Global financial crisis of 2007 has its long-term effect on many countries, making it a great recession of that period. The main driving factor behind the crisis was identified as the breakdown of financial system and consequent financial bubbles. The great recession until reached to its lowest point, destructed approximately $20 trillion assets of U.S household. Consequently, unemployment rate rose significantly in US. Impact of the recession was not limited To USA only. It has well documented effect on cross border countries. With an economic downturn in USA, many countries have faced a depressed demand for their export and a decline in their investment in USA. Most of the Americans believe that the cause for the great depression was subprime mortgage crisis, Wall Street greed and Lehman brothers. However, there are number of other factors that affect that together cause economic downturn.
Apart from weak financial condition, USA economy was suffering from various structural problems. Problems begin with a speculative growth of demand generated prior to recession. The financial and structural problems cumulatively result in an inevitable crisis for the economy. A self-reinforcing crisis cycle was created because of a combining effect financial breakdown and consumer debt. These two effect together results in severe financial crisis, ultimately triggering the Great Recession.
Recession indicates a situation where there is an overall declining trend in different economic activities including production, trade and industrial expansion leading to a contraction of both demand and supply side phenomenon. This actually triggered from a low aggregate demand. Low demand discourages producers to contract their supply (Greenglass et al. 2014). The related effect of low aggregate demand and aggregate supply is the increasing unemployment, lower wages and finally a declining living standard in the economy. Recession is often responsible in creating a circular effect that pushes the economy in a continuous downturn. In this situation intervention through fiscal and monetary tool, become necessary.
Some possible factors leading to economic recession are as follows.
Interest rate is the cost of investment. High interest rate increases the cost of investment, which means it restricts liquidity in the economy. High interest rate reduces tendency for investment (Hyra and Rugh 2016). Low availability of investible fund means lower production and hence low income and low demand.
Inflation refers to a gradual increase in general price level. In times of inflation, value of money decrease and this reduces the purchasing power of people. Therefore, with same amount of money people demand less.
Demand in an economy depends on the confidence of the consumers. In case, they believe the economy is in a bad state they restricts their spending.
Another important factor determining state of the economy is the prevailing real wage. Real wage is obtained by dividing actual wage with the price level. Thus, it shows the inflation adjusted income of the workers. In phase of rising, declining real wage means workers are not compensated for price rise and hence experienced a decline in purchasing power (Heyes, Lewis and Clark 2014).
The National Bureau of Economic research identified ten recessions to be taken place from 1948 to 2011. Among them, the most severe recession is that occurred between 2007 and 2009 (bls.gov 2017). The economic condition during this time is reflected in different components of economy.
A highly recognized indicator of recession is rising unemployment rate in the economy. Recorded unemployment rate in December 2017 was 5.0 percent. The unemployment rate was same or even at a lower rate in previous 2-3 years. The recession ended up with an unemployment rate of 9.5 percent. In the month, succeeding end of the recession unemployment rate picked up to the 10.0 percent (aeaweb.org 2017).
Figure 1: Unemployment rate in US from 1948-2011
(Source: Bls.gov, 2017)
Prior to recession consumption had increased rapidly from $46,114 in 1984 to nearly $53,349 in 2006. However, aftermath of recession recorded a decline in consumption. Average expenditure for personal consumption declined to $48,109 in 2010 (journals.elsevier.com 2017). People cut down their budget for different component of consumption leaving only health care expenditure.
In times of recession, productivity in an economy declines at a fast pace. Output decreased more rapidly than factor input especially for labor input. This indicates a sharp fall in productivity of laborers. Productivity increases in times when there fall in input is greater than the fall in output.
Figure 2: Productivity in non-firm business sector
(Source: Bls.gov, 2017)
A major determinant of macroeconomic stability is aggregate demand. Household consumption is a major component of demand in US. The declini9ng demand of household consumption with a depressed housing construction demand is responsible for the great recession. From the beginning of mid 1980’s there was massive growth in consumption demand. It was the only component of real GDP, which accounted 37% growth between 1984 and 2007 (muddywatermacro.wustl.edu 2017). The rise in consumption demand was associated with speculative rise in expenditure of the household. Because of a rapid increase in consumption demand, the time period is known as ‘Consumer Age’ in US history. This was characterized as a period of economic boom for US. US accounted a relatively high growth rate as compared to other contemporary developed countries. T5he trend of long-term unemployment was downing. Meanwhile, the economy experienced two mild recessions one in 1990-91 and another in 2001.
Rapid increases in household consumption spending and associated high growth rate have ac dark side too. From 1980s, consumption grew rapidly, however growth rate in income had slowed down nearly for all groups excluding to earning groups. The consumption demand remained strong for all groups. When earned income fell short of consumption expenditure then people had a general tendency to borrow money to fulfill their demand. As a result, debt to income ratio for American household became doubled in the time span (Cynamon and Fazzari 2015). Meeting consumer demand by borrowing fund is not a sustainable means for the economy. In this situation, lending had almost ceased to the already indebted household. In order to recover negative saving consumers cut down their consumption expenditure for nearly everything. The demand for new constructed house declined drastically. The rapid decline in household demand that was high since early 1930 resulted in great recession.
Housing demand had played an important role in the Great Recession occurred in 2008. People borrowed a lot to fulfill their expenditure. Most of the borrowings were in the form of mortgage debt. To encourage borrowing a low interest rate was charges and loans were made easily available. Even citizens with a weak financial record were given loans through scheme name subprime mortgage (Rothstein 2017). The easy and low cost borrowing scheme made housing ownership attainable and more attractive for Americans. People had an expectation about a rising price of houses. In anticipation of a future high price they kept on purchasing more houses. They attracted towards purchasing bigger house and renovated their existing houses. Following law of demand, increasing housing demand pushes housing price up. This justifies people’s expectation of rising price for houses and owners of these houses in the economy become the wealthier members of the society. All these accelerate borrowing by Americans against equity of the houses.
In consideration of rising borrowing tendency by American constitutes need for special institution to stand on the other side of the borrowing. Many new mortgage institutions were formed in the preceding decade of great recession (Teulings and Baldwin 2014). These institutions provided great assistance to the borrowers in times of borrowing and purchasing houses. In this way, they hold equity in forms of housing. Bundling up many such loans were sold in the form of Mortgage backed securities (MBS). Investment banks took complete advantage of this situation. They repacked these securities and offered those a mortgage debt to global investors from the US household. The scheme had proved highly profitable. With rising house price, return to investors goes up. People all over the world got tempted to have a place in American Mortgage market (Hansen 2015). The desire for participating in the mortgage market encourages borrower even greater for taking additional loans out of the door. The increasing loan volume largely reduced interest rate. For easy availability of loans credit standard are relaxed. This accelerated borrowing brought a flood in house market and increases housing price. This supports the decision of the investors to invest in the house market. Borrowing became more lucrative with rising equity price for housing. The values of their collateral increases leading investment in MSB market in a better position. This pumps greater money in the housing security market. With easy availability of loans at a comparatively cheaper rate, funds flew to the hands of risky borrower. Matching of borrowers and lenders interest triggered a financial bubble (Mian and Sufi 2015).
The bubble started building up in gradually from 1980s outbursts in 2006. During this time inflation rates leads to a hike in the in the interest rate in the short run. In times of inflation, borrowers are always at a disadvantageous position. This creates tensions for Federal Reserve as borrowers especially the finically weakest borrowers faced difficulties to refinance their loan amount (Kroft et al. 2016). Refinancing was important to maintain the finance bubble and keep on the consumer demand. Interest rate was in a very risky position. Loans were initially offered at a low rate but finally revised t a high rate that made loan financing unaffordable for many borrowers. People had expectation that they would get opportunities to refinance their borrowings in better terms. The expectation was made before revising the set up (Ball 2014). When interest rate starts rising, the usefulness of the earlier strategy became reluctant. A tightened credit market forced the borrowers to disinvest that means they went for selling their houses. In the housing market, increasing availability of houses drops housing prices. With this, confidence of investors over mortgage backed securities stalled and they had defaulted mortgage, which reduces mortgage loan availability. More agents in the housing market became interested in selling their housing asset. Drastic reduction in housing price cause a short of home values in comparison to the mortgage value. As a result, agents are forced to be in default position.
The financial bubbles in 2006 affect Americans more severely than earlier crises such as that in early 1990s or oil patch bubble in early 1980s (Christiano, Eichenbaum and Trabandt 2015). Most of the house owners in USA found their wealth to be evaporated in the phase of declining housing price. New house construction in America was completely ceased. To compensate loss from investing in housing market people cut back their personal consumption as much as possible. Consumption fell even more rapidly than in times of earlier recession. In response to lower consumption, firms’ production in the economy fell largely. This brought an overall depression for the economy generated from a downing aggregate demand (Jagannathan, Kapoor and Schaumburg 2013). This explains the arrival of great recession.
Conclusion
The Great recession originated in USA affected all over the globe. During recession, US economy experienced a declining trend in many aspects including consumption, investment, and employment and finally reflected in nation GDP. The primary factor responsible for the great recession is the outburst of housing sector bubble. The bubble formed in the housing market during the period 1984 to 2006. Lucrative housing market in US attracts many investors to build up their housing market. Conditions in the credit market had been made favorable in terms of easy access to credits and a low interest rate. However, a sudden rise in interest rate in response to inflation rate influences people to sell houses for loan refinance. This leads to a decline in the housing prices. To recover mortgage houses, people reduced their consumption expenditure. Reduced consumption expenditure had a direct impact on aggregate demand and finally US economy met with the “Great Recession”.
References
Bls.gov (2017). [online] Available at: https://www.bls.gov/web/empsit/cps_charts.pdf [Accessed 7 Sep. 2017].
Aeaweb.org. (2017). American Economic Association. [online] Available at: https://www.aeaweb.org/journals/aer [Accessed 9 Sep. 2017].
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Muddywatermacro.wustl.edu. (2017). Causes of the Great Recession | Muddy Water Macro. [online] Available at: https://muddywatermacro.wustl.edu/node/92 [Accessed 9 Sep. 2017].
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