The 2007-2009 economic recession was mainly caused by collapse of the housing sector. It was characterized by high rates of unemployment, low interest rates, decline of the stock market, loss of payroll jobs, and decline of GDP growth. Unemployment rate rose to 10 percent, the highest since 1983. The Federal Funds rate was reduced to 0%. The government created the stimulus package to stimulate economic growth.
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The Fed conducted quantitative easing (QE) to counter the recession. QE1, QE2, and QE3 contained varying incentives. The GDP growth declined and the stock market declines.
The Dow Average went as low as 6,594.44. Today, the economy has recovered significantly experiencing a 0.4 %GDP growth in the first quarter of 2013. Unemployment rate has dropped to 7 %, the lowest rate since 2008. Economic recovery is evident even though effects of the recession are still evident.
The main objective of this report is to examine and evaluate factors that led to the 2007-2009 recession. It will present a critical evaluation of the monetary and fiscal policy measures put in place by policy makers to avert the recession’s adverse effects. Section 2 will analyze the causes of the recession. Section 3 will analyze the impact of the financial crisis on the US economy in different sectors.
Section 4 will discuss monetary policy measures put in place by the Federal Reserve to alleviate the negative effects of the recession on the economy. This will be followed by section 5 that will discuss the fiscal policies established y the government in reaction to the recession.
Section 6 will evaluate the effectiveness and usefulness of fiscal and monetary policies. Section 7 will evaluate the current state of the economy after the recession. Finally, section 8 will conclude the entire report by reiterating the findings.
Causes of the recession
The global financial crisis of 2007 largely distorted the economic landscapes of many countries leading to what has been labeled as the “great recession.” The crisis was triggered by collapse of the housing market in the US towards the end of 2007 (Moseley 35). The housing bubble originated in the 1980s. The role of Government Sponsored Enterprises increased thus expanding the secondary mortgage market (Brezina 45).
This led to creation of a new type of mortgage referred to as mortgage-backed securities (MBS). For example, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation bought mortgages from the secondary market and later sold them as mortgage-backed securities (Brezina 48).
This led to issuance of mortgage to lenders without legal documentation at rates that did not match the risk involved (Grusky et. al 64). As a result, rate of mortgage lending went high. Buyers from foreign countries invaded the US housing market. Oil-producing countries used dollars obtained from oil to purchase houses in the US. As a result, borrowers took mortgages whose servicing was long-term.
On the other hand, surge in house prices stopped and the house prices collapsed (Grusky et. al 67). Many borrowers failed to service their mortgages because many of them lacked financial ability to do so (Grusky et. al 64).
As a result, borrowers defaulted on payments, MBS were rendered useless, banks and other financial institutions began to collapse, and foreclosures increased. For example, institutions central to the mortgage bubble went bankrupt and credit markets froze causing the recession.
Another cause of the financial recession was decline in interest rates that encouraged borrowing. As a mitigation measure of the 2001 terrorist attacks and disintegration of the dot-com bubble, the Federal Reserve lowered interest rates to levels that raised rates of borrowing and lending (Grusky et. al 72). In addition, high debt deficit piled pressure on interest rates.
This happened at the same time when the housing sector was in shambles. Low interest rates encouraged people to take loans from banks and other financial institutions (Jagannathan and Kapoor par2). It also increased demand for financial assets thus lowering their interest. At one time, the interest rates were as low as 1% (Wall Street Journal Staff par4).
This measure effectively managed the 2001 recession. However, it contributed and paved way for the 2007 recession. Loose policies by the Federal Reserve lowered rates below expectations. High rates of borrowing led to bad debts because loans were issued based on borrowers’ personal income information.
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The inflation-suppression policy also contributed to the recession. Regulation of inflation using the policy created a superficial notion that the business cycle was less volatile due to lowering of interest rates (Jagannathan and Kapoor par5).
Consequently, this led to a misleading notion of financial sufficiency by many households that increased their borrowing. Many households increased their spending and neither saved nor invested in financial assets that had potential for high returns (Jagannathan and Kapoor par6).
Impact of the financial crisis on the US economy
One of the impacts of the 2007 recession was high rate of unemployment. At the close of 2007, unemployment rate was 5.0 percent (Sum and Khatiwada 2010). This was an increase from previous rates. The situation worsened as the recession carried on. In 2009, the rate of unemployment increased to 9.5 percent (Sum and Khatiwada 2010). Few months after end of the recession, unemployment rates went as high as 10 percent.
This rate had been experienced in 1982 when unemployment rate was as high 10.7 percent. During the recession, job opportunities and rate of employment declined by a big margin. The stock market was also affected adversely by the recession. Before the recession, the Dow Jones Industrial Average closed at 14,164.43 (Stockman par3).
However, after collapse of several large corporations and decline in GDP, the Dow Average dropped by 20%. The stock market declined further after collapse of Lehman Brothers. Investors panicked and the markets lost $ 144 billion as investors fled (Stockman par5). This almost caused collapse of the stock market. The decline continued and the Dow Average went as low as 6,594.44.
First, the Federal Reserve lowered the Federal Funds rate (Frieden 63). Prior to the recession, the Fed had increased the rates to 5.25 %. The recession prompted the Fed to lower rates to 4.75 % in 2007 when the recession set in. As the recession persisted, the Fed continued to lower rates. In April 2008, rates were as low as 2 % (Yilmaz 76).
The Lehman crisis led to further cuts that lowered rates to a range between 0% and 0.25 % (Abel 33). These rate cuts were ineffective in averting the recession because financial markets were not responding appropriately. As a result, the Fed resulted to open market operations (Hubbard 502). They established the Troubled Asset Relief Program (TARP).
TARP was a program developed by the Federal Reserve that involved purchasing assets and equities from financial institutions in efforts to address the crisis in the housing sector (Frieden 65). This involved purchase of short-term treasury instruments and mortgage-backed bonds (Yilmaz 78). The objective was to leverage the mortgage and housing markets.
Expansion of the Fed’s balance sheet was a threat that increased risk of inflation (Chukwuogor 88). Another strategy by the Fed to alleviate effects of recession was quantitative easing (QE). QE refers occurs when the FED purchases bonds mainly using mortgage-backed securities and treasury notes (Hubbard 503).
It involved QE1, QE2, and QE3. For example, EQ1 involved buying MBS worth 500 billion dollars. It was later increased by $750 billion. Operation Twist was launched in 2011. The Federal Reserve used earnings from auction of short-term treasury bills to purchase long-term treasury bills (Chukwuogor 91).
The fiscal policy involved implementing several tax and spending measures in efforts to increase spending by households (Hubbard 549). Spending was increased by raising government’s purchase of goods and services. In 2008, the government created a stimulus package that included tax rebates that aimed to increase spending and enhance operations of businesses.
The stimulus package created by President Obama cost $787 billion (Moseley par4). The main objective of the package was to stimulate economic growth that would emancipate the US from the adverse effects of the recession (Abel 39). In addition, it aimed to create approximately 2 million jobs.
The contents of the stimulus package included $288 billion to cover tax deductions, $224 billion to cater for education, healthcare, and unemployment benefits, and $275 billion to create new jobs ((Hubbard 551). The stimulus package was highly successful because it surpassed its initial objectives.
Evaluation of Fiscal and Monetary Policies
The bad state of the US economy during the recession necessitated expansionary monetary and fiscal policies. For example, the stimulus package was necessary because rate of employment was 10% in 2008 (Brezina 99). It was necessary to stimulate economic growth by creating more jobs. The fiscal stimulus was criticized because its effects on deficit spending were adverse.
It caused high debts that raised the nation’s debt deficit (Wall Street Journal Staff par5). This piled pressure on the economy that was declining. In 2013, US debt deficit stood at approximately $ 11.959 trillion. This is approximately 75% of the United Sates’ GDP. The total public debt is currently $16.805 trillion, including intra-governmental debts and holdings.
Increase in size of deficit and federal government debt affects economic growth because it increases interest rates, which consequently crowd out private investments (Brezina 105). In addition, high debt levels predispose the economy to inflation (Moseley apr6).
The measures implemented by the Federal Resave to handle the recession involved expanding money supply to stimulate economic growth. Their response to the recession put the economy at risk of inflation. The Fed claimed that incase the monetary policy became inflationary they were prepared to handle it.
Current state of the economy
Currently, the economy is doing well based on statistics obtained from the Bureau of Economic Analysis. Economic growth of 2.5 % was observed in the first quarter of 2013 (Bureau of Economic Analysis 2013).
This was preceded by GDP growth of 0.4 percent in the fourth quarter. Increase in GDP during the first quarter resulted from increase in personal consumption expenditure, exports, fixed investments, and private inventory investments (Bureau of Economic Analysis 2013). In the first quarter of 2013, the market value for goods and services increased by 3.7%, and a further 1.3 percent in the fourth quarter (Bureau of Economic Analysis 2013).
In February, unemployment rate dropped to 7.7 % down from 7.9 % (Schwartz and Appelbaum par4). This resulted from creation of 236,000 jobs in February. This rate was lower than any rate experienced since the start of the recession in 2007.
This is an indication that the economy is improving and recovering from the adverse effects of the 2007 recession. The Dow Jones Industrial Average responded to decrease in unemployment rate by surging to a value of 14,397.07.
The financial recession of 2007 had adverse effects on the economy. It was so severe that its effects are still felt today as the global economy struggles to recover. It was caused by collapse of the housing sector, and poor monetary policies by the Federal Reserve. The recession had several similarities and differences from previous recessions.
For example, failure of the stock market was greater during the depression than during the great recession. Unemployment rates during the great recession and great depression were comparable. The monetary and fiscal policies implemented by the government were highly effective in alleviating the effects of the recession. For example, the stimulus package reduced unemployment rates by creating new jobs.
Fannie Mae and Freddie Mac played critical roles in the recession. They headed the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation respectively. They bought mortgages from the secondary market and later sold them as mortgage-backed securities. This led to freezing of the credit markets that resulted in recession. The economy would have crumbled completely if the government did nothing.
The monetary and fiscal policies helped to stimulate economic growth. Otherwise, more financial institutions would have collapsed and unemployment rates would have soared. Creation of acts such as the Dodd Frank Act brought regulation to the financial markets.
Poor regulation of the financial markets would have deteriorated the economy further because financial institutions would have acted to remain on the markets regardless of potential dangers of their actions to the economy.
The effects of the recession are still felt today. However, the economy has improved tremendously. Unemployment rate has gone down to 7.7% due to creation of new jobs. There is danger of inflation because of high government debt deficit.
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