Macroeconomics

Posted: October 17th, 2013

Macroeconomics

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Macroeconomics

The financial crisis of 2008 was one of the worst economic depressions since the Great Depression before the first and second World Wars. Also described as the global financial crisis, the economic crisis resulted into the disintegration of considerable financial institutions, the bailout plans of banks by nationalized governments as well as downward trends in shares and stocks in the stock markets globally. In numerous vicinities, the real estate segment, especially the housing sector, repressed leading to foreclosures and evictions. In the United States, the crisis caused the fall out of various businesses around the country leading to reduction in consumer wealth amounting to losses estimated to be in trillions of American dollars. Moreover, the housing bubble in the United States erupted leading to the devaluation of real estate securities thus destroying financial institutions and investments. The cause of the depression was attributed to the imposed monetary and fiscal policies, which encouraged credit access, home ownership and overvaluation of mortgages (Davies, 2010).

Part 1

The causes of the economic crisis originated from changes effected in the legislations, regulations and regulatory supervision. Consequently, the causes of the global economic depression were attributed to negligent monetary and fiscal policies. The Federal Reserve decreased its rate for federal finances sharply and maintained the low rate for an extended period. Concurrently, the global financial imbalances, the significant current account discrepancy in the United States, and the developed nations maintained long-term rates of interest despite the increase of the rates for federal funds by the Federal Reserve. The low interest rates and the account deficit created a superfluous extension of monetary supply. The excess credit was invested profoundly and intently in the United States through the purchases of government securities such as Treasury bonds and bills and investments in the derivatives market creating a housing bubble in prices and products (Krugman, 2009).

The monetary policies implemented revolved around increasing the rate of money supply in the American economy. One of the policies implemented was the reduction of interest rates by the Federal Reserve. Interest rates for federal funds were lowered from 6.5 percent to 1.0 percent. This was adapted in order to lessen the effects of the technology bubble and the 9/11 Terrorist attacks and the risk of deflation. The changes in the rates of federal funds influenced other market interest rates which, consequently, affected savings and investments (Foster & Magdoff, 2009). Moreover, during economic downturns, the Federal Reserve adapts expansionary monetary policies. These policies provide firms with the inducement to expand and employ more workers due to the reduction of the federal finances rate. Furthermore, the policy provides consumers with a reason to increase their spending. Hence, by lowering the rate to 1.0 percent as well as the high unemployment rates, the authority adapted quantitative easing. Quantitative easing involved the purchase of financial assets that included Treasury and mortgage-backed securities in order to lessen the continuing interest rates thus increasing the supply of money (Soros, 2008).

Moreover, the depressed interest rates encourage decreased returns on risk-free assets such as the Treasury bonds and bills. Managers with the thought of achieving minimal yield for customers, who were mostly retired, as well as investors reposition their portfolios and direct them to profitable but riskier assets. The low rates also motivated investors and other financial entities to utilize leverage extremely. The low rates of interest also encourage excessive borrowing of funds. Moreover, the resolution to receive high returns on investments in a low interest rate environment leads to an increased use of leverage. This is because the low interest rate environment possesses various financial consequences. The first consequence amounts to the sudden increase of credit in the economy. The second consequence is characterized by the returns on investments, which are low and thus enhance the need for investors to increase the acquisition of hedge finances and private capital. The main aim of reducing the interest rates to a rate of one percent allowed for the reduction in the costs of capital. This encouraged borrowing mainly for growth and development, investment and expansion projects. Moreover, low interest rates, by facilitating growth and development of businesses, would create employment (Soros, 2008).

However, the low interest rates would later, affect the American economy. The credit explosion that encouraged Americans to borrow heavily caused the United States to gain a deficit in the current account, which had already commenced in 1992 and continued to deepen with every year. The deficit forced the United States to borrow funds from other international countries that had surpluses arising from trade. Financing the deficit necessitated the nation to borrow considerable amounts of money from the countries, which specified the inclusion of a similar surplus of the capital account to the current account. Hence, significant amounts of foreign capital from countries such as China were accepted by the country to fund its imports (Hu, 2008). Apparently, demand was created for various financial assets leading to increase in asset prices as the rates were lowered. A bulk of capital was received by the nation’s financial markets. U.S utilized the finances to fund the consumption and upward bidding of housing assets investing largely in mortgage-backed securities as well as Collateralized Debt Obligations (CDOs). The Funds rate was then hiked by the Federal Reserve leading to increase in rates of Adjustable Rate Mortgages (ARM) thus making it costly for homeowners (Cagnin, 2009).

On the other hand, mortgage lenders relaxed underwriting standards and avail risky mortgages to fewer creditworthy borrowers. The mortgage market was regulated by the Government Sponsored Agencies (GSAs) which maintained high underwriting principles. However, competition from private agencies undermined the power of the GSAs leading to a reduction in mortgage standards and an increase in risky loans. Simple credit conditions created by low interest rates increased sub prime mortgage lending before the crisis. Chief investment banks and GSAs such as Fannie Mae and Freddie Mac expanded lending while relaxing mortgage standards to compete with private agencies. Sub prime mortgages increased by a margin of 10 percent from 2004 to 2006, the climax of the housing bubble. Fannie Mae and Freddie Mac extended mortgage loans to low and temperate income persons while struggling to maintain profit growth. Moreover, the GSAs were pressed by other financial institutions, such as banks and mortgage firms, to provide sub prime mortgage loans, which had a greater risk of default than prime mortgage loans. Moreover, a higher percentage of the sub prime loans were ARMs, which over 90 percent by 2006. With the climax of the housing bubble in 2006, ARMs started increasing their interest rates leading to elevated monthly payments that increased mortgage delinquencies causing the devaluation of the mortgages slowing economic growth due to reduced mortgage-backed debt purchases in the long term (Cagnin, 2009).

The fiscal policies implemented focused on the changes in taxation and government spending. During an economic depression, expansionary fiscal policy is utilized. Expansionary fiscal policy is established by the increase of government expenditure or the reduction of taxes in order to heighten total spending and persuade companies to increase production and hire extra employees to stimulate the economy (Davies, 2010). In order to address the effects of monetary policies on the economy, the government initiated legislations aimed at increasing taxation and providing funding for the public amenities such as infrastructure. For instance, the federal government initiated the American Recovery and Reinvestment Act (ARRA). The US $ 787 billion act was a temporary stimulus that was inclusive of tax deductions and benefits that amounted to US $ 288 billion. The stimulus also provided for more than US $ 150 billion for contributing sectors such as transportation and energy. The stimulus was regarded to contribute to economic development in the short run because the use of such large expenditures to facilitate economic growth in the country would only amount to the heightening of future taxes, which will lead to the reduction of business investments in the succeeding years (Taylor, 2009).

Another proposal was also established for the control of the financial crisis, The Troubled Assets Relief Program (TARP). The TARP required as estimated US $ 700 billion, which was to be utilized in the purchase, and holding of distressed loan assets in which most were related to the plummeting of the country’s housing market. Through the bill, the Treasury was supposed to purchase assets at the buck price, through auctions or from institutions. The assets to be purchased foremost were simple assets such as mortgage-backed securities to be seconded by complex assets such as derivatives. The bill was supposed to confine executive compensation for specific companies from which the Treasury would purchase assets. For instance, a winding company selling assets to the Treasury will not receive any compensation for the resigning executives. Moreover, Treasury will not provide executive compensation to the executives of the firms that sell over US $ 300 million in assets. The Treasury will also purchase mortgage-backed securities, CDOs, mortgages and assets protected by real estate by reducing foreclosures and encouraging loan solvency as well as insure the mortgage backed securities, which would require firms to pay fees for insurance. In the short run, the proposal will alleviate defaulters from foreclosures and evictions. However, in the long run, the citizens will be heavily taxed in order to cater for the functioning of the bill thus leading to slow economic recovery and development (Taylor, 2009).

Part 2

The intervention of the government is largely attributed to the panic arising from the financial crisis before and after 2008. For instance, before 2008, the government intervened into solving the crisis that had begun showing signs by introducing the Term Auction Facility (TAF). The introduction of the act was to control the spread of the money market attributed to the sudden increase of the rates of federal funds by the Federal Reserve. The same facility was introduced in other federal banks in each state (Taylor, 2009). The main objective of the facility was to decrease the spreads encompassing the money markets. By decreasing the spreads in the money markets, the government would be able to increase the influx of credit as well as the lowering of the interest rates. However, the facility proved to be ineffective. This is because the amount of credit to be accessed was limited due to the increase of interest rates by financial institutions such as investment banks and mortgage financiers. Moreover, the increase in rates led to the increase in the number of loan defaulters that led to foreclosures and insolvency of loans. The unusual level of spread provided the government with the objective of including monetary policies to decrease the spread in the money markets.

The government also intervened by the creation of the Economic Stimulus Act of 2008. The bill was passed in February and advocated for the provision of large amounts of funds to consumers in the United States. The Act was supposed to provide US $ 100 billion to families and persons throughout the United States (Taylor, 2009). This move was purely based on aggregate demand and supply. This is because the act would enable persons and families increase their purchasing power and provide more finances to the economy at a higher rate in order to alleviate the economy after the effects of the global financial crisis. The proposal sought to provide checks to American families and citizens to encourage them to spend and hence augment money supply in the economy. By availing such considerable finances to the consumers, total demand during the specified period would increase leading to increased total supply of products and services during that specified period. In the short run, the rate of total demand will be higher than the rate of total supply leading to an increase in the prices of existing products and services. In the long run, the supply will gradually increase due to the revenue received from hiking the prices. Assuming that the specified period is constant; the rate of demand and supply will eventually become equalized leading to macroeconomic equilibrium. However, the bill did not succeed since the people did not spend much with the available funds.

The reduction of the federal funds rate also led to financial panic. The rates were decreased sharply before the financial crisis in 2008 leading to the devaluation of the US dollar and the increase in global oil prices (Taylor, 2009). Due to rising prices of oil, the automobile industry in the United States increased the prices for the vehicles, which at the same time did not translate to increased revenue since Americans were bent on achieving savings rather than investing or spending. The devaluation of the dollar forced an increase in inflation on the prices of products and services. Apparently, the inflation was attributed to the increase in the prices of imports against a weak dollar that would not fetch enough revenue for the exports. Most production firms imported various raw materials and with the increase in import prices, lowered production costs by laying off employees and increasing the prices of products in order to remain afloat. This explains the increase on the unemployment rate to 10 percent in 2009. Moreover, the real Gross Domestic Product (GDP) slumped resulting from the decrease in the output of products and services created by labor as well as the reduced purchasing power of consumers leading to a sharp decrease in the national income. The distribution of wealth also slouched. The majority of Americans who are middle class were gravely affected by experiencing huge wealth declines denoted by the reduction in spending attributed to increased house prices and a downturn in the shares and stocks in the stock market (Foster & Magdoff, 2009).

The intervention of the government and the combination of the monetary and fiscal policies compounded the economic and financial crisis by sustaining low interest rates for a long period as well as laxity in the monitoring of the deficits in the current account. The low rates of interest increased excessive borrowing and risky investing while the deficits comprised the risky securities that were the main cause of the housing bubble. Presently, the government and state monetary authorities acknowledge the impact of the crisis, which has led to the Global Recession and are hence creating adjustments and new legislations that will counter the financial crisis.

References

Cagnin, R. F. (December 01, 2009). The housing cycle and U.S. economic growth: 2002-2008. Estudos Avancados, 23, 66, 147-168.

Davies, H. (2010). The financial crisis: Who is to blame?. Cambridge, United Kingdom: Polity Press.

Foster, J. B., & Magdoff, F. (2009). The great financial crisis: Causes and consequences. New York: Monthly Review Press.

Hu, Y. (January 01, 2008). A defensive battle: China jumps into action to counteract the fallout from the crippling U.S. financial crisis. Beijing Review: a Chinese Weekly of News and Views, 51, 42, 28-29.

Krugman, P. R. (2009). The return of depression economics and the crisis of 2008. New York: W.W. Norton.

Soros, G. (2008). The new paradigm for financial markets: The credit crisis of 2008 and what it means. New York: Public Affairs.

Taylor, J. B. (2009). Getting off track: How government actions and interventions caused, prolonged, and worsened the financial crisis. Stanford, California: Hoover Institution Press.