Throughout history, financial crises and economic recessions have taken place in different parts of the world. After the collapse of the Soviet Union, the United States of America emerged as a force to reckon with in the global market. The emergence of the United States of America as a financial power house is attributed to the liberalization of the markets and the focus on the development of the IT and communication sector. Given the pivotal role of financial epicenters in global financial markets, a crisis in any of the financial epicenters can have devastating effects. In 2008-2009, there was a financial crisis that had numerous consequences hence was aptly named the “The Great Recession” just like the Great Depression of the 1930’s. In the United States of America, the Great Recession in losses amounting to $4.1 trillion and a rise to the rate of unemployment to more than 10%. In other countries in Europe, the unemployment rates were higher than that. American investors lost more than 40% of their savings. The stock market collapsed, manufacturers reduced their production units and eventually lay off some of their workers. The consumers experienced a reduction of their buying power therefore reduced their spending, global trade declined and most countries opted to adopt measures to protect themselves from the effects of the recession. In addition to that, the financial crisis that took place in 2008-2009 weakened countries that were deemed as super powers therefore resulting in a significant shift in the power hierarchy on the global front. There were massive protests all over the world over the rise of the cost of living and unemployment rates. The European Union and the US Congress were embroiled in numerous meetings over how to salvage the world’s economies.
The economic recession that took place between 2008-2009 was a significant event on the global financial front. This paper shall therefore critically examine the root causes of the recession and the policies that were developed in order to rectify the situation.
The Root Causes of Economic Recession of 2008-2009 Crisis
There are several root causes that resulted in the financial crisis that took place between 2008- 2009 as outlined below:
Executive compensation
In the months leading up to the financial crisis, Wall Street embraced excessive compensation with little regard for the regulatory measures that have been put place to govern compensation. Wall Street suddenly began to attract smart Americans who were looking for an opportunity to make a quick buck. Executives received stock options which gave them the opportunity to make more money. Corporates no longer handled their operation ethically therefore they merged or acquired companies with higher growth often committing accounting fraud in the process. Such shrewd practices were the reason behind the collapse of several top notch companies such as Enron, WorldCom and Global Crossing.
Low Interest Rates
The financial crisis was partly attributed to the availability of a high volume of cash on the global markets. The availability of huge amounts of cash resulted in high liquidity and therefore triggering low interest rates. After the terrorist attacks that took place in 2001, Alan Greenspan who heads the Federal Reserve reduced the interest rates about 1% in 2001 setting a precedent that was followed by the European Central Bank and the Bank of Japan. The American government encouraged its citizens to buy homes or borrow more money from the banks with their homes as security. Most citizens and the USA government were living beyond their means thus had huge reserves of money borrowed from their developing partners. Global trade was at all time high as a result of the measures initiated by the USA government. The surplus money in the global market was partly attributed to the loss of faith in Asian Markets after the 1997 Asian financial crisis. The oil producing countries in Europe and the Middle East were enjoying surpluses accrued from selling oil at $ 5 trillion in reserves. While it is assumed that the policies on banking were set by central banks by United States of America, Europe and Japan, the reality reflected a different situation. Three fifths of the supply of world’s money came from emerging markets such as China, India and Persian Gulf States.
Subprime loans
Subprime loans refer to credit that is extended to individuals who fail to meet the stringent standards that have been set by lending institutions. There were adjustable rate mortgage, piggy back mortgages, balloon mortgages and interest only rates. This was one of the reasons that led to the financial crisis that took place between 2008 and 2009. Individual are deemed as credit unworthy if they have a poor record of repaying their loans or cannot afford to meet the monthly repayments. Before a lending institution can extend credit to any individual, the borrowers are required to make a down payment. In the months leading up to the financial crisis, interest rates were at an all-time low and there was a surplus of funds within the global economy. However, persons with poor credit records are more likely to be charged exorbitant interest rates. One of the fundamental principles of finance is that the stronger the financial capability of the borrower, the lower the yield and vice versa. The flooding of the market with subprime loans marked the start of a culture of entitlement and egalitarianism. The USA government sold its citizens the promise of owning home hence driving masses to procure loans to secure homes in spite the fact that they could not repay the loans. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation availed more loans to the insatiable market by procuring loans from lending institutions and reselling them to secondary markets. Huge amounts of money were diverted to subprime loans in the United States of America and Europe which ultimately led to the weakening of other markets globally. Given that financial markets globally are interconnected, the effect of subprime loans spread from the United States of America to other parts of the world.
An influx of funds was directed to the commercial and real estate sector leading to an appreciation of the price of houses in USA and Europe. On average the cost of houses in USA and Europe rose by 1.4% per annum. The low returns on prime loans made the home owners hold back from utilizing their homes as cash minting machines. There was a wide variety of sub- prime loans that were being floated.
Easy access to mortgage loans
In the period after the terror attacks, it became easier for applicants who in the past could not qualify for mortgage loans to get loans to purchase bigger homes or vacation homes. Given that mortgages are issued as collateralized loans, banks found it easier to utilize the mortgage loans as a base in order to issue other categories of securities that are more profitable. In order to use mortgage loans as a base, banks came up with other categories of mortgages such as mortgages that require little or no documentation, adjustable interest rate mortgages and mortgages with “zero down”. The rigorous securitization of the mortgage loans resulted in novel derivatives that were worth trillions of shillings being injected into global market and the US market. As a result of this injection, the banks were keen on the newly created securities- collateralized debt obligations. Collateralized debt obligations are the result of the secondary securitization of the “mortgage backed securities.” The banks profited not only from the creation of the CDO in the market but also from the management of the CDO’s. The banks distanced themselves from any issues regarding profitability and liquidity hence the buyers of the CDO’s shouldered the risk burden. As the crisis crunch caught up with America, the quick gains that had been made in the real estate sector began to slow down .As the value of the houses began to decline, so did the value of CDOs; an effect that directly affected the buyers who were American investors. This led to a loss of over 1.4 trillion dollars of savings that had been made by American investors.
The impact of the economic crisis
The global financial crisis had an effect on literally every sector of economy. The crisis resulted in the crashing of the prices of houses in addition to foreclosures. The foreclosures involved the abandonment of the building projects that had been going on prior to the crisis. One out of every 45 households in the USA received a foreclosure filing and banks were forced to start repossessing homes. It is estimated that about 1 million homes were repossessed during the economic crisis. By extension, all the industries that supply building materials experienced sharp declines in their sales. Given that owning a home is a symbol of wealth, the decline in the prices of houses resulted in economic insecurity among the home owners.
The unemployment rate in the United States of America was at 10% or higher with the trend also being common in Europe. Manufacturing industries particularly the automotive sector were forced to make cuts. Even students had a difficult time given that the colleges also faced a difficult time as the high cost of living did not exempt them. There was also a shift in the global powers with the United States of America bowing to countries such as China, India and Brazil. The mortgage crisis spread to other financial institutions therefore causing collapse of several renowned Wall Street firms such as Lehman Brothers to collapse. The response to the global economic crisis varied from one country to another but the United States mounted the strongest response to the crisis as outlined below:
Policies implemented in order to rescue the US economy
In order to salvage the USA economy, the Bush administration decided to act by coming up with a proposal to reverse the effects of the financial crisis. The aim of the policies developed by the US government was to contain the effects of the recession in addition to prevent the contagion of the effects further. The proposal was drafted by Henry Paulsen who was the treasury secretary in the Bush administration and the Federal Reserve Chairman Ben Bernanke. It entailed the injection of $ 700 billion into the US economy in order to revitalize sectors that had been crippled as a result of the economic crisis. The administration of the funds was a collaborative effort by the following institutions: the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Thrift Supervision, the Treasury and Comptroller of the Currency. The proposal was known as The Troubled Asset Relief Program .The proposal was approved by the Congress in October 2008. The initial purpose of the stimulus package was to use the funds to buy back assets particularly the mortgage backed securities that were in the possession of banks and financial institutions. This move was meant to stem the “toxic” trend that had been set by the securities: participants in the financial markets were unwilling to trade or lend money to banks or institutions that held huge volumes of such securities. As a result, there was poor flow of credit between banks and non-banking institutions. The role of the Congress during the economic crisis that took place between 2008 and 2009 was to ensure that the USA citizens’ interests were protected from exorbitant interest rates and ensure that businesses continued with their operations uninterrupted. They also had an obligation to prevent such crises from taking place in the future through the legislation of protective legislative measures. There was a need to change the policies of the USA thus the Congress had the duty to deliberate and chart the way forward.
The Treasury invested in several banks, General Motors, Chrysler and the insurer AIG. Investments made by the Treasury were in form of stocks which paid dividends after every three months. On the other hand, the US Federal Reserve committed about $1.2 trillion towards revitalizing the financial sector. Some of the emergency measures that were put in place by the Federal Reserve were: loan services for consumers and businesses to enable them to purchase securities, implementation of a safety net for the commercial banks, the rescue of Bear Sterns which is a lending facility for investment firms and brokerage firms, provision of loans for money market assets and commercial paper.it must however be noted that the policy had strengths and weaknesses as shall be outlined in the next section:
Strengths and weaknesses of the policy implemented to rescue the US economy
The intervention measures that were put in place by the government have been praised and criticized in equal measure. To begin with, the decision by the Federal Reserve and the Treasury came in at a time when even the market forces could not correct the financial crisis that had grasped the US, Europe and other parts of the world. As a result of the injection of stimulus package into the economy, about 1.5 million more jobs were created by the summer of 2009. However opponents of the stimulus package argue that this number is a drop in the ocean given that since December 2007, about 8.4 million jobs had been lost. Estimates indicate that if the pre-economic crisis status is to be restored, over 11.1 million jobs have to be created. Based on those figures, it can be argued that the stimulus package only saved the economy from sinking further into depression but did little to alter the unemployment rates that were being experienced at that time. The modest outcome is partly attributed to the positive attitude of the key actors at the time of the implementation given that they did not anticipate the duration of the economic crisis and the effect on the labour markets.
The decision by the Federal Reserve and the Treasury to inject huge amounts of money into the economy had several negative impacts. The stimulus package resulted in an increase in the amount of liquidity in the economy therefore the reducing the risk of credit that was previously shouldered by the banks. However, this had negative ramifications given that the credit risk remained at an all- time high even after the injection of funds. Lending and borrowing among financial and non- financial institutions which were meant to be promoted by the stimulus package halted for quite some time after the injection of the funds by the Federal Reserve and the Treasury. As a result the economic recession lasted for much longer that the previous recessions that took place in 1991 and 2001.
The injection of funds into the economy contributed to the revitalization of several financial institutions during the recession. For instance, the Bear Starnes which is a lending institution that lends to financial institution and the brokerage firms was saved from collapsing by the intervention of the government. AIG was also saved from the same fate by the intervention from the government. However, not all institutions benefited from the stimulus package. Lehman Brothers collapsed after both the Federal Reserve and the Treasury failed to intervene. Both institutions failed to intervene because they believed that the investors had foreseen the shaky prospects the company had and could therefore come to its aid. The Lehman brothers’ collapse sent panic waves to other lending institutions since they realized that the government was not necessarily going to bail them out. This resulted in a credit freeze which the stimulus package was supposed to prevent.
In conclusion, the policy measures undertaken by the government did more harm than good since they were enacted in a hurry and with little consideration for the duration of the recession and outcomes. Such measures can be avoided if more efforts are devoted towards predicting the crisis rather than preventing the damage.
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