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The current Recession of America
With a reference to an economy of my choice, I choose examine the current recession of America. This recession is not just only affecting the lives of Americans, but also millions of people around the world. It has been and is still a topic that many people talk about. In this essay, I will analyse the current recession, to find out what where the causes of this financial crisis and what is the American government doing to stabilities the economy. I will also in brief describe the history of the American recessions, to find out if there are similarities between the recessions from then and now.
Definition of recession:
"A recession is a significant decline in activity spread across the economy, lasting more than few months, visible in industrial production, employment, real income, and wholesale-retail trade. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades." According to the National Bureau of Economic Research; the Business-Cycle Peak of March 2001.
Signs of a recession:
Many factorscontribute to a fall of the economy into arecession, but one of themajor causesis inflation. Inflation refers to ageneral rise in the prices of goods and services over a period of time.
A recession is characterised by:
- Lower Output
- Lower investment
- Higher Unemployment
- Increased PSNCR
- Lower Inflation
The higher therate of inflation is, thesmaller the percentage of goodsand services that can be purchased with the same amount of money. Inflationcan occur for many reasons as varied fromincreased production costs, higher energy costsand national debt. In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. But as individuals and businesses it is curtail to cut down in the expanses to trim the costs, this causes GDP to decline. Unemployment rates rise because companies lay off workers to cut costs. It is these combined factors that causes the economy to fall into a recession.
History of US Economic Recessions
The United States suffered its first recession back in the years between 1797 and 1800. It was called the panic of 1797, and it was primarily caused by the deflating effects of the Bank of England as they crossed the Ocean to American soil. This disrupted commercial real estate markets in the U.S. Britain's economy was in a bad state already, because it was fighting France in the French Revolutionary wars at the time. This is just one example of how the effects of recession on one country can travel quickly to another. Most economists agree that what effects one country, especially a key country, will affect the rest of the world in at least one way, shape, or form, before the recession is over.
The next recession confirmed occurred in the years between 1807 and 1814. This was called the Depression of 1807. This was caused by the Embargo Act of 1807, which was signed into effect by President Thomas Jefferson. This Act destroyed a good part of the shipping related industries. This was fought hard by the Federalists, who in turn allowed smuggling into New England as result of the Act.
All of these things together kick started a global downturn that put the entire world up in its vertical spiral downward. This led to businesses being closed, rise of unemployment, market stock being worthless and even the richer class Americans suffered from this financial catastrophe called the Great Depression.
The Great Depression (1929) is among the greatest financial catastrophes to hit the world in all of history. It lasted 43 months. This has led to crashes of the stock markets all over the world, banking collapse in America and thousands lost work, some people lost everything. People who had a lot invested ended up mostly with nothing.
Recessions continued to plague not only America, but the rest of the world as well. Considered part of the natural cycle of the modern economic system, no one can really escape recession in the long run. Countries like Germany, the U.K., China, and Japan have all had trouble with recessions. Japanese economic recession has also played a huge part in their history. Japanese recession, just like economic recessions in America, can be linked to the dreadful cycle of imbalanced inflation, money supply, and interest rates that keep things in balance and functioning properly.
The collapse of the dot.com bubble in 2001 was truly the cause of these recessions, as well as the attacks that occurred on September 11th on the WTC Twin Towers in New York City. Accounting scandals also ran rampant, contributing to the overall downward financial spiral that America faced.
Figure 1 shows the recent movements of employment superimposed on the average movement over the past six recessions. Employment reached a peak in March 2001 and declined subsequently. The figure also reflects on the effect of the attacks on September 11.
(National Bureau of Economic Research; the Business-Cycle Peak of March 2001, page 3)
And lastly, America has been hit by what has been called the Late 2000s recession. The collapse of the housing market really set this one off on a bad note, and it, coupled with bank collapses in the U.S. and Europe, have caused consumer confidence and credit availability to plummet to new lows.
Fortunately, though, the average recession has lasted only eleven months from the peak of activity when the recession began to when the recession ended and the economy turned up. In American history the longest of the downturns only lasted 43 months while the shortest was over in just six months.
Fact: The United Sates has faced 22 economical/financial calamities throughout its history, but only 14 times it was called recession, 5 times as Panic, once as crisis and 2 times as a Depression: Depression of 1807 and The Great Depression. (Source: recession.org).
The 2008-2009 Financial Crisis of USA: Causes, Effects
And USA Government Intervention
What is the financial crisis of credit?
The economic crisis can be described as "a worldwide failure involving terms like sub-prime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps" according to Patrick (2008).
The credit crisis brings 2 groups of people together: homeowners and investors. The homeowners represent the mortgages and the investors represent the money. Continually the mortgages represent the homes and the money represents large institutions like pension funds, insurance companies, sovereign funds, mutual funds etc. These groups are brought together by the financial system, which contain of a group of banks and brokers. In this case the financial system is Wall Street. These groups of banks and brokers are closely connected with houses on what is called the Main Street (the homeowners).
How did it happen?
Years ago investors were waiting for a good investment to turn their money into more money. These investors traditionally go to the Federal Reserve were they buy Treasury Bills, which was considered to be the safest investment. However in 2001 and the effect of the dot.com bust of September 11, the Federal Reserve lowered their interest rate to low as 2% to keep the economy strong. This rate is a low percentage return on investment, so the investors weren't too happy with this and were looking for other means. On the other hand this meant that the banks on can borrow money for only 2%. This is what the banks did and the availability of cheap credit caused the banks to go crazy with leverage. "Leverage is borrowing money to strengthen the outcome of a deal" according to Patrick (2008). What this meant was that Wall Street borrowed millions of dollars and made great deals that make them grow extremely rich and then paid the borrowed money back. They were able to do so by buying mortgages from mortgage lenders. The investors also saw this as an opportunity and got involved in this great profitable way of making more money.
Fig. 1: Treasury bill rate index history by year.
Source: illustrated from thirdtreasury.com (2006)
Here is how it works:
When a family wants to buy a house they save for a down payment and contact a mortgages broker. The mortgages broker then connects the family to a mortgage lender who will give them a mortgage. The broker will then make a commission on it and the family will then buy a house and become a homeowner.
The mortgages lender will then be contacted by an investment banker who will buy the mortgages of the lender for a profitable fee. The investment banker then borrows millions of dollars to buy more mortgages. This means now that the investment banker will receive every month the payment of the homeowners of the mortgages he owns. The banker will then divide the mortgages into three groups; this is called the "collateralized debt obligations, also commonly known as CDO" according to Patrick (2008). The three groups can be classified as "Safe, Okay and Risky". A CDO can work like three cascading trays. As money comes in the top tray (Safe) it fills it in and then spills it over to the middle tray (Okay) and whatever is left in to the bottom (Risky) tray. The money comes from homeowners paying of their mortgages. If some owners don't pay and default on their mortgages less money will come in and the bottom tray may not get filled. This makes the bottom tray riskier and the top tray safer. To compensate for the higher risk, the bottom tray receives a higher percentage rate of return, while the top tray receives a lower rate of return. To make the top even safer the banks will insure it for a small fee. This is called a "credit default swap" according to Patrick (2008).
The banks will do this, because the credit rating agency will rate the "trays". For example the top tray will be rate AAA, which is the highest rate there is and the middle tray BBB and the bottom tray will be rate Risky. Why the banker does this, is because he then can sell these rated "trays" to investors who want to invest their money on whichever "tray" they want. After selling of the "trays" the investment banker repays his loans.
The investors now see a great opportunity to make money, more than the return they would have received from the 2% of buying Treasury bills. They now want more of CDO's. Now that there is a demand in CDO's, the investment banker contacts the mortgage lenders and ask for more mortgages, but unfortunately everyone who is qualified for a mortgage has have a mortgage. Now the investment banker has to come up with a new idea, in order to sell mortgages.
When homeowner defaults on their mortgages the lenders gets the house and houses are always increasing in value. Now the lenders sell their mortgages instead to responsible homeowners called prime mortgage, they know sell it to less responsible homeowners called sub-prime mortgage, without asking for proof of income and not requiring down payments. This is the turning-point. Just as explained before, the mortgage broker connects the family with a mortgages lender, which in turn sells it to the investment banker who then turns it into a CDO and sells "slices" (trays) to the investors. This was thought to make them all rich, but if the homeowner were to default in payments they didn't care, because they would sell it to the next person which would have been not their problem anymore.
So that's what happened, the homeowners did default on their mortgage, which on this moment is owned by the banker. This means that the banker forecloses and one of his monthly payments turns into a house. The banker would put the house back on the market for sale, but more and more homeowners default on their mortgages and the banker's monthly payments turned into houses. Now there are more houses for sale on the market creating more supply than demand and also housing prices are not rising anymore, but are dropping in price. This creates an interesting problem for homeowners still paying their mortgages. As all their houses in the neighbourhood are going up for sale the value of their house goes down. Now these homeowners decided to stop paying for their mortgages, even though they can afford it, because they are paying for a mortgage which is now more than what their house is worth. This creates now a big problem for the investment banker who now has mortgages he can't sell and huge amounts in loan that they need to repay, which they can't at this moment. But they are not the only one, because the investors have already bought mortgages from the investment banker and now they are in the same situation. The mortgages lender is also trying to sell his mortgages to the investment banker, but the banker is not interested anymore and the broker is out of work. The whole financial system is now frozen. This has lead to everybody going bankrupt.
The United States housing market correction (consequences of United States housing bubble) and subprime mortgage crisis has significantly contributed to a recession.
The 2008/2009 recession is seeing private consumption fall for the first time in nearly 20 years. This indicates the depth and severity of the current recession. With consumer confidence so low, recovery will take a long time. Consumers in the U.S. have been hard hit by the current recession. Not only have consumers watched their wealth going down, they now fear for their jobs as unemployment rises.
Although the US Economy grew in the first quarter by 1%, by June 2008 some analysts stated that due to an extended credit crisis and "rampant inflation in goods such as oil, food and steel", the country was nevertheless in a recession. The third quarter of 2008 brought a GDP fall of 0.5% the biggest decline since 2001. The 6.4% decline in spending during Q3 on non-durable goods, like clothing and food, was the largest since 1950.
They project real GDP declining at an annual rate of 2.9% in the fourth quarter and 1.1% in the first quarter of 2009. These forecasts represent significant downward revisions from the forecasts of three months ago.
A 2008 report from the NBER stated that the U.S. has been in a recession since December 2007 (when economic activity peaked), based on a number of measures including job losses, declines in personal income, and declines in real GDP.
Figure four show how the consumer confident is affected by the current recession. Since July 2007, consumer confidence has fallen 60 percent (Nov). Now stands 47 percent below post 9-11. It rose in July and August (but will likely fall in September).
U.S. employers shed 63,000 jobs in February 2008, the most in five years. Former Federal Reserve chairman Alan Greenspan said on April 6, 2008 that "There is more than a 50 percent chance the United States could go into recession." On October 1st, the Bureau of Economic Analysis reported that an additional 156,000 jobs had been lost in September. On April 29, 2008, nine US states were declared to be in a recession. In November 2008 Employers eliminated 533,000 jobs, the largest single month loss in 34 years (see fig.3).
USA Government Intervention
The global economic downturn, the sub-prime mortgage crisis, investment bank failures, falling home prices, and tight credit pushed the United States into a recession by mid-2008.
"To help stabilize financial markets, the US Congress under President George W. Bush established 700 billion dollars for Troubled Asset Relief Program (TARP) in October 2008. The government used some of these funds to purchase equity in US banks and other industrial corporations." (MSNBC.com)
"In January 2009 the US Congress passed and President Barack Obama signed a bill providing an additional 787 billion dollars fiscal stimulus (also known as the "Stimulus Bill") to fight the worst recession since the Great Depression. Two thirds would be going to additional spending into banks and other industrial corporations. The remaining one third would be used to provide tax cuts." (MSNBC.com)
Obama's plan is to get the economy moving again, by enabling a creation of more jobs. The Stimulus Bill hopes to help create more than 3.5 million jobs for the American people within the next two years. "The White House has officially pared its own projection to 3.5 million jobs in recognition of the bill's smaller size. But Christina Romer, who leads Obama's Council of Economic Advisers, said the administration remains convinced that the package of tax cuts and spending initiatives has sufficient power to boost the sagging economy toward recovery by year's end" (Washingtonpost.com).
However, not everyone is happy about Mr. Obama's stimulus bill. No single member of the Republican's House of Representatives voted for it, and only three Republican senators voted for it. "Without a single Republican vote, President Obama won House approval on Wednesday for an $819 billion economic recovery plan as Congressional Democrats sought to temper their own differences over the enormous package of tax cuts and spending" (NYTimes.com).
What Can the US Government Do To Limit the Impact of a Recession?
There are a number of steps that the US can take to address the many problems facing the global economy. These include continued action to recapitalize financial institutions under the Emergency Economic Stabilization Act, low interest rates, liquidity measures by the Federal Reserve, actions to lead in the currency crisis, direct intervention in the housing market, and new forms of financial regulation, both domestic and international.
The US has to set short-term and long-term programs to limit the impact of the recession. For the short-term is to extended unemployment benefits, expanded food stamp aid, loan modifications for distressed homeowners and temporary tax cuts. For the long-term, they will have to investment in basic infrastructure, job retraining programs, expanded small business & student's loans and investment in alternative energy, through tax incentives or other means.
The USA is in the middle of a very severe recession that is going to continue through all of 2009 and is the worst recession over the past 50 years. And it's all reversing right now in a very, very massive way. At this point it's not just a U.S. recession, but global. All of the advanced economies are also affected. Despite the number of available methods to fight a recession, a recession will badly affect large companies, small businesses and homeowners. However, after a recession it is followed by stages of economical development and upturn. Also there are many similarities between the Great Depression and the current recession, but the unemployment level is not neat the level as then. Many economists predict that this financial credit crisis will soon end in the beginning of the year 2010.
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