U.S. Economy Status and Recession

U.S. ECONOMY STATUS AND RECESSION

U.S.Economy Status and Recession

Thegovernment of the United States has made aggressive attempts torevive the economy following the great recession of 2008. Severalmonetary policies and fiscal policies have been brought intooperation in attempts to steer up economic activities and help thenation get into the recovery path. These policies receive applausefrom some quarters, while others feel that the policies employed areinappropriate and misguided. This paper examines the causes ofrecession and the monetary and fiscal policies employed by Fed duringand after the 2008 recession. Various models have been employed toestablish the effectiveness of these policies.

Causesof Recession

Arecession is said to occur when there is a significant decline incountry’s economic activities. The decline is can be viewed inmeasurable terms of the economic indicators such as real GDP,unemployment, wage levels, industrial production, real income andretail-wholesale volumes. There are three major causes of recession.First is a negative demand-shock that affected the components ofaggregate demand. It is characterized by a slump that followed in theeconomy of a major trading partner, a fall in asset prices such asproperty and share prices, and a major fluctuation of exchange ratesthat reduces demand for exports and increases the demand for imports.Another significant characteristic is a credit crunch, that is, thebanks and financial institutions reduce the amount available ascredit for firms and households. The loans available are offered atsignificantly higher interest rates (Krugman,2009).

Anothercause for the recession is a supply-side shock like cost-pushinflation that affects profits and investments. This can be broughtabout by increased fuel prices such as gas and crude oil, the rise ofprices of non-fuel inputs, rise in prices of foodstuff and economicchanges in other world’s biggest economies. Thirdly, recession maybe caused by deflationary macroeconomic policies. A measure such asincreased interest rates may be introduced so as to counter inflationthat may arise domestically or from foreign economies. High-interestrates may reduce money interest and result in a downturn of economicactivities, thus fewer jobs. Taxes could be increased so as tocounter a budget deficit. However, this increase may result in lessdisposable incomes leading to low rates of savings and investments(Krugman,2009).

Thesource for the Unites States economic recession of 2008 originatedfrom the downturn in the housing sector that started in 2006. Thehousing bubbling was a result of poor lending practices and very lowinterest rates. There was a great fall in the housing prices, and thecost of purchasing and constructing homes went down considerably.Mortgage foreclosures rose sharply, leading to the loss of billionsof dollars by the leading banks in the country (Tcherneva,2011).This also led to the tightening of credit. Collateralized MortgageObligations (CMOs), which are not part of the commercial bankingsystem were issued by financial institutions and allowed to operatewithout regulation by the federal government. CMO is a kind of amortgage-backed collateral where the principal repayment is organisedaccording to maturity and risk. Through CMOs, the problems spread toother sectors of the economy, with particularly huge effect on thefinancial sector.

Further problems were inflicted by the Credit Default Swap (CDS).CDSs were insurance contracts on CMOs that dragged the both financialand insurance sectors down. The sellers of CDSs introduced matchingCDSs in order to protect themselves from default risks till allparticipants in the insurance and banking investment market werebound together with them. CDSs and CMOs had become toxic assets sincedefault on mortgages led to a collapse in the corresponding CMOs,thus causing problems in the balance sheets of the investment bankingplayers. The final result was freezing financial credit markets. Theproblems with liquidity turned to insolvency and financialinstitutions such as banks, and insurance companies could not accessthe financing they required in order to operate normally, thuscreating a problem for the whole economy.

Afterthe crisis in the US, the recession spread globally when foreignbanks realized a fall in the housing in the US and took it as an easyinvestment opportunity. They did this through CMOs. Securities fell,and the value of assets went down and in 2007, the investors tried toliquidate their assets. However, because of there were no buyers amidthe several housing companies in the market, the assets becamefrozen. There was a lack of confidence with money and foreign banksraised their interest rates. In addition, this recession in US led toa decline in imports from its major trading partners. Exports inthese countries fell in turn and led to a decline in their real GDP,and this trend spread across the world (Krugman,2009).

MonetaryPolicies Taken By the Fed

Followingthe 2008 depression, the US economy began to decline in the lastquarter of the year (Allard,et al., 2013).The country began to experience high unemployment rates, making Fedrespond. FOMC designed two major monetary policy guidelines. Theseinclude forward policy guidance and large-scale asset purchase.

ForwardPolicy Guidance

Forwardpolicy guidance was a communication by the Central Bank whose aim wasto signal the future trend of the lending rates. The three majorcentral banks including Fed made official communication using ‘codewords,” such as policy accommodation removal through a ‘measuredpace.’ Fed’s believe was that this initiative could stimulateeconomic activities since businesses, for instance, would tend to getinto long-term financial commitments, only with assurance that theinterest rates will lower throughout the loan period. Forwardguidance was more explicit and more detailed. The expected time framewas extended in September 2012, and Fed offered exceptionally lowrates for federal funds, after the date threshold was replaced by aneconomic threshold. The loan period was extended to December 2015,and Fed committed to preserving &quotexceptionally low&quot targetfor federal fund provided the inflation is low, and the unemploymentrate is above 6.5 percent (Labonte, 2014).

Fedhas concentrated its monetary policy strategy on low bank rates thatare near zero. Federal Open Market Committee (FOM) members agree thatat the point of low economic activity, lowering the federal fundinterest rates may stir up economic activities to desirable levels.The actual impact of this policy can be assessed using appropriatepost-crisis short-term model. New Keynesian model for inflationforecasting can be applied to establish a monetary policy effect onvarious microeconomic and macroeconomic variables. Justification forthe choice of short-term interest rates at zero lower bound can beevaluated by the new Keynesian models (Gali et al., 2011).

Assuming interest rates from an agent`s discount factor is high,then, the real interest rates should be lower because at zero lowerbound the interest rates are very low such the central bank cannotsignificantly lower them further. The possible response is for theCentral Bank to make commitments on future monetary policycorrections. The change of situation will, therefore, depend on thegovernment’s commitment to meet the promise. Since the time ofcrisis, Fed has been making promises about the future changes for abetter economy but nothing much has changed. According to this model,the forward guidance policy will be propelled when the central banksets the nominal interest rates to zero.

CentralBank Liquidity Swaps

Fedcreated the central bank liquidity swap lines in 2007. These arelending facilities that were offered during the recession crisis. Theswap lines were open to other central banks, unlimited in size, andmany of them subscribed to the bid. About thirty-five countries hadsubscribed in October 2008. The first batch expired in February 2010.The subsequent batch was reopened in May 2010 and the EuropeanCentral Bank, and the central banks of England, Canada, Switzerlandand the Japan subscribed, as a reaction to Eurozone crisis. Theexpiry period for swap lines has been extended several times untilthey were transformed to stable standing arrangements in October 2013(Dokko et al., 2009).

Upto $583 billion swaps were recorded in December 2008 but lowered tozero in early 2010. Following their restoration in May 2010 untilMarch 2011, only limited amounts were drawn. There was an outstandingincrease from December 2011 until February 2012, with the periodrecording above $100 billion. Since then, swap subscription hasfallen considerably and since august 2013, only about $1 billion hasbeen outstanding, with only the Bank of Japan and European CentralBank as the main subscribers. Swipe lines were intended to supplyliquidity in foreign denominations to private banks. Banks lend on along-term basis, but borrow on short-term. Therefore, solvent bankscould attain liquidity. Swap lines also targeted to provide access toUS dollars to Eurozone banks since their access to the dollar haddeteriorated during Eurozone crisis. Private Banks can only borrowfrom the central bank of their country, and swap lines were to availthe dollar to the central banks for access for local private banks(Dokko et al., 2009).

Thesepolicies can be tested using the FRB/US model. FRB/US model is a toolfor analyzing macroeconomic policies and is used for forecastingissues on both fiscal and monetary policies. According to this model,monetary policy will affect households’ wealth the user costs ofhousing through the conventional asset price channel (Dokko et al.,2009). The housing demand is very sensitive to important changes inthe federal funds rate. Since houses are long-term assets, this shifthas a great impact on the user cost of housing. Assuming that amonetary policy takes two paths, that is, the output gap andinflation. By observing the paths taken by the actual federal fundrates and the path taken by the long-term mortgage rates theyproduce, at any time, the long-term mortgage rates are higher thanthe actual federal funds rates. The real GDP level will be lower, butits decline is small compared to the level of investment by theresidents. Other macroeconomic aggregates affect are employment thatcould be slightly lower compared to the level of GDP.

FiscalPolicy Taken By the Government

Followingthe recession, fed applied a conventional fiscal policy that focusedon boosting aggregate demand through increased government spending.The approach was taken based on the contemporary economists such asNourielRoubini,and RaghuramRajanbelieve that the effectiveness of fiscal policy can be evaluatedusing the “leaky bucket” analogy. The government increased itsspending to achieve a corresponding increase in GDP in a level thatis sufficient to reduce unemployment to below six percent. Theconcept of the leaky bucket emerges from the work of the economist,Arthur Okun. He developed a law that states &quota 1 percentincrease in unemployment would generate an approximate 3 percentdecline in GDP growth&quot (Tcherneva,2011). This law suggests that the government can significantly reduceunemployment by stimulating the economy in a level that is fastenough to reduce unemployment to 6.5 percent or less.

Okun`stheory has been greatly applied especially during the greatrecession. Economists believe that an increase in government spendingwill have a corresponding increase in aggregate demand. However,Okun`s theory is criticized for lack of proper guidance to thegovernment on exact measures that will increase aggregate demand. Itlacks clear guidelines on what type of growth should be applied inorder to realize a significant reduction in unemployment. The USgovernment has applied fiscal policies that are based on this theorysince the 2008 recession (Tcherneva,2011). During a recession, there is an automatic increase ingovernment spending, with increased welfare benefits allowances,unemployment compensation and jobless transfers to the poor. Inaddition, due to a fall in economic activities, tax revenue declines,thus stimulating countercyclical deficit.

The figure below shows the trend in government spending.

Year

GDP- $ billion nominal

Population- million

Total Spending -total$ billion nominal

2007

244.426

5.602

46.69

2008

245.277

5.628

49.30

2009

245.898

5.655

52.66

2010

254.242

5.691

55.49

2011

263.076

5.709

56.70

2012

272.086

5.725

54.63

2013

282.486

5.743

53.59

2014

292.191

5.761

53.40

(Leeet al., 2014)

Theeffectiveness of the fiscal policy can be evaluated using theKeynesian unemployment model. According to Keynes, the effectivenessof the policy will be measured by its effects on employment creation.The government spending should end with improvement in job creation.The policy makers increase the government spending expecting toincrease the employment rate in the long run. This model reveals thatspending on intermediary projects has very little positive outcome ofemployment. The government should spend directly on employmentcreation. The unemployment rate in the US remains high (table below)even after the fiscal policy interventions because the expansionarypolicies applied do not create employment directly, thus making itdifficult to attain full employment.

Contrary to the Keynes argument, Fed’s spending has not generateda corresponding change in employment rates. The figure below showsthe unemployment rate for people aged sixteen and above.

Year

Jan

March

June

Sep

Dec

2006

4.7 4.7 4.6 4.5 4.4

2007

4.6 4.4 4.6 4.7 5.0

2008

5.0 5.1 5.6 6.1 7.3

2009

7.8 8.7 9.5 9.8 9.9

2010

9.7 9.9 9.4 9.5 9.4

2011

9.1 9.0 9.1 9.0 8.5

2012

8.2 8.2 8.2 7.8 7.9

2013

7.9 7.5 7.5 7.2 6.7

2014

6.6 6.7 6.1 5.9

(U.SBureau of Labour Statistics, 2014).

Thefiscal policy applied in 2008 followed the above pattern with a fewother increases in government spending, which were not commonmeasures for countercyclical stabilization. The government undertookto purchase a large number of non-performing assets held by thebanks. Since Fed lacked the legal mandate to purchase assets fromprivate banks without the authority of congress, the purchase wasexecuted from the Federal Reserve. Congress assigned $700 billion toFed to execute a large purchase of private banks’ agency paper,asset-backed securities, and other varied assets. It was passed inthe first phase of the program referred to as TroubledAsset Relief Program (TARP). TARP oversaw the injection of governmentfunds in several financial and insurance sectors and other companiesincluding Citigroup and General Motors. In addition, TARP facilitatedthe virtual nationalization of AIG (Tcherneva,2011).

Theidea is driving the application of TARP as a fiscal policy was toreplace the nonperforming assets of the private companies and replacethem with government reserves so as to provide incomes to individualcitizens and states. The second phase of this fiscal policy wasintroduced in 2009 through the American Recovery and Reinvestment Actof February 2009 (ARRA). Through this policy, $787 billion wereapportioned to stir up economic growth. Part of this included $275billion for grants, loans and contracts, $288 billion as benefits toindividuals and firms in the form of tax cuts and $224 billion forentitlements.

Fedintroduced restrictive measures in 2013 after the expansionarymeasures that operated from late 2008 until 2010. The CongressionalBudget Office revealed that the government spending has since reducedby half (Allardet al., 2013).Both state and local governments have embarked on a contractionaryfiscal policy in attempts to adjust their tax revenues. Todemonstrate the tightness of the current fiscal policy, a referencecan be made to the 2001 recession. In the recovery path after the2001 recession, the level of employment increased by close to 600,000jobs in the government sector (Langdana,2009).In the current recovery, employment in the public sector has reducedby approximately 700,000 jobs. Fed has tightened the fiscal policy inorder to balance it with the current monetary policy, which has keptthe interest rates to near zero.

Balanceof Trade Deficit and Government Deficit

.Since 1975, United States has recorded unfavorable Balance of Trade.The highest balance of trade recorded by the US was $1946 million in1975, with 2006 recording the lowest ever BOT, which amounted to$67823 million. In October 2014, the US recorded a trade deficit of $43400 million. Considering the previous months of the year,Thisfigure was a slight improvement from April`s $45977 million. Theconsistency in the trade deficit has been blamed on high importationof oil as well as consumer products. In a recent year, US trade withChina, Mexico, Germany and Japan has yielded a big trade deficit.However, the US has recorded trade surplus with countries such asUnited Arab Emirates, Netherlands, Australia and Hong Kong (US.Census Bureau, 2014).

Thegovernment deficit refers to the amount by which the federalgovernment`s budget outlay exceeds its total collection in a fiscalyear. The statistics reveal that the US federal government has forseveral consecutive years run a budget deficit. This implies that thegovernment spends more than it can produce. In the current fiscalyear, the government is operating a budget deficit of $483 billion. Abudget deficit implies that the federal government has to borrowmoney in order to finance its activities fully. The money borrowed tocover the budget deficit constitutes the government debt. Thegovernment debt is more than the actual budget deficit because thegovernment may not borrow the exact deficit amount and because thedebt administration and transfer costs are factored. The chart belowshows the actual and the estimated federal government deficit from2009 to 2019.

(Chantrill,2014).

Isthe Persistent Deficits a Matter of Concern?

Thegovernment debt is an issue of concern because the debt borrowed tocover the debt is a direct burden to the US taxpayers. In addition,the money borrowed is not used to generate incomes to the citizens.Instead, the government uses a lot of money in dead weight projectssuch as international aid. The position of persistent trade deficitscausing a concern is dependent on several factors. If certainconditions are favorable, it is likely that trade deficit cannotcause a major concern. The negative US balance of trade implies thatthe US consumes beyond its production in the net investment. Thisdeficit is financed in two ways. First, it can be financed throughreduction of the country`s external assets. Second, it can befinanced by increasing the country`s external liabilities (Janice,2002).

Apersistent balance of trade deficit implies that the US assetsoverseas can be depleted and probably lead to insolvency in the longrun. However, it depletion of assets may not be a big case becauseassets are linked to capital gains, and they pay dividends. Eventhough the present difference between the US liabilities and externalassets is negative, the US can return to produce a net inflow due tothe return difference between the external liabilities and externalassets. According to the economists Hélène Rey and Pierre-OlivierGourinchas (2007), the US overseas assets generate a higher rate ofreturn compared to the cost of payment it makes to foreigners on itsliabilities. The difference in return is very large.

TheUS external assets produce, on average, 3.3 percent returns on anannual basis than the claims made from the external liabilities. Thedifference is explained by the composition and nature of theliabilities and assets. Assets such as private equity and foreigndirect investments have a higher risk and higher returns on the otherside. Such assets contribute to a large share of portfolio onexternal assets owned by the US. This large difference in returnsimplies that the in spite that the US is a debtor, it can registernet inflow. In total, if there is sufficiently large net investmentincome generated by the external accounts held by the US, it ispossible to pay for trade deficit. Thus, trade deficit is thiscircumstance should not be a major concern (Gourinchas &amp Rey,2007).

of Current US Economic Problems

TheUS is still in the path of recovery fro the Great Recession. Thereare a number of economic problems facing the nation. Among theseproblems include unemployment, Federal budget deficit and generaleconomic issues such as social welfare and interest rates. SSeveralAmericans cite unemployment as the leading economic problem in thecountry. Many Americans are concerned with employment issues and abigger percentage vote employment as the most pressing issue. In2011, president Obama announced a plan to deal with unemploymentthrough creation of new jobs. However, not many jobs were created,and the country has not been able to attain full employment. Anotherproblem ailing the economy is the government deficit that has beenconsistent. The money borrowed to finance the deficit creates morefractures to the economy and creates more debts to the country.

Thesolution of the economic problems can be approached with an effectivefiscal policy. An expansionary monetary policy is likely to fuelinflation without direct increase in real incomes to the citizensbecause it will cause direct competition in the desire for lending. Amore expansionary fiscal policy should be applied. The governmentbudget should be drawn with major allocation on the primary concernssuch as employment and social welfare. Less money should not becommitted to dead weight programs.

Conclusion

Asrevealed by the Okun theory, and the models discussed herein,effective monetary and fiscal policies should have visible positiveoutcomes in the economy, such as a reduction in the unemploymentrate, reduced taxes, increased transfers to the weak and poor andreduction in banks’ interest rates as well as affordable mortgages.Very little change has been realized since the US started itsrecovery from the recession. Unemployment level has been on thedecrease, but much is needed in order to realize full employment.Better monetary and fiscal policies should be introduced, or theexisting ones are revised and managed properly so as to make themmore effective for attainment the intended purpose.

References

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