Topic: The Great Recession.
The great recession in the U.S began at the last quarter of the year 2007 and went on to around mid-2009. It went on to become the worst recession since 1930, leading to enormous wealth loss and later major cutbacks in consumer spending. This lack of spending from the consumers meant less revenue for businesses thus massive loss of jobs to reduce the loss to the business. This loss of jobs further meant that the percentage of poverty rose across the country. The recession spread across the world even leading to financial ruins in some countries. The recession meant that the average GDP dropped significantly. Major mortgage providers declared bankruptcy and banks started to close down. But what led to this?
The unethical decisions made by most banks greatly impacted and fuelled the great recession. Although these decisions made were not illegal, they caused a lot of damages to those who did not know what they had gotten into. Negative spending rate meant that instead of saving money every year, Americans went deeper into debt. This meant they had to keep borrowing and would finally run out of that capability to borrow and the ability to pay back borrowed loans. This would mean that banks had to take away part of their wealth to compensate for the debts. Banks offered mortgages to borrowers who could not afford them. Then they would include terms that would increase the interest rate for the borrowers after they failed to meet the stipulated time of payment. These were known as subprime mortgages. The accumulation of these subprime mortgages and loans from creditors and banks posed a major threat known by those offering them. Insurance companies knew that they could not offer what they had stipulated to give in case of any occurrence since they could not honor their commitment in the event of a collapse in the market for the Collateralized Dept Obligations. The role of CDO was to determine how each mortgage could be separated from the other and evaluated the risks they had and the amount of interest they would accumulate. But these unethical decisions could be avoided by sticking to the bank’s corporate culture, of not allowing their employee get involved in activities that put their clients interests at compromising situations.
Inflation is the general increase in prices for goods and services and fall in purchasing power of money. Government debt is when the government has more borrowing than spending. The government may opt to increase the number of bills or order the minting of more money within the country to increase the amount of spending by the citizens to improve money circulation. This, however, increases the money in the market with fewer goods to buy, thus increasing the prices of goods and services to insignificant levels. Due to poor money circulation, inflation can also be caused by too much importation and little exportation, inhibiting the exchange of currency in the international market. Inflation leads to overpricing of goods and services, making currency irrelevant and also the loss of market for goods that do not match up their current prices. To overcome inflation, the government needs to regulate the money hoarding and amplify the circulation. It also needs to lower exportation rates to attract more local exporters and create more exportation markets.
Banker’s pay is viewed as one of the causes of the Great Recession. The taking of excessive risks by the banks’ executives gave them higher benefits, thus getting higher bonuses and salaries. The pay, however, should not be regulated, but certain rules have to be set up. Banks that have requested for government bailouts should, first of all, pay all the debts they owe before rewarding those executives and employees huge bonuses. The banks also focused mostly on the short-term pay, which led to much risking by the banks. But consequently, by creating rules that restrict financial institutions, the government would lose a lot of revenues that comes from the high risks taken by the institutions.
The capital requirement is the amount of capital a bank, or a financial institution should hold as per the financial regulator. This is to avoid insolvent from institutions that take too much leverage. The requirements are to ensure that banks are properly managed to ensure the security and safety of the banks’ finances. These requirements monitor and dictate the ratio of equity and debt, and ensure that the bank records of assets and liability are well balanced. The roles of these requirements include:
Risk management. The regulators weigh the benefits and the problems of the asset. And by the use of leverage ratio, which is not risk based, the ratios are seen as a pillar against risk-weighted results. Banks and financial institutions having leverage encourages them to take risks they know they can handle.
By having resolutions. This is to avoid the failing of institutions termed as ‘too big to fail.’ and cater for the financial crisis. Increasing the level of capital helps in making it less of a necessity to take big risks and creates ample time for regulators whenever there is a crisis. The potential requirements for the biggest and riskiest financial firms to hold long-term unsecured debts that can be changed to capital in case the firm failed, easing up the work of the regulators.
Making firms are less likely to fail. This is by making sure banks have enough capital to cater for a risk without borrowing or being liquidated. This will limit the rate at which banks offer loans because there is a limit to the amount of money they should have in their reservoirs. It also encourages the banks to increase their investments to be able to offer more capital for borrowing. It also prevents the unethical behavior of offering excessive loans to those who cannot pay them back.
Manage the credit cycle that is known to be lower when the economy is rising and high whenever the economy is declining. This is not how the market is supposed to work, and this leads to poor income generation whenever the market is on the low. By creating regulations that avoid such situations, the cycle can be reversed to the right direction.
Liquidity crisis. Liquidation is when a financial institution is disbanded, and all its assets and property redistributed. An institution can be liquidated voluntarily, or when it fails to pay up and has not contingency plan that can come up with the amount required to clear its debts. The Liquidation Coverage Ratio is made to ensure that banks have enough assets that can be converted to cash if the need arises. This also encourages financial firms to aim for a long-term survivability by use of funds that is less likely to disappear in case of an unexpected occurrence.
The size of firms and institution should have the same ratio as their ability to handle risks. Big firms should have ample equity. The larger the firm, the more attention it draws. This affects the level of management because they need to prove that there is no special treatment from the government. The consideration of the size will help reduce the number of firms that fake their records and attain the status of firms ‘too big to fall’ to receive funding from the government.
The government should also avoid interfering with the market directly, and let the market find a way to suppress its problems. Most of the motives of the government whenever it is involved in the market are always political. The only thing it should do is to create an ideal environment for the entrepreneurs and businesses to operate in. Its involvement creates an imbalance in the market, leading to losing of certain commodities in the market due to poor returns for the producers and entrepreneurs. The small markets play a very great role in the growth of an economy, and by taking them out, you create a void that the remaining businesses cannot fill, thus contributing to a market decline and decline of economic growth. The involvement of the government in the market was one of the major causes of the great recession and not the faults in the free market.
The protection of banks, financial institutions, and certain firms by the government led to the making of unethical decisions due to the protection from possible losses caused by the recession. They made those risky loans, driving small players out of the market because they could not keep up with them. This protection gave them an upper hand and consequently destroyed the free market balance. The direct involvement of the government and banks should be cut out, and make these commercial banks independent institutions. This is to offer privately owned banks a chance to offer fair competition in the financial market. The unnecessary credit expansion by the central banks would be stopped. Government bailout for these banks would also be stopped. It would also make it hard for the government to go into excessive debts because there would be no central bank to use in the borrowing. These central bank privileges had also played a role in the recession.
With this requirement, a crisis like the great recession will be easy to manage and overcome, without having to affect those being credited by these financial firms too much. It will also open up the market for small players who are overshadowed by these big firms, creating competition and thus helping in reducing rates of borrowing and mortgages. The government then will be mandated in ensuring healthy competition in the financial market is maintained, and set rules and regulations are followed by all those in the market. Safety of the citizens’ and shareholders’ wealth should be the main goal for these institutions and should be overlooked by the government. Ensuring no future crisis is experienced again because it drags the world economy too whenever it affects the U.S.
Bebchuk, Lucian A., and Spamann, Holger, “Regulating Bankers’ Pay” (2009). Harvard Law School John M. Olin Center for Law, Economics and Business Discussion Paper Series. Paper 634.
Hall R. E: Introduction to “Inflation: Causes and Effects” University of Chicago Press 1982.
“Liquidation”. Australian Securities & Investments Commission. Retrieved 30 July 2014.
“The Economics and Law of Sovereign Dept and Default.” Journal of Economic Literature.2009. Retrieved 2014-06-18.