Sunday, August 2, 2009

Problems of Economic Downturn

Readers Question: Have we addressed the core reasons for this economic downturn?

The core reasons for this economic downturn:
  • Credit Crunch - bank losses and consequent decline in bank lending
  • Falling House prices
  • Falling consumer spending due to confidence and declining asset values
Credit Crunch. The main reason for the severity of this current economic downturn was the funds lost by banks in various subprime lending schemes. The huge losses by major banks led to a restriction of credit harming ordinary economic activity.

To some extent this has been addressed through painful and expensive government bailouts. For example, in the UK, the government have increased public sector debt by £141bn due to financial sector bailouts.

These bailouts helped to calm the panic that was threatening the markets. But, normal lending conditions have still not returned. There is also concern that banks may have more losses to write off - especially as house prices continue to fall and the recession leads to an increasing number of bankruptcies.

2. Falling House Prices. The turnaround in house prices has been dramatic. After rising at above inflationary trends, house prices have been falling in US since 2006 and in the UK since mid 2007. This fall in house prices caused a decline in consumer wealth and consumer spending.

There are signs that the fall in house prices has moderated. The UK has seen some positive monthly house price rises. But, these price rises are on thin trading volumes; it hardly reflects a return to the pre- 2007 levels. Also, in other European countries such as Spain and Ireland, house prices could have much further to fall. In overvalued housing markets, we saw how US house prices were far from being the most overvalued. If European house prices continue to fall, it could cause a rise in bank losses, which will cause further problems

3. Fall in Demand. The combination of a fall in house prices, decline in confidence and collapse in bank lending has led to a fall in aggregate demand in the economy. This has been maintained by low interest rates and large scale government budget deficits. However, we can't keep relying on ever increasing budget deficits to boost the economy. By addressing the core problems we have created another problem - very large levels of government borrowing.

See also:

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