The Dreaded R-Word

Firstly, let me clarify that this is not a blog totally dedicated to economics and you can look forward to a tad bit more trippy and interesting entries in the future. And you can probably gauge the level of my joblessness given that I started a blog out of sheer boredom notwithstanding the fact that I'm submitting my first entry one and a half years after starting a blog :-))). So here goes.........

Recession. A word which appears to be there on everybody’s lips these days. Any conversation is seemingly incomplete without a single mention of this word and its cascading yet deteriorating effects. With prominent banks declaring bankruptcy, unemployment rates spiraling out of control, leading automakers succumbing to overproduction, stock markets crashing like a pack of cards, investors scurrying for cover and grappling to minimize losses, we are currently in the midst of a global economic meltdown and its repercussions seem to be mind-numbingly unimaginable. The global recession has without a shadow of doubt greatly affected all our lives. That apart, there have been enough hue and cries over the recession and there appears to be a lot of confusion over how and why the world sunk into recession.

In plain economic terms, a “recession” is defined as the decline in a country’s gross domestic product (GDP) for two or more consecutive quarters of a financial year. Generally, a recession is always preceded by several quarters of slowdown during which a country registers positive growth but the growth rates indicate a reduction. Although, this definition does not take into account other economic variables and after-effects like unemployment rates, inflation, buoyancy of stock markets etc, but it succinctly describes in precise terms what a recession is. A recession is normally caused when an economy which grows over a period of time tends to slow down the growth as a part of the normal economic cycle or if there is an imbalance in the control of money supply and cash flow in the economy. This leads to a decreased demand for goods and services, which in turn leads to a decrement in the production, lay-offs and a sharp rise in unemployment. In such an environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. Investors spend less as they are apprehensive about stock markets and thus stock markets plunge on negative sentiment. As investors and businesses curtail expenditures in an effort to trim costs, this causes GDP of an economy to fall. As economic conditions continue to worsen, tight credit slows down growth, which in turn raises unemployment and saps consumer and investor confidence. Unemployment rates rise because companies lay off workers to cut costs in order to meet the diminished demand. These circumstances coupled with relaxed policies in lending practices result in unsustainable economic activity and the economy comes to a standstill.

The current economic crisis is distinctly catastrophic and is unlike any other recession which we have witnessed in the past. Caused primarily due to sub-prime mortgage lending, uncontrolled expansion of credit and excessive speculation, the present financial crisis violates all norms of a normal business cycle. It merely took one bank to collapse to throw the whole US economy in shambles. Soon after Lehman’s downfall, other major banks like Merrill Lynch, Bear Stearns and Countrywide Financial followed suit. As a direct consequence of the breakdown of the financial system, other leading companies suffered a major setback. Detroit's Big Three namely GM, Chrysler and Ford which dominated USA's automobile industry are battling bankruptcy troubles. Simply put, the banks lent away more money than they had to high risk people with unstable incomes to buy homes (sub-prime mortgage lending), who were less likely to pay them back.

The sub-prime mortgage crisis is a precarious financial crisis propelled by an unprecedented rise in mortgage delinquencies and foreclosures primarily in the United States which has crippled almost all major banks and exposed pervasive weaknesses in the financial industry. Foreclosure refers to the acquisition of a borrower’s assets, offered as security at the time of loan, by the concerned bank, given that the borrower has failed to repay his loan within the stipulated time period. The crisis began with the bursting of the United States housing bubble and high default rates on sub-prime mortgages during 2005–2006. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices. But, once there was a hike in the interest rates and housing prices started to decline moderately in 2006–2007 in many parts of the US, refinancing became more difficult. Foreclosure activity increased exponentially as easy initial terms expired and home prices failed to go up as anticipated which triggered a global financial crisis through 2007 and 2008. Mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the US realty sector. Banks and financial institutions had borrowed and invested immensely in MBS and reported losses of approximately US $435 billion. Low interest rates, sub-prime lending and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom thereby driving prices to dizzying heights. This eventually led to a surplus of unsold homes, which caused US housing prices to peak and begin a downward spiral in mid-2006. By September 2008, average US housing prices had declined by over 20% from their mid-2006 peak. Thus, when the US housing market crashed, the value of the houses reduced considerably and ultimately banks ended up incurring huge losses. The causes for a crisis of this magnitude are complex and varied. But in general, it can be attributed to the inability of homeowners to make their mortgage payments, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, concealment of risk of sub-prime mortgages, monetary policy and inadequate government regulation which ultimately led to the crumbling of the financial system and brought about a global recession.

Undoubtedly, the US economy has been badly shaken by the ongoing financial turmoil. And as the famous cliché goes, “whenever the US sneezes, the whole world catches a cold”. As far as India is concerned, it would be highly presumptuous of us to live under the delusion that the recession cannot affect our economy in the slightest. It is quite evident from the way Bombay Stock Exchange crashed from 20K to 10K taking a cue from the probable recession in the US that a global economic slowdown spells bad news for the Indian economy. A significant chunk of our GDP comes from major outsourcing companies and those companies are likely to be severely affected, given USA is our biggest client. In addition, other multinational companies having ties with the US would also see their profit margins shrinking. According to a survey which included major sectors like textile and garment industry, metals, Information Technology, automobiles, gems & jewelers, transportation, construction and mining industries, the total employment in all these sectors had come down from 16.2 million in September 2008 to 15.7 million by December 2008. The diamond industry itself has handed a pink slip and bid farewell to more than 1 lakh employees. Automobile industries have shed about 4.79 percent of their workforce and reduced the number of shifts. As far as the Sensex is concerned, the fact that it took such a enormous hit, might seem baffling at first. But pondering deeper, one is forced to question as to why the stock markets suddenly rise to a whooping 20K in the first place? It most definitely was not because our economy had performed some unheard of miracle. The only definitive explanation is that the Sensex soared because a large number of foreign investors, mainly the US, had invested vastly in our markets perceiving India to be one of fastest growing emerging economies. But when recession struck, the stock markets plummeted because the foreign investors desperately needed their money back and pulled back all their investments. Thus, it’s quite apparent that the global slowdown has far-reaching implications on the Indian economy and it is imperative that the government undertakes preventive and ameliorative measures to minimize the effect of the global recession.

In order to save the US economy from complete economic turmoil, the US government passed the Economic stabilization Act of 2008 which grants the US Secretary of Treasury up to $700 billion with which it can purchase toxic assets and mortgage-backed securities from banks teetering on the brink of bankruptcy. This type of plan, popularly known as the ‘financial bailout’, would plant new life into the economic sector by giving liquidity to bankrupt or near bankrupted entities so that they can continue to survive until the short-term problems which have caused the crunch are resolved. But as the recession continues to deepen, it’s frighteningly clear that the world’s dramatic financial rescue efforts are both unprecedented in scope and creativity, and wholly inadequate. The need of the hour is probably a big-bang global bailout. Subsidizing the sale of Merrill Lynch cost the US Treasury $38 billion, bailing out AIG cost $123 billion and the bill for Citigroup’s rescue could come to about $326 billion. Depending on how we add up all these measures, for a full bailout, the total reaches as high as $8 trillion. Unfortunately, there is no way to finance such a massive stimulus without going into deeper deficit and incurring extraordinary levels of debt. The United States cannot act alone. Europe and Japan as well as emerging economies like China, India and Brazil would be required to make concerted efforts of similar magnitudes in order to uplift the global economy. Experts believe that the current recession is deeply structural caused by rampant misallocation of resources and imbalance in trade surplus and deficits and therefore only injecting money into the economy is not the solution. The consequent bust cannot be ended by pumping in more money. Rather, the entire economic structure must change to correct the historical misallocations, and make future growth sustainable. This involves wrenching changes in individual, corporate and political behaviour. The global boom of 2003-2008 was based on an unsustainable economic structure and it had to come crashing down someday. In future, all economies need to focus on ending the existing global imbalance as far as trade is concerned and restructure their economies in such a way so as to ensure stable economic growth. There is indeed light at the end of the tunnel and if the right steps are taken at the right time, it will certainly lead us into a brighter and more successful tomorrow.