10 October 2016

The current global recession has been caused to a large degree by debt-fuelled growth in the housing market, often due to irresponsible lending practices, coupled with unregulated trading of mortgages on the bonds and derivatives markets. One of the key factors that allowed for the property bubble to expand so rapidly was the ubiquitous nature of ‘subprime’ mortgages. These were essentially loans, which generally required no deposit, that were extended regularly to people without the requisite income to pay off the debt.

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In an effort to fight off a recession arguably as bad the Great Depression, governments worldwide have attempted to combat growing unemployment and shrinking economies by way of massive stimulus packages. This essay will analyse the aforementioned issues surrounding the causes and severity of the current recession, governmental responses to the economic crisis, and how these responses differ from the Great Depression, in the context of relevant macroeconomic theory in order to reach an informed conclusion regarding the effectiveness of contemporary government intervention.

The subprime mortgage is widely agreed to have been the catalyst for the recession as a whole. There were, however, a number of other causes that contributed to the problem. Firstly, in the case of the USA, the Federal Reserve was slow to raise the interest rates after the US economy recovered from the 2000/01 recession. As the interest rate continued to remain low, the interest rate effect on aggregate demand encouraged greater spending on investment goods. In the case of many Americans, investment goods equated to housing and thus many took out mortgages to purchase houses purely on the basis that they could resell them for a profit.

This was made possible in large part due to the prevalence of subprime loans and interest-only loans. A sub-prime mortgage is a mortgage that is given to a borrower whose credit rating would not ordinarily qualify them for a conventional mortgage; hence they inherently have a higher risk. Interest-only loans, of which a large percentage were also subprime, are structured in such a way that the borrower is initially only paying back the interest on the mortgage of a house at a lower interest rate for a period usually between 1 to 5 years.

Whilst many consumers took out these types of loans with the idea of reselling the house for a profit before the interest rate rose, this concept only worked if house prices continued to rise. Inevitably, when interest rates settled at a higher equilibrium due to the high demand (Mankiw, 2002), many people with interest-free loans were stuck with houses they couldn’t sell and interest rates that they weren’t able to afford, leaving the bank with a house that would have to be sold at a loss.

These high-risk loans becomes tools of financial engineering as banks bundled good and bad loans into derivatives which were in turn often bundled into CDO’s (collaterised debt obligations) whose worth was tied to the value of the mortgages. When these mortgages began to default rapidly, many investment funds began to panic and began selling these CDOs as quickly as possible, causing a shift of the aggregate demand curve to the left due to the pessimism in the market and removing trillions of dollars of value from many of the major funds.

As Investment (I) constitutes a portion of GDP, this massive loss caused a substantial decline in GDP, and because GDP is inversely linked to income this led to much higher than usual levels of unemployment. (Garrison, 2000) This is due to a large drop in aggregate demand, which caused companies to lay off workers in an effort to reduce costs and remain in business. The fallout from the CDOs was global, many of the investment funds that had purchased these bonds represented international or foreign investors and as such the impact was both severe and worldwide.

Key economic indicators all indicate that the effects of the recession have been harsh: World industrial production is down 10%; World stock markets down 30%; and the Volume of world trade down 20%. Governmental response to the economic crisis so far has been based primarily on large stimulus packages designed to reduce unemployment and revive the economy. Obama’s stimulus plan, the “American Recovery and Reinvestment Act of 2009”, alone has spent $787 billion (USD), on top of the $152bn spent on the 2008 stimulus bill. This policy is supported to a certain extent by the concept of the multiplier effect.

This theory states that government purchases have a ‘multiplier effect’ on aggregate demand, so that each dollar of public spending will generally raise the aggregate demand by more than one dollar, with the formula equating to m = 1/(1 – MPC). (coursebook ref) A number of factors, however, combined to dampen the impact of this government spending. Pessimism about the economic climate, along with the perception that the rebate was a one-off measure, caused some individuals to change their spending habits, leading to a number of people using the lump sum tax rebates of the 2008 stimulus package to either pay off debt or save the money.

This effect, in fact, was not as widespread as many economists predicted, household spending actually rose on average by 3. 5%, causing some studies to label the plan as a success (Broda & Parker, 2008). The 2009 plan suffered to an extent from the crowding out effect, caused by higher interest rates due to elevated levels of government spending. An application of the laws of supply and demand reveals that an increase in the price of a loan, i. e. the interest, leads to a decrease in the amount of credit demanded.

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