Thursday, March 20, 2008

Why is the US Economy Facing A Recession?

Readers Question: Why is the US economy facing an economic meltdown?

The US economy faces many severe problems, a falling stock market, record levels of public debt, banks on the verge of bankruptcy, frozen money markets, a plummeting dollar and the imminent threat of a recession. How did the US economy get into such a desperate situation?

The Housing market

The housing market plays a crucial role in determining consumer spending and therefore the rate of economic growth. When house prices are rising, consumers experience an increase in wealth; this boosts their confidence and enables them to remortgage and gain equity withdrawal to spend. When house prices fall, the opposite happens.

The Housing Bubble.

Up until 2006, US house prices rose rapidly; against a backdrop of rising house prices many analysts felt that even risky mortgage loans were safe and this encouraged even more unsuitable mortgages. For example, it was hoped 100% mortgages would be easier to pay back because rising prices would give homeowners an effective deposit.

The combination of low interest rates, aggressive marketing of mortgages and overly optimistic predictions for the housing market caused house prices to rise. However, the ratio of house prices to income went far above the long run trend rate; making mortgages increasingly unaffordable for first time buyers. Then in 2006 the Fed were forced to raise interest rates to over 4% because of inflationary pressure in the economy. This increase in interest rates caused many mortgage owners to struggle with their repayments. Also, there was another problem - many new mortgages were 'balloon mortgages' this means that for the first two years homeowners had a specially low introductory rate. However, after two years, the mortgage rate suddenly shot up increasing monthly payments very significantly. Therefore, first time buyers who had stretched themselves to get a mortgage suddenly found themselves with a large increase in monthly payments. There are several examples of homeowners with mortgage payments greater than their total income. These mortgages should never have been sold, but, in the housing boom there was a lack of self regulation. The needs of the consumers were ignored in the pursuit for selling 'profitable mortgages'

The Housing Bubble Bursts

Therefore, with a rise in defaults and fall in affordability, the US housing market turned. Suddenly after years of growth, the 'unthinkable' happened and house prices started to fall. This came as a shock to many who assumed house prices could only rise. Therefore, people who had been speculating in the housing market felt this was the time to get out and sell. Therefore, prices fell even more. Since their peak in 2006, house prices have fallen by 10% (in some areas it is much higher, the housing market is very localised). Furthermore, there is still the prospect of even more falls in house prices. As house prices fall consumers have less confidence to spend. There has also been a worrying increase in unemployment in real estate related jobs, such as construction.

The Credit Crunch

The problems in the US housing market and in particular the subprime mortgage sector soon spread to the rest of the finance system. Many big investment banks and commercial banks had been enthusiastic purchases of these CDOs. Basically, big banks had been refinancing these risky mortgage loans. When mortgage defaults started to occur, the commercial banks realised they were facing huge losses. Their losses were exaggerated by the risky nature of the loans. Some hedge funds collapsed completely. Despite the magnitude of the defaults, many of the big banks could afford to write off billions of pounds and still remain solvent.

However, the experience left Wall Street and the global finance system realising the dangers of risky lending. Therefore, the market sentiment changed to one of great conservatism. Banks were reluctant to lend to anyone, even each other and usually secure lending. This led to a shortage of funds in the money markets (such as interbank lending). This credit crunch is basically about a shortage of liquidity in the finance sector. The effects are that ordinary borrowing becomes more expensive and more difficult. Both the UK and US have seen most 'subprime' lending products withdrawn.

The credit crunch has also caused great difficulties for banks such as Northern Rock in UK and Bear Sterns in the US. Basically the banks couldn't raise enough money on the money markets so had to resort to some kind of rescue package. The concern is that more banks could suffer a similar fate and future bank rescues will be more difficult.

Because of the credit crunch, since July, the monetary authorities have been forced to inject liquidity into the money markets three times to avoid a complete shortage of funds. However, there is no guarantee that the markets won't keep freezing again.

Effect on Consumers and Economic Growth

Falling house prices, falling confidence, higher costs of borrowing have all contributed to a fall in consumer spending and it is this which is the main factor causing a downturn and likely recession. Furthermore, the credit crunch has caused difficulties for many borrowers, who now struggle to borrow at affordable rates. The US also has very high levels of consumer borrowing, therefore, increased cost of borrowing has caused widespread problems. - although the rate cuts by the Fed have made it less painful, it may still not be enough.

It Gets Worse

On its own the Housing crash and credit crunch would cause serious problems. However, the US economy has other underlying problems which makes it more difficult to deal with the problem.

Devaluing Dollar. In one sense the depreciating dollar is helping to increase exports and maintain growth in the export sector; to some extent this may counter the fall in consumer spending. However, the depreciating dollar is contributing to both cost push inflation and declining living standards. This means the US could face the unpleasant occurrence of both inflation and lower growth. It makes the job of the Fed more difficult; in particular rate cuts further weaken the dollar and increase inflation. At the moment, the Fed have decided the recession is more serious than inflation, and rates have been cut.

Current account deficit. The current account deficit is an indication of an unbalanced economy - too much spending, low savings ratio. A downturn in the economy and depreciation in dollar are necessary to deal with this.

National Debt. The US national debt stands at 65% of GDP, (even more if you include future pension liabilities). This gives the economy little room for expansionary fiscal policy. It means the US pays a lot in debt interest payments and the forthcoming recession will only aggravate the debt situation

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Anonymous said...

"It Get's Worse" should be "It Gets Worse"

pbuxton said...

How do you talk about all this and not mention Fannie and Freddie, Federal government-sponsored enterprises (GSE) which manipulated the real estate markets?

Congress set aside $700 bn ($640 bn already spent) for TARP, which goes to Citigroup, BoA, AIG. Bad enough. But Congress has committed $1500 bn for Fannie, Freddie and Ginnie -- and already spent $641 bn.

I do not expect the government to solve recessions. But why did they cause one?

Really, this blog is quite biased.