Free Economics Essay Sample
The 2007-2008 economic and financial crisis was the worst and greatest to grip United States since the 1930' Great Depression. The crisis resulted in 26 million Americans losing their jobs or unable to find permanent employment or just not ready to engage in job hunting because of the gloomy employment prospects (Angelides et al, 15). Moreover, 4 million Americans lost the ownership of their homes due to foreclosure and about 4.5 million others reneged on their mortgage payments thus fell in the foreclosure process. The amount of wealth that households lost totaled to about $11 trillion with savings and retirement incomes making the largest percentage of this. In addition, businesses, both small and large, experienced the ramifications of the economic recession. The collapse in the performance of the housing sector was responsible for the ignition of events that led to the economic recession. The United States housing bubble was a result of available and easy to obtain credit, low-interest rates on mortgages and poor regulation of the sector. Trillions of dollars invested in insecure mortgages had pervaded every part of the financial system, and with the collapse of the housing sector, losses running into hundreds of billions of dollars were made due to depreciation of mortgages and securities. This shook financial markets and financial institutions that were exceedingly exposed to the depreciated mortgages and had used them as security to borrow huge loans. Moreover, financial players in the United States ignored warnings of an impending recession and hence failed to manage the responsible risks (Angelides et al., 17). The Federal Reserve failed to control the flow of mortgages deemed to be toxic. It could have done this by setting mortgage-lending standards that were more prudent. Moreover, financial supervision and regulation experienced numerous failures and this contributed to the economic recession (Angelides et al., 17). The financial system was looped into the crisis because of excessive borrowing, opaqueness in their activities and risky investments made by financial institutions. Households, and financial institutions had borrowed excessively hence exposed themselves to financial distress in case their investments took a beating.
The 2007-08 financial crisis and economic recession in the United States put the U.S Federal Reserve on a pedestal because it was depended upon to provide solutions. Mortgage-related securities were falling in prices and credit conditions were contracting sharply and a fast action was needed to maintain the financial system’s stability (Cecchetti 51). Central banking tools failed to rescue the financial system, and this necessitated the intervention of the Federal Reserve to come up with innovative solutions that targeted the restoration of the financial system. The role of the Federal Reserve encompassed protecting the financial system from sliding further into ruins and reclaiming its stability. Moreover, the Federal Reserve was supposed to contain the risk that had occurred in the markets.
Federal Reserve role in meeting Economic goals
The Federal Reserve is the United States official central bank, and Congress created it to provide the nation with a financial and monetary system that is more stable, flexible and safe. The responsibilities of the Federal Reserve are categorized into four areas. The first role of the bank is taking care of the money policy of the nation through influencing the economy’s credit and money conditions so as to ensure creation of employment and stable prices of goods and services (Federal Reserve Bank 15). The second role is to regulate and supervise the banks and other fundamental financial institutions to ensure that these systems are safe and sound. At the same time, it oversees the protection of the consumers’ credit rights. The third role of the Federal Reserve is to control inflation and maintain the financial system’s stability. The fourth Federal Reserve's role is providing the United States’ government with specific financial services that ensure the integration of the financial system. The Federal Reserve sets the monetary policy of the nation so as to expand employment opportunities, ensure economic growth, and realize stable prices for commodities and maintain interest rates that are moderate for the long-term (Federal Reserve Bank 15).
The Federal Reserve is tasked with managing the monetary policy of the nation. Control of the monetary policy involves stabilization of prices therefore ensuring prices of goods, services, labor, and materials are free from the influence of inflation. Stable prices can be used in guiding the allocation of resources ensuring economic growth and realization of higher living standards. Stable prices encourage the adoption of a saving culture and ensure accumulation of capital to be used in setting up investments and starting of businesses. The adoption of a saving culture and capital accumulation results from the minimization of the inflation risk and development of mechanisms to counter inflation whenever it crops up.
One role of the Federal Reserve is serving as a regulatory body, and it can leverage on this role to control inflation. By regulating payment systems and banking institutions, it can be crucial in promoting resilience of the financial system. In addition, the Federal Reserve cushions the economy and financial markets by availing liquidity to banking institutions through lending using the discount window or via open market operations. All these are aimed at curbing inflation and maintaining financial markets’ stability.
The severity of the 2007-08 financial and economic crisis in the United States necessitated the adoption of the fiscal policy in the stabilization of the economy. A fiscal stimulus program adopted was the Troubled Asset Relief Program (TARP). The purpose of the program was to purchase or provide insurance to assets that were considered troubled. The assets included banks, automakers, and insurers. The purpose of advancing this money to automakers such as General Motors was to improve the companies’ liquidity and hence provide it with a chance to get back on the profit making path and thus pay back the money to Treasury (Head 227). Improving liquidity was necessary to ensure that the companies’ balance sheets were balanced are stabilized and that they were saved from making additional losses. Initially, the program had been developed to rescue banks but the auto industry was attached to the program because of fear that imminent collapse of the United States auto industry could cause the economy to slide deeper into depression. The government was in charge of the financials of General Motors and Chrysler. In the case of automaker General Motors, a $49.5 billion bailout was advanced to it (Head 229). The bailout plan was that the Treasury would be part of the company shareholders. The focus of the program on troubled assets like the automaker was the significance of these companies in the economy. Inaction in rescuing the automakers would have cost the economy dearly through loss of millions of jobs lost, billions of dollars of personal savings in terms of shareholding could have gone down the drain, and ultimately a contracted economic production would have resulted. The Trouble Asset Relief Program was one important fiscal policy adopted to safeguard jobs, ensure expanded economic production and protect the savings and investments people had made through shareholding in these troubled companies.
In order to sustain the fiscal policy, the American recovery and reinvestment was passed by Congress. The Act was aimed at providing stimulus to companies that had been hit by the financial and economic crisis. The Recovery Act aimed to immediately enhance economic activity, create investments that had long-term growth, save existing jobs and expand the employment opportunities, and ensure that government spending was transparent and accountable to the people (Recovery.gov, n.p). To achieve these goals, the Recovery Act was marshaled to provide funds for initiating tax cuts and offering benefits for many businesses and families, welfare benefits, and for federal grants, loans, and contracts (Recovery.gov, n.p).
Monetary Policy- Traditional Tools
Initially, the Federal Reserve was focused on controlling the incessant drop in liquidity hence control inflation. It did this by injecting large amounts of short-term funds into the financial system in collaboration with the European Central Bank (Cecchetti 51). Additionally, in an attempt to prevent further drop in liquidity, the Federal Reserve cut the rate of federal funds and primary lending rate seven times within a period of eight months (September 18, 2007 to April 30, 2008). These policy initiatives failed to reign in credit and hence control inflation, and this necessitated the Federal Reserve to take nonconventional actions.
Another traditional tool that was used in restoring the financial system was sending cash that totaled over $100 billion to families and individuals in the US. This was done in order to sponsor the spending of the people. Spending by families and individuals is necessary to jumpstart the consumption of goods and services and ultimately put the economy on the resurgent path (Taylor 18). This action is not purely monetary because the rebate advanced to the families and individuals had been availed through borrowing.
A third traditional tool that fall under the monetary policy was making cuts in interest rates. A sharp decrease in the rate of federal funds during the first half year of the 2007-08 was noted. The rate of federal rates went down from 5.25% at the beginning of the crisis to 2 percent at the end of third quarter of 2008. The reduction in interest rates of federal funds was to enhance market liquidity and ensure cash-strapped organizations had access to cheap credit. The reduction in interest rates led to depreciation in the value of the dollar and increment in the price of oil. Essentially, the cut in interest rates resulted in the raising the oil prices which led to higher commodity prices (Taylor 21).
Monetary policy: Non-Traditional tools
The non-traditional tools’ purpose is two-fold; to provide a source of liquidity that is more reliable to banks, markets, and other financial institutions, and coordinate the organized lending of credit to the private sector.
The Federal Reserve initiated the Term Auction Facility in December 2007. The TAF was a facility that enabled banks to avoid borrowing from the discount window and borrow funds directly from the Federal Reserve (Taylor 17). The Term Auction Facility was accessible to more than 7000 United States’ commercial banks. The fundamental aim of this facility was to reduce interest rates in money markets and thus ensure the flow of credit was increased, and interest rates were lowered.
The second non-traditional tool that was applied in the management of the financial crisis was the Term Securities Lending Facility. The tool involved taking a lending program of existing securities and lengthening the terms, providing loans totaling $ 200 million and broadening collateral requirements (Cecchetti 52). This program was instrumental in helping the Federal Reserve to sell Treasury holdings and make purchases of mortgage-backed securities. This raised the repurchase agreement rate of the Treasury to a level that was closer to that of the federal funds. The Term Securities Lending Facility did not stabilize the market.
Another non-traditional tool that was used in restoring the financial system was the asset purchases, and this was seen in the case of Bear Stearns investment bank. The bank was on the brink of collapse despite the fact that its outstanding value for derivative contracts was standing at $14.2 trillion of notional value. With such a huge value in notional value, the bank had a footprint in the entire financial system. The Federal Reserve realized that a collapse of the bank would cause its assets to be transferred to a less liquid market (Cecchetti 51).
The Federal Reserve was focused on preventing the bank from collapsing, and it directly loaned money to Bear Stearns then engaged with JPMorgan Chase to purchase Bear Stearns (Cecchetti 52). The acquisition of Bear Stearns by JPMorgan ensured that the bailout of the investment by Federal Reserve would be successful because the company was being bought by another entity that was well performing.
Moreover, Federal Reserve used Commercial Paper Funding Facility to ensure the improvement of conditions of money market. The Commercial Papers Funding Facility was instrumental in lowering the Libor rates over the rates of federal funds (Federal Reserve Bank, n.p). Libor rates are used as benchmarks of loans whose rates are adjustable such as mortgages hence the Commercial Paper Funding Facility was crucial in restoring money markets
In the next 1-2 years, the interest rates are to rise as there is the need to raise money to cover the deficit. The deficit in the economy can be funded by raising the rates on loans resulting in higher rates than normal. People will be forced to dig deeper into their pockets to pay for loans which will be basically financing the deficit. The economy is experiencing a deficit of 17-18 Trillion dollars and seeking increased borrowing may exacerbate the problem. It is necessary to repay the existing loans first and, therefore, plug the deficit. Moreover, the financial institution should expand their investments to ensure they generate profits to bridge the deficit.
It may be accurate to outrightly agree with number of people who are purported to have lost their jobs during the 2007-08 financial and economic crisis. The number may be an overrepresentation or underrepresentation. Moreover, the age groups of those who supposedly lost their jobs are not given to help identify the kind of jobs they were holding. To arrive at the exact number of people who lost their jobs requires collecting information about layoffs of people which may be tedious.
Angelides, Phil, and Bill Thomas. The financial crisis inquiry report: Final report of the national commission on the causes of the financial and economic crisis in the United States (revised corrected copy). Government Printing Office, 2011.
Cecchetti, Stephen G. "Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis (Digest Summary)." Journal of Economic Perspectives 23.1 (2009): 51-75.
Federal Reserve Bank. "Monetary Policy and Economy." Federalreserve.gov. 2015. Web. 11 Apr. 2015.
Federal Reserve Bank. "Can You Describe Some of the Key Actions the Federal Reserve Took in 2007, 2008, and Early 2009 to Address the Crisis That First Hit the Financial System in August 2007?" Federal Reserve Bank of San Francisco. Http://www.frbsf.org, 2009. Web. 11 Apr. 2015.
Taylor, John B. The financial crisis and the policy responses: An empirical analysis of what went wrong. No. w14631. National Bureau of Economic Research, 2009.
Head, John W. "Local to Global: Rethinking Spheres After a World Financial Crisis: The Global Financial Crisis of 2008-2009 in Context---Reflections on International Legal and Institutional Failings," Fixes," and Fundamentals." Pac. McGeorge Global Bus. & Dev. LJ 23 (2010): 43-339.
Recovery.gov. "Recovery.gov - Track the Money." The Recovery Act. Web. 11 Apr. 2015.