1 / 58

From US Subprime Crisis to European Sovereign Debt: US Fiscal and Monetary Policy to Cope with the Great Recession

Explore the US government's fiscal and monetary policy response to the global financial crisis, including the Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009.

dquirk
Download Presentation

From US Subprime Crisis to European Sovereign Debt: US Fiscal and Monetary Policy to Cope with the Great Recession

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. The Global Financial Crisis Chapter 5 From the US subprime mortgage crisis to European sovereign debt

  2. Chapter 5 US fiscal and monetary policy to cope with the Great Recession

  3. Introduction • On December 18, 2013, the Federal Reserve and the US Senate announced two historical decisions: • The Fed announced the ending of its quantitative easing (QE) program on October 14, 2014. • The US Senate (at approximately the same time) approved a Federal Budget after operating without one for four years. • After a sequence of failures by the Democrats and Republicans to reach an agreement on a program to reduce the US public debt, the two parties accepted sequestration.

  4. Sequestration • Sequestration consisted of an automatic tax increase and a reduction in federal expenditures; it was adopted by the US government on March 13, 2012. • Sequestration followed a previous fiscal threat known as the “Fiscal Cliff.” • The Fiscal Cliff was expected to occur on December 31, 2012, when several tax cuts were set to expire and several expenditures were set to be cut.

  5. Sequestration • The Fiscal Cliff was avoided after a last minute compromise, thus the US avoided “falling off the cliff.” • As a result, the simultaneous announcement of the Fed to end QE and the Senate to approve a budget marked the beginning of a new era, essentially ending the aggressive monetary and fiscal policy adopted to end the Great Recession.

  6. Fiscal policy • The US Fiscal Authorities, the President, and Congress launched three fiscal stimulus plans. • The first program was the Economic Stimulus Act of 2008, known as “Bush’s Tax Rebates.” • This Act provided a total of $152 billion in tax rebates to individuals and married couples of up to $600 and $1,200, respectively. • The government must have miscalculated the severity of the US recession, as unemployment kept increasing and GDP declined.

  7. Fiscal policy • In Figure 5.1(a), the US GDP is depicted in constant 2009 US dollars. The drop in the US GDP is shown through 2009 Q3. • Similarly, in Figure 5.1(b), the US unemployment rate is shown to be increasing from 2007 until 2010 when it reached its peak close to 10%.

  8. Figure 5.1(a)

  9. Figure 5.1(b)

  10. The Emergency Economic Stabilization Act of 2008 (Bush’s fiscal stimulus program) • Starting in the fourth quarter of 2006, economic conditions in the US began deteriorating. • The US housing bubble burst when home prices begun tumbling. As interest rates began increasing, homeowners were unable to refinance their homes. As a result, the number of home foreclosures and delinquencies at the end of 2006 began rising. • To cope with the US subprime mortgage crisis, on October 3, 2008 the US Government introduced “The Emergency Economic Stabilization Act of 2008”, a $700-billion bill, during the George W. Bush presidency.

  11. The Emergency Economic Stabilization Act of 2008 (Bush’s fiscal stimulus program) • The initial aim of the US government was to remove all toxic assets from the balance sheets of US corporations. To achieve this objective, the Troubled Asset Relief Program (TARP) was launched. • However, it was realized that it would have taken trillions instead of billions of dollars to accomplish this, thus the TARP was abandoned. • Instead of buying the toxic assets, the government decided to help financial institutions directly by lending them money at a predetermined agreed interest rate.

  12. The Emergency Economic Stabilization Act of 2008 (Bush’s fiscal stimulus program) • Many financial and nonfinancial institutions (934 in total), received loans from the US government under this program. • The most important recipients of TARP loans include bank holding companies, investment banks, automobile companies, and insurance companies. • The institution that received the largest bailout was an insurance company: AIG (The American International Group). • AIG had issued a vast number of CDSs insuring private and public securities in the US and abroad.

  13. The Emergency Economic Stabilization Act of 2008 (Bush’s fiscal stimulus program) • Since several of the insured institutions were failing, AIG was itself in financial trouble, thus it was bailed out by the government because it constituted systemic risk. • The bailout recipient institutions and the amounts they received are listed in Table 5.1.

  14. Table 5.1 The American Reinvestment and Recovery Act (ARRA) Source:http://www.recovery.gov/arra/Pages/default.aspx

  15. The American Recovery and Reinvestment Act of 2009 (ARRA) (Obama’s fiscal stimulus plan) • Despite an extraordinary expansionary monetary policy and the two fiscal stimulus programs, the US recession deepened and spread in the US. • The US government introduced the ARRA into law; this was a massive fiscal bill of $787 billion to prevent the US mortgage crisis from further spreading. • The fiscal program provided funding for 11 years (2009-19) in terms of tax reductions and expenditures. • It provided $80 billion for each of the following: Healthcare; Education; and Welfare; as well as funding for renewable energy.

  16. The American Recovery and Reinvestment Act of 2009 (ARRA) (Obama’s fiscal stimulus plan) • This fiscal bill is divided into three major programs: • Tax Incentives - $290.7 billion. This includes tax reductions for individuals and businesses. • Contracts and Grants - $257.8 billion. This is discretionary spending in the real economy, aiming to increase employment by 3.5 million people. • Entitlements - $254.6 billion. This portion provides for spending in Medicare and Medicaid, unemployment insurance programs, and more. • Table 5.2(a) and 5.2(b) below show a more detailed list of Obama’s fiscal bill.

  17. Table 5.2(a) The American Reinvestment and Recovery Act (ARRA) Source:http://www.recovery.gov/arra/Pages/default.aspx

  18. Table 5.2(b) The American Reinvestment and Recovery Act (ARRA) Source:http://www.recovery.gov/arra/Pages/default.aspx

  19. The American Recovery and Reinvestment Act of 2009 (ARRA) (Obama’s fiscal stimulus plan) • Most of the funding provided by the ARRA was designed to take place within the first five years; indeed, this occurred. • Table A5.1 indicates both the spending and revenues of the ARRA fiscal stimulus plan from 2009 to 2019.

  20. Table A5.1 Projected Budgetary Impact of the ARRA of Fiscal Year 2009-2019 Sources: Congressional Budget Office, and own calculations. Recovery and Reinvestment Act of 2009, American Recovery and Reinvestment Act of 2009 (P.L. 111-5): Summary and Legislative History Congressional Research Service

  21. The American Recovery and Reinvestment Act of 2009 (ARRA) (Obama’s fiscal stimulus plan) • The US has generated the world’s largest chronic public deficits and debts. • Figure 5.2 (below) shows the US Federal Government deficit for the period 1995-2014. • On the left-hand side of the axis, the government deficit-to-GDP ratio is shown to have increased from a little over1% in 2007 to over 10% in 2009. • Similarly, in the right-hand side of the axis the government deficit is measured in terms of absolute dollar amounts. It increased from a little over $100 billion to approximately $1.4 trillion. This constitutes by far the largest deficit of any country in the world.

  22. Figure 5.2

  23. US GDP and public debt • In Figure 5.3(a), both the nominal GDP and public debt are shown for the period 1950-2014. According to Figure 5.3(a), both nominal public debt and GDP have been increasing. • For a long time, GDP has been exceeding and rising faster than public debt. Nevertheless, this changed in the first year of the crisis. In 2007, the US public debt began rising faster than GDP. • Since 2012, the US public debt has exceeded GDP.

  24. Figure 5.3(a)

  25. US debt-to-GDP ratio • Figure 5.3(b) shows the US public debt-to-GDP ratio from 1940 to 2015. It can be seen that the public debt-to-GDP level has been increasing since the early 1980s, but starting in 2007,public debt almost exploded. • High public debt is a reason of concern for investors who lose confidence and become hesitant to buy the bonds of such countries. • Because of high US indebtedness, the US lost its AAA rating in 2011 for the first time in the country’s history.

  26. Figure 5.3(b)

  27. US monetary policy during the financial crisis • As a response to the crisis, the Fed applied an exceptionally expansive monetary policy. • The Fed employed its instruments, programs, and broader policies to achieve its goal of stabilizing the economy. • First, the Fed relied on its traditional monetary instrument to apply monetary policy: the federal funds rate. • Once it drove the federal funds rate down to the unprecedented level of 0-0.25 of 1 percent and could not reduce it further, the Fed launched other programs and policies.

  28. The federal funds rate • Figure 5.4 shows the federal funds rate together with two other long-term interest rates: • The 10-year government bond, one of the most important long-term interest rates. • The 30-year mortgage bond rate, the most important US mortgage interest rate.

  29. Figure 5.4

  30. The federal funds rate • It is clear from Figure 5.4 that the Fed was effective through drastic reduction in the federal funds rate to reduce the two long-term interest rates to cope with the US subprime mortgage crisis starting in September 2007. • The Fed had followed the same policy to cope with the dot-com crisis starting in January 2001, when it reduced the federal funds rate down to 1%, a 42-year record low.

  31. Short-term liquidity programs • After driving the Federal Funds Rate to zero-lower bound and without being able to reduce it further, in October 2008, the Fed launched a new monetary policy: the “short-term liquidity programs.” • The Fed exercised its authority as a lender of last resort by lending liquidity to firms, markets, and foreign banks in order to restore the lost confidence in the economy. • Through short-term lending, the Fed aimed to safeguard and secure the smooth functioning of the US financial system. • In Figure 5.6, five short-term liquidity programs are depicted , showing the amounts of loans from January 2007 to January 2014.

  32. Figure 5.6

  33. Short-term liquidity programs • The five programs are: • Other Assets • Other Loans, which consisted of two main components: • (a) Term Asset Backed Securities Loan Facility (TALF),which aimed to increase consumer loans. The New York Fed was authorized to lend up to $200 billion. • (b) Money Market Investor Funding Facility (MMIFF) provided funding to money market investors. The New York Fed was authorized to offer up to $540billion.

  34. Short-term liquidity programs • Foreign Central Bank Swap lines. The Fed offered dollar short-term liquidity (loans) to 17 foreign central banks to avoid knock-on affects from dollar shortages overseas. • Commercial Paper Funding (lending to businesses). The New York Fed provided short-term liquidity to businesses by facilitating purchases of their commercial paper. • Term Auction Facility (bailing out banks). The Fed created the term auction facility to provide short-term liquidity to financially stressed institutions. Figure 5.7(a) and 5.7(b) show the amounts which US and foreign banks borrowed.

  35. Figure 5.7(a)

  36. Figure 5.7(b)

  37. Short-term liquidity programs • The Fed lent massive amounts to US and foreign bank branches in the US. For example, Morgan Stanley, Citigroup, and Bank of America received more than $200 billion each. US banks also received large loans from the US Treasury under the TARP program. • The US government was compelled to extend loans to large financial institutions to avoid the “too big to fail problem.” • However, US citizens became angry with large banks when information leaked of their role in the crisis and particularly in the proliferation of the toxic securities.

  38. Short-term liquidity programs • The public became more outraged when information leaked that some bank executives pocketed large amounts of the government bailouts as bonuses. • Nevertheless, big banks (both domestic and foreign) paid back almost the entire amounts of the bailouts to the US government by 2009-10. • All the Fed’s short-term liquidity programs did not trigger inflation, however, as these short-term loans were repaid to the government rather quickly.

  39. Quantitative easing (QE) • Since the recession in the US persisted, the Fed introduced a new, unorthodox monetary policy at the end of 2008 known as Quantitative Easing (QE) that focuses on the quantity of money in the economy instead of the price of money, i.e., interest rates. • This program entailed purchases by the Fed of both public and private securities.

  40. Quantitative easing (QE) • The Fed implemented the new QE policy by launching three different programs, QE(1), QE(2), and QE(3). • The Fed purchased: • Treasury bonds; • Fannie Mae and Freddie Mac debt; • Mortgage Backed Securities (MBSs) issued by investment banks.

  41. Quantitative easing (QE1) • (1) Quantitative Easing (QE1). This involved purchase of: • $1.25 trillion MBSs; • $300 billion government securities; • $175 billion agency debt. Figure 5.8(a): QE1 (December 16, 2008 – March 31, 2010)

  42. Quantitative easing (QE2) • The Fed announced its second round of QE in November 2011 to purchase $600 billion of treasury securities. Figure 5.8(b): QE2 (November 3, 2011 – June 30, 2012)

  43. Quantitative easing (QE3) • The third round of QE was announced by the Fed on September 13, 2012. This was an open round and it was completed on October 31, 2014. Figure 5.8 (c): QE3 (September 13, 2012 – October 31, 2014)

  44. The bigger picture • Expensive monetary policy increased the Fed’s excess reserve balances to over $2.5 trillion, and they still stand above this amount as of June 2015, which is shown in Figure 5.5 below.

  45. Figure 5.5

  46. The bigger picture • The end result of these operations was an increase in the balance sheet of the Fed to the unprecedented amount of $4 trillion. • Then the Fed decided to reduce the monetary stimulus that was injected during the subprime mortgage crisis. • This began with the tapering of QE, starting with the departure of Fed chairman Ben Bernanke, and his successor, Janet Yellen.

  47. The bigger picture • The short-term liquidity programs are shown to have contributed to lending in mid-2008, but by 2009 they were tapered off. However the Fed, through QE3, purchased treasury securities, agency debt, and MBSs. • Figure 5.9 shows all of the Fed’s operations during the subprime mortgage crisis.

  48. Figure 5.9

  49. Evaluation of fiscal and monetary policy • Disentangling the effects of fiscal and monetary policy is almost impossible because the effects of the two policies occurred simultaneously. • It is almost impossible to disentangle the effects of the three fiscal stimuli from the fiscal automatic, or built-in, stabilizers of the US economic system.

  50. Findings from other studies • Some authors criticized the mega-stimulus of the government as being ineffective. • One such critic of the US discretionary fiscal and monetary policy during the crisis was Professor John Taylor (2010, 2014) who claimed that the two policies created economic instability and thus he recommends that the US returns to rules-based policies.

More Related