The Great Recession: Causes, Effects And Models

Overview of The Great Recession

Question:

Discuss About The Affecting Many Countries Around The Globe?

The financial crisis that began with the bursting of US housing market lasted from December 2007 to June 2009 affecting many countries around the globe. It was the deepest economic downturn called “The Great Recession”.  This was considered to be largest after the great depression caused by the sharp decline in economy. This phenomenon began after the U.S housing bubble resulting the mortgage backed securities and derivatives value was drastically lost.  This was the longest recession after the world war II causing the destruction of nearly $20 trillion worth of financial assets owned by U.S. households. Due to such massive loss, there were major cutbacks in the spending of consumers that causes chaos in the financial market initiated by the bursting of the bubble which lead to declination of business investment. This crisis spread around the world as consumption and investment decreases in US leading to reduction in exports from other countries. As a result, GDP was reduced by 2% in 2009.The US unemployment rate also increased from 4.7% to 10% which was a severe job loss. Due to job loss family incomes dropped and poverty raised.

It is apparent that during this period the U.S government faced many challenges, the banks lost their wealth and were about to get bankrupt, public debt increased greatly, stock market crashed, people lost their jobs and there were instances when highly qualified professionals had to join underqualified jobs, the dollars rate fell, etc All these led to global financial crisis. The main causes of this recessions are discussed in brief:

There was the boom in prices in housing due to the increasing demands, speculation and ebullience. This what gave rise to housing bubble which happens when the supply is limited. After the dotcom bubble, along with 2000 stock market crash there was this shift of dollars from the stock market to real state. Additionally, getting loans were relatively easier to neutralize the economic recession. The central banks along with other banks favoured the housing marketing for creating more wealth and giving a secured asset that people could borrow money to support the economy. There were loans of different nature such as interest only loans, zero down loans and interest adjustable loans all to make loans easily available to public.

 It is said that 56 percent of housing purchases in this period were made by the people who could not afford to buy in normal lending conditions. Fake subprime burrowers and people were changing homes to take advantage of the situation. With every single loan bank would readily securitize the loans and the move on the risk to other parties. Even the rating agencies would put AAA rating on these loans to attract the foreign investors. As a result, the amount of derivatives held by the financial institutions crashed and the total amount cash became lesser and lesser. In the period of 2003 to 2007 there was humongous increase in subprime loans to 292 %, 332 billion to 1.3 trillion (DeGrace, 2011).

Causes of The Great Recession

During the span 2000 to 2007, the economy was stable, inflation rates were low and there were less number of unemployed people. The Federal bank were successful in maintain the low inflation rates which ensured stable economy. But there was growing instability in credit and financial markets.

The effect of great moderation made the financial institutions to less worry about the riskiness of assets. Foreign institutions were not thinking much on investing on U.S mortgages thinking there were secured investment. Moreover, the truth was that these investments were made on duped foundations. As a result, when the market collapsed bank were left with heavy losses (Pettinger, 2013).

In this period banks became more flexible in giving loans to the public. Mostly the American banks and mortgage companies went beyond their criteria while giving mortgages. They were not checking the paying capabilities of the people and were issuing large amount of mortgages. Afterwards the people were left with the mortgages they could not pay back.

To ensure that they were not losing any money, the U.S bank sold these loans to the financial institutions of different countries. Those countries invested in these as they thought they are investment are secured.

The volume of bank losses increased as it became difficult for the banks to borrow money on money market. This gave to a situation when banks decreased their loans and mortgages. They were losing wealth as it became very tough to get credit and liquidity. There were many instances when government had to bail out the banks. This ultimately lowered the confidence of investor and consumer which led to decrease in investment and spending.

The interest rates were relatively low during the subprime crises, a need of savings entering the America’s economy from countries like Japan and China assisted to keep the interest rate low. The investors from these countries always believed investing in securities which promised good returns with less risk. The foreign investors thought, these low risk securities can never collapse as the federal bank would will bail out before anything like that happens.

Additionally, the credit rating agencies like Moody’s and standard and poor gave favourable rating to these securities making the investor grow in confidence and they grew bolder kept on investing in mortgages backed by the wall street firms (Holt, 2009)

The great recession lasted so long because it was difficult for the people and financial institutions to invest seeing the condition of the market. If the markets performed smoothly then the interest rate would have fallen balancing the demand and supply and thereby reducing the unemployment rate. For this the interest rate have to be negative which is practically impossible as the nominal rate cannot fall below 0. As this happened, there has to be different solution to ball out from these situations to clear the debt market. That solution was the significant fall in output and income which permitted the debt market to clear by decreasing the saving as people didn’t wanted to reduce their consumption. It can be explained by paradox of thrift. These fall in the output arisen from paradox of thrift lasts for long period of time.

Effects of The Great Recession

This recession can be viewed from new Keynesian model. This model provides a comparative study of great recession with two previous recession of 1990-91 and 2001. It draws as all these recessions revolved around aggregate demand and supply imbalances. The recent recession lasted longer than other two. The need of monetary policy for stabilizing the economy were blocked by the zero-lower bound on the nominal interest rate as it happened in the past in those recessions. In other scenario without this factor, the output could have been recovered sooner in less period of time (Ireland,2010).

This model follows Canova’s (2009) by applying a small-scale model which stresses on three main equations. They are the new Keynesian IS curve which describes the optimizing behaviour of house hold representative, the second being the new Keynesian Philips curve which describes the optimizing behaviour of monopolistically competing firms, which relates to the Taylor rule (1993) which states, how the central banks knowingly alter the short- term nominal interest rate by checking the movements of output and inflation. Similarly, the third factor being the empirical analysis which is in relation to the output, short term nominal interest rate and inflation. (Kirman,2011). This model concludes that it still serves as one of the most trusted and reliable tool for analysing the monetary policy and market analysis.The results drawn out from this model’s states that there is a dire need of analysing the monetary policy and business cycle in context of zero lower bound on the short-term nominal interest in this great recession of 2008 (Ireland,2010)

This recession had tremendous impact on macroeconomics. Firstly, it led to reconsider the two theories which were not considered and secondly it made the economist to rethink about ways to find out means to study financial sector and macroeconomic theory together. The both of these theories are explained below in brief (Christiano,2017)

This brings the very traditional approach of macroeconomic paradigms explained by the IS-LM model or the “Hicks- Hansen” model. This model keeps the demand shocks of this nature of the business cycle fluctuations, at the core of its theory. The paradox of thrift also comes under the Hicks-Hansen model.

his IS-LM paradigms, paradox of thrift along with point that a collective decision taken by the group of people could result in welfare reducing drop in output which was largely dis regarded by the macroeconomist till this period. Alternatively, its practically impossible to understand this great recession without the paradox of thrift concept and showing to the shocks of aggregate demand. As a result, it brought back the concept of IS-LM model and the New Keynesian Model. The concept of IS-LM model says that economy could crash at some point and needs government intervention to bring back the balance.This is the change in thinking of the economist of 1980 as many economists of that time believed the market adjust itself with time and government intervention is seldom needed.

The New Keynesian Model

The was a believe that impact on financial sector had no effect on macroeconomics. In other words, what happens in financial markets stays on that market. This perception was backed by the past incidences which happened in 1987 and in the early 2000s, where there was no or zero effect on macroeconomics even the stock markets were highly volatile. But this perception died with this great recession.

Due to this recession now the modern economist studies the financial sector along with the economic factors and its effects on the either sectors. This also gave rise to new models which included finance and the models which were successful by incorporating the financial factors as in the new Keynesian model which is explained above. In those models, banks finance studies long tern assets with the short-term liabilities. This discrepancy between the liabilities and assets explains that in real world financial institutions are vulnerable. The constant re modelling of these models is required to analyse the economic imbalance and implement steps that can predict and tackle economic downturns like this.

Conclusion:

This great recession had made us learn that monetary policy should be constantly reviewed and the central banks should keep a check and should mould the regulations according to the changing financial markets. The mortgages debt should be backed by security and bank should check the consumer ability whether they can repay their loans or not. This also made the foreign banking institutions learned the bitter lesson that they should not invest blindly.It also ended the conventional concepts of economics which neglected the financial markets from the economics. The government should forecast and intervene at the early stages so that situation like could be neutralised earlier rather than balling out at the later stage.

References:

Pettinger, T. (2017) The great recession, Economics Help. Available at: https://www.economicshelp.org/blog/7501/economics/the-great-recession/(accessed 11 September, 2017)

Kirman, A. (2011) The crisis in Economic Theory. Available at: https://www.parisschoolofeconomics.eu/docs/guesnerie-roger/kirman2011.pdf (accessed 11 September, 2017)

UK Essays. (November 2013) Cause and Consequences of Great Recession Economics [online] Available at: https://www.ukessays.com/essays/economics/cause-and-consequences-of-great-recession-economics-essay.phps ( accessed 11 September, 2011).

Holt, J. (2009) A summary of primary causes of the housing bubble and resulting credit crisis: A none Technical paper, The journal of Business Inquiry, volume (8) pp. 120-129. Available at: https://www.uvu.edu/woodbury/docs/summaryoftheprimarycauseofthehousingbubble.pdf (accessed 11 September, 2011).

Christiano, L (2017) The Great Recession : A Management Earthquake, Economic Policy Paper. Available at: https://www.minneapolisfed.org/~/media/files/pubs/eppapers/17-1/the-great-recession-a-macroeconomic-earthquake.pdf (accessed 11 September, 2011).

Ireland, P (2010) A New Keynesian Perspective on the Great Recession, Boston College, Department of Economics. Available at: https://fmwww.bc.edu/EC-P/wp735.pdf