Fannie Mae and Freddie Mac. The former was created in 1938 under the Roosevelt administration to buy and securitize mortgages to ensure liquidity for lending institutions. The role of Fannie Mae and Freddie Mac is to purchase loans from mortgage sellers such as banks and financial institutions, securitize them into mortgage backed bonds and resell those on the secondary market, guaranteeing the principal and interest of the loan in exchange of a fee. Fannie Mae and Freddie Mac have also been instrumental at varying levels by US administrations to expand housing credit to middle-and low-income families as well as in distressed areas. Second, the US tax system contained several incentives for home-owners to take mortgage. In addition, the 1997 Tax Payer Relief Act quadrupled the tax exemption for capital gains-giving further incentives to buy houses-and the 2002 Single-Family Affordable Housing Tax Credit Act and the 2004 American Dream Down payment Act provides further fiscal measures in favor of home ownership.
Financial institutions reacted to this by opening the credit lap, helped by more lax regulations. Risk taking was also encouraged by released rules on capital adequacy and new accounting standards. In this context, the proportion of subprime mortgages soared from 7.2% of the total in 2001 to over 20% in 2005 and 206. Gambling was also at play as some studies pointed out that over a third of the houses bought were made for investment or second residence purposes and those specific acquisitions were made with the hope that continued price increases would allow buyers to resell with profit. Accordingly, a third of loans made in 2002 were either interest only or negative amortization loans. The spread of mortgages in particular subprime loans was largely helped by the development of new financial instruments, in particular, the technique of securitization, which consists of pooling the loans into an investment vehicle called special purpose vehicle and then selling securities backed by payments for these loans. This securitization process was itself helped by the emergence of a new class of derivatives which allowed transferring the credit risk to a third party: The Credit Default Swaps. The CDS market grew exponentially from virtually zero in 2001 to about USD 15 trillion in 2005 and over USD 60 trillion in 2007. With US inflation rising from 1.6% in 2002 to 2.3% in 2003, 2.7% in 2004, 3.4% in 2005 and peaking at 4.3% in June 2006, the Federal Reserve gradually raised interest rates from 1% to 5.25% and the first cracks appeared in the housing market. Financial institutions started to be hit as they were heavily indebted and exposed via Mortgage Backed Securities, whose value are based on mortgage payments and house values. The banking crisis also quickly spread to stocks markets.
To bolster the liquidity of the financial system and stimulate the economy, during 2008 and 2009, the Federal Reserve aggressively applied conventional monitory stimulus by lowering the federal funds rate to better channel needed liquidity to the financial system and induce greater confidence among lenders. Following the worsening of the financial crisis in September 2008, the Federal Reserve grew its balance sheet by lending to the financial system. By the beginning of 2009, demand for loans from the Federal Reserve was falling as financial conditions normalized. In the spring of 2009, the Federal Reserve judged that the economy, which remained in a recession, still needed stimulus.
Congress and the Bush administration enacted the Economic Act of 2008. This act was a $120 billion package that provided tax rebates to households and accelerated depreciation rules for business. Congress and the Obama administration passed the American Recovery and Reinvestment Act of 2009 which was a $787 billion package with $286 billion of tax cuts and $501 billion of spending increases that relative to what would have happened without ARRA is estimated to have raised real GDP between 1.5% and 4.2% in 2010. In terms of extraordinary measures, Congress and the Bush administration passed the Emergency Economic Stabilization Act of 2008 creating the Troubled Asset Relief Program. TARP authorized the Treasury to use up to $700 billion to directly bolster the capital position of banks or to remove troubled assets from bank balance sheets. Congress was an active participant in the emergence of these policy responses and has an ongoing interest in macro-economic conditions.
In 2010, many economists argued that another dose of fiscal stimulus was warranted because the effects of the first stimulus package were beginning to fade, and because of evidence that private spending lacked sufficient vigor to sustain a healthy recovery. In this situation, the risk of not applying further fiscal stimulus could be several years of sub-normal growth, and even worse, dipping into a second recession. In response to concerns that the recovery was faltering, Congress passed and President Obama signed in December 2010 the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The essential features of that measure were an extension for two years of the Bush tax cuts, a 2% point cut in the payroll tax during 2011, a 13-month extension of the unemployment benefits, and allowance for more rapid expensing of business investment in 2011.
On November 3, 2010, the Federal Reserve announced that it would provide more monetary stimulus by means of the purchase an additional $600 billion of Treasury securities at a pace of about $75 billion per month, and continue the practice of replacing maturing securities with Treasury security purchases.
Evidence indicates that the economy, as measured by real GDP growth, began to recover in mid-2009. However the pace of growth has been slow and uneven. The strength of the recovery forces continues to be uneven, and a slowing of growth during 2011 indicates concern about the recovery’s sustainability. However, the economy began to recover in mid-2009. Real GDP increased at an annualized rate of 2.2% and 5.6% at the third and fourth quarters of 2009, and 3.7%, 1.7%, 2.5% and 3.1% over the four quarters of 2010. Also credit conditions have improved making getting loans easier for consumers and businesses, loosening a constraint on many types of credit supported expenditures. Manufacturing activity has increased over the time and also employment has increased by about 2 million jobs, and stock market has rebounded and interest rate spreads on corporate bonds have narrowed.
On the other hand, significant economic weakness remains evident such as consumer spending although improving, remains tepid, generally slowed by households’ nee to rebuild substantial net worth lost during the recession. Employment conditions remain weak, this high rate of unemployment after more than two years of economic recovery is unusual and a source of concern. Also, the housing market remains depressed and mortgage loan foreclosures continue to rise, and house prices are still falling in many regions. In addition, growth in the Euro area remains weak and the ongoing debt crisis there threatens to push the region back into recession and transmit a contractionary economic shock to the United States.
Fiscal stimulus is not without its critics. The case against more fiscal stimulus comes in three forms: one, no further stimulus is needed; two, fiscal stimulus does not work; and three, stimulus increases the budget deficit, makes the US long term debt problem worse, and dampens economic growth.
One of the important lessons from the Great Depression is to guard against an overly hasty withdrawal of fiscal and monetary stimulus in a fragile economy still recovering from a sharp economic decline. To address the deep and severe crisis, President Obama started from two main premises. First, the most immediate priority was to rescue the economy by restoring confidence and breaking the cycle of financial failure. Second, the recovery from the crisis would be built not on the filmy foundation of asset bubbles but on the firm foundation of productive investment and long term growth. This was the core idea on which the entire recovery process was built up.

Tags

Economic Crisis, Recession, Recession Economies

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author avatar harshsingrodia
I have been in writing business since last 3 years. I was writing on studentoffortune.com. I have written more than 2000 article. And have been working for other organizations too.

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