US Economic downturn – Cause?

March 26, 2008

We are all hearing about the US economic downturn, and therefore, I decided to find out as much as I can about it.  The US economy tends to affect the whole world and therefore, would be beneficial to understand the reasons behind the downturn.

First of all,  I am refraining from the word recession, since many Economists are not yet calling it a recession. A recession is termed as two or more consecutive quarters of negative economic growth, and according to this definition it would be false to call it a recession as of yet since the US have not experienced what the recession definition requires.  As demonstrated in the following chart:

GDP 

Now that we are clear, what contributed to the US economic crisis?  The subprime mortgage crisis.  Lenders were issuing mortgage loans to borrowers that had less than adequate credit rating.  The ability to take out mortgage loans coupled with rising house prices enticed the borrowers to commit to mortgage contracts in hopes of benefiting from the rising trend of house prices, and the ability to refinance at better rates if required.  However, housing prices began to decline in 2006-2007 which made it difficult for the borrowers to refinance their mortgages causing them to default on their obligations.  During 2007, an estimated 1.3 million US property was involved in default (foreclosures), up 76% from 2006. 

Continuing with the crisis, many financial institutions / lenders, had passed the rights to the mortgage payments and risk to other investors through securitization.  This led to the formation of Mortgage Backed Securities (MBS).  However the value of the MBS is derived from the underlying mortgage.  As housing prices started declining so did the values of the various MBS.  The uncertainty of these complex securities have made investors shy away from purhcasing them which have also impacted their values significantly.  One such financial institution impacted by owning a huge amount of MBS / complex securities is Bear Stearns.  According to this site, investments banks are highly leveraged and therefore, any thin decline in their assets value (such as MBS) would cause them significant liquidity issues.  “A typical banking crisis like this costs about 10% of GDP in the long run”, mentioned here.

These activities caused financial institutions to reduce lending activities or lend at a higher interest rate.  Our GDP consists of consumer spending and business investments as their components.  Both of the above activities (reduced lending, higher interest rates) discourage consumer spending and investments.  Due to the higher rates, both activities are postponed which further hurts the economy.  That is why we saw the US federal reserve (central bank) reducing their short term interest rates ( a monetary policy tool) to stimulate economic growth.

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2 Responses to “US Economic downturn – Cause?”

  1. Gina Says:

    Hi Imran!

    I am a MBA student of University of Wales. I am asking permission from you on whether i can copy and include the above GDP chart to my Business research project about in- house training during economic downturn. The chart is helpful in explaining the definition of “recession”.

    Thank you in advance.

    Gina

  2. Matt Says:

    Hello,

    I am a economics student at the University of Saskatchewan and thought your insight into the cause/s of the US Economic downturn where both easily understood and accurate. I throughly enjoyed reading this.

    Best of luck in uncertain times,
    Matt


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