Financial Crisis Impact on Us Economy

The Impact of Financial crisis of 2007 on the USA Economy
Names
Mohammed AlAjmi
MANSOUR AL-AHMADI
OMAR AL-AL-SHAIKH
HUSSAIN AL-ALI
ABDULLAH AL-AMER
YOUSEF ABABUTAIN

Course
Fin 410
Prepared for
Dr. Ahmed Khalifa
Date
20th of December 2011
4492 words

Table of Contents I Financial Crisis and Its Causes 1

II Macroeconomic variables 3

A. GDP 3

B. Unemployment 7

C. Inflation 11

D. Exports and Imports 13

II. Government efforts to overcome the crisis 13

A. Government bailout 13

B. Government stimulus package 14

IV. Federal reserve 15

A. Interest rates 15

V. Conclusion 18

Financial Crisis and Its Causes:
Several debates have been raised concerning the causes of the recent financial crisis. Analysts and policy makers alike have come up with different theorems that seek to explain why the financial crisis occurred and why it had such a broad and long-lasting impact. The US economic sectors are expected to continue experiencing the effects of this crisis for years to come. The crisis has been attributed to various causes including: inefficient credit rating agencies, the 2005 US housing bubble, systemic risk caused by a lax in credit control regulations, government imposed subprime lending, shadow or parallel banking systems, increased mortgage fraud and underwriting, poor securitization, and increased risk taking behaviors by financial institutions.
The U.S Federal Reserve offered constructive environment for banks by reduced the lending interest rates in 2008. Large amount of loans were taken by people therefore, increased economy liquidity because of increase in good prices. The money flow in the economy replicated in the whole banking segment, thus reduced the lending interest rates. To start with, the failure of some major sectors, contributed to the financial crisis in US. These sectors include mortgaging industry and shadow banking industries, which were favored by the rules of Federal Reserve of the US. The stability of most productive industry; mortgaging industry, greatly determined the status of the U.S economy. Therefore, any descending minor change in it could cause many disturbances in the economy. The demand for houses became extremely high in the year2008, because of the comfortable lending rules of the Federal Reserve, which encouraged the borrowing of more money by the mortgage firms to at reduced rates. Before long, credit firms started lending mortgages to each potential purchaser. That promoted the demand for houses, and therefore more people rented mortgages, even those with unstable financial base, were still issued the mortgages. So, majority of the mortgage firms were lending with assumption that if a borrower was unsuccessful in making the payment, they could sell their houses to recover the cash. Of course, this was a better idea, but it was ideal to some situations.
A crisis occurred when the mortgages were finally adjusted upwards. It became difficult for the borrowers who had been lend the mortgages from firms and those who had borrowed money from the bank for housing purposes to pay (Shiller, 2008). Most of the borrowers were incapable of paying their debts, this lead to losses in mortgage firms, and other institutions, which can give loans such as banks.
It became so difficult for the Mortgage firms to resell their clients’ houses since the liquidity positions of all the monetary institutions had been already immensely affected. There were inadequate finances in all economic institutions thus the decline of the economy. Overestimations of prospect house prices was done during the 2007/2008 financial period, where they expected arise in housing price therefore majoring most of the investments in that sector, which eventually flooded leading to excessive supply of materials with a limited demand. This greatly affected the economic status of US, which requires further concentration in order to become stable.
The shadow banking industry, which comprises of non-depository banks and financial institutions also, has weight on the economy of United States. This is where the investors loan and then after some time they demand their funds back. The industry’s down fall was a puff to the economy because less investors did little investment to these financing institutions in the year 2007, thus contributing to their eventual collapse (Pinyo, 2008). In addition to this, a leading financial services company of Lehman Brothers also declined causing a crisis in New York Stock Exchange and equity markets in the year 2008 (Canstar, 2009). The Wall Street activities of Lehman Brothers directly affect the global economy.
The U.S government was forced to assist some leading banks that were entangled in the economic crisis. The government came up with strategies such as a$1 trillion financial plan bundle, which was aimed at stimulating the already declined economy as many banks were running on losses. There was reduced borrowing which implied that there was no profits which could be made by banks for the few day to come, which further, frustrated the already terrible condition of the U.S economy (Shiller, 2008).
It is not just the investors’ confidence that brought the economy down, but also the consumer’s confidence declined, as they were not sure of what could happen with the economy. Still, the Federal Reserve became more responsive by injecting more funds into the economy as stocks on the U.S market became more unstable, though it has not saved the situation much as the investors had already lost confidence in the stocks market.
Macroeconomic variables (2002-2011)
GDP
There was reduced economic growth in USA due to the crisis. Causes for the decline in economic growth ranged from falling revenues for the government to increased government expenditure. This means that the government was putting more money into areas that may not have been planned for. The real estate industry is also one of the drivers of the economy. Its strong growth had supported the continued growth of the country and its economy prior to the financial crisis. The start of the crisis brought the industry to its knees. The country suffered greatly from the reduced prices of the assets. Despite the low prices, the demand for the assets also plummeted during this period and this meant that the income and other revenue that was gained from this sector were reduced. In addition, investors stopped putting their money in the real estate fearing that they would lose their money. The growth of the economy, which was supported by the development of the real estate business, was in danger since the credit markets could not provide loans to the investors. Investors lost confidence in the financial sector of the country when the government bailed out a bank.
The loss of confidence by the investors meant that the government had little foreign exchange and this led to slowed growth and increases in prices of commodities. With limited input from the investors, the country was bound to suffer from decreased spending by the public. This was due to high prices of commodities. Consumers, in such times, only purchase the necessary items and cut spending on luxurious items. Reduced consumer spending can have devastating effects on the economy of a country as it can reduce the cash available in the market. This was the case in USA and the government had to redirect its funding to other areas in order to ensure that people were protected from the crisis. The economic growth of USA during this period was expected to be almost zero although some analysts were more pessimistic and forecast negative growth. The result was spending on areas that the government may not have anticipated. The result was reduced spending in development and more input into short term measures such as food security. This meant that some aspects of economic growth had been neglected and hence the decreased economic growth in the country. the following the graph showing national GDP changes

Year | GDP growth rate | 2002 | 2.45% | 2003 | 3.10% | 2004 | 4.40% | 2005 | 3.20% | 2006 | 3.20% | 2007 | 2% | 2008 | 1.10% | 2009 | -2.90% | 2010 | 2.80% |

(Data 360, 2011) Regression Statistics | R Square | 39% | Standard Error | 0.01740197 | Before the crisis | 3.20% | Effect of the crisis | -2.50% | P-value | 6.70% | Mean | 2.15% | Equation | y=3.2%-2.5%x+1.7% |

As we can see from the regression statistics the impact of the crisis on GDP growth rate is insignificant and 39% of the variation of in the GDP growth rate is explained by the financial crisis

Unemployment-
There was an upward-adjustment in unemployment figures in the United States spelled fear among many people. Lack of a stable job indeed presents a challenge to the entire population, as unemployment and crime are closely associated. Many youths sprawling around aimlessly made the already devastated lives of many Americans even harder as they braced themselves for the inevitable. To some extent, it was not their desire to live as criminals but the tough living conditions just left them with no options, courtesy of the greed of a few mortgage lenders who put their interest before that of the nation.
Walking to work or home, hiring a taxi or using public transport were common scenes in United States for the past two years. As stated earlier, everything had to be prioritized due to the ailing economy, which affected directly and negatively on everyone’s income. Considering the cost of fueling a private car in comparison to the use of public transport, it was much cheaper to use public transport and instead abandon the car at home, a car that had become a burden! After all, every single cent matters in an economy that is experiencing recession. Oil producing and exporting countries in Asia (Middle East), Africa (such as Nigeria, Algeria, and Angola) and Latin America felt the effect too as the demand for oil decreased, resulting in a drop in oil prices.
A number of African families had a firsthand experience of what a financial crisis in U.S means. Africans working in U.S regularly send part of their earnings back home. However, since the financial crisis struck in early 2008, many African families have not received any money from their relatives working in the U.S. Any remittances back home were in minute proportions (Mvunganyi, 2010). The African economies also benefit from foreign currencies send by families working in U.S.A hence a reduction in remittances had a negative effect on such economies.
The economic crisis was not simple and its effects remain evident presently. In fact, it is not just on the side of human beings that the crisis was felt; animals too felt the wrath of the limping economy.
It has become harder for employees to advance at their place of work. According to Reuter’s Zieminski, majority of the employees in U.S and in other developed countries have reportedly become ‘nesters’ (Zieminski, 2010). This means that they are now willing to shift employers, majority of them prefer to work for one employer for their entire life because of risks associated with moving from one organization to another. As staying with one employer for a long time guarantees one of income in comparison to moving away to a place where one is not sure of employment, Americans have been fixed in job places. Some of the employers pay low salaries and their working conditions are not the best but shifting organizations is accompanied by the risk of losing a job in the present nation where unemployment figures are dropping at a slow rate. Presently, most employees in the United States find themselves held up in places of work where they do not like. It is discouraging and the productivity of such employees is low, negatively affecting the U.S economy. Other than helping banks to increase value to shareholders, the Fed has not done much to increase employment (Masaccio, 2010). year | Unemployment rate | 2001 | 4.74% | 2002 | 5.78% | 2003 | 5.99% | 2004 | 5.54% | 2005 | 5.08% | 2006 | 4.61% | 2007 | 4.62% | 2008 | 5.80% | 2009 | 9.28% | 2010 | 9.63% | 2011 | 9.03% |
(USA department of commerce, 2011)

Regression Statistics | R Square | 40% | Before the crisis | 5% | Standard Error | 0.015876006 | Effect of the crisis | 2% | p-value | 3.50% | Mean | 6.37% | equation | y= 5%+2%X+1.5% |

As we can see from the regression statistics the impact of the crisis on unemployment is significant and 40% of the variation of in the unemployment rate is explained by the financial crisis

Inflation –
The US Federal Reserve System has had much success in curbing inflation over the last two decades. Unlike other countries, which adopted the Inflation Targeting strategy the US, has maintained a nominal GDP targeting and has done quite well. Inflation targeting has various advantages but is sometimes very difficult because of the difficulty in accurate prediction of inflation. The lack of predictability makes it very difficult to control and thus it is not possible to make an accurate judgment of whether the Federal Reserve with its monetary policies has reached its inflation targets. This has made the US prefer the GDP target, which does not have an outright strategy but has an implicit nominal anchor that helps to control future inflation. This strategy unlike inflation targeting involves foresight and monitoring of any sings for inflation and putting up strategies to counter the inflation. This is forward-looking strategy, which has been in operation at the Federal Reserve under the leadership of Alan Greenspan, has achieved sound economic performance and was very influential in keeping the 2001 recession to very mild levels despite the then present conditions of terrorism and some corporate scandals (Mishkin, 2007).
Although the rate of inflation has been kept relatively low for, a long time but there is no guarantee of any success of having a stable value of money in future. This is because the U.S monetary system works in discretion and independence and therefore there it is not legally possible for the Congress to enforce a commitment for long-term stability of prices. The independence and discretion that is exhibited by the Federal Reserve create uncertainties, which limit the power of the congress to provide a legal framework that would make the Fed accountable. The lack of accountability makes the Fed lack a monetary rule that would keep it tied to the objective of maintaining future stability of prices. The lack of such a rule continues to be the reason business fluctuations are witnessed (Mishkin, 2007). year | Inflation rate | 2001 | 2.83% | 2002 | 1.59% | 2003 | 2.27% | 2004 | 2.68% | 2005 | 3.39% | 2006 | 3.24% | 2007 | 2.85% | 2008 | 3.85% | 2009 | -0.34% | 2010 | 1.64% | 2011 | 3.53% |
(USA department of commerce, 2011)

Regression Statistics | R Square | 25% | Standard Error | 0.01239097 | Before the crisis | 2.60% | Effect of the crisis | -0.30% | p-value | 64% | Mean | 2.50% | Equation | y= 2.6%-0.3%+1.2% |

As we can see from the regression statistics the impact of the crisis on inflation is insignificant and 25% of the variation of in the inflation rate is explained by the financial crisis

Exports and imports- the imports and exports were also affected because the world purchasing power came down.
Government efforts to overcome the crisis
Government Bailouts- The return to normalcy in USA was unexpected despite the strength of the economy. Consumer spending continued to be low while investor confidence was also in the red. This meant that the government had to come up with measures that would mitigate these effects and enable the country to stabilize. One such measure was the increase in government spending. The government had to intervene and it injected billions of cash into the economy. This measure was not only meant to boost investor confidence but also to provide liquidity in the economy. Access to capital was limited at the time and thus investors did not have any liquid cash with which they could trade. The result was the need by the government to inject cash in the market to enable various sectors market to recoup its losses.
As has already been noted, consumer spending was at an all time low and the government needed to jump-start the economy to avoid a situation that would require massive resources. Banks had little money to give to consumers and allowing them to draw on their reserves was a government move to increase liquidity in the area. It is important to understand that the flow of money in the public is an important aspect in the development of a country. By allowing banks to have, more money that could be given out, the government was encouraging consumer spending to avoid a stall of the economy. Some of the banks had also gone under and the government was obligated to bail them out to ensure they continued to provide services to the people. Although this form of spending by the government does not entail direct input by the government to the public, it enables the banks to act as intermediaries between the government and the people. The public through the banks can access the money and this is expected to enhance consumer spending.
Government stimulus package – the stimulus package was meant to help boost the economy. However, it was lesser than its expected amount. To reduce unemployment, the increase in GDP should be higher than before. It involved assisting states were able to provide a third of the total government spending (Stiglitz, 2010). States had to maintain a balance between the total expenditure and total revenues to maintain the balanced budget framework. As the values of properties and profits decreases, the tax revenue will also decrease. the stimulus program did not give any importance to this aspect of the economy. Government could not attain their principles because after the implementation of this program, the most affected people were the poor. To reduce the gap between the rich and poor was one the main principles but they did the opposite work. To come out from the crisis, reduction in poverty was very important.
It was very necessary to fill up the holes in the safety net of the economy (Stiglitz, 2010). People observed much more necessity of insurance or coverage system. The government was providing employer-based insurance contracts in companies. In the recession period, most of the people had lost their jobs. As a result, people lose their health insurance contracts after losing their jobs. Some insurance companies were providing insurance schemes as the earlier reforms. They would provide the schemes only to them who were able to afford it (Stiglitz, 2010). People were running out of money and jobs and this reduced the power of affordability of those insurance contracts. Therefore, poor and middle-income people could not afford health insurance.
The government gave prior importance on the investment strategies and its proper distribution. There was shortage in total expected investment. This shortage was mainly in the public sector. There were many constraints in the public sectors to invest more (Stiglitz, 2010). Government can do that by reducing tax. This would help to increase the cash flow and to invest more in the public sector. However, the stimulus package did not provide this kind of improvement in the investment strategies.
To increase the total investment, mainly in public sector, government should go for a tax-cut (Stiglitz, 2010). The government went for the implementation of tax-cut rule but unfortunately, that was inefficient and ineffective to provide higher investment. This benefited rich people because most of the increased money went into their pockets. Therefore, the gap between rich and poor was increasing gradually. Most of the principles were carefully designed but the implementation procedure was not effective for the economy under the circumstances of financial crisis.

The Federal Reserve action
In the United States, the principal organization charged with the implementation of the policy is the Federal Reserve System (Fed) which is the country’s central bank. As stipulated in the Federal Reserve Act (1913), The Federal Reserve sets policies that affect the availability of money in order to promote the nation’s economic goals. The Federal Reserve is responsible for controlling the Open Market Operation, reserve requirements and the interest rates which results in influence over the supply and demand of money and which affects the funds rate. The monetary policy made usually affects any financial or economic transaction that is made by everyone in the country. Other than influencing economic decisions among its citizens, being the world’s economic giant makes the U.S monetary policy affects other countries’ economic decisions. Sound economic performance is the primary objective of the reserve system and therefore it uses various tools to influence the demand of goods and services, and one of these tools is the variation of the short-term funds rate. As a body that is independent of the current political pressures, the Federal Reserve System has had many successes over the last decade in rooting for the country’s good economic performance. In the midst of the successes, there are also challenges and failures that have been encountered.
As the institution responsible for controlling and regulating the banking sector, the Federal Reserve has been responsible for the efficiency in the commercial banks by instituting measures that increase harmony in the banking sector. A program dubbed quantitative monetary ease was established in 2007 to continue with the goal of monetary expansion in the economy. The move meant to recapitalize the banking system saw an increase in monetary base from $855 billion by the end of 2007 to more than $1,728 billion by the end of 2008. This made the economy more liquid by increasing the reserves held by banks (Free, 2010). The financial institutions in the country have been known to be reluctant in providing credit to one another, a phenomenon that has created a financial crisis in the country.
In order to solve the reluctance, the Federal Reserve has made it possible for any financial institution that requires liquidity to access credit directly from the Fed. Previously, the Federal Reserve lending would not provide liquidity to other financial markets for example the commercial paper market but would only provide liquidity to banks. This is now possible as the non-bank paper markets and money market mutual funds can access credit directly from the Fed. This was in line with the program called Term Auction facility initiated by Ben Bernanke the chair to the Federal Reserve in 2007. This program was set to provide liquidity to financial institutions and paper markets that did not perform efficiently due to the credit crunch. These programs were very effective in reducing the funds rate, which stood at 4.25% in 2007, fell to 0% at the end of 2008, and consequently increased lending (Free, 2010). The Fed has also taken up the place of private and commercial banks by starting facilities for providing backup liquidity for the money market mutual funds (Office of Management and Budget, 2010).
Various actions by the Federal Reserve System have eased credit crisis and increased credit facilities. This includes the decision to buy longer-term debts and securities unlike the past when it used to limit its operation short-term securities. This policy provided a monetary stimulus to borrowers by easing the pressure from the long-term interest rates such as mortgage rates (Free, 2010). Expanding the Fed’s credit facilities has made it to realize increases in its balance sheet, which increased to over $2 trillion in 2010. Such an increase also translates to potential increase in the supply of money in the country (Office-of-Management-and-Budget, 2010). The programs instituted to support the financial market as well as the low interest rates set a policy that helped to expand the economy.
The Federal Reserve System and the monetary policies over the last decade have helped to keep the banking system afloat and profitable but that profitability comes at the expense of the consumer. The low Federal funds rate which keep the interests rates to a minimum help the banks to stay afloat by accessing credit from almost interest-free lines while the consumers and the government feel the effects of financial crises. Very low interest rates enable banks to borrow and recapitalize. The monetary policy’s almost-free interest rate leveled by the Federal Reserve is intended to have the banks borrow at a very low interest rate and subsequently lend to consumers at low interest rates. The banks upon getting this money do not lend out but invest it in profitable area such as government bonds, or they sometimes would use the money to speculate in areas that would threaten the economic stability of the country as it happened in 2008. The monetary policy is not very strict on the type of investment made from the money lent to the banks and the banks sometimes use the money to expand their activities or give bonuses to some of their executives. The monetary policy has gone a long way to keep the private banks profitable through unorthodox means in order to keep their shareholders happy at the expense of the consumers (Brown, 2010).
Conclusion:
The global financial crisis originated from greed and irresponsibility by a few individuals in the real estate’s mortgage lending sector, and it eventually spread to the rest of the banking institutions, attributable to the Federal Reserve’s relaxed interest rates. From the United States, the crisis spread globally due to United States’ influence in global economic issues, ranging from fallen stock markets to reduced demands for products from abroad. The price of valuables such as oil decreased, which tremendously affected the economies of countries that depend on income generated from exporting such products. the crisis hit every part of Americans’ lives from the stock exchange at Wall Street to work offices to the kitchen at home. Stocks shot down instantly despite intervention by the government. Unemployment figures soured and crime became an inevitable encounter. At the place of work, advancement was not guaranteed even if it was due because of low profit levels for employers. Everyone was compelled to adjust their budget and to consider priority before undertaking on anything, resulting in the cancellation of luxuries such as tourism. Quality of food consumed decreased and health was compromised because of limited finance. The global economic crisis experienced between 2007 and 2009 was a nightmare not only in the United States where it began, but in the entire world and its effects are still evident to this day.

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