Financial Crisis in USA: Economic Environment of Business Assessment Answer

Financial Crisis (2007-2009)

The financial crisis of 2007-2009 is now also known as the Global Financial Crisis (GFC) with many considering it as one of the worst financial crisis ranking just after the Great Depression, that is till COVID-19 struck a global pandemic worse than GFC.

This happened because the banks had been lending aggressively due to low interest rate environment, huge liquidity in the economy and high demand for loans. The banks lent loans even to subprime borrowers where probability of default was high and hence, the bank’s credit risk increased multiple times (Singh, 2019).

The 2007 financial crisis began in the United States when values of houses started declining, and specifically hit the subprime mortgage industry that faced high rate of foreclosures as the borrowers defaulted on their loan payments due to increasing interest rates and reduced house values. This further led to a domino effect as even the prestigious banks, such as, Lehman Brothers, Merrill Lynch, collapsed leading to a huge shock to the US banking system and its credibility. Soon, US had to announce a huge economic stimulus package of more than USD150 billion so as to support the collapsing economy (CNN, 2008).

The collapse of multiple international banks sent shockwaves through not only US economy but also had a huge global impact that particularly affected the Asian markets, including China, Hong Kong, India, Japan etc. Even European markets got impacted adversely, specifically United Kingdom. Majority of economies, including Australia announced stimulus packages so as to save the economy from going into recession (Investopedia, 2019). 

2. Effect on GDP in long run

The above graphs depict GDP and GDP growth rate for United States from 2008 till date (2020 are forecasted numbers). It can be seen that GDP reached rock bottom in 2009 and the growth rate was negative as it hit the trough (Trading Economics, 2020). 

Then, GDP started increasing 2010 onwards and has increased consistently in terms of absolute numbers. In terms of growth rate, the GDP growth rate has indicated fluctuations with rate peaking in 2011 and 2015 (Trading Economics, 2020).

The decline in 2009 was the impact of the financial crisis of 2007-2008 when the economy was very badly hot with multiple banks collapsing and lot of foreclosures. The government had to provide economic stimulus package that would lead to increase in fiscal deficit. The economy went into recession as indicated by the 2009 GDP growth rate. The GDP declined in absolute terms due to the impact of the financial crisis. It led to decline in employment, decline in income and decline in investment. According to Irons (2009), post the financial crisis of 2007-2008, United States faced loss of around 3.5 million jobs, 20% decline in private investment levels (excluding residential investment), thousands of businesses filing for bankruptcy and the financial stock markets facing minimal number of issues and decline of tremendous magnitude.

3. Effect on Inflation in Long run

The Bureau of Labour Statistics calculates a parameter called Consumer Price Index or CPI on a monthly basis which is a good measure of inflation in an economy. The above graphs depicts inflation rate for United States from 2008 till date (2020 are forecasted numbers). It can be seen that inflation was negative and at the lowest level in ten years in 2009 due to the impact of the financial crisis (Trading Economics, 2020). 

The inflation is targeted by Fed to regulate it to remain in a particular range. Fed’s target for inflation has been around 2% and since the recession, it has been struggling to regulate it at this target level. The central bank of a country determines the target inflation which is best for the economy such that the employment flourishes and also stable prices of essential commodities (Shelvingrock, 2018).

After peak high rates of inflation in 2008 as indicated in graph above, the economy went into deflation in 2009 with negative inflation rates. 

4. Effect on Labour Market in Long run

The above graphs depicts employment rate in the United States from 2008 till date (2020 are forecasted numbers). It can be seen that the rate deep dived from 2008 till 2010 mainly because of impacts of the financial crisis in 2008 which led to large unemployment. The employment levels remained range bound and below the trend line till 2015 and then started coming above the trend line. In 2020, it again has hit an all-time low due to COVID-19 pandemic (Trading Economics, 2020). 

According to some estimates, post the financial crisis of 2007-2008, United States faced loss of around 3.5 million jobs and thousands of businesses filed for bankruptcy (Economic Policy Institute, 2009).

As the above graph indicates, the cost of labour also declined post the crisis period because due to high rate of unemployment, the supply of labour was in excess of the demand for labour, leading to decline in the cost. However, it has recovered post the period to reach high levels in later years as the economy stabilized and demand for labour increased.

5. Effect on levels of Consumption in Long run

The above graph depicts consumer spending (or consumption) in the United States from 2008 till date (2020 are forecasted numbers). It can be seen that the rate declined in 2009 mainly because of impacts of the financial crisis in 2008 which led to large decline in income and hence, spending or consumption. The consumer spending has again picked up 2010 onwards to reach much higher levels (Trading Economics, 2020). 

This is intuitive because as the economy went into recession post the financial crisis of 2007-2008, there were shockwaves in the entire economy, particularly banking and financial sectors. As even the ‘too large to collapse’ banks also collapsed, there was widespread unemployment in the economy due to which income and purchasing power of the people got limited. A large majority of people were defaulting on their loan instalment payments. In such an environment where economy is contracting and facing economic shocks, the consumption is bound to go down as people become conscious about spending money due to negative outlook and they also have limited purchasing power (NBER, 2020).

6. Effect on levels of USA’s Investment in Long run

The above graph depicts business confidence in the United States from 2008 till date (2020 are forecasted numbers). It can be seen that the rate deep dived in 2009 mainly because of impacts of the financial crisis in 2008 which led to shockwaves through the economy. After the government announced the stimulus package for the economy, the business confidence gradually returned in the economy. It can be seen that the confidence has remained stable post 2010 with slight fluctuations as is expected in an economy as large as United States (Trading Economics, 2020). 

As the economic growth declined and economy went into contraction, employment, income and purchasing power declined leading to decline in consumption. Additionally, the business and investor confidence in the economy also nosedived leading to decline in investments. In such an environment, consumers are unable to spend much leading to decline in demand and businesses are unwilling to do much investment and focus on their core products and services only. According to some estimates, in 2009, the non-residential private investment reduced by as much as 20% as an aftereffect of the financial crisis of 2007-2008 as reflected in below figure that depicts the change in share of private investment through the period (Economic Policy Institute, 2009):

7. Effect on levels of USA government’s budget in Long run

A budget is nothing but a statement of government’s anticipated revenue and expenditure. A government earns major portion of money or revenue through the taxes collected from various people that may be individuals, corporations, etc. Apart from this, government earns interest income and dividend income on investments such as bonds and securities. Hence, if an economy is in recession where people are losing their jobs and have very less income, the government will face a steep decline in its revenue as lesser people and corporations will be paying taxes (Britannica, 2020). 

The above graph depicts federal government budget for the United States from 2008 till date (2020 are forecasted numbers). It can be seen that the numbers are in negative indicating presence of budget deficit, a situation where government expenditure exceeds the government revenue. It can be seen that 2009 had the largest budget deficit of 9.8% of the GDP, mainly because of impacts of the financial crisis in 2008 which led the government to announce huge stimulus packages. The budget deficit reduced 2010 onwards to reach the lowest level in 2015 equivalent to deficit of 2.4% of GDP but the deficit again started to increase afterwards (Trading Economics, 2020). 

8. Recovery from Crisis by Changing Macroeconomic Variables

From the above discussion, it can be seen that the financial crisis of 2007-2008 sent shockwaves through the US economy such that economy went into recession. The signs were already there with high level of liquidity and very low interest rates making availability of credit very easy. The heated housing market where even subprime borrowers could get loans at attractive rates led to the beginning of the crisis that was waiting to happen. Once the recession set in, the employment was at an all-time low with income levels declining. The inflation was at low levels and confidence in the economy was shaken such that the financial markets nose-dived. The consumption and investment expenditure reduced considerably. All of this indicated clearly that the economic growth had declined to negative with reduction in absolute GDP numbers.

The first and foremost step to let the economy recover is to ensure that the confidence and trust in the economy returns. For this, the government would have to save the major institutions to let the economy revive and this can be done through providing required economic stimulus packages to impacted industry. In this case, the banking industry will be at the centre as they faced liquidity crunch due to foreclosures and forced to go bankrupt.

A combination of expansionary monetary policy and expansionary fiscal policy can be used to let the economy grow. While expansionary fiscal policy will involve increasing government expenditure and reducing taxes by introducing tax rate cuts. An expansionary monetary policy will involve increasing the money supply and lowered interest rates that encourage consumption and investment. 

By providing stimulus package, the first problem was tackled whereby the trust and confidence in the USA economy was shaken was restored to some extent. People who had started distrusting the system felt that government is there to rescue them. Not only this, it lent stability to stock markets all around the globe that were in a tizzy to see international banks collapse one after the other. 

The fiscal policy further introduced tax rate cuts and increased government expenditure in form of stimulus package which was spent in multiple areas such as compensation jobless workers, pension receivers, transportation, energy, education etc. This encouraged the production and consumption in the economy.

The expansionary monetary policy ensured that the low interest rates and increased money supply helps and encourages investment from various businesses etc. This was done by government by purchasing government securities and other financial assets such that liquidity in the economy could be increased (Liborio, 2011).

Apart from these measures, the government must also look into the cause where the entire banking system failed to notice the high credit risk. More stringent regulations must be introduced so that the banks are not able to lend incessantly and increase the default risk. Further, the regulatory framework must be stronger so as to catch such activities at an early stage rather than later.

9. Recovery in Output Gap in case of Expansionary Gap

Expansionary gap occurs when the economy is temporarily operating at a level where actual or real GDP is higher than the economy’s potential GDP. Hence, actual output is greater than the potential output. This is also known as inflationary gap. The economy does not have resources as economy is operating at a level higher than its potential output. Hence, the businesses try to attract resources and labour by giving higher prices, and all of this leads to higher inflation (Business Dictionary, 2020). 

It can be seen from graphs in above discussion that the inflation as very high in 2007-2008. There were low interest rates and high flow of funds in the economy. The market, including housing market, was very heated with high demand, due to extreme flow of liquidity at cheap rates.

This should have been tackled by introducing contractionary policy. The contractionary fiscal policy would include increasing tax rates, reducing discounts and reducing government spending. The contractionary monetary policy will include increasing interest rates which will make loans dearer for the borrower. All of this will give the economy time to cool down and bring the actual output level below or at potential level and also control inflation (Investopedia, 2019).

10. Recovery in Output Gap in case of Contractionary Gap

Contractionary gap occurs when the economy is temporarily operating at a level where actual or real GDP is lower than the economy’s potential GDP. Hence, actual output is lower than the potential output. This is also known as recessionary gap. The economy faces high unemployment and downward pressure on prices such that economy operates at a level lower than its potential output. The consumption and investment decline, as the purchasing power (income) of consumer declines (Business Dictionary, 2020). 

It can be seen from graphs in above discussion that the inflation bottomed out in 2009 just after the crisis. There were low income and low spending and investment environment. This was because many people lost their jobs leading to high unemployment and much lower purchasing power.

This should have been tackled by introducing expansionary policy. The expansionary fiscal policy would include decreasing tax rates, increasing discounts and increasing government spending. The expansionary monetary policy will include decreasing interest rates which will make loans cheaper for the borrower. All of this will give the economy time to increase investment and consumption activities so as to bring the actual output nearer to the potential level of output (Investopedia, 2020).