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The Great Recession

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WEEK 3 ASSIGNMENT: THE GREAT RECESSION

JONATHAN MOONEY

MARCH 24, 2013

MBA 510: ECONOMICS

Most economists consider the Great Recession of 2008 to be the worst financial crisis since the Great Depression. The sequence of economic events affected the entire global economy, with certain countries being hit harder than others. In the end, the collapse resulted in the total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The housing market also suffered, resulting in evictions, foreclosures and prolonged unemployment. The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to a global recession and contributing to the European sovereign-debt crisis.

Most experts agree that one of the most important contributors to the recession was the collapse of the housing bubble. This led to an extremely high rate of loan defaults for people who probably should not have been given those loans in the first place. Due to the practice of predatory lending, many unsuspecting people were offered mortgages that they could not afford; however these people were convinced by lenders and realtors that they would be able to refinance those properties in a year or two and make tons of money. Since, the housing market was strong at the time, many people jumped on this opportunity, knowing that the property they were signing for was more than their budget could handle. Another part of the problem was the relationship between mortgages, the housing crisis and Wall Street. When Wall Street giants such as Bear Stearns, Lehman Brothers and Merrill Lynch jumped into the void left open by the collapse of the Government Sponsored Enterprises (GSE) Fannie Mae and Freddie Mac; this led to Wall Street becoming a leader in the sub-prime lender market. Wall Street believed that by taking over the loans vacated by the GSEs, they could bundle them and sell the mortgages off to one of their giants (like Lehman Brothers), and those investors would make money from the interest payments. (Reich, 2011) During the sustained real estate surge, this seemed to be a sound investment. When the housing market bubble began to burst, Wall Street had assumed significant debt burdens while providing the loans and did not have the financial cushion needed to absorb the loan defaults (Greenspan, 2009).

Another issue that contributed to the Great Recession was a failure of oversight. Even where regulators were in place to oversee the trading they often misjudged the market. Alan Greenspan, the chairman of the Federal Reserve at the time, said he was in a state of “disbelief and shock”. Paul Krugman makes the argument in his article How Did Economists Get It So Wrong? that “over the years there has been a movement away from Keynes vision of financial markets where government regulation and assistance was required at times towards the ‘efficient market’ theory which implies markets will make the correct decision themselves.” Krugman states that even the economists who retained Keynes’s views moved toward the idea that markets generally will get it right. Highlighted here is a fundamental change in the idea of how markets work and how governments should regulate them. This may explain how government and regulatory agencies allowed for these things to happen.

Robert Reich in his book Aftershock ties all of these causes into a fundamental issue that has plagued the American economy for the last 30 years. Reich bases his arguments for the financial crisis in the current over all structure of the United States Economy. His main argument lies within the breaking of the “Basic Bargain”. Reich sees the basic bargain as the deal between employers, workers, and consumers. Reich states, “Workers are also consumers. Their earnings are continuously recycled to buy the goods and services other workers produce” (Reich, 2011). This is highlighted by his example of Henry Ford and the production of the Model T. Ford began paying his assembly line workers much higher wages than the typical factory worker was earning at this time, eventually allowing his workers to also become his consumers which would lead to higher productivity and higher profits in the long term. This bargain was broken when wealth began to become concentrated within a small percentage of the people and wages along with purchasing power remained steady or declined meanwhile prices continued to increase. (Reich, 2011) When workers wages do not grow with prices of good their purchasing power declines and demand is not driven. This is what would lead to coping mechanisms of the middle class to continue living the lifestyles they were used to or wanted to pursue to keep up with the super wealthy.

Reich mentions three mechanisms that allowed the middle classes to keep up this standard of living the first of which is women moving into the paid workforce. With double incomes families were able to afford much more and questionable enjoy them much less. The second form of coping was longer hours. When double incomes weren’t enough to support growing needs people spent more time working. Reich claims that in the early 2000’s Americans worked 350 hours more than the average European. The fourth way to cope was to stop saving as much and use credit to purchase what they wanted. This last coping mechanism would lead to the pursuit of loans and refinanced mortgages that would culminate in the Financial Crisis. Reich’s arguments for the cause of the Great Recession differ from other arguments made as he addresses an overall greater problem. He claims that “it was not solely the government’s lack of regulation, the private sectors quest for profit, or the American consumers urge to spend but instead it was the breaking of a social contract that gave middle class consumers the purchasing power to drive the economy.” (Reich, 2011) When purchasing power is concentrated at the top, it is not allocated as efficiently as it would be if it were spread around. A more equal spread of money allows for a greater purchasing power resulting in greater demand, driving supply and productivity resulting in a more efficient and profitable economy.

In order to combat the recession, the government was forced to take a variety of actions. They bailed out the banks and the auto industry as well as passed an economic stimulus package. These bailouts have been the cause of much debate by the American people. Some people believe that years of neglect and poor management should not be rewarded with government funds to start the process all over again. On the other side of the coin, the domino effect of letting those industries simply go out of business would be catastrophic and far-reaching. The idea behind the stimulus package was to increase government spending to help create new jobs, help consumers spend more and gain more production out of businesses. Tax credits for companies offering more jobs, low interest loans for individuals wanting to open their own businesses, and more government sponsored programs like “Cash for Clunkers” were all included in this policy. Another important step that was taken to ensure the avoidance of these economic busts in the future was the passage of financial regulatory reform, in the form of the Dodd Frank Bill and Consumer Protection Act that was passed in July of 2010. This bill is suppose to address how our financial system is regulated and operated with organizations like the Consumer Protection Agency and implement stricter rules on derivatives markets. While these are a step in the right direction, I fear they will not be able to stop the lobbying power of the big banks in Washington, leaving us vulnerable once again.

The Great Recession of 2008 was an economic crisis that negatively affected millions of people and continues to hurt and hinder the world to this day. There were a number of factors that combined and led to this market meltdown, but overall the Great Recession was a culmination of a variety of major issues and negative trends that have been facing the U.S. for some time. Many of these problems have been addressed through the bailouts that brought the American economy back from the brink of disaster and legislation such as the Dodd Frank bill; however, these types of solutions may not impact the underlying fundamental problems of growing income inequality and the gap between rich and poor. It is this problem that requires a restructuring of how the U.S. currently operates to prevent future booms and busts of which the impacts will be felt globally. By addressing this essential problem the U.S. may put itself on the path for long-term sustainable growth and retain its place as a leader within the international economy.

REFERENCES

Greenspan, A. (2009, March 26). “We Need a Better Cushion Against Risk”. Financial Times. http://www.ft.com

Krugman, Paul. (2009, September 2) “How Did Economists Get It So Wrong?” New York Times. http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?pagewanted=all&_r=0 Reich Robert. (2011, April 5) Aftershock; The Next Economy and America’s Future. Vintage Books Paperback.

Schiller, B. (2010). The Macro Economy Today. New York, NY: McGraw-Hill/Irwin.

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