Financial crisis is a situation which is outcome of several factors, it mainly shows huge loss that is faced by an economy or country. The global financial crisis of 2007 to 2008 is marked as one of the contraction period of the world and this situation affected many countries. The main reasons behind any financial crisis are crashes of stock market, bursting of financial bubbles, devaluation of currencies and credit defaulters. Countries which are affected by financial crisis of 2007 to 2008 took a huge time to recover its losses and have recorded even negative growth during that period. The recession which was observed during this period of global financial crisis was very large and affected all the sectors of the economy and as a result of this country that are affected by global financial crisis suffered a large extent of loss.
Among the countries that were affected by recession during 2007 to 2008, USA stands in a visible position. The extent of loss suffered by US economy was very large and all the economic indicators of the country was affected as a result of this recession. During this period US economy recorded negative growth and economy even showed sluggish growth after the recovery from this period.
The main aim of this report is to explore the reasons that are liable for occurring of the great recession in USA during 2007 to 2008. Paper focused on the core causes and their effect on economy. The effect of recession economic indicators are also considered in this report.
Recession shows a significant decline of economic activities across the economy. It is mainly observable when an economy records negative growth in two consecutive quarters. In order to understand recession in a clear way , business cycle can be used. Business cycle mainly shows the phases through which an economy passes through.
Occurrence of recession can be understood by considering business cycle. Business cycle mainly shows a cyclical pattern which every economy faces during its process of development. Business cycle consists of four phases and these are: expansion of economy, peak of the economy, contraction in an economy and finally the trough situation faced by an economy. National Bureau of Economic Research determine the business cycle of an economy and they mainly uses the quarterly GDP growth rates; economic indicators like unemployment rate , trade balance, inflation rate, exchange rates are also used (McClelland and Rust, 2016).
Figure 1: Four phases of business cycle
The above figure shows different phases attained by an economy over time. It shows that the economy starts from the trough or depression phase and this phase shows low economic growth. The second phase attained by the economy is expansion, the third phase is the peak phase and finally the last phase is the contraction phase. A reduction in overall economic activity is the main reason behind the contraction phase and this phase deals with the recession phase of the economy. The main features of recession are- increase of unemployment, slumping sales, business failures increase, lower income level and expansion in underemployment.
Considering business cycle, recession that occurred in USA economy can be shown. US economy in 2008, contracted to 2.7 percent in the first quarter of 2008. Second quarter shows that the economy rebounded to 2 percent and during this period another contraction took place which recorded 1.9 percent in the third quarter finally in the fourth quarter the economy reached to 8.2 percent.
The global financial crisis of 2007 to 2008 evolved from the middle of 2007. This period created history since several events took place at one time, the most visible ones were crash of stock market, collapse of financial institution, rise in unemployment rate and vulnerable position of trade. In order to rescue economy from the grasp of global financial crisis several economies adopted several measures. US economy was largely affected by the recession period during 2007 to 2008, country’s all economic indicators have shown low level of development even negative results were recorded. In order to explore the main reasons of recession that broke out during this period several aspects are to be considered, these aspects are discussed below in an detailed manner.
US government provided housing loans post 19th century and these loans were easily available to most of the citizens. During this period government basically provided loan to the citizens with a view to generate wealth and this conception crop up within government because national median home prices increased from 2.9 to 3.1 percent in 2001 and 4 percent to 4.6 percent in 2006. This is the reason government provided easy credit and it was expected by the government that housing prices will appreciate and government may earn more revenue from this process of appreciation (Cheng, Raina and Xion, 2014). Government encouraged subprime borrowers to attain adjustable rate mortgages and these borrowers were entitled to give below market interest rate. However, this expectation of government was hampered since later in 2007 the housing market crashed and this was due to decline in the price of the houses. This affected the borrowers who were encouraged to obtain loans and this was due to the borrowers were unable to pay high monthly payments (Fligstein and Goldstein, 2015). Thus refinancing became difficult as housing prices fall. In 2007 credit market of USA froze and the situation deteriorated. Subprime credit stopped and federal fund rate for credits of other borrowings increased.
Figure 2: Number of houses sold
Source: (U.S Census)
The above figure shows that during the period from 2002 onwards the housing prices was very high and this high price grabbed the attention of US government to encourage borrowers to obtain loans for buying houses and government encouraged to increase its wealth . The period 2005 have recorded maximum sale of houses and this was due to credits that were easily available by the Banks. But post 2006, as housing prices began to fall due to its increase in demand, the sale of houses decreased and this was due to increase in number of borrowers who were unable to repay the interest amount and this affected the overall economy resulting in recession (Kivedal, 2013).
A sudden decline of stock market prices is defined as stock market crisis and this mainly results in loss of paper wealth. The reasons behind this stock market crash are: extended period of rising stock prices, economic optimism in an extreme level, when ratio of price equity ratio increases than long term averages and lastly extreme usage of margin debt and leverage.
Massive failure of financial institutions in USA in 2008 occurred mainly due to exposure to packaged subprime loans and swaps of credit defaults that were issued to cover these loans and the issuers (Bates, 2012).
Figure 3: USA bear market
Source: (Commons.wikimedia.org, 2017)
The figure above shows that US stock market peaked in 2007 and then it began to fall. Dow Jones Industrial Average closed at low level. DJIA dropped 18 percent with a decline of points. The S & P also fell by 20 percent. Finally NYSE volume fell during this period (Lleo and Ziemba, 2012).
Credit default is a financial swap agreement that a broker of CDS will pay return to the buyer in the incident of a loan or other credit event.
In 2007 -2008 subprime securities market crisis in US economy was a threat as this market decreased the market value heavily. This was because financial institutions heavily invested in mortgage securities but this investment resulted to crumble. Many of the failing institutions owned credit default swap on their subprime securities. Credit crunch mainly caused freezing of exchange of money and this affected the entire economy. Since CDS are intangible in nature here source of capital is difficult to be recognized to payout the CDS exactly. Thus this created situation in USA more vulnerable (Eichengreen, 2012).
CDS thus contributed significantly to financial crisis in 2007. However, market tried to rectify the market by making the market for CDS fairly liquid. Market also handled large defaults like Lehman brothers. Lehman brothers is one of the large firm that collapsed during the financial crisis but however were merely protected by CDS.
In 2007, Federal Reserve eased the credit availability , this was mainly due to the crash of stock market and the subsequent slowdown of economic growth which was faced by the economy and for this reason the interest rate level was decreased . This low interest rate initiated the growth of debt and among private debt mainly and this as result resulted in more purchase of housing. These high levels of debt have been identified as causal factor behind the recessions (Summers, 2014). Most of the housing debt was in turn caused by the credit default swap, mortgage security and collateralized debt obligation sectors of the industry, who were offering low interest rate and when the value of assets began to fall, debt consumers were unable to pay off the industry. In USA, the ratio of household debt to income increased from 39 percent to 138 percent.
Figure 4: Household debt to disposable income
Source: (US, Federal Reserve)
Dumping means the General Agreement on Tariffs and Trade and it shows product opening of one country into the commerce of another country accessible at below normal value of the products. China’s name comes first when dumping is considered.
As a result dumping from China in 2007, US firms incurred losses at a higher level and this resulted in financial crisis in USA . Chinese industries dumped US industries to a large extent. Steel industry was mainly affected due to dumping (Shen and Fu, 2014).
Figure 5: Dumping
Source: (IIT policies)
The above figure shows the before and after scenario, case of anti dumping. After the imposition of anti dumping policies share of production is stabilized.
Figure 6: USA GDP
Source: (OECD)
The figure shows that period of financial crisis recorded negative growth in USA and all these was due to events that negatively affected the economy.
Figure 7: Unemployment rate
Source: (US Bureau of labor statistics)
The rate is considered from 2006 to 2009 in the above figure. The rate began to increase post 2007 and it increased at a high level.
Conclusion
The conclusions drawn from report consist of various aspects of recession. . USA being a developed country was affected by recession in a large scale and the main causes behind this are: housing market bubble which can be considered as core element of driving the recession within the economy. Although, the main reason behind this housing bubble market is Government itself because they encouraged citizens to engage in credit activities with the view to increase the wealth . Other causes such as stock market crash, credit default, low interest rate and dumping from China also played important role behind creation of recession.
Thus period of recession from 2007 to 2008 is a remarkable one for USA, as the economy faced severe problems during this period and the growth of the economy post the period of financial crisis was also sluggish one as it took time for the economy to recover its losses at the cost of things.
References
Bates, D.S., 2012. US stock market crash risk, 1926–2010. Journal of Financial Economics, 105(2), pp.229-259.
Bls.gov. (2017). U.S. Bureau of Labor Statistics. [online] Available at: https://www.bls.gov/
Cheng, I.H., Raina, S. and Xiong, W., 2014. Wall Street and the housing bubble. The American Economic Review, 104(9), pp.2797-2829.
Commons.wikimedia.org. (2017). File:2007-2009 Bear Market.png – Wikimedia Commons. [online] Available at: https://commons.wikimedia.org/wiki/File:2007-2009_Bear_Market.png
Eichengreen, B., Mody, A., Nedeljkovic, M. and Sarno, L., 2012. How the subprime crisis went global: evidence from bank credit default swap spreads. Journal of International Money and Finance, 31(5), pp.1299-1318.
Fligstein, N. and Goldstein, A., 2015. The emergence of a finance culture in American households, 1989–2007. Socio-Economic Review, 13(3), pp.575-601.
Kivedal, B.K., 2013. Testing for rational bubbles in the US housing market. Journal of Macroeconomics, 38, pp.369-381.
Lleo, S. and Ziemba, W.T., 2012. Stock market crashes in 2007–2009: were we able to predict them?. Quantitative Finance, 12(8), pp.1161-1187.
McClelland, J. and Rust, J., 2016. Gains from investment timing over the business cycle: Machine replacement in the US rental industry.
Shen, G. and Fu, X., 2014. The Trade Effects of US Anti?dumping Actions against China Post?WTO Entry. The World Economy, 37(1), pp.86-105.
Summers, L.H., 2014. US economic prospects: Secular stagnation, hysteresis, and the zero lower bound. Business Economics, 49(2), pp.65-73.
The OECD. (2017). United States – OECD Data. [online] Available at: https://data.oecd.org/united-states.htm.
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