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The Financial Crisis: Policy Intervention

The sub prime crisis is a massive macroeconomic catastrophe in need of an effective policy response. However, what kind will require a more targeted strategy rather than one size covers all policy. However, despite the limitations of monetary policy, its absence will lead to a steep and long session of recession, and have far-reaching consequences. Policy intervention can only minimize the damage to the economy and modestly reduce the losses; it cannot prevent massive losses and sharp falls in asset prices from occurring. Higher interest rate cuts are the need of the hour and central banks should consider this alternative to prevent collateral damages.

The Federal Reserve helped finance J. P. Morgan take over Bear Stearns when it collapsed. The Federal Reserve has also devised means to fight off depression and is attempting to stop the various feedback loops, which could cause runs in the financial institutions, finally leading to their collapse. For instance, these financial institutions do not even have to run out to affect the country’s economy. If their capital is diminished enough to stop them from further lending, it will cause more economic weakness, producing more stress for the financial institutions. Most economists are under the impression that this depression in the USA’s economy will sustain for quite a long period of time as it may continue till mid 2009. They are advising the retail investors not to panic and to reconsider their portfolios so that they do not have to sell out at rock bottom prices. (Doskoch, 1)

Rising unemployment has prompted the Federal Reserve to cut down its lending rates. The USA’s unemployment rate rose sharply around June this year. Just after this news was reported, the Federal Reserve immediately responded by lowering its interest rates so as to encourage the drooping economy. According to the analysts, the Federal Reserve had no other choice but to do so, even if it meant bowing down to political considerations. The percent of jobless people in the nation rose from 7.5% in May to 7.8% in June this year. The discount rate of the Federal Reserve was 3.5% to 3%. This has been its lowest rate since 1963. They have also reduced the Federal Funds Rate, which is the rate the different banks charge each other for taking overnight loans, from 3.75% to 3.25%. This action was also followed by several other banks, which also cut down their prime interest rates.

These cuts in the interest rates help economic growth as it lets the people doing business borrow more money for their investments. It also makes it cheaper for the consumers to borrow while spending. The Federal Reserve said that the actions they had taken were due to the weakness in the money and credit growth, irregular progress of the economy’s recovery and for continuous progress towards price stability. As there was a slow growth in the money supply, there was not enough money available for giving loans in order to increase the nation’s economic growth. Analysts have further said that the Federal Reserve should lower their rates more as feeble money supply could cause the economic recovery to slow down, just as a slow monetary growth caused the economy to descend low last year.

It is also being said that these rate cuts may be too late to help as the time lag before the lowered rates seep into the economy to encourage growth, investment and spending, is about six months. Economists argue that the economy’s recovery has been held back due to the huge debts of the customers and business expenses. (Greenhouse, 1)

It would be relevant to mention that the current account is an extremely important tool that can determine the entire business cycle of a country as current account can be determined according to trade balance as the difference of import and export of tangible goods and services like consulting and legal. Current account is also instrumental in determining the overseas factor incomes like dividend and income along with the net overseas Unilateral Transfers like gifts, grants, and aids. (GORTON, 1185)

In the US, five of the leading banks of the world, including the Federal Reserve Bank of USA came together to invest huge amounts of fresh money into the global market to combat the international credit crunch failing economy with about one trillion dollars. (Grynbaum, 1, 2) This move is largely stimulated by the concern of leading economists who were predicting a recession in US markets as a slowing down or decline of US and British housing markets. In an emergency set of solution seeking procedures, the Federal Reserve Bank drastically diminished interest rates, splurged out innovative lending programs, sought to modify the poor condition of Bear Stearns and provide loans to boost the nearly crippled mortgage agencies of Fannie Mae and Freddie Mac.

The most innovative plan to diminish the credit crunch has been to increase lending with the motivation to restore liquidity to troubled markets and look after the demands of the inter-bank loaning facilities. The current crisis made the Federal Bank to decrease the interest rates on lent amounts and lengthen the time limit for the repayment of the loan. “Term Auction Facility” was adapted as a scheme for slow banks through which loans at a cheaper rate could be made available from discounts windows and the deals were guaranteed anonymity.

Although banks have been the most popular method of economic growth, they are quickly becoming one of the least reliable sources. Private enterprise is taking a new face in the modern world and is helping to facilitate strong economic growth, even during a time of recession. In this modern day and age, businesses are becoming more personal, which most people enjoy. This gives people a larger sense of trust with companies and allows them to get more loans. When people have more money, the spend more and put more back into the economy. It is plain to see why market based financial systems are the superior method of economic growth. Whenever you deregulate how business is run, people tend to show the good side of them more and help each other out more. Laissez faire is an important cornerstone in today’s free world market, and it should stay that way. Banks are still regulated by the government, and obviously have been failing to keep up to par. The choice is obvious and hopefully the government begins to support private financial groups more in the future.

However, it has been reported that the “US Senate approved a $700 billion bailout of the financial industry”. (Reuters, 1) But it should be kept in mind that the $700 billion plan for bailout would “improve the financial position of the banking system but will not stop a recession” (Reuters, 4). However, it should be noted that even if this measure is not termed as enough, it is a fact that such measures would certainly help the economy. Additionally, “congressional leaders added two sweeteners to the bill — a tax cut and extended federal protection for bank deposits”. (Reuters, 4)

There is however, a second bailout plan. It is referred to as Plan B. The Federal Reserve endorses this plan after the failure of Plan A. It has been reported, “tax credits for the production and use of renewable energy sources, like solar energy and wind power have been. Possible other inclusions originating in the House bill are an extension of the unemployment benefits, protection from foreclosure for individuals, and tax credits for low and medium income households.” (Ranking, 1) Under such parameters, it can be stated that this plan was initially supposed to be workable but a Plan C was initiated to be effected as a proper bailout method.

Plan C includes an additional input of US$800 billion by the Federal Reserve. The amount of US$800 billion would be instrumental in buying the debts related to mortgage and the credits of the consumers in order to instrument a lending free up. At this point of time it appears that there are two major problems related to this Plan C. The first one is the fact that there is not enough retail economy spending in relation to consumers. Secondly, there is a lack of consumer credit and there is no presence of a sound economy to sustain this amount. Under such parameters, if plan B is taken into consideration, it can be stated that this plan appears to be a very slow process. This could be a very dangerous ploy and the result could be devastating for the economy. It should be noted that a very fast and effective measure is needed and Plan B lacks that speed of operations that is required in this case.

The market appears frozen and the credit system is crippled as investors pulled out $240 billion out of the market particularly from the field of auto loans and credit card market. The Federal Reserve bailout plan of $180 billion could be instrumental in luring investors into the market. In a way, this could prove to be the ideal stage to implement Plan C though there are enough risk involved. Nevertheless, Plan C is quite complicated in nature and it the Federal Reserve is reluctant to use it right now and hold it until July 2009.

In the meantime, it has been reported that “to buy as much as $1 trillion in troubled mortgages and related assets from financial institutions” (Andrews, 1). The fundamental approach of this scheme is “to offer generous subsidies, in the form of low-interest loans, to coax investors to form partnerships with the government to buy toxic assets from banks” (Andrews, 2). Accordingly, one of the most important aspects of the buyout of these toxic assets is to “help protect taxpayers, who would pay for the bulk of the purchases, the plan calls for auctioning assets to the highest bidders’ ‘ (Andrews, 3).

As a bailout plan, the article “In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans” by Stephen Labaton and Edmund L. Andrews published in New York times on September 7, 2008 can be very useful for its logical reasoning. This article is a take on the recent credit crunch of US. Huge amount of capital inflow is needed in this case and even if the bailout plan succeeds, it is evident that there would be difficult times. However, in the event of magnifying unemployment and inflation, the Federal Bank cannot afford to sit still. It has to fight for a stable equilibrium in prices and combat unemployment. (Labaton, 1, 4)

Works Cited

Andrews, Edmund L., Eric Dash and Graham Bowley. “Toxic Asset Plan Foresees Big Subsidies for Investors”. nytimes.com. 2009. Web.

Doskoch, Bill; “Breaking down the U.S. credit crunch crisis”. CTV.ca News. 2008; Ctv. Web.

Greenhouse, Steven. “Unemployment Up Sharply, Prompting Federal Reserve To Cut Its Key Lending Rate”. NYTimes.com; 2008; Query NYT. Web.

GORTON, G. B. PING HE. “Bank Credit Cycles”. Review of Economic Studies; 75: 4; 1181-1214.

Grynbaum, Michael M. “Persistent Anxiety Over Tight Credit Sends Stocks Plunging”. NYTimes.com. 2008. NYT. Web.

Labaton, Stephen & Andrews, Edmund L. “In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans: NY Times; 2008; NYT. Web.

Rankin, Kyle; “Plan B: Go to Congress, Make a Right; Black and White Program” Black and white. 2008. BW. Web.

Reuters. “Senate passes $700 bn bailout package”. Indian Express. Thursday , 2008. Web.