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US Recession

(Sub Prime Crisis) 

Macro Economics Report 

Submitted to: Subhalakshmi Mahopatra.

Submitted by :

Ravi Shavak(80)Anu Sudhavan(15)Arpit Gupta(21)Gunjan Rahi (39)Rahul Khajuria (115)

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US RECESSION (SUB PRIME CRISIS)

ABOUT RECESSION

In economics, a recession is a business cycle contraction, a general slowdownin economic activity.[1][2] During recessions, many macroeconomic indicatorsvary in a similar way. Production, as measured by gross domestic product(GDP), employment, investment spending, capacity utilization, householdincomes, business profits, and inflation all fall, while bankruptcies andthe unemployment rate rise.

Recessions generally occur when there is a widespread drop in spending, oftenfollowing an adverse supply shock or the bursting of an economic bubble. Governments usually respond to recessions by adopting

expansionary macroeconomic policies, such as increasing moneysupply, increasing government spending and decreasing taxation. 

ABOUT SUB PRIME CRISIS

The sub prime crisis refers to the collapse of sub prime mortgage markets in

USA due to the sharp rise in foreclosures beginning in 2006 and led to the

failure, merger and government bailout of leading American financial

institutions and enterprises such as Bear Stears, AIG, Fannie and Freddie,Merrill Lynch, Citi Group, Lehman Brothers and etc. The sub prime crisis

triggered a financial crisis which rapidly spread to other countries around the

world and became a global financial crisis in 2008. It affects every country and

everyone through the global nature of the financial system. In late 2008, the

global financial crisis began to affect the real economy and triggered a global

economic crisis. It resulted in the worst global economic recession since the

Great Depression of 1920s and 1930s. The sub prime crisis is basically the crisis

of the overspending of governments and individuals beyond their financialcapacities. It is the crisis of over-consumption. It is the imbalance between

consumption and production. It is the result of consumptionalism. This report

examines the causes of the sub prime crisis and the impact of the sub prime

crisis and that of the global financial crisis caused by the sub prime crisis.

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HISTORY OF US ECONOMY

The economic history of the United States has its roots in European settlements

in the 16th, 17th, and 18th centuries. In the 19th century, recessions frequentlycoincided with financial crises. 

Recessions after World War II appear to have been less severe than earlier

recessions, but the reasons for this are unclear. The Depression of 1893 was one

of the worst in American history, with the unemployment rate exceeding 10%

for half a decade For many years following the Great Depression of the 1930s,

when danger of recession appeared most serious, the government sought to

strengthen the economy by spending heavily itself or cutting taxes so that

consumers would spend more, and by fostering rapid growth in the moneysupply, which also encouraged more spending. Ideas about the best tools for

stabilizing the economy changed substantially between the 1930s and the 1980s.

From the New Deal era that began in 1933, to the Great Society initiatives of 

the 1960s, national policy makers relied principally on fiscal policy to influence

the economy. The approach, advanced by British economist John Maynard

Keynes, gave elected officials a leading role in directing the economy, since

spending and taxes are controlled by the U.S. President and the Congress. 

CHANGE IN GDP OF US FROM 1980 TO 2010

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The economy and living standards grew strongly during this era, but a period of 

high inflation, interest rates and unemployment after 1973 weakened confidence

in fiscal policy as a tool for regulating the overall pace of economic

activity.[28] Following a series of periodic credit tightening measures designed to

combat inflation, a combination of loose monetary policy and record budgetdeficits, both financed with foreign direct investment and public debt, became

routine economic policy after 1981. The most vigorous, sustained periods of 

growth, on the other hand, took place from early 1961 to mid 1969, with an

expansion of 53% (5.1% a year), from mid 1991 to late in 2000, at 43% (3.8% a

year), and from late 1982 to mid 1990, at 37% (4% a year).[30] In 2006, the U.S

economy had its lowest saving rate since 1933.[35] These issues have raised

concerns among economists and national politicians.[36] US share of world GDP

(nominal) peaked in 1985 with 32.74% of global GDP (nominal). The second

highest share was 32.24% in 2001.

US share of world GDP (PPP) peaked in 1999 with 23.78% of global GDP

(PPP). The share has been declining each year.

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THE CAUSES OF THE SUB PRIME CRISIS 

The Breakdown of the Global Financial System 

In July 1944, a new international monetary system was agreed upon at the

United Nations Monetary and Financial Conference held in Bretton Woods,New Hampshire, USA. The system was based on fixed exchange rates and acommon standard. In the 19th and early 20th centuries, the role of monetarystandard was played mainly by gold. The value of currencies was benchmarkedagainst a fixed weight of precious metal. A country with a deficit in its balanceof payments would make up the shortfall with sales of some of its gold reserves,with a concomitant reduction in its money supply.

The Bretton Woods system adopted a ‗gold exchange‘ standard whereby one

ounce of the metal was worth a fixed USD35.00, a rate the US governmentpromised to maintain. Together with chronic US external deficits, this systemestablished the hegemony of the US dollar in the global financial system, whereit became the near-exclusive reserve currency. However, the US governmentfound it increasingly difficult to meet its commitments.

In the post-war decades, the USA acted as the main engine of world economicgrowth, importing more goods and services than it exported. The resultingsurfeit of dollars around the world was the near-exclusive source of international liquidity. The problem was that if dollar supply was perceived as

excessive, confidence in the currency became weaker, and so did its gold peg.After a succession of currency crises in the late 1960s, the US government on15 August 1971 unilaterally 

Excessive Public Spending and Excessive Growth of Government 

For many years, many countries have been advocating for market principles andsmall governments. But their practices or what they actually do are often

different from what they preach. For example, public spending has soared.Government does not reduce public spending but rather increases itdisproportionately. In the USA, it increased about five fold in the last twodecades. The outstanding public debt in USA stood at around USD 10 trillion in2008. The US government spends excessively. The US Government faced hugedeficit (Figure 1 and 2). However, the US government tried to solve theproblem by repeating the cause of the problem. That is to solve the deficitproblems by borrowing more money and creating more deficits. This is why aformer EU chairman critises the approach of over-spending and recently warned

that further public excessive spending is not a solution, rather a way to the hell.

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Recent debt crisis in Greece, Spain, Iceland, Portugal and Italy has more clearlydemonstrated the problem of excessive public spending.

President Obama‘s budget blueprint wouldraise a total spending to USD3.9

trillion in 2009, an increase of nearly 32 percent. This is the highest level since

World War II. In the next five years, his plan would double the national debt. In

10 years, the debt would triple. Many would argue that the US government and

the UK and EU had no option but to rapidly increase government spending and

to bail out the banks whose reckless lending and use of dubious financial

derivatives brought the problem in the first place. But it will ultimately lead to

the overburden and depreciation of currencies, which affects the affordability of 

governments and shrinkage of people‘s wealth due to currency depreciation and

could lead to another wave of crisis sooner or later.

Public Debt in USA (in USD) 

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Oversupply of US Dollars Making Financial Institutions Lowering Lending Criteria

Oversupply of US dollars largely increased the ―liquidity‖ of US dollars. US

financial institutions are full of US dollars. The financialinstitutions haveincreased pressure to lend outthe oversupplied money. Financial institutions

need to expand their client base to absorb themoney. They lowered their lending

criteriaand innovated new products or instruments such as sub prime mortgage

loans. They lent money to clients who are not qualified forloans on

conventional criteria. Eventually it contributed to the sub prime mortgage crisis

because people could not repay their loans.Freddie Mac, Fannie Mae and etc

were remiss in underwriting mortgage loans, the majorUS banks and mortgage

lenders such as Washington Mutual played a key role.

The United States housing bubble is an economic bubble affecting many parts

of the United States housing market in over half of American states. Housing

prices peaked in early 2006, started to decline in 2006 and 2007, and may not

yet have hit bottom as of 2011. On December 30, 2008 the Case-Shiller home

price index reported its largest price drop in its

history. Increased foreclosure rates in 2006 – 2007 among U.S. homeowners ledto a crisis in August 2008 for the subprime, Alt-A, collateralized debt

obligation (CDO), mortgage, credit, hedge fund, and foreign bank markets. In

October 2007, the U.S. Secretary of the Treasury called the bursting housing

bubble "the most significant risk to our economy."

Any collapse of the U.S. Housing Bubble has a direct impact not only on home

valuations, but the nation's mortgage markets, home builders, real estate, home

supply retail outlets, Wall Street hedge funds held by large institutional

investors, and foreign banks, increasing the risk of a nationwide recession.Concerns about the impact of the collapsing housing and credit markets on the

larger U.S. economy caused President George W. Bush and the Chairman of the

Federal Reserve Ben Bernanke to announce a limited bailout of the U.S.

housing market for homeowners who were unable to pay their mortgage debts.

In 2008 alone, the United States government allocated over $900 billion to

special loans and rescues related to the US housing bubble, with over half going

to Fannie Mae and Freddie Mac (both of which are government-sponsored

enterprises) as well as the Federal Housing Administration (which is a UnitedStates Government agency). On December 24, 2009 the Treasury Department

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made an unprecedented announcement that it would be providing Fannie Mae

and Freddie Mac unlimited financial support for the next three years despite

acknowledging losses in excess of $400 billion so far. The Treasury has been

criticized for encroaching on spending powers that are enumerated for Congress

alone by the US constitution, and for violating limits imposed by the Housing

and Economic Recovery Act of 2008. 

Housing Price Increase over the Previous Year 

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IMPACTS OF SUBPRIME CRISIS

The Bursting of the Housing Bubble

From 2000 to 2006, the USA observed a rapid rise in housing prices. In some areas housingprices doubled, which increased beyond the rate of fundamental economic growth. Te housingbubble was mainly the result of oversupply of the housing market through the provision of low interest rates by the US FederalReserve. TeFederal Reserve cut interest rates by a total of550 basis points between 2001and 2004. Te lowreturn on the stock markets and treasury bonds further pushed money to flow into the housingmarket to boost the housing bubble. Much of this money was lent to the households whootherwise would not be qualifed for mortgage loans. In 2008, the housing bubble burst.Housing prices fell signifcantly in many parts of United States

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The Rapid Increase of Unemployment

International Labour Organisation (ILO) reports that the global Financial crisiscould increase world unemployment by an estimated 20 million. It will bring

the total world unemployment to over 200 million in2009. However, thesituation seems far worsethan thatIMF‘sestimate shows that the unemployment causedby the global financial crisis is more than 30 million, which pushes the total worldunemployment to more than 210 million. To unemployment caused by the global financialcrisis can be far more than this figure too. In China alone, the global financial crisis led totheclosure of more than 67,000 small and medium-sized enterprises and more than 20millionpeople lost their jobs. Another 300,000small enterprises are partially closing down.The hardest-hit parts have been the manufacturing sectors in China. The same is true for the United States.The manufacturing regions such as Michigan, Ohio and RhodeIsland, and regions which hadhuge housing bubbles such as California, Florida andNevada have highest unemploymentrates. In El Centro, California, the unemploymentrate is as high as 22.6 percent .Theunemployment rates have a negative co-relations with the level of education. It causes more joblosses among the less educated than those with high education. Those without high schooldiplomas are hit hardest. Te next worst hit group are high school graduates. In other words, thepoor people are hit hardest by crisis.

Effect on world economy:

The US Subprime Crisis has not only resulted in US economy recession but its

ripple effects has touched the countries like UK, Spain, Japan and Singapore as

well. Emerging economies like China and India are also affected by the

negative influence of the US Subprime Market Crisis. At present it seems that

this subprime crisis of US is going to generate a global recession by affecting

the major countries of the world.

The US Subprime Market Crisis has already resulted in US EconomyRecession. The countries like Britain, Spain, Japan, Singapore are going to bear

the negative effects of US economy recession. Emerging economies like Chinaand India are also suffering from the ill effects of the US Subprime Crisis. Allthese countries together form a major part of the global economy. So, it can besaid that the US Subprime Market Crisis is going to affect the global economyas a whole. As all the countries mentioned above are being influenced in anegative way by the US economy recession, it is expected that the growth rateof the world economy would experience a significant fall.According to AlanGreenspan, the Former Federal Reserve Chairman, Global Recession is surelygoing to take place in some form or other.

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As the US Federal Reserve is opting interest rate cuts in order to fight with theproblem of subprime crisis, countries like UK and Japan are also introducinginterest rate cuts in their country. India is also thinking over introducing a cut ininterest rate in its next monetary policy. This is because all these countries are

speculating that cut in US interest rate will result in capital inflow in theireconomies which will in turn result in high levels of inflation.

This problem of US Subprime Market is generating Credit Crunch in someeconomies and accelerating Global Recession in a way. The Economy of Singapore has already entered into recession. The total factory output of thecountry has got reduced and export of electronics goods has declinedsignificantly. The real estate sector of the country is also experiencing a slowdown.

The UK economy is also suffering from the problem of credit crunch as the rateof loan taking for home purchase has been recorded at a two year low.

Other than Japan, China, Singapore, UK, Spain there are other countries likeGermany which are showing signs of slow downs , thereby accelerating thepace of global recession

How INDIA survived recession?

Lower impact of recession in India was the quick adoption of correctivemeasures by the reserve bank of india the RBI saved Indians from overspendingby changing the interest rate wherever required.The RBI first lowered interestrate during global slowdown in order to boost demand in economy at the sametimeRBI ensured tightening of credit in the more speculation oriented industrylike real estate, which was sustaining high property price.To manage inflationand promote the RBI has raised its key policy rates six times since march 2010when the crises began in sreptember 2008 the RBI repetedlyreversedits earlier

tightening of credit to meet the new and changed circumstances of the globalscenario.The CRR,REPO RATE ,REVERSE REPO RATE was rapidly loweredin series of quick steps.

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Why Such a Slow Recovery of the U.S. Economy?

Unlike the previous ten post World War II recessions that the United Statesendured, the 2007-09 downturn as precipitated by a financial crisis. Economic

research, including that by the International Monetary Fund (2009) andReinhart and Rogoff (2009), shows that financial crises tend to lead torecessions that are more severe and recoveries that are substantially slower.

In some cases, the crisis may affect economic growth for as much as a decadeafter the recession‘s official end.

What the researchers find is that financial crises create an uncertain environmentthat disrupts the relationships between lenders and investors and undermines

private investment and job creation, which reduces consumer confidence andlowers consumer spending. The result is weakened economic activity and moreuncertainty, both of which further undermine investment. Slower economicactivity also puts stress on government revenues, which can lead to curtailedspending, higher tax rates and higher budgetary deficits. All these factors feedon each other, deepening the recession and slowing the subsequent recovery.

In a late August 2011 report, Ryan Kennelly and I examined the prospects for adouble dip recession and found no reliable indication that another U.S.recession was imminent. The most recent readings on the seven indicatorsthat we examined — GDP growth, the stockmarket, fiscal policy,theunemployment rate, oil price shocks, the yield curve, and the U.S. index of leading economic indicators — still show that another U.S. recession is notimminent.

Can Policy Make a Difference?

We can take some comfort in the prospect that the U.S. economy is likely toshow more robust growth in the near future. Nonetheless, we also face the

prospect of the economy running well below potential and unemploymentremaining at high levels for a sustained period of time. In early September 2011,Charles Evans (president of the Federal Reserve Bank of Chicago)said, ―It bears keeping in mind that …predictions of a slow recovery are based onhistorical averages of macroeconomic performances across many differentcountries. There is nothing pre-ordained about these outcomes. The economycan perform better than it did in these past episodes if policy responds betterthan it did in those situations.‖ 

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What policies might be recommended?

Evans has recommended redirecting U.S. monetary policy toward a hybridtarget of lower unemployment and inflation fighting, an idea that Federal

Reserve Chairman BenBernanke (2011) opposed as eroding Fed credibility.

A few days later in September 2011, Richard Fisher (president of the FederalReserve Bank of Dallas) maintained that the Federal Reserve System hasprovided all the monetary liquidity necessary for a recovery. It is up to thebanks, investors and consumers to restore economic activity to its potential.If banks, investors and consumers are to restore economic activity to its potential,more needs to be done to improve bank and consumer balance sheets. Ken

Rogoff (2011) recently recommended a burst of inflation to make such

improvements, but that may be too blunt an approach. A more surgical policywould be to restore consumer balance sheets by using government funds toreduce the amount that consumers owe on their mortgages to the marketvalues of their houses. Those areas of the country where economic activity hasbeen the strongest in recent years did not see the big swings in property valuesthat left consumers holding mortgages that are much greater than the value of their houses.