Back To CourseCollege Macroeconomics: Tutoring Solution
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Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.
Over the past century, the setup for recessions in the United States has been largely based on the economic cycle of growth and contraction. After a few years of a robust and flourishing economy, the wheels of industry take a brief rest. When the economy slows, the Federal Reserve can set interest rates lower, making money cheaper and thus encouraging growth. Once the economy is growing again, the Fed quietly backs out and carefully observes.
This strategy, one that was used for nearly 100 years before the financial crisis of 2007-2008, has been used plenty of times before. Alan Greenspan, Chair of the Federal Reserve, used it again to help push along a slowing economy still suffering from 9/11. But, there was a slight difference this time that would end up leading to financial disaster, and, for some countries, financial ruin. No one bothered to turn off the faucets of cheap money (low interest rates).
Low interest rates make the economy grow because it means money is easier to borrow. Interest is the cost of money, so just like any asset, when the price goes down, demand goes up. Businesses could borrow cheap money to expand their capacity and consumers could borrow cheap money to buy things from those businesses. This meant more production, more jobs, and more credit-worthy citizens. This is the sign of a healthy economy, except for one small detail - much of the money that was paying for the growth in the economy after 9/11 was borrowed.
After years of record profits for banks, homebuilders, and all kinds of companies - reflected by all-time high levels in financial markets - it came time to pay the piper. Investors weren't the only ones hit; homeowners had created demand that had inflated asset prices (home prices) to unsustainable levels. Suddenly, no bank was willing to be the one that took the next bit of risk. Everyone (individuals and companies) seemed so leveraged that no one wanted to lend. No lending meant no buying. No buying meant no production. No production meant no jobs. No jobs meant defaults on loans. In 2007, the cycle began.
A recession is when a country experiences two or more quarters of contraction in their economy. GDP in the United States had averaged around 1% per quarter prior to 2007, but beginning in the fourth quarter, those numbers started to shrink. In the fourth quarter of 2007 and the first quarter of 2008, the United States hit a recession. Technically, the recession ended in the second quarter of 2009 after four quarters of negative GDP growth, but because of the severity of the recession, it took longer for many parts of the economy to turn around.
As discussed earlier, years of cheap money, excessive spending, and negative savings rates led to the recession, but the ultimate trigger for the recession was the uncertainty surrounding the financial industry. By the fall of 2008, four major mortgage providers had declared bankruptcy, and in September 2008, three of the largest financial institutions in the country, with roots back as much as 100 years, declared bankruptcy. When AIG, Lehman Brothers, and Bear Sterns all collapsed, everyday Americans were faced with the question, 'If the smartest minds in finance couldn't get their money, can I?'
Soon, consumer banks started shutting down. Fifth/Third Bank, Washington Mutual, and Wachovia - consumer banks serving people all over the country - were forced to sell out to larger banks. Many feared this would cause a run on the banks, which would have worsened an already fragile situation. To provide assurance to nervous account holders, the Federal Deposit Insurance Corporation (FDIC) increased the amount guaranteed by the government to $250,000.
In March of 2009, the great recession was in full force and every part of the economy was feeling the pain. The stock market had lost over 50% of its value, with the Dow Jones hitting 6,500 and the S&P 500 hitting 675. Just 18 months earlier, the Dow Jones had hit an all-time high of over 14,000 and the S&P 500 had peaked as well at over 1,560. The unemployment rate, which had been under 5% when the stock market was hitting high levels in 2007, was at 9.5% in June 2009 and spiked over 10% for the first time since 1983 in October 2009.
The increase in the amount of deposits insured by the FDIC discussed earlier was not the only intervention by government. In fact, that was probably insignificant compared to some of the other steps the government took. When the economy needs a boost, the Federal Reserve can use open market operations to increase the money supply. When the Fed buys bonds, it has the effect of lowering interest rates. For the first time since the Federal Reserve began using interest rates as a tool in monetary policy, the target rate was set at 0% - meaning banks could access capital from the Fed, on an emergency basis, for 0% and from each other for .25%. It also meant that credit-worthy consumers could get loans for historically low rates, as well.
Lowering interest rates had an impact but was far from enough to trigger a recovery from the great recession. The financial industry was in ruins and the big three auto makers - also heavily dependent on consumer loans because of their internal financing companies - were all headed towards bankruptcy. In an extremely controversial move, Congress extended bailouts to banks in the form of TARP, the Troubled Asset Relief Program. TARP was signed into law by President Bush in October of 2008 and allowed the Federal Government to buy troubled assets from banks, relieving them of troubled assets and giving them cash that they could hopefully lend, fueling growth and creating jobs.
While the $700 billion in funds authorized under TARP were aimed at helping financial companies, the executives of Chrysler, GM, and Ford asked Congress in December of 2008 for a $34 billion loan to help them weather the recession. Congress eventually lent $25 billion, and in late 2012, all three companies had paid back the loans. As an additional help for the auto industry, President Obama created the Cash for Clunkers program, where people could sell their old, fuel-inefficient vehicles to the government for $4,000, which they could then apply towards the purchase of a new vehicle.
According to government data, the U.S. economy grew in the second quarter of 2009 (July), meaning the great recession had ended. While the recession technically ended in 2009, it may not have felt like it for many people. Unemployment stayed high even well into 2013, hovering around 7.5%, much higher than the post-recession average. Wages have stayed flat over the first decade of the 2000s, and even with inflation staying low, purchasing power has declined, so the average wage earner feels like they make less. On top of all of that, many people didn't declare personal bankruptcy during the recession, so they continue to have to dedicate precious disposable income to high payments on the loans they took out five or more years ago.
A recession is when a country experiences two or more quarters of contraction in their economy. GDP in the United States had averaged around 1% per quarter prior to 2007, but beginning in the fourth quarter, those numbers started to shrink. In the fourth quarter of 2007 and the first quarter of 2008, the United States hit a recession. Years of cheap money, excessive spending, and negative savings rates led to the recession, but the ultimate trigger for the recession was the uncertainty surrounding the financial industry. The unemployment rate, which had been under 5% in 2007, was at 9.5% in June 2009 and spiked over 10% for the first time since 1983 in October 2009. According to government data, the U.S. economy grew in the second quarter of 2009, meaning the great recession had ended.
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Back To CourseCollege Macroeconomics: Tutoring Solution
15 chapters | 139 lessons