Reasons and consequences of recession.

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1.Reasons and Consequences of Recession.

1.1 How is Recession Defined

According to National Bureau of Economic Research, "Recession" is defined as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales” (NBER, 2008).

There is widely known another definition of the recession - two successive quarters of negative growth - but there are many controversies regarding it, mostly because it does not reflect all the recession indicators relying only on the GDP data. (Layton & Banerdji 2003; NBER 2008). This definition has either been published from A.Okun at the time working for the White House to support the argument that the economy was in good conditions (Layton & Banerdji 2003: Sparrow 2009) or it originates from J.Shiskin who provided a list of rules to spot recession. In time, somehow, all the other rules faded away such living behind only “two negative quarters of GDP”. Any definition of recession must include output, employment, income and sales (Layton & Banerdji 2003; Achuthan & Banerji 2008; NBER 2008).

1.2 Business Cycle: Elements and History

Business Cycle is the short term fluctuation in output, employment, financial conditions and prices (Samuelson and Nordhaus 2009).

Shcumpeter labelled the four elements of the business cycles as “prosperity - recession - depression - recovery” (Schumpeter 1939).

A cycle consists of expansions, which then are followed by recessions or contractions, and after that revivals which serve as the start of the expansion phase in the next cycle; this sequence of changes is not regular (Burns and Mitchell 1946).

1.2.1 Business Cycles. Types and Causes.

Business cycles may be Exogenous or Internal.Exogenous shocks are found outside the economic system. Wars, natural disasters or gold discoveries are a few examples. Internal shocks are caused by the economic system itself (Samuelson and Nordhaus 2009). The multiplier and the accelerator effects, along with the inventory cycles, are among the factors that explain these shocks.

The multiplier is the amount by which we would multiply an initial change in expenditure to find the ultimate change in income”.

While the accelerator principle can be defined as:

The level of planned investments varies with changes in the level of output itself”. (Maunder et.al 2000, pp.288 / 292)

The aggregate effect can be summarised in the below diagram:

Diagram 1. Source: Maunders et.al 2000

Accelerator and Multiplier enhance each-other's effect by such causing a change in national income (Maunders et.al 2000).

Inventory cycle is a cycle caused by companies trying to keep inventories at desired levels as the expected level of sales changes”. (Magin 2007, pp.175) In the expansion phase of the inventory cycle, businesses predict an increase in their sales so they produce more by such boosting the economy and vice-versa. Inventory cycles last usually 2-4 years (Magin 2007). There is evidence that inventory in investment sector in particular has a significant influence in output and business cycles (Wen 2005).

Schumpeter divided the business cycles according to their durations. (Schumpeter 1939).

Type of Business Cycle

Duration (in years)

Seasonal

0 - 1

Kitchin

3

Juglar

9 to10

Kuznets

15 to 20

Kondratiev

48 to 60

Table .1.1 Type of business cycles and their duration. Source: Schumpeter 1939

Marx and Schumpeter were the first ones to recognize that innovation was the primary source of competitive advantage in capitalist economies (Morgan 1997).

1.2.2 Historical Evidence

Business cycles duration differs from country to country. While the duration of the cycles in time is somewhat constant, expansions seem to get longer and contractions shorter. In the post-war period, the fluctuations also tend to become less severe. Although the short-term fluctuations are called “cycles” the actual pattern is irregular. As a conclusion, even though individual cycles share important similarities, they are all different from each-other so that is why forecasting based on business cycle data only is never precise. (Zarnowitz 1992)

1.2.3 Kondratiev's Historic Long Waves:

  • The Industrial Revolution (1787-1842)
  • The Bourgeois Kondratiev (1843-1897)
  • The Neo-Mercantilist Kondratiev (1898-1950?)
  • The Fourth Kondratiev (1950?- 2010?).

1.3 Economic Models

There seem to be two major causes of recession: reaction to excessive boom phases and downward exogenous shocks (Dow 1998).

The following models offer more detailed illustrations:

1.3.1 The Classic Model

Adam Smith stressed that there must be limits to the amount of the paper money created by an individual bank. Paper money could substitute metallic money efficiently but individual bankers need to hold some reserve of gold and silver in order to able to convert this money back upon demand. If the bank could not meet these demands the bank will fail. If the public is overtaken by panic, the situation will extend to the whole economy such causing a financial crisis (Smith 1776). Smith also drew the attention that the matter might get even more complicated when many different banks are involved in discounting each other's bills.

1.3.2 Monetarist Model

Friedman and Schwartz argued that the contraction of the economy in the Great Depression was caused by a wrong monetary policy from the Central Bank because FED had continuously increased the interest rates. As a result the deflationary forces took over and some banks. They believe that the government causes business cycles, not the free market and found a correlation between the money supply and the economic activity (Friedman and Schwartz 1963). Monetarists believe that fluctuations in money supply cause fluctuations in GDP (Lipsey and Chrystal 2004).

1.3.3. The Keynesian Model

In contrast, the Keynesian Model shows that the central bank can not respond to any inflation before wages and price reach equilibrium. (Keynes 1935). The Keynesian model accepts both monetary and non-monetary forces to be important in explaining the economic cycles. Wages and prices fall only slowly in response to recessionary gaps and so Keynes introduced the Aggregate Short Run Supply, which opposed the constant Aggregate Supply of the classic model, by explaining how the economy reacts to shocks in the short run (Lipsey and Chrystal 2004). All Keynsians agree that aggregate economic instability represents some sort of market failure (Mankiw 1990). Fluctuations in GDP are often caused by fluctuations in autonomous expenditures and private investment. Expectations are also taken into very serious considerations as a possible cause of shock. (Lipsey and Chrystal 2004).

1.3.4 The New Classic Model

The New Classic School of economic thought supports a model in which markets are always in equilibrium, which does not rely on monetary shocks. Actors in the private sector have rational expectations so exceptional errors in forecasting are not systematic. (Robert Lucas 1972). The explanation of cyclical fluctuations that arises in Real Business Cycle (RBC) models is based on the role of supply shocks originating from sources such as technical progress or changes in tastes (Lipsey and Chrystal 2004).

1.3.5 The Marxism: The Crisis of Capitalism

Karl Marx predicted probably the worst possible scenario for the capitalist system.

Lowering costs, falling profits, monopolistic power, under consumption, massive unemployment of the working class—all these conditions lead to more and more destructive crises for the capitalistic system (Marx 1887; Marx and Engels 1848). All this was a result from Marx's labour theory of value. There was no stability in capitalism; supply does not create its own demand and no tendency toward equilibrium and full employment exists. (Marx 1887)

1.3.5 The Political Cycles

Government can use both monetary and fiscal policy to regulate aggregate demand. The policy is tight after the elections by such creating spare capacity. As the next elections approach, the government adopts an expansionary policy that creates rapid growth so that the voters misinterpret this as permanent potential output by such re-electing the government. This model assumes that the voters are naive.

1.4 The current recession causes

The current recession 2007-2009 was generated by asset-market prices first busting and then suffering a sharp decline and as a result producing a profound financial crisis which led to deep and long recession (Samuelson and Nordhaus 2009).

Banks have been liberal in giving credit and buying each-others securities as in the classic model where they issued “paper money” and discounted each-other bills. (Smith 1776)

By the end of 2007, when it was the peak of this business cycle (NBER 2008), Federal Reserve's interest was at highest level since 2001 for the whole year (Federal Reserve 2009) when can say that it failed to counter deflationary forces and bank collapses as explained in the Monetary Model (Friedman and Schwartz 1963).

Since this recession's main cause was an un justified price increase in the asset-market prices, there is evidence of a market failure as explained by the Keynesian Model. The prices were up because of misleading expectations that they would go even higher. So the expectations factor gives a plausible explanation as described in the Keynesian and Neo-Classic model. Since buying houses can be considered as a private investment we can see that the Keynesian Model has a wide application in the current recession. (Lipsey and Chrystal 2004).

It is obvious in this case that the asset-market could not create its own demand as Marx predicted. Furthermore, the partial nationalization of the banks in order to avoid their bankruptcy is a development predicted in detail by the Marxist Model. (Marx 1887).

The fourth wave of Kondratiev has foreseen this recession as well.

1.5 Previous Financial Crisis

There have been five previous major financial crises from the 20th century. Details are given in the table below

Crisis

Who caused it

Why it happened

The break-down

The Effect

The Dot.com crash 2000

Internet companies such as Amazon and AOL.

Their share value increased despite that fact that few of the firms actually made a profit.

In March 2000, the bubble burst, and the technology-weighted NASDAQ index fell by 78% by October 2002.

Business investment falling and the US economy slowing in the following year.

Long Term Capital Management 1998

The collapse of hedge fund Long-Term Capital Market (LTCM)

Investors fled from other government paper to the safe haven of US Treasury bonds, and interest rate differences between bonds increased sharply.

LTCM, which had borrowed a lot of money from other companies, stood to lose billions of dollars - and in order to liquidate its positions it would have to sell Treasury bonds, plunging the US credit markets into turmoil and forcing up interest rates.

Fed decided that a rescue was needed. It called together the leading US banks and persuaded them to put in $3.65bn to save the firm from imminent collapse.

The Crash of 1987

Investors

Fearful Expectations.

The widespread belief that insider trading and company takeovers on borrowed money were dominating the markets, while the US economy was entering into an economic slowdown.

The crash seemed to have little direct economic effect and stock markets soon recovered. But the lower interest rates, especially in the UK, may have contributed to the housing market bubble of 1988-89 and to the pressures on the pound sterling which led to the devaluation of 1992.

U.S Savings and Loan Scandal

US Savings and Loans institutions

Under financial deregulation in the 1980s, they were allowed to engage in more complex, and often unwise, financial transactions, competing with the big commercial banks.

By 1985, many of these institutions were all but bankrupt, and a run began on S&L institutions in Ohio and Maryland. The US government insured many of the individual deposits in the S&Ls, and therefore had a big financial liability when they collapsed.

The cost of the bail-out eventually totalled about $150bn.

However, the crisis probably strengthened the bigger banks by weeding out their weaker rivals, and laid the groundwork for the wave of mergers and consolidations in the retail banking sector in the 1990s.

The Crash of 1929

Speculative new industries

Huge speculative rise

Despite efforts by the stock market authorities to stabilise the market, stocks fell by another 11% the following Tuesday, 29 October.

It took 25 years before the Dow Jones recovered to its 1929 level. Big consumer goods such as cars and houses purchases were cut, while businesses postponed investment and closed factories. By 1932, the US economy had declined by 20%, and one-third of the workforce was unemployed. The US central bank raised interest rates to protect the value of the dollar and preserve the gold standard, while the US government raised tariffs and ran a budget surplus.

2.The current recession

The current recession registered the first decline in global output since World War II. Developed countries are all experiencing signs of decline in economic activity especially in the last quarter of 2008. Before the crisis stroked, the world economy has eight years of extraordinary fast growth especially in developing countries with a two-digit investment rate increase. The 2007 and ongoing credit crunch hit hardly the investments by causing an immediate contraction in industrial production (World Bank 2009). The decline in industrial production has come to an immediate fall in commodity prices by suggesting a backward multiplier and accelerator effect (Maunders et.al. 2000). It affected mainly the economies that had specialised in investment goods (World Bank 2009).

2.1 Forecasts for the Global Economy

Economic growth will be expected to reach 2.5 percent in 2010. Among the developed countries, the United States and Japan are probably the ones that will register the first signs of revival. Despite the economy is slowly stabilizing, the recession can still continue since the growth is still expected to be slow and financial institutions are still fragile. Public policies are expected to be less present in the coming months. Although some positive figures in growth might be present the aggregate output is still far distant from its potential. As a result, unemployment is expected to increase further in the 2010 (IMF 2009).

The volume of world trade is expected to decrease of 6.1% in 2009. The world trade will contract much more because of the fall in prices of commodity goods (World Bank 2009).

In the US, data suggest a slowing depreciation in the labor and housing markets. The inventory cycle is entering the revival stage and confidence is improving. The output has stabilized in the second half of 2009. Risks are not in the extreme levels of only a few months ago and the global financial system is starting to regenerate slowly. Central banks and governments undertook unprecedented policy actions to stabilize the financial and banking sector. As a result, risks of another systemic failure have been reduced but policymakers should continue with the reforms (IMF 2009).

Even when the global GDP will turn positive as expected in 2010, the economy will still continue to be under potential and the contraction will be present until 2012. The crisis had already hit poor people during the food and fuel crisis, but the situation is likely to deteriorate because of the decreasing aids. The number of people living below the poverty limit of 2$ per day is estimated to be 65 million in 2010 (World Bank 2009).

2.2 Policies to Exit Recession

The Federal Reserve (Fed) has eased significantly its monetary policy in order to respond to the tightening of credit conditions. To help financial markets, the FED provided easier credit terms and longer maturities to banks. It injected liquidity not only to the US banking institutions but also to other financial actors (Kohn 2009).

To regenerate the credit flow, the Fed has purchased longer-term securities and targeted lending programs. As economic recovers, FED will have to eventually narrow its monetary policy to avoid an inflation. The FED balance sheet holds the keys of the recession exit (Bernake 2009).

Because of the market instability, banks have dominantly held their surplus funds as deposits to the Fed. Banks should seek alternative ways to lend out their balances as the economy starts recovering. That should generate fast growth in M1 or M2 indicators and easier credits. To prevent inflation, counterbalancing policies should be undertaken. These large reserve balances must either eliminated or their potential to cause undesired effects on the economy be neutralized when the time comes to tighten monetary policy(Bernake 2009).

The work should concentrate on preparing strategies that minimise market risks. All countries should collaborate to harmonise both their monetary and fiscal policies in order to build a long-term equilibrium of financial stability (IMF 2009).

The Fed has been granted by the FED the right to pay the banks interest over the balances they hold there. As international experience suggests short-term market rates are managed well by paying interest on reserves. There are four ways to tighten monetary policy:

  • Decrease the extra liquidity of the banks by using reverse repurchase agreements in large amounts.
  • The Treasury could some bills from its portfolio and hold the proceeds at the FED.
  • Offer banks similar certificates of deposits as banks offer themselves to their customers.
  • The Fed could decrease its own reserves by selling parts of the long-term securities it holds.

(Bernake 2009)

The private sector has suffered heavily the financial crisis but within 2009, many countries might experience fiscal difficulties as well. As in a domino effect, since the businesses have seen a decrease in their revenue figures, revenue from taxes are likely to be decreasing as well. This is will push up borrowing costs and as a result government will be under pressure to limit where possible their budget expenditures (World Bank 2009).

3.RECESSION - WINNERS AND LOOSERS.

McDonald's

The famous fast-food chain is one the most successful companies of 2009 and the absolute leader of the industry (Forbes 2009a). Its brand is the sixth most valuable global brand in the world. (Plunket 2009) .

Table 3.1. McDonald's Income Statement in USD* December 2008-September 2009 Source: Forbes 2009b.

McDonald's is one of the only two DJIA listed companies which ended 2008 with gain (Forbes 2009).

But what makes McDonald's so successful even in recession?

The company has improved significantly its image by redesigning the restaurant staff uniforms, persuading the change of the “McJob” definition in the Oxford Dictionary to restore the reputation of its workers (BBC News 2008). It gave to its mascot a more contemporary look and serves salads and fruit alongside to its traditional meals in order to become a healthier brand (BBC News 2005). McDonald's pays special attention also to the international market. They are more active in supporting both national (The Guardian 2009) and international sport events (Klayman 2009), and introduced the “halal meat” [allowed by Islamic Law] for their Muslim customers (Qureshi & Smithers 2009). In terms of diversification McDonald's has introduced its McCafe shops by such competing with other big chains like Starbucks (Irvine 2009).

While other companies are facing contractions, McDonald's restaurants umber is expected to increase by 1.000 next year with the expansion being concentrated in the fast-growing markets of Russia and China (Dorfman and Baertlein 2009). The recession seems to have helped more than harmed the Golden Arches since many people cannot afford restaurants as they used to so they drive into a McDonald's for a cheap meal instead (Zieminski 2009).

Versace

The recession has struck the whole fashion industry (Holmes 2009). The value of the whole luxury sector has decreased to 153 billion Euros^ in 2009 from 167 billion Euros that it was last year (Boland 2009) but the Milan-based luxury-design company Versace, is probably suffering more than many of the others in the industry.

The company posted a loss of 400.000 Euros in 2008 (Gumchian and Holmes 2009). The debt is expected to increase 30 more million Euros this year while the sales are expected to decrease of 19% (Kenna 2009).

The company is trying hard to get out from this situation. The board forced the CEO, Di Risio to resign (Gumchian and Holmes 2009) and the new CEO which took power in July, Ferraris is already taking some measures to reorganize the corporation in order to increase efficiency (Judge 2009). The reorganization consists in reviewing the network of 85 stores, reduce capital investment and cut overhead costs (Boland & Daneshkhu 2009). This will result in 350 people losing their jobs. The cut which consist of about 26% the company's worldwide staff will not affect the design, product development and brand management areas of the business (Boland 2009). In addition, the company is totally pulling out from Japan where it has been operating since 1981 (Holmes 2009). Ferraris hopes to return the group to profitability in 2011(Judge 2009).

1 USD= 0.6013 GBP Source Reuters 2009a.

^1 Euro = 0.9007 GBP Source Reuters 2009b.

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