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Table of Contents

A Look Into the Monetary Policies During the Great Recession and the Great Depression - Part 4

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2.2 The Great Recession

The Great Recession began in December 2007, and lasted until June 2009. The recession began with the burst of the housing market that was valued at approximately eight trillion dollars (Sage Foundation, 2014). When the bubble burst, it lead to a loss of wealth among people as they lost their equity in homes. This loss of wealth caused consumer spending to drop, that in turn, reduced the demand for goods and services. This contraction, along with the lack of liquidity in the market, affected the operations of businesses in a big way. To cope with this loss, businesses had to cut back on employees. In 2008 and 2009 alone, the US economy had lost 8.4 million jobs, that accounted for more six percent of the total payroll. These levels of job loss were the most significant since the Great Depression. Even the 1981 recession, that was considered to be deep, had only a job loss rate of three percent, which was less than half of the Great Recession.

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In fact, this economic downturn was called the Great Recession because of its high unemployment rate. Though recessions are in general defined on the basis of the output (real GDP), the number of people working in the economy is also an accessible measure of the severity of downturns. However, unemployment is an important measure because it affects the entire population, and also it is the measure for the public perception and confidence in an economy.

In the four recessions that preceded the Great Recession, unemployment levels never increased by more than three percent. However, the Great Recession saw an increase of more than six percent, and this high rate contributed to the slow and unusually long recovery that followed. During the other recessions, the unemployment rates returned to pre-recession levels within four years after the recession, but in this one, the employment rates even today is less than the levels that existed in the early part of 2007. Furthermore, the recovery of the Great Recession was longer and more sluggish than the previous ones, and this is why it was rightly called the Great Recession.

The Great Recession was the second largest economic downturn the world had ever seen after the Great Depression. Prior to this recession, the downturn that took place in 1981-82 was regarded as the most severe one after the Second World War. However, the magnitude and effects of this recession simply dwarfed the previous one as the latter lasted for only sixteen months. “In comparison to past recessions, the increase in joblessness has been greater, the long term unemployed are a larger fraction of total employment, and the recovery of the labor market, in terms of job growth, and falling unemployment, has been very slow” (Grusky, Western & Wimer, 2011,p.4).

Other than the high unemployment rates, other features also distinguished the Great Recession from other downturns. One distinguishing aspect is the enormous financial crisis that took place at the beginning of the recession. In fact, there is debate whether this financial crisis started or precipitated the Great Recession. Though this financial crisis and the resulting stock market crash was similar to the Great Depression, its magnitude and impact was much lower than the Great Depression itself.

However, this does not mean that the financial crisis was relatively unimportant.  In fact, it is the financial crisis that caused the stock market to fall dramatically, and the market capitalization fell by more than half its original value. In this sense, the financial crisis made the recession truly great!

Another unique aspect of the recession is the housing crisis that sustained the recession. The housing market began to rise drastically since 1990s. It gained a lot of momentum between 2004 to 2006 when the market value for properties across most cities in the US went up. In some cities like Las Vegas prices increased by 49 percent while in Miami, the prices went up by 60 percent.

After the values peaked in 2006, the prices began to fall fast and hard. In fact, between the period from May 2006 to May 2009, the real housing prices fell by more than one-third across the entire nation. In some cities like Las Vegas and Phoenix, the prices fell by more than 50 percent. As a result of this housing bubble burst, many people lost their home equity, and this further precipitated the crisis.

The third aspect where the Great Recession was different was the role of mortgage-backed securities. A simple mortgage was packaged and sold as complicated structured products, so when the housing industry fell, these securities as well as its associated products failed too. The failure of such products reduced the amount of liquidity in the market, and it led to a credit crunch situation within the economy. Such a credit crunch severely restricted companies from performing at the optimal levels that in turn led to high unemployment rates.

The final unique aspect is the many ways in which the government responded to mitigate the crisis. During the initial stages, the government resorted to buying the equity or other assets of troubled financial institutions. However, when the housing bubble burst, the mortgage-backed securities became untradeable. As a result, liquidity fell in American and European markets, and this led to a tightening of monetary conditions in many Western countries. Therefore, the Fed had to intervene with higher intensity to set right the markets.

2.3 Events that Led to the Great Recession

To understand the events that led to the Great Recession, it is important to go back into history and see the position of the market since 1980s. The idea of mortgage remained a fairly simple process during the 1980s. Individuals who wanted to buy a house would choose the one they liked, and as the next step, they would visit their local bank to fill the application for a mortgage. Based on the details given, the bank made a decision to offer the mortgage to the applicant in most cases, and it would hold on to the mortgage until the loan was paid off. In most cases, the homeowner paid off the mortgage and eventually got it transferred to his or her name. There were little instances of foreclosures, mainly because the mortgages were confined to local banks that operated within a specific geographical area. This system was based on a set of regulatory laws that protected the local banks from national banks, and overall it promoted the American dream of home ownership.

This scenario changed since the late 1990s, and especially during the 2000s.  Today, the mortgages that are given to homeowners travel many miles to the offices of major banks and financial institutions that have their sprawling headquarters in New York City. In these offices, the mortgages are packaged into bonds called mortgage-backed securities. These securities could be bought or sold in the open market like commodities such as gold and silver. In fact, these securities were resold to investors who lived not just in the US, but around the world.

These mortgages were bought by government sponsored enterprises (GSE) like Freddie Mac and Fannie Mae, and also by corporate banks. These institutions packaged them into new products called “special purpose vehicle” (SPV). By packaging the mortgages into this form, the different mortgages were converted into assets that usually paid a fixed rate of interest generated by the income streams sitting on top of the mortgages. Furthermore, these bonds were rated by agencies based on their level of riskiness and depending on this risk level, the bonds were sold by investment banks to investors around the world. Once sold, these bonds were managed by securities companies that acted as its trustees. They performed administrative tasks that included the collection of monthly mortgage payments and the disbursement of the same to bond holders for a fee.

Over time, the structure of these securities became more complex. During the early 2000s, these securities were divided into many strata based on their risk, and these strata were called tranches.  Each of these tranches had different risk profiles, so investors who bought riskier tranches were paid higher rates of interest when compared to those who opted for low-risk tranches. These difference in rates was due to the fact that the risky mortgages would be the first to default which meant the bond-holder would be the first to lose money in the case of a default on mortgage payment. To make up for this risk, higher rates of interest were paid. The banks believed that the risk was low because mortgages were pooled in such a way that if one homeowner defaulted, it would not impact the entire tranch in a big way.

Due to this risk-aversive nature, the tranches were also called collateralized debt obligations (CDOs). The pricing for these CDOs was tricky because it had to take into account several factors. Furthermore, these CDOs were used to create derivative products called synthetic CDOs to generate more revenue out of it. These synthetic CDOs were an offshoot of CDO that used credit swaps and other complex derivatives to meet the financial goals of investors. Thus, a simple mortgage was complicated to the best possible extent by the banking system with an aim to make more money out of it, and it is this greed that eventually led to the financial crisis.

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The difference between 1980s and 2000s is that the banks that issued mortgages in 2000s did not want to hold on it. Rather it was packaged and sold, thereby complicating a simple system. In this sense, the role of the banker was that of an intermediary who made fees by giving mortgages and then selling it as bonds. This transformation came about because banks wanted to generate higher profit, and were not content with the mere paltry interest that came from mortgage lending. Moreover, when they sell mortgages as securities, banks get the money back to increase their lending. Had they held on to the mortgage like the previous times, then their money would have been locked, and they would not have been able to reach out to more people or generate the fees that came by acting as an intermediary.

This greed became a costly mistake when the housing prices began to fall as a means of a regular correction. Due to this fall in prices, people who had bought homes beyond their means could no longer refinance their mortgage. As a result, they were unable to pay their mortgage, and eventually defaulted. When more people began to default, the investors who had bought CDOs started facing losses. Soon, these financial institutions had more dummy assets in the form of foreclosed homes than they had ever imagined. At the same time, they did not have the liquidity needed to continue their operations. This lack of money from the banks forced them to stop lending to businesses and individuals. Lack of funding forced businesses to scale down their production levels, and to meet their operating expenses within a certain budget, they began to lay off people. When people were laid off, they did not have the means to pay the mortgage, so more people defaulted. This led to a vicious circle where there was no liquidity in the market, the financial world collapsed, and these events led to the greatest recession seen in modern times.

Now that we have briefly understood the background and the events that led to both the economic downturns, it is time to get an insight into what different economists think about the reasons and causes of the Great Depression and the Great Recession.

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