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Quantitative Easing After the Financial Crisis

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  • Jose Nunez

Research Paper

The global financial crisis started in August 2007 and lasted to 2009, which was the collapse of the subprime mortgage market (lenders with higher interest rates demand, and borrowers that can repay their loans) that led to a huge amount of losses to financial institutions in that time. The crisis led to one of the worst markets in the past 50 years. The impact it had on the economy was severe, it lead to a downward growth for U.S. companies, and an increase of uncertainty for the U.S. economy. The causes of the 2007- 2009 financial crisis were: financial innovation in mortgage markets, agency problems in the mortgage markets, and the role of asymmetric information in the credit rating process.

There weren’t as many innovations back then, so before the year 2000 only credit worthy borrowers could get mortgages unlike others that didn’t have good credit. After advances in technology and new statistical techniques, that led to better evaluations on credit risk for a new risky loan to be made. FICO was developed by the Fair Isaac Corporation, which just predicted the outcome of how likely it was for a borrower to default on their loans and not pay the loan back. By lowering the cost of transactions, newer technology was able to bundle smaller loans that were similar to mortgages into debt securities. With these factors the banks were able to give out subprime mortgages to borrowers with less than good credit scores. Also, there were agency problems in the market, the brokers who made the loans usually did not make an effort to see whether the people taking the loans could actually pay the loans back, in other words they just gave out the loans to almost complete strangers that they knew very little about and they did not have the same interest as the investors had; once the broker earned his or her commission from the loan he or she did not care about the whether the borrowers paid or did not pay the loan off. Credit rating agencies were also a factor because of their asymmetric information; they were telling clients how to structure financial instruments at the time they rated the products so different information was being passed from firms to the borrowers.

The effects it had on the U.S. economy were; housing prices went down, many subprime borrowers were finding that their mortgages were going underwater meaning that the house value was falling below the amount of the mortgage. Many homeowners just walked away from their homes giving the keys back to the lenders because the prices were going down. The default on mortgages rose tremendously, which led to many foreclosures. Value of mortgages backed securities and CDOs went down as well, and left the value of those assets to banks and financial institutions. Many of the well-known firms from had to be sold off to other larger companies for less than what they once worth and others had to file for bankruptcy. With all the things that happen in 2007-2009 in the economy, the crisis did not lead to a depression because of the actions of the Federal Reserve and government bailouts of the financial institutions but many call it a “great recession” instead. The economic recovery has been slow because people are now scared to invest their money in the markets and do not what to take on other risks, jobs are going overseas, inflation is rising, and economies of other countries are going down as well. Michael Farr said in an article from the Huffington “Corporate managers are just doing what works. Following the financial crisis, investors are not in the mood to take big risks. They would rather have the certainty that comes with higher dividend payments and increased stock buybacks”.

When the economy is about to slip into a recession or depression the government uses a tactic called quantitative easing. Quantitative easing is when the central bank makes purchases from the market to bring down the interest rates so more people can have money in their pockets to spend and invest in the market. Federal Reserve gives the financial institutions money so they can lend out to the consumers and increase liquidity. Some of the down sides of quantitative easing are that it can cause inflation to increase due to being a certain amount of goods that are being sold when the money supply of the consumers has increased, and another is that instead of the banks lending out the money that was meant to be loaned out to people or companies was being kept by the banks instead. This strategy of the government in our last financial crisis was not really affective because the banks kept the money for reserve instead of lending it out the people and companies to increase liquidity and spending. Many articles have been saying that the government has ended QE but according to an article by Terry Burnhamon pbs.org argues,

By all accounts, theFederal Reserve ended its bond buying program, known as quantitative easing, at its policy meeting at the end of last month. Over six years, the central bank bought $4.5 trillion worth of mortgage-backed securities and Treasury bonds. But since the beginning of this year, the Fed has been gradually drawing down its purchases by $10 billion a month to now, zero.

It’s not that simple, though, says economistTerry Burnham. The Fed is continuing what he calls “Stealth QE,” or the purchase ofmorebonds with the interest the Fed earns on the bonds it has already purchased. In order to stop that, he writes, the Fed would need to shrink its balance sheet by the amount of interest that it earns.

Deleverage is when banks start to lose capital so they fall back on loaning money to others. They try to reduce the debt they have by selling their assets. Losses on their loans they gave out begin to drop in value which drops the net worth of the banks and financial institutions. Tejvan Pettinger said “To reduce debts people sell off assets to gain liquidity. Selling assets causes fall in the price of shares and house prices. Falling house prices cause lower consumer spending, negative equity and more losses for banks.” With less capital the banks and financial institutions have, the more risky they look towards others causing lender-savers to take out their funds. The decrease in funds will mean fewer loans to produce investments. Deleverage hurts the economy for those reasons.

Globalization is when different countries trade with each other things such as products, ideas, aspects of their cultures, and other subject matters. Globalization has been increasing and has been getting easier due to the fact of newer and more advanced technology that has been invented till today to help us communicate with each other and transport product from one place to another. With globalization the cost of goods that we are buying that are coming from different parts of the world are low, compared to if we were to make them here because, it cost less for others to make it in their own country. Also the variety of goods within a country will increase because maybe we can’t produce certain goods here like other countries are able too. With globalization we have free trade, promoting jobs, keeping cost of goods low in the economy, and it’s making business more competitive thus stimulating the economy. Globalization also has a negative impact on the economy, that is jobs are being moved over seas and outsourcing jobs to other places in the worked. The rich will continue to get richer and people looking for jobs will have to take on new jobs for less money because companies are moving out of the country.

Both inflation and deflation can have a negative impact in the economy if inflation and deflation rises are severe. Inflation means the prices of goods and services are going up, lowering the purchasing power of the people and lowering the value of the dollar. A certain amount of inflation can also mean that we have a healthy economy because prices of goods and services will continue to go up. Deflation is the opposite of inflation, so instead of the rising prices of goods and services the prices are falling. When deflation is happening people tend to save more money and spend less because the value of the dollar is increasing. By not spending more the demand for goods and services drops and unemployment increases because not many people want to buy things. Deflation can be caused by a decrease in spending by the government, and people. There are also pages that say QE can also lead to deflation. The Wall Street Journal said “Nearly a decade after Japan’s central bank first experimented with the policy, the country remains mired in deflation, a general decline in wages and prices that has crippled its economy.” Moderate levels of both inflation and deflation are normal have little effect on the economy.

Works Cited

  • Burnham, Terry. “So you thought quantitative easing was over? Think again” PBS News Hour. 24 November 2014.
  • Farr, Michael. “What Is Causing the Drag?” The Huffington Post, 21 November 2014.
  • Mishkin, S. Frederic. “The Economics of Money, Banking, and Financial Markets Tenth Edition.” Colombia College. Pearson, 2013. Print.
  • Pettinger, Tejvan. “Paradox of Deleveraging.” Economics Help, 6 May 2009.
  • WashingtonsBlog. “Why QE May Lead to DEFLATION In the Long Run.” Washington’s Blog. 18 November 2014.

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