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DR.

RAM MANOHAR LOHIYA NATIONAL LAW


UNIVERSITY, LUCKNOW

FINAL DRAFT

ECONOMICS

TOPIC-: Recession in 2007-09 and related government policies

SUBMITTED TO: SUBMITTED BY:

Prof. (Dr.) MadhuriSrivastava Vikramarth Sheo Chand

Dr. RMLNLU, Lucknow. Semester II

ROLL NO-150
ACKNOWLEDGEMENT

I would like to extend my sincere thanks to my teacher and mentor Mrs.


Madhuri Shrivastava for her able guidance and advice, my seniors for
sharing theirs valuable experience and tips and my classmates for their
constant support.
TABLE OF CONTENTS

 Introduction
 Recession : Introduction
 Causes of 2007- 2009 recession
 The 2007-2009 Recession: Similarities to and Differences from the
Past
 Effect on economy during recession : India
 Government policies
 Conclusion
 Bibliography
INTRODUCTION

The late-2000s recession, sometimes referred to as the Great Recession, the Lesser
Depression, or the Long Recession, was a severe global economic problem that began in
December 2007 and took a particularly sharp downward turn in September 2008. The Great
Recession has affected the entire world economy, with higher detriment in some countries than
others. It is a major global recession characterized by various systemic imbalances and was
sparked by the outbreak of the late-2000s financial crisis.

There are two senses of the word "recession": a less precise sense, referring broadly to "a period
of reduced economic activity", and the academic sense used most often in economics, which
is defined operationally, referring specifically to the contraction phase of a business cycle, with
two or more consecutive quarters of negative GDP growth. By the economics-academic
definition of the word "recession", the Great Recession ended in the U.S. in June or July
2009. However, in the broader, layperson sense of the word, many people use the term to refer to
the ongoing hardship (in the same way that the term "Great Depression" is also popularly
used). In the U.S., for example, persistent high unemployment remains, along with low consumer
confidence, the continuing decline in home values and increase in foreclosures and personal
bankruptcies, an escalating federal debt crisis, inflation, and rising gas and food prices. In fact, a
2011 poll found that more than half of all Americans think the U.S. is still in recession or
even depression, despite official data that shows a historically modest recovery.
RECESSION : INTRODUCTION

A significant decline in activity across the economy, lasting longer than a few months. It is
visible in industrial production, employment, real income and wholesale-retail trade. The
technical indicator of a recession is two consecutive quarters of negative economic growth as
measured by a country's gross domestic product (GDP); although the National Bureau of
Economic Research (NBER) does not necessarily need to see this occur to call a recession.
Recession is a normal (albeit unpleasant) part of the business cycle; however, one-time crisis
events can often trigger the onset of a recession. The global recession of 2008-2009 brought a
great amount of attention to the risky investment strategies used by many large financial
institutions, along with the truly global nature of the financial system. As a result of such a wide-
spread global recession, the economies of virtually all the world's developed and developing
nations suffered extreme set-backs and numerous government policies were implemented to help
prevent a similar future financial crisis.
A recession generally lasts from six to 18 months, and interest rates usually fall in during these
months to stimulate the economy by offering cheap rates at which to borrow money.
In simpler words, a period of general economic decline, typically defined as a decline in GDP for
two or more consecutive quarters. A recession is typically accompanied by a drop in the stock
market, an increase in unemployment, and a decline in the housing market. A recession is
generally considered less severe than a depression, and if a recession continues long enough it is
often then classified as a depression. There is no one obvious cause of a recession,
although overall blame generally falls on the federal leadership, often either
the President himself, the head of the Federal Reserve, or the entire administration.
CAUSES OF 2007 – 2009 RECESSION.
The immediate cause or trigger of the crisis was the bursting of the United States housing
bubble which peaked in approximately 2005–2006. Already-rising default rates on "subprime"
and adjustable rate mortgages (ARM) began to increase quickly thereafter. As banks began to
give out more loans to potential home owners, housing prices began to rise.
In the optimistic terms, banks would encourage home owners to take on considerably high loans
in the belief they would be able to pay them back more quickly, overlooking the interest rates.
Once the interest rates began to rise in mid 2007, housing prices dropped significantly. In many
states like California, refinancing became increasingly difficult. As a result, the number of
foreclosed homes also began to rise.

Share in GDP of U.S. financial sector since 1860

Steadily decreasing interest rates backed by the U.S Federal Reserve from 1982 onward and
large inflows of foreign funds created easy credit conditions for a number of years prior to the
crisis, fueling a housing construction boom and encouraging debt-financed consumption. The
combination of easy credit and money inflow contributed to the United States housing bubble.
Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers
assumed an unprecedented debt load.
As part of the housing and credit booms, the number of financial agreements called mortgage-
backed securities (MBS) and collateralized debt obligations (CDO), which derived their value
from mortgage payments and housing prices, greatly increased. Such financial
innovation enabled institutions and investors around the world to invest in the U.S. housing
market. As housing prices declined, major global financial institutions that had borrowed and
invested heavily in subprime MBS reported significant losses.
Falling prices also resulted in homes worth less than the mortgage loan, providing a financial
incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the
U.S. continues to drain wealth from consumers and erodes the financial strength of banking
institutions. Defaults and losses on other loan types also increased significantly as the crisis
expanded from the housing market to other parts of the economy. Total losses are estimated in
the trillions of U.S. dollars globally.
While the housing and credit bubbles were building, a series of factors caused the financial
system to both expand and become increasingly fragile, a process called financialization. U.S.
Government policy from the 1970s onward has emphasized deregulation to encourage business,
which resulted in less oversight of activities and less disclosure of information about new
activities undertaken by banks and other evolving financial institutions. Thus, policymakers did
not immediately recognize the increasingly important role played by financial institutions such
as investment banks and hedge funds, also known as the shadow banking system. Some experts
believe these institutions had become as important as commercial (depository) banks in
providing credit to the U.S. economy, but they were not subject to the same regulations.
These institutions, as well as certain regulated banks, had also assumed significant debt burdens
while providing the loans described above and did not have a financial cushion sufficient to
absorb large loan defaults or MBS losses. These losses impacted the ability of financial
institutions to lend, slowing economic activity. Concerns regarding the stability of key financial
institutions drove central banks to provide funds to encourage lending and restore faith in
the commercial paper markets, which are integral to funding business operations. Governments
also bailed out key financial institutions and implemented economic stimulus programs,
assuming significant additional financial commitments.
The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It
concluded that "the crisis was avoidable and was caused by: Widespread failures in financial
regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic
breakdowns in corporate governance including too many financial firms acting recklessly and
taking on too much risk; An explosive mix of excessive borrowing and risk by households and
Wall Street that put the financial system on a collision course with crisis; Key policy makers ill
prepared for the crisis, lacking a full understanding of the financial system they oversaw; and
systemic breaches in accountability and ethics at all levels."
THE 2007 – 2009 RECESSION: SIMILARITIES AND
DIFFERENCES FROM THE PAST.
According to the National Bureau of Economic Research (NBER), the U.S. economy was in a
recession for 18 months from December 2007 to June 2009. It was the longest and deepest
recession of the post-World War II era. The recession can be separated into two distinct phases.
During the first phase, which lasted for the first half of 2008, the recession was not deep as
measured by the decline in gross domestic product (GDP) or the rise in unemployment. It then
deepened from the third quarter of 2008 to the first quarter of 2009. The economy continued to
contract slightly in the second quarter of 2009, before returning to expansion in the third quarter.
The recent recession features the largest decline in output, consumption, and investment, and the
largest increase in unemployment, of any post-war recession.

Previously, the longest and deepest of the post-war recessions were those beginning in 1973 and
1981. Both of those recessions took place in a context of high inflation that made the Federal
Reserve (Fed) hesitant to aggressively reduce interest rates to stimulate economic activity. The
Fed has not shown a similar reluctance in the recent recession, bringing short-term rates down to
almost zero. Although inflation exceeded the Fed’s “comfort zone” in 2007 and 2008, it was not
nearly as high as it was in the 1970s or 1980s recessions. The economy briefly experienced
deflation (falling prices) at the end of 2008, and inflation has generally remained very low since.
Deflation may be a bigger threat to the economy in the near term, although some economists are
fearful that the Fed’s actions will cause inflationary problems once the economy returns to full
employment.

Both the 1973 and 1981 recessions also featured large spikes in oil prices near the beginning of
the recession—as did the recent one. Disruptions to oil markets and recessions have gone hand in
hand throughout the post-war period.

The previous two recessions (beginning in 1991 and 2001) were unusually mild and brief, but
subsequently featured long “jobless recoveries” where growth was sluggish and unemployment
continued to rise. The recent recession did not feature a jobless recovery longer than the norm,
but employment growth has been weak in 2010.

A decline in residential investment (house building) during a recession is not unusual, and it is
not uncommon for residential investment to decline more sharply than business investment and
to begin declining before the recession. The recent contraction in residential investment was
unusually severe, however, as indicated by the atypical decline in national house prices. One
unique characteristic of the recent recession was the severe disruption to financial markets.
Financial conditions began to deteriorate in August 2007, but became more severe in September
2008. While financial downturns commonly accompany economic downturns, financial markets
have continued to function smoothly in previous recessions. This difference has led some
commentators to instead compare the recent recession to the Great Depression. While the onsets
of both crises bear some similarities, the effects on the broader economy have little in common.
In the first contraction of the Great Depression, lasting from 1929 to 1933, GDP fell by almost
27%, prices fell by more than 25%, and unemployment rose from 3.2% to 25.2%. The changes in
GDP, prices, and unemployment in the recent recession were much closer to those experienced
in other post-war recessions than the Great Depression. Most economists blame the severity of
the Great

Depression on policy errors—notably, the decision to allow the money supply to contract and
Congressional Research Service thousands of banks to fail. By contrast, in the recent recession
policymakers have aggressively intervened to stimulate the economy and provide direct
assistance to the financial sector.
EFFECT ON ECONOMY DURING RECESSION: INDIA.
In the age of globalization, no country can remains isolated from the fluctuations of world
economy. Heavy losses suffered by major International Banks is going to affect all countries of
the world as these financial institutes have their investment interest in almost all countries.

As of now India is facing heat on three grounds:

 Our Share Markets are falling everyday


 Rupee is weakening against dollars
 Our banks are facing severe crash crunch resulting in shortage of liquidity in the market.

Actually all the above three problems are interconnected and have their roots in the above-
mentioned global crisis.

For the last two years, our stock market was touching new heights thanks to heavy investments
by Foreign Institutional Investors (FIIs). However, when the parent companies of these investors
(based mainly in US and Europe) found themselves in a severe credit crunch as a result of sub-
prime mess, the only option left with these investors was to withdraw their money from Indian
Stock Markets to meet liabilities at home. FIIs were the main buyers of Indian Stocks and their
exit from the market is certain to wreak havoc in the market. FIIs who were on a buying spree
last year, are now in the mood of selling their stocks in India. As a result our Share Markets are
touching new lows everyday.

Since, the money, which FIIs get after selling their stocks, needs to be converted into dollars
before they can sent it home, the demands for dollars has suddenly increased. As more and more
FIIs are buying dollars, the rupee is loosing its strength against dollar. As long as demands for
dollars remain high, the rupee will keep loosing its strength against dollar.

The current financial crisis has also started directly affecting Indian Industries. For the past few
years, the two most preferred method of raising money by the companies were Stock Markets
and external borrowings on low interest rates. Stock Markets are bleeding everyday and it is not
possible to raise money there. Regarding external borrowing from world markets, this option has
also become difficult.

In the last fiscal year alone, India borrowed $29 billion from foreign lenders and got $34 billion
of foreign direct investment. A global recession has hurt external demand. International lenders
who have become extremely risk aversive can limit access to international capital. If that
happens, both India’s financial markets and the real economy will be hurt in the process.
Suddenly, the 9% growth target does not seem that ‘doable’ any more; we should be happy to
clock 7% this fiscal year and the next.

However, one positive point in favor of India is the fact that Indian Banks are more or less
secured from the ill-effects of sub-prime mess. A glance at Indian banks’ balance sheets would
show that their exposure to complex instruments like CDOs is almost nil. In India, still the major
banking operations are in the hands of Public Sector Banks who exercise extreme cautions in
disbursing loans to needy people/companies. As a result, we are not likely to see a repeat of sub-
prime crisis in India. Though there have been a presence of big US/European Banks in India and
even some Indian banks (like ICICI) have some foreign subsidiary with stake in the sub-prime
losses, there presence is miniscule as compare to the overall size of Indian banking industry. So
at least on this major front we need not worry much.

However, a global depression is likely to result in a fall in demand of all types of consumer
goods. In 2007-08, India sold 13.5% of its goods to foreign buyers. A fall in demand is likely to
affect the growth rate this year. Our export may get affected badly.

A negative atmosphere, shortage of cash, fall in demands, reducing growth rate and uncertainties
in the market are some of the most visible aspects of an economic depression. What started as a
small matter of sub-prime loan defaulters has now become a subject of global discussion and has
engulfed the global economy scenario.
CONCLUSION.
Whether researchers lean toward the financial explanation, the policy explanation or another
hypothesis altogether, it is clear that deeper exploration of labor markets is essential for
understanding the Great Recession. The large labor distortion that occurred during the U.S.
recession remains unexplained. Why similar distortions didn’t occur during previous postwar
U.S. recessions, nor in high-income countries in 2007-09, is not understood.
Other questions are also unresolved. Factors behind large productivity deviations during the
recession in other high-income countries must be explored. The relationship between distress in
financial markets and the “real” economy—why the recession continued long after financial
crisis abated—is unclear.
Fortunately, much promising research is under way:
 examinations of labor market distortions in earlier economic crises
 efforts to connect hypothetical financial events to labor deviations
 research linking use of corporate debt and labor markets
 analysis of how implicit labor income taxes can suppress employment levels
 study of productivity fluctuation due to resource misallocation from financial imperfections.
Clearly, much work remains to be done. Furthering this research will be essential not only to
economists, but also to policymakers and other decision makers who will, inevitably, again
confront the challenge of macroeconomic crisis.
If you think about this with a cool mind, you will find that the underlying cause of this
depression is the greed of those who failed to anticipate the consequence of their actions. On a
more ideological front, it is high time to have a rethink on the very idea of free markets and
capitalism. I think the time has come to evolve a capitalism where everything works under a
broad regulatory framework and we do not see a repeat of this condition where greed of some
people can affect the lives of billions.

So here concludes my attempt to explain the current economic crisis which has started to affect
the lives of all of us. The above explanation is very simple and by no means it presents an
accurate picture (i.e the one that includes all the micro/macro factors) of the crisis. However, I
hope that it must have given you a broad idea of the reasons behind current economic depression.
Feel free to post your comments on this issue.
BIBLIOGRAPHY.
 www.investopedia.com
 www.money.cnn.com
 www.pewsocialtrends.org
 A People's History Of The Great Recession : Arthur Delaney