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Government Response and Aftermath

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us-government-response-to-financial-crisis-bailout-wall-street-why-what-happenedIn the United States, there were a number of government responses to the recession of 2008-09. The first response available was a tool known as monetary policy.  Monetary policy is essentially the practice of governing the money supply of an economy to promote economic prosperity, employment, and to maintain an adequate balance of growth and stability.  In the U.S., the Federal Reserve System is responsible for achieving these goals, as the country’s central bank.  After the American economy experienced rapid losses in production and employment, the Federal Reserve, or “Fed”, made appropriate decisions to expand the money supply in order to support the slowing U.S. economy.

Over the last three years, two main tactics were used by the Fed to achieve this objective.  The first came in the form of a decreased discount rate and federal funds rate.  The discount rate is the interest rate that the Fed can charge lending institutions for borrowing its reserves.  The discount rate is typically lowered in the hope that lenders will pass a greater number of reserves to consumers, in the form of credit.  If this occurs, consumers should spend more, boosting economic activity. Similarly, the federal funds rate represents the interest rate that lenders charge each other to trade reserves.  The Fed decreases this rate in hopes that it will achieve a similar positive economic effect.  Before the crisis, these rates remained between 5 and 6 percent.  Post-crisis, however, both were lowered to near 0 percent.  The graph below illustrates the behavior of the discount rate, with the rapid lowering of interest rates by the Federal Reserve visible from 2007 onwards.


This graph shows the discount rate since 1990.

Due to the fact that these efforts did not adequately encourage any meaningful economic recovery, the Federal Reserve considered a second, more drastic option.  Known as quantitative easing, this unconventional method was initiated when the Federal Reserve began to purchase government bonds and other assets like mortgage-backed securities with newly minted currency, to provide further liquidity and push down interest rates for consumers.  By 2010, the Fed had purchased over $2 trillion of assets through quantitative easing.  Many economists and policymakers warned that these actions could cause rising prices in the future, commonly known as inflation.  While these concerns are warranted, as of January 2012 inflation rates have remained very muted.

In addition to these monetary policies, the federal government also employed the use of fiscal policy. The most common tools of fiscal policy are government spending and tax collection, both of which are primarily controlled by the federal government, though state and local governments have a role as well.  In this most recent post-recession scenario, the size of major government spending programs grew in their scope.  Overall, total government spending increased significantly during this time period, from $2.98 trillion in 2008 to $3.65 trillion in 2009.  At that time, this $650 billion dollar increase represented the largest one-year expansion in the country’s history. 

While some of this increase can be attributed to permanent spending programs like health care, social security, education and defense, the largest portion was due to temporary expenditures aimed at jump-starting the U.S. economy.  The most expensive of these programs was the Troubled Asset Relief Program.  TARP, as it was termed, was a bailout package from the federal government granted to the economy’s most illiquid firms.  Most bailout recipients were in the financial sector, including Citigroup, Bank of America, AIG, JPMorgan Chase, and Wells Fargo.  Automakers General Motors and Chrysler were covered as well.  In a smaller bailout similar to TARP, government-sponsored lenders Fannie May and Freddie Mac also received assistance.  In total, the amount dispersed to these firms reached $596 billion.  The chart below illustrates how bailout funds were distributed amongst each type of firm.


This graph shows the distribution of bailout funds amongst recipient firms, in dollar terms.  All loans granted total $596 billion.  As of February 2012, $245 billion is still outstanding.

These bailout packages aimed to create liquidity in the financial markets by allowing lending institutions to provide essential credit to consumers and businesses, while also reducing uncertainty in the American economy. This funding was not without opposition, however, as it was heavily criticized for increasing moral hazard in the banking system by reinforcing the risky behavior of lenders.  Additionally, critics say the funding will increase expectations of more government bailout packages in the future.

Other large programs included the American Recovery and Reinvestment Act of 2009 valued at $787 billion, and the $858 billion Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.  Additional efforts like the Car Allowance Rebate System, or “Cash for Clunkers” program, and the Cash for Appliances Rebate Program were smaller in scope, and allowed consumers to trade in aging assets for rebates towards new purchases in an effort to spur consumer demand.  Aside from these efforts, the government maintained lower income tax rates, introduced payroll tax cuts, and provided additional tax cuts for families and small businesses.  All of these initiatives were aimed at increasing the disposable income of U.S. consumers, so they would increase their consumption of goods in the U.S. economy.

In the summer of 2009, the recession officially ended in the United States, as GDP growth became positive once again.  Unfortunately, a significant number of American workers still remained unemployed.  The unemployment rate peaked at 10 percent in October 2010, and still sits at 8.3 percent, well above the 4.4 percent rate prior to the crisis.  Continued government efforts have focused on providing assistance to homeowners, in the hope that a full economic recovery can be achieved by healing the housing market.  The most notable of these programs is the Home Affordable Refinance Program, which is a loan-refinancing program for borrowers whose homes are worth less than the value of their outstanding mortgage loan.  HARP, as it is termed, allows these particular homeowners the option to refinance their mortgage at the lower rates available since the Fed’s extensive monetary easing actions. 

From the fiscal and monetary policies mentioned above, to the economic crisis described in Lesson 3 of this series, the fall of the American housing market has had far-reaching effects on the broader economy.  As illustrated in Lessons 1 and 2, the failures brought on by a boom in subprime lending were exacerbated by the securitization practices of a variety of institutions.  In the future, it is imperative that lending is performed with greater care, because securitization exposes the entire economy to any gaffes in the handling of risk.  In fact, it is crucial that any markets that are heavily securitized be managed with this same level of caution.  In the U.S. economy today, a long-needed recovery has just begun to take hold, and while job creation challenges still exist, investors are looking toward the horizon with a sense of optimism.