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Fiscal and Monetary Policies in Response to 2008/2009

No one can deny that the world economy is on a constant change, which compels us to look at economic cycles from a more serious perspective than ever. Today, we are existing in a time of economic reforms that pivot the need for further studies in the impact of economic policy on society. Since the economy greatly affects the forward propulsion of society, every nation must have its own way of dealing with factors that affect economic growth and development. In other words, we cannot avoid dealing with these issues in the contemporary world, majorly because the parameters that affect economic growth are not constant.

For this reason, the role of economic policy, both in economy and economics, has been one of a major debate. Various players have tried to share knowledge on how the world can organize economic knowledge to respond to guiding and regulating economic systems. This is a traditional approach that has continuously been improved upon to offer a wider perspective of the underlying issues. For instance, Eggertsson (1997) (2) includes the presence of knowledge, endogenous politics, and institutional change in his thought on economic policy. At large, the theory of economic policy has received much more contribution, dating many decades before. In any of them, the main focus is certainly on the effects of economic interventions in the markets’ economies. This simply shows that government policies have always been a significant intervention in market economies.

Another great contributor to this issue is John Maynard Keynes. He, in his publication of the General Theory of Employment, Interest, and Money (1963), initiated a very critical step in the argument for active fiscal policy in economics. Friedman, 1959, on the other hand, came up with a different proposal based on a ‘monetization’ as an alternatives macroeconomic policy. He quotes the tradition.

These arguments all point to the 2007-2008 Great Financial Recession, whose consequences, and the financial crisis the came sooner after, we are still feeling until today. This is true, especially when referring to the more advanced nation. The rates of unemployment are still high, where are economic growth rates have greatly depreciated, whereas, on the same line, some nations still feel high rates of fiscal imbalance. Although the consequences may not be as high as the years that came immediately after, as seen from the latest data on Eurostat and IMF, it is still notable that they take us back to the ages. And the reports also indicate that shares of public debts in GDPs continue to surge. It is not only in specific countries where these consequences are eminent; the whole world feels the impact when it comes – the shares reached a historical record in 2014. When such happens, it only attracts debates from various economic experts and policymakers. They will want to look at specific policies that a chosen nation’s government should be promoting, at the current state, and for the years that follow. Often, these economic debates and differences in views refer to what happened in the 1930s (as recorded in Wapshott, 2011).

The USA and European Union

Paul Krugman (2013), in one of his blogs, appreciated how wide the differences are. He may have confirmed views of Larry Summers is a research seminar at the IMF a few months prior to his posting. He stated that the world was then riding a ‘liquidity trap’ where the ‘natural interest rate, which he was concerned would be the same as saving and investment, especially in the case of the USA, was negative. According to his argument, the ‘normal rules’ of economic policy were no longer applicable because then, there was still a great depression on the economy. And because of this state, he emphasized on more spending, productive or unproductive, to boost the state of things. He further continued to state that public debts are normal, and any panic over it would be fooling as there was no impact from service debts on a nation like the USA. And this meant governments should keeping spend as much as possible to bring about balance in their economies.

These arguments can be greatly related to the fiscal situation in the US and many other nations. The most current data for the general government is of 2013, where the fiscal deficit was 5.8% GDP, whereas the gross debt has gone to 104.2% (from 64% back in 2007). It was compared to the European Monetary Union of 95.2% GDP. In 2007, the public share debt was at 35%, but it rose to 74% in 2014. The same reports indicate the levels of fiscal deficit has been reducing from 2009, which, by default, was partly linked to the Bush tax cuts and the other part to the sequestration of some public expenses in 2013. These figures would be sustained in the political realm, as even recovery was already underway. But things changed a bit in 2014 when the public debt continued on an upward trend, whereas fiscal deficit was expected to shift closer to 6% of the GDP.

Fiscal policies are always in part and in whole, a critical issue in the recovery and sustainability of an economy. However, the US economy has always been a significant determinant for many other nations, which is the reason their policymakers and fiscal experts are always worried and concerned about the USA economy, and as well as that of European countries. They also have to worry and take concern about the medium and long-run consequences of economies in the existing fiscal and monetary laws. For these reasons, asking which policies selected countries would follow seems very much important, since these are the same laws that will take them in the short and medium run until they are the crisis. It is never easy, if not possible, for a nation to sail in the same laws as before when a crisis. If they do, and even intensify the policies, which, at large, still hold large fiscal deficits, surging public debts and the lowest interest rates, as some economist seems to suggest, is a question of minding what would happen next. It can be related to whether the USA and other European nations should refer back to the traditional and more orthodox laws.

Features of the crisis

And in order to establish how fiscal and monetary policies work together in the effect of the crisis, it would be prudent to feature the crisis. Certain things came up, and which, if not handled as they should, could cause an even bigger problem for the parties concerned, in this case, the economies. One of the significant characteristics of the recession is how its deepening adverse results continue to haunt many economies with financial strains, which, in any case, have weakened many economies, leading to credit losses and visible financial struggles. It is believed the crisis, which started in the summer of 2007, as a result of a weakening housing market, where a straight uprise in delinquencies on subprime mortgages. They resulted from, as experts explain, the breakdown of foundational standards, which showed, partly, a loop in incentive that came from securitizing problems. Lenders did not care enough to consider careful underwriting since it was, they who would hold the loans. As if that is not enough, prices have been rising over the previous years, leading investors to believe things would continue at the same pace. Hence, they forgot to compliment the bubble in the high house prices; as such, they did not consider very much weather the followers were able to pay for loans or not. And because of the complex and opaque securitization of loans serviced as expected on the underlying credits become extremely difficult.

As anyone would have expected, there were huge losses on the subprime loans. Investors used securities that were highly rated, and which, as they discovered, would soon be down-written, making their prices to drop sharply. As a result, there arose doubts on how far the mortgage-related losses had taken root, and if the said banks still had potential liquidity needs to take care of off-balance-sheet parties. With such uncertainties, banks were less willing to extend their lending to others ( including other financial institutions. As anyone would expect, such uncertainties soon broke a huge gap in the risk spreads across the lending markets. Previously, leverages in the financial sector had greatly contributed to a higher profit when economic was on the rise, but now they were seen as excessive. Financial markets make quick movers to mark themselves, becoming less willing to contribute to the markets, which caused a decline in the liquidation of any securities.

It was determined that other factors contributed to this situation, even though the housing markets were the triggers. As time went by, experts discovered the issues were broader than they had earlier thought. For instance, the risks on different other assets have not been properly priced, something that spread across different markets. In this case, markets for private asset-based securities were the most hit. Since the funding conditions were steadily deteriorating, any attempts to conserve capital and liquidity forced banks and other lenders to put in place more stringent measures.

The feedback loop was already evident towards the end of 2007, and it continued to intensive for several months. Many major financial institutions failed while others came to near fall, a situation that that caused many to lose their faith in the institutions, which consequently meant tighter credit conditions would be imposed. 

The spread of risk, which was already wide, escalated further, leading to low-security prices. Further effects were felt when there was less consumer and business confidence. All these situations caused a significant deterioration in consumer expenditure as they adjusted to reduced wealth and the rising cases of unemployment, which would extend to the near future. As such, producers become worried about the demand for their products, which had reduced significantly; hence, they cut back on production so they could not have to deal with unsold inventories. The rest of 2008 continued to witness a gradual decline in economic activities as things continued to worsen.

Policies and responses

As stated, it was evident the financial sector was the leading cause of the threat that was not facing economic stability. For this reason, many of the counter-active policies that case up has focused on these institutions. The policies have also stretched to financial markets and the supply of credit to individuals and firms. The laws have been targeting the strengthening of financial conditions that came by as lenders tried more to evade risks, taking steps that seemed to conserve capital liquidity. In this regard, one of the steps included the Federal Reserve lowering the interest rates. They also backed up sources of liquidity present to private lenders while trying to get involved in the recovery of some markets. Together with the federal reserve, the Treasury and the Federal Deposit Insurance Corporation have applied different measures to take care of these issues.

One of the responses by the FR has been to ease monetary policy aggressively. The rate of federal funds was rapidly cut in the second half of 2007 through the spring of 2008. In addition, there was an intensification of the financial turbulence towards the last fall, where also, the economic outlooked dropped significantly. The Federal Open Market Committee (FOMC) brought down the target further by setting a range of 0 to ¼% by the close of the year. Since the federal funds were near zero, FOMC anticipated a warranty of their rate for a more extended period. They communicated their expectation, whereby the committee emphasized the market stand that these policies would remain intact, as a result reducing pressure on longer-term rates – since it is, they, which have more impact on spending behavior.

There are fiscal and monetary policies that were introduced, and which are still in effect. Easing of interest rates, which, as we can feel today, have increased the markets. Today, we can still see how interbank funding markets received lending on lighter termsFiscal and Monetary Policies, enabling them to reduce pressure on the interest rates charged and paid by banks. And the Federal Reserve has been working in the same manner as other financial institutions beyond the US industry.

Author: James Hamilton


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