Great Recession of 2007–2010

Abstract

The recession refers to a slump in economic activity in an economy over a considerably long period. The great recession of the 2007-2009 was the most profound and extensive economic slump in recent times. The 2007/2009 recession is mainly attributed to the US subprime crisis. However, most scholars and experts attribute it to slack policies and new financial innovations. This has put a lot of question marks on the key elements of a capitalist economy. This essay will focus on the Great Recession of the 2007-2009. The essay will explore the causes and nature of the Great Recession. Also, the essay will compare and contrast the Great Recession and the Great Depression.

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Introduction

The term “recession” became common in 2007 after the slump in the international money market (Gupta, 2009, p. 1). Recession is defined as a fall in economic activity in an economy over a considerably long period, or a cycle of business contraction. In other words, it is a period of two or more successive quarters where there is a deep slump in the gross domestic product (Langlois, 2009, p. 2). The recession of the 2007-2009 was the most profound and extensive economic slump ever experienced in recent times (Gupta, 2009, p. 2; Simpson, 2009, p. 4).

According to Gupta (2009, p. 3), the global output declined significantly in the 3rd quarter of 2007 and continued to drop in the 4th quarter. Also, energy prices increased, and business growth slumped. The slump in business growth and an increase in energy prices caused stagnation in wages and an increased in the cost of living, respectively (Langlois, 2009, p. 3). Recession is a natural and unavoidable component of any market economy (Simpson, 2009, p. 20). Classical economists assert that both monetary and real factors are involved in a series of boom and bust and that the causality runs in either direction (Simpson, 2009, p. 21).

The complete theory of the economic cycles was brought forward by Schumpeter. Schumpeter believed that prosperity and recession were as a result of the growth in a capitalist economy. He argued that uncertainty linked to human behaviour means that things rarely turn out as expected. In other words, human beings normally suffer from cognitive prejudice when handling things (Clemence & Doody, 1950, p. 5).

Schumpeter paid special attention to specific sources of disturbances in a market economy, that is, confusions and disruptions caused by the introduction of innovations. Innovations tend to turn up in bunches, and their emergence not only results in a growth in investment but also frequently set free a wave of absurd enthusiasm (Clemence & Doody, 1950, p. 6). The global economic crisis of the 2007/2008 was the most profound and extensive economic slump ever experienced. Economic policy experts in the entire capitalist economies did not anticipate it. Most of them denied it is ever taking place, and, after it had happened, they were not able to explain it. Also, the mainstream economists, both Keynesian and neoclassical economists, did not see it coming (Parker, 2009, p. 8).

The global economic crisis of the 2007/2008 cast its darkness on the fate of many countries, leading to what is generally known as the Great Recession. Something that began as an ostensibly remote case in the US housing market changed into a full-scale global crisis by the end of 2008. The crisis confirmed the old saying that when the US is in a mess, the rest of the world suffers. 2009 was the first time since the 2nd world war that the world experienced an extensive financial meltdown, an appalling turn around on the economic prosperity that was being experienced since 2002 (Verick & Islam, 2010, p. 3).

The causes of the Great Recession have become a principal subject in most economic forums across the globe. The discussion surrounding this subject has often emphasized the role of market failures in hastening the crisis. However, most scholars and experts attribute it to slack policies and new financial innovations. This has put a lot of question marks on the key elements of a capitalist economy. As a result, this essay will explore the causes and nature of the Great Recession. Also, the essay will compare and contrast the Great Recession and the Great Depression.

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Causes and Nature of the Great Recession

Most economists attribute the credit crunch to the fall of the sub-prime mortgage market in the United States (Adair et al., 2009, p. 14). Even though reports on the sub-prime crisis became public as early as 2007, its impact was not felt immediately. In many EU countries, the slump was originally assumed to be a United State’s problem. The impact of the crisis was already being felt all over the world. The US financial institutions were heavily criticized for their reckless loaning practice and for developing monetary tools that violated global monetary policies. The financing vehicles developed by the US financial institutions played a major role in the globalization of funds and real estate market (Adair et al., 2009, p. 15).

Before the 2007 financial crisis, there were several indicators that should have triggered some form of response. The vast majority of the policymakers, scholars, and investors chose to ignore the indicators. Instead, they made numerous assertions regarding a new era. Also, there was a general excitement regarding the condition of the global economy. Therefore, one of the simple causes of the crisis is an utter disregard of crisis signals (Verick & Islam, 2010, p. 12; Simpson (2009, p. 5).

At the same time, numerous contributions to the ongoing post-crisis debate acknowledge government failures, especially in regulating banks and financial institutions as one of the leading causes of the crisis. Loopholes in government policies played a significant part in allowing banks and financial institutions to enhance leverage and returns (Taylor, 2009, p. 4). Taylor (2009, p. 5) points out that the excessively slack US financial policy led to a high level of unjustifiable lending, whereas Elmendorf (2007, p. 12) believes that the interest rates were exceedingly low. Besides these dimensions, some authors have considered both the role of domestic policies and global inequities (Verick & Islam, 2010, p. 14).

Drawing from numerous literature related to the 2007/2008 financial crisis, four interconnected causes can be identified. These are interest rates, global inequities, risk perceptions, and financial regulatory systems in place. All the post-mortem analyses have not avoided the role of the US governments in shaping the events that led to the crisis. Following the “dot.com” recession of 2001, the US banks and other financial institutions belligerently reduced the interest rates to extraordinary levels and, therefore, promoted a loan-financed consumption that ultimately affected the global aggregate demand. In the year 2003, the interest rates in the US reduced to one percent. This helped to avert the “dot.com” recession of 2001 within a short period, but it ironically propagated the seeds of the Great Recession.

In that respect, Gupta (2009, p. 4) argues that the decade before the crisis the US monetary policy was loose leading to interest rates that were extremely lower than the conventional standard, which is based on Taylor’s principle on the interest rate. Taylor’s principle is a monetary rule that regulates the level of interest rates bearing in mind the prevailing economic conditions. It represented the biggest deviation in the last four decades. Indeed, the real funds were negative from 2002 to 2005.

Acharya and Richardson (2010, p. 12) argue that interest rates were too easy for a considerably long time, but the alterations that seem optimal in retrospective would not have affected the housing cycle and allied development. Whatever the case may be, by emphasizing on a shallow meaning of price stability, the US financial policies failed to regulate the bubble in the real estate sector. At the same time, Verick and Islam (2010, p. 7) point out that the boom in the housing sector began way before the millennium and, therefore, predates the low-interest-rate period, but concedes that slack financial policies contributed to the ballooning bubble in the real estate sector. Moreover, the returns on the government bonds were extraordinarily low in the period before the crisis.

Acharya and Richardson (2010, p. 15) attribute the low-interest rates to the Middle East oil exporters and the Asian giants who developed an abnormal appetite for expanding foreign reserves in assets that are denominated in US dollar, for instance, treasury bills. This led to the so-called “global imbalance.” The deficit economies were excessively spending, whereas the surplus economies were saving. The supporters of the global imbalance theory argued that such discrepancies were untenable and would have caused a major financial crisis, even if the Great Recession did not implode in the 2007/2008 (Simpson, 2009, p. 66).

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In the period leading up to the Great Recession, some economic experts predicted a forthcoming crisis as a result of the huge deficit in the US. Based on the earlier current account balance, they felt that the US deficit, which was more than five percent, was a recipe for disaster (Simpson, 2009, p. 66). Parker (2009, p. 19) even warned of the probability of international crisis unless the inequities were averted. In the developing economies, crisis characteristically took place due to low confidence and reverse capital flow. The reverse wealth flow led to an acute decline in the domestic currencies. However, during the 2007/2008 crisis, the US did not experience reverse capital flow. Hence, the dollar did not crumble as anticipated by some experts (Gupta, 2009, p. 22; Parker, 2009, p. 20).

Acharya and Richardson (2010, p. 16) explain that the flow of capital from the Middle East oil exporters and the Asian giants fed into the United States’ ballooning bubble in the real estate sector and credit boom. As a result, interest rates remained low even after the US treasuring began tightening monetary laws. The excessive consumption in the deficit economies could only have been sustainable through incessant capital flow from surplus economies (Gupta, 2009, p. 22).

According to Simpson (2009, p. 56), the low-interest rates and higher returns of government bonds in the US encouraged risky behaviour among the investors. The investors began to search for higher-yielding assets, hence the high demand for mortgage finance. In the US, banks and other financial institutions exploited the low-interest rates to expand their products. Having exhausted the credit-worthy clients, the American Banks and other financial institutions resorted to riskier market segments. The riskier market segments included sub-prime loans and other non-standard loans. Verick and Islam (2010, p. 18) attribute the risky behaviour by banks and financial institutions to slack regulations of the financial systems, which dates back to the 90s and culminates in the late 90s when the Gramm-Leach-Bilely Act was ratified. The Act reversed the restrictions posed on financial institutions by the Glass-Steagal law of the 1930s.

Besides the lax regulation of the financial system, high-risk loans were encouraged by the political class who were advocating for affordable housing for the poor and disadvantaged. Nevertheless, the role of government regulations on the Great recession has been disputed by some authors (Verick & Islam, 2010, p. 18). Simpson (2009, p. 58) adds that the obstinate incentives in the real estate sector and the objective of increasing homeownership among the disadvantaged and low-income groups led to the emergence of the sub-prime housing market in the United States. Under the sub-prime market, individuals who would not be considered as creditworthy under the normal standards were funded by the US banks. The increased lending and deterioration of credit standards led to the growth of sub-prime mortgage loans. The sub-prime mortgage loans fall under what the economies describe as “non-prime loan.” Besides the growth of non-prime loans, speculations in several states helped fuel the ballooning bubble (Bordo, 2012, p. 16).

The emergence of new financial products beyond the range of prevailing laws proved to be a key regulatory failure. On the whole, the core aspects of this failure were: derisory requirements on some products; insufficient use of credit ratings; and the high incentive for risk-taking among banks and other financial institutions. Therefore, mortgage-backed securities were at the centre of the Great Recession but were not the only cause (Bordo, 2012, p. 17; Verick & Islam, 2010, p. 20).

The Breton Wood institutions had also expressed concern over the delicateness of numerous security products provided by the US and EU financial institutions. They felt that the borrowers were not taking the negative aspects of such products with the seriousness it deserves (Adair et al., 2009, p. 16). The principal concern was the sharp decline in the prices of houses because securitization was based on the supposition that any difficulty faced by the investors would be offset by the growing property market. However, in the fourth quarter of 2007, it was obvious that the property market was also declining sharply. As the value of the property was plunging and the rate of defaulters increasing, the asset backed-securities attached to the US housing sector began to devalue at a higher rate than was anticipated (International Monetary Fund, 2008, p. 5).

The slump in the US property market negatively affected the global balance sheet (International Monetary Fund, 2008, p. 5). According to Adair et al. (2009, p. 16), the drop in the value of residential property took away the incentive to pay back the mortgage, thus increasing the rate of the defaulters. The slump in the US property market robbed the international market of two important components, namely: confidence and trust. The financial institutions were exposed and had to suck up massive losses, though it was not clear which bank was most affected. The uncertainty increased mistrust among the financial institutions, forcing them to stop lending funds to each other as they were unaware of each other’s financial statement.

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As the banks and other financial institutions tried to switch and minimize risks, their readiness and capability to give credit were held back, hence tightening of fiscal and monetary policies. The availability of liquid assets in the global monetary market worsened in the 3rd quarter of 2008 when two major financial and insurance companies nearly collapsed. The fall of Lehman Brother destroyed confidence in the monetary market. Also, the fall of Lehman Brothers was enormously figurative. Not just because of its position in the international monetary market, but because it exposed the level of integration within the international banking system (Adair et al., 2009, p. 16).

Comparing and Contrasting the Great Recession and the Great Depression of the 1930s

The first thing to point out is that in terms of the decline of the real economy, the Great Recession was a comparatively smaller event. In the 1930s, the US economy fell by nearly a third, while during the Great Recession, it only declined by about 5 percent. Secondly, both the Great Recession and the Great Depression were global phenomena. However, the Great Depression of the 1930s had a major impact on the global economy compared to the Great Recession. The 2007/2008 crisis was -2.95 percent compared to -9.35 percent during the Great Depression. The percentages show that the Great Recession was not as bad as the Great Depression of the 1930s (Gupta, 2012, p. 55).

However, the nature of their recovery was more or less the same. Both events had lethargic recoveries in terms of the real economy, which is measured by real GDP, unemployment rate, and industrial production, among others. The recovery after the Great Depression was more sluggish. One possible reason behind the sluggish recovery is the National Industrial Recovery Act (NIRA), which tried to restrict both commodities and products market. The recovery of the 2007/2008 crisis was also lethargic (Bordo, 2012, p. 4).

Bordo (2012, p. 5) attributes the sluggish recovery of the Great Recession to the Banking crisis. Most banks and financial institutions collapsed, while some survived by a whisker. Another similarity between the Great Depression and the Great Recession is that both events were preceded by booms and busts in asset prices. In the 1920s, there was a real estate boom and bust. However, there was a crash in Wall Street towards the end. During the 2007/2008 financial crisis, there was a sub-prime mortgage-related real estate boom and bust that led to the crisis.

The major disparity between the Great Recession and the Great Depression is like the banking crisis. The 1930s event was a traditional liquidity-based banking crisis caused by the Government’s failure to act as the lender of the last resort. On the contrary, the 2007/2008 crisis was more or less similar to the late 90s solvency-driven banking crisis. However, Parker (2009, p. 13) argues vehemently that there was a traditional panic in the money market and other elements of agency banking.

In the 30s, the problem started with a sequence of banking crises that started in the early 1930 and concluded in 1933. The panics prompted the banks to reduce the deposit currency and reserve rations, thus minimizing the money supply. The panics became worse in the1931. This reflected a spread of fear as the public resorted to withdrawing and hoard currencies leading to enormous bank deferments. In other words, there was a massive liquidity shock. The decline in money supply led to a decrease in consumption and eventually decreases in aggregate output and employment (Acharya & Richardson, 2010, p. 12).

The situation was worsened by the insolvency of banks that initially had sound balance sheets because of dumping their earning assets and deflating their debts. Debt deflation was prompted by real debt burden due to falling prices. Therefore, banking panics were the main cause of the Great Depression. Bank insolvencies weakened the financial intermediation mechanism. This is evident in the quality spread (Acharya & Richardson, 2010, p. 12; Bordo, 2012, p. 5).

On the other hand, the Great Recession is attributed to the fall of the sub-prime mortgage market. It began with an asset price boom that later busted. The fall of the sub-prime mortgage market caused an alarm in the shadow banking system. The shadow banking system, which had expanded after Gramm-Leach-Bilely Act was ratified, had much more leverage than the conventional banking system and was highly susceptible to risk (Bordo, 2012, p. 5). When the 2007/2008 financial crisis hit, the US banks were forced to leverage through earning assets. This reduced the value of their assets and institution at large. The crisis spread to the rest of the world after the fall of the Lehman Brothers in September 2008 (Simpson, 2009, p. 67).

Conclusion

Recession is a slump in economic activity in an economy over a considerably long period. The great recession of the 2007/2008 was the most profound and extensive economic slump ever experienced in recent times. The 2007/2009 recession is mainly attributed to the US subprime crisis. Even though reports on the sub-prime crisis became public as early as 2007, its impact was not felt immediately. In Europe and the rest of the world, the profound effect of the crisis started to be felt in the 3rd quarter of 2008.

The impact of the recession was very devastating, especially in the property market. The Great Recession and the Great Depression have some similarities and differences. They were both global and had a sluggish recovery. However, the key disparity between the Great Recession and the Great Depression is like the banking crisis. The 1930s event was a traditional liquidity-based banking crisis caused by the Government’s failure to act as the lender of the last resort. On the other hand, the Great Recession was mainly caused by the fall of the sub-prime mortgage market.

References

Acharya, V. V. & Richardson, M. (2010). Causes of the financial crisis. Critical Review, 21 (2), 2-33.

Adair, A., Berry, J., Haran, M., Lloyd, G., & McCreal, S. (2009). The Global Financial Crisis: Impact on Property Markets in the UK and Ireland. Ulster: University of Ulster.

Bordo, M. D. (2012). The Great Depression and the Great Recession: What Have We Learned? Stanford: Stanford University Press.

Clemence, R. V., & Doody, F. S. (1950). The Schumpeterian System. Cambridge, Mass: Addison-Wesley Press.

Gupta, U. (2009). Recession: causes, problems and effects. New Delhi: Abhishek Publications.

International Monetary Fund. (2008). Global Financial Stability Report: Financial Stress and Deleveraging, Macro-Financial Implications and Policy. Washington, DC: IMF Multimedia Services Division.

Langlois, K. (2009).What is recession. Duluth: EAP.

Parker, R. E. (2009). The Economics of the Great Depression: A Twenty First Century Look Back at the Economics of the Interwar Era. Edward Elgar Publishing.

Simpson, D. (2009). Recession: Causes and Cures. London, UK: Adam Smith Institute.

Verick, S. & Islam, I. (2010). The Great Recession of 2008-2009: Causes, Consequences and Policy Responses. IZA Discussion Paper No.4934 (pp. 3-57). Canberra, Australia: International Labour Office.

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