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)

US RECESSION (SUB PRIME CRISIS) ABOUT RECESSION In economics, a recession is a business cycle contraction, a general slowdown in economic activity.[1][2] During recessions, many macroeconomic indicators vary in a similar way. Production, as measured by gross domestic product (GDP), employment, investment spending, capacity utilization, household incomes, business profits, and inflation all fall, while bankruptcies and the unemployment rate rise. Recessions generally occur when there is a widespread drop in spending, often following an adverse supply shock or the bursting of an economic bubble. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, 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 financial capacities. 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.

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 frequently coincided 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 money supply, 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

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 budget deficits, 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.

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 a common standard. In the 19th and early 20th centuries, the role of monetary standard was played mainly by gold. The value of currencies was benchmarked against a fixed weight of precious metal. A country with a deficit in its balance of 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 government promised to maintain. Together with chronic US external deficits, this system established the hegemony of the US dollar in the global financial system, where it became the near-exclusive reserve currency. However, the US government found it increasingly difficult to meet its commitments. In the post-war decades, the USA acted as the main engine of world economic growth, importing more goods and services than it exported. The resulting surfeit 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 on 15 August 1971 unilaterally

Excessive Public Spending and Excessive Growth of Government For many years, many countries have been advocating for market principles and small 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 it disproportionately. In the USA, it increased about five fold in the last two decades. The outstanding public debt in USA stood at around USD 10 trillion in 2008. The US government spends excessively. The US Government faced huge deficit (Figure 1 and 2). However, the US government tried to solve the problem by repeating the cause of the problem. That is to solve the deficit problems by borrowing more money and creating more deficits. This is why a former 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.

Recent debt crisis in Greece, Spain, Iceland, Portugal and Italy has more clearly demonstrated the problem of excessive public spending. President Obamas 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 peoples wealth due to currency depreciation and could lead to another wave of crisis sooner or later.

Public Debt in USA (in USD)

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 have increased 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 20062007 among U.S. homeowners led to 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 United States Government agency). On December 24, 2009 the Treasury Department

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

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 housing prices doubled, which increased beyond the rate of fundamental economic growth. Te housing bubble was mainly the result of oversupply of the housing market through the provision of low interest rates by the US FederalReserve. Te Federal Reserve cut interest rates by a total of550 basis points between 2001and 2004. Te low return on the stock markets and treasury bonds further pushed money to flow into the housing market to boost the housing bubble. Much of this money was lent to the households who otherwise would not be qualifed for mortgage loans. In 2008, the housing bubble burst. Housing prices fell signifcantly in many parts of United States

The Rapid Increase of Unemployment International Labour Organisation (ILO) reports that the global Financial crisis could increase world unemployment by an estimated 20 million. It will bring the total world unemployment to over 200 million in2009. However, the situation seems far worsethan thatIMFs estimate shows that the unemployment caused by the global financial crisis is more than 30 million, which pushes the total world unemployment to more than 210 million. To unemployment caused by the global financial crisis can be far more than this figure too. In China alone, the global financial crisis led tothe closure of more than 67,000 small and medium-sized enterprises and more than 20million people lost their jobs. Another 300,000small enterprises are partially closing down.The hardesthit 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 had huge housing bubbles such as California, Florida andNevada have highest unemployment rates. In El Centro, California, the unemploymentrate is as high as 22.6 percent .The unemployment rates have a negative co-relations with the level of education. It causes more job losses among the less educated than those with high education. Those without high school diplomas are hit hardest. Te next worst hit group are high school graduates. In other words, the poor 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 Economy Recession. The countries like Britain, Spain, Japan, Singapore are going to bear the negative effects of US economy recession. Emerging economies like China and India are also suffering from the ill effects of the US Subprime Crisis. All these countries together form a major part of the global economy. So, it can be said that the US Subprime Market Crisis is going to affect the global economy as a whole. As all the countries mentioned above are being influenced in a negative way by the US economy recession, it is expected that the growth rate of the world economy would experience a significant fall.According to Alan Greenspan, the Former Federal Reserve Chairman, Global Recession is surely going to take place in some form or other.

As the US Federal Reserve is opting interest rate cuts in order to fight with the problem of subprime crisis, countries like UK and Japan are also introducing interest rate cuts in their country. India is also thinking over introducing a cut in interest 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 their economies which will in turn result in high levels of inflation. This problem of US Subprime Market is generating Credit Crunch in some economies and accelerating Global Recession in a way. The Economy of Singapore has already entered into recession. The total factory output of the country has got reduced and export of electronics goods has declined significantly. The real estate sector of the country is also experiencing a slow down. The UK economy is also suffering from the problem of credit crunch as the rate of loan taking for home purchase has been recorded at a two year low. Other than Japan, China, Singapore, UK, Spain there are other countries like Germany which are showing signs of slow downs , thereby accelerating the pace of global recession How INDIA survived recession? Lower impact of recession in India was the quick adoption of corrective measures by the reserve bank of india the RBI saved Indians from overspending by changing the interest rate wherever required.The RBI first lowered interest rate during global slowdown in order to boost demand in economy at the same timeRBI ensured tightening of credit in the more speculation oriented industry like real estate, which was sustaining high property price.To manage inflation and promote the RBI has raised its key policy rates six times since march 2010 when the crises began in sreptember 2008 the RBI repetedlyreversedits earlier tightening of credit to meet the new and changed circumstances of the global scenario.The CRR,REPO RATE ,REVERSE REPO RATE was rapidly lowered in series of quick steps.

Why Such a Slow Recovery of the U.S. Economy? Unlike the previous ten post World War II recessions that the United States endured, the 2007-09 downturn as precipitated by a financial crisis. Economic research, including that by the International Monetary Fund (2009) and Reinhart and Rogoff (2009), shows that financial crises tend to lead to recessions that are more severe and recoveries that are substantially slower. In some cases, the crisis may affect economic growth for as much as a decade after the recessions official end. What the researchers find is that financial crises create an uncertain environment that disrupts the relationships between lenders and investors and undermines private investment and job creation, which reduces consumer confidence and lowers consumer spending. The result is weakened economic activity and more uncertainty, both of which further undermine investment. Slower economic activity also puts stress on government revenues, which can lead to curtailed spending, higher tax rates and higher budgetary deficits. All these factors feed on each other, deepening the recession and slowing the subsequent recovery. In a late August 2011 report, Ryan Kennelly and I examined the prospects for a double dip recession and found no reliable indication that another U.S. recession was imminent. The most recent readings on the seven indicators that we examinedGDP growth, the stockmarket, fiscal policy,the unemployment rate, oil price shocks, the yield curve, and the U.S. index of leading economic indicatorsstill show that another U.S. recession is not imminent. Can Policy Make a Difference? We can take some comfort in the prospect that the U.S. economy is likely to show more robust growth in the near future. Nonetheless, we also face the prospect of the economy running well below potential and unemployment remaining 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 on historical averages of macroeconomic performances across many different countries. There is nothing pre-ordained about these outcomes. The economy can perform better than it did in these past episodes if policy responds better than it did in those situations.

What policies might be recommended? Evans has recommended redirecting U.S. monetary policy toward a hybrid target 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 Federal Reserve Bank of Dallas) maintained that the Federal Reserve System has provided all the monetary liquidity necessary for a recovery. It is up to the banks, 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 policy would be to restore consumer balance sheets by using government funds to reduce the amount that consumers owe on their mortgages to the market values of their houses. Those areas of the country where economic activity has been the strongest in recent years did not see the big swings in property values that left consumers holding mortgages that are much greater than the value of their houses.