The Great Recession (2007-09):

 Precipitated in the US and quickly spread to other countries

 Officially lasted from December 2007 to June 2009. Longest and deepest economic
downturn in many countries including the US since the 1929 to 1939 Great Depression
 The net worth of US households declined, erasing $19.2 trillion in wealth
 Gross domestic product (GDP) fell 4.3%, the largest decline in 60 years.
 The unemployment rate reached 10% in October 2009 — rates were even higher among
Black and Hispanic households at about 15% and 12% respectively
 The US lost $7.4 trillion in stock wealth from July 2008 to March 2009
 Home foreclosures skyrocketed, with nearly three million a year in 2009 and 2010
 Poverty rate in the US increased from 12.5% in 2007 to over 15% by 2010
 As the financial crisis spread from the United States to other countries, particularly in
western Europe (where several major banks had invested heavily in American MBSs), so
too did the recession.
 Severe political repercussions in some countries:
o In Iceland, the government collapsed, and the country’s three largest banks were
nationalized.
o In Latvia, GDP shrank by more than 25% in 2008–09, and unemployment reached
22% during the same period.
o Spain, Greece, Ireland, Italy, and Portugal suffered sovereign debt crises that
required intervention by the European Union, the European Central Bank, and
the International Monetary Fund (IMF) and resulted in the imposition of painful
austerity measures.
o In all the countries affected, recovery was slow and uneven, with social
consequences such as lower fertility rates, historically high levels of student debt,
and diminished job prospects among young adults, were expected to linger for
many years.
 Stock market began to rebound in 2009 – other aspects of economy took several more
years to recover:
o GDP did not recover its pre-recession strength until 2011, despite the Great
Recession officially ending in June 2009
o Unemployment rate remained above 5% until 2015
o Real household income did not increase until 2016
Causes and lead-up to the Great Recession:

1. Immoderate investments and deregulation:

 The period from mid-1980s up till 2007 was called the Great Moderation – GDP rises,
low inflation with only two relatively mild recessions
 Contemporary belief that the traditional boom-and-bust business cycle had been
overcome in favor of middling but stable economic growth
 Led to immoderate spending, especially by risk-loving investors – risky behavior such as
aggressive investments, leveraging strategies, excessive debt sounded safe
 The Glass-Steagall Act was rolled back in 1999. The Act had been a landmark
Depression-era legislation passed in 1933 that separated commercial and investment
banking, and in order to counter regulatory loopholes for risky activities – period of
deregulation spurred by economic growth
 Glass-Steagall Act’s rollback brought a period of national expansion for corporations.
Small, independent institutions were therefore gobbled up, which created entities that
were "too big to fail" — or so everyone thought!

2. Loose lending standards in the housing market:

 Up till 2007, real estate and property value rose steadily, encouraging investment in
buying homes and property:
o Average home prices in the United States more than doubled between 1998 and
2006, with larger gains recorded in some regions
o Home ownership rose from 64% in 1994 to 69% in 2005
o Residential investment grew from about 4.5% of the US GDP to about 6.5% over
the same period
o Roughly 40% of net private sector job creation between 2001 and 2005 was
accounted for by employment in housing-related sectors
 The expansion in the housing sector was accompanied by an expansion in home
mortgage borrowing by US households:
o Mortgage debt of US households rose from 61% of GDP in 1998 to 97% of GDP in
2006
o Historically, it was difficult for borrowers to obtain mortgages if they were
perceived as a poor credit risk, perhaps because of a below-average credit history
or the inability to provide a large down payment.
o But during the early and mid-2000s, high-risk, or “subprime,” mortgages were
offered by lenders to millions of customers who repackaged these loans into
securities. A subprime mortgage is a type of loan issued to borrowers with low
credit ratings. The result was a large expansion in access to housing credit,
helping to fuel the subsequent increase in demand that bid up home prices
nationwide
 While interest rates at the time were low, subprime mortgages were adjustable-rate
mortgages, which charged low, affordable payments initially, followed by higher
payments in the years thereafter
 Borrowers who were already on shaky financial footing stood a good chance of not
being able to make payments when the interest rate rose in the years following – loans
taken by millions of home buyers without knowing the risks involved.

3. Risky Wall Street Behavior:

 Lenders found another way to make money off of the real estate industry – by
packaging subprime mortgage loans and reselling them in a process called securitization
 Loans bundled together by subprime lenders sold to investment banks – in turn sold to
investors around the world as mortgage-backed securities (MBS)
 Investment banks started repackaging and selling MBSs on the secondary market as
collateralized debt obligations (CDOs)
 Multiple loans of varying risk levels and quality combined into a single portfolio
 Wall Street mathematical models anticipated combination of variety of loans would
reduce the CDO’s risk, although in reality, a lot of the loan tranches were of poor
quality, dragging down returns of the entire portfolio – significant sums borrowed by
investment banks around the world, viewing the financial market stability at the time
 Credits default swaps (CDS) used by banks to insure default against CDOs – banks and
hedge funds started buying and selling swaps on CDOs in unregulated transactions,
which did not show up on the balance sheets – investors, therefore, could not assess
actual risks these enterprises assumed.

4. Weak Watchdogs:
 The "Big Three" credit rating agencies include Moody's, S&P, and Fitch Group –
awarded AAA ratings, usually reserved for the safest investments – on many MBS and
CDO securities, despite their significant share of risky mortgages.
 There was an inherent conflict of interest since the banks issuing the securities were the
ones paying the agencies to rate them

5. Subprime mortgage crises:

 After staying low throughout the early 2000s, interest rates began to rise starting in 2004
in response to an overheating economy and fears of inflation
 Federal funds rate was 1.25% in mid-2004 while by mid-2006, the interest rate was at
5.25%. The rate hike came at the worst possible time
 Mid-2006: home prices peaking, market slowing down – supply began to outpace
demand – home prices spiraled. Combination of falling home prices and high interest
rates made it extremely difficult for buyers to make payments on their homes
 Subprime mortgage crisis began – defaults on subprime mortgages shot up. Loan after
loan became worthless. In April 2007, New Century Financial, the largest independent
provider of subprime mortgages, declared Chapter 11 bankruptcy
 CDOs made the collapse to be felt beyond the real estate industry
 The defaults meant big CDO investors, like hedge fund managers, investment banks,
and pension funds, saw the value of the investments nosedive. Since CDOs didn't trade
on any exchanges, there was no way to get rid of them, so those holding them had to
write off a substantial amount of their value
 One of the biggest investment banks, Bear Sterns, saw its entire balance sheet decimated,
losing investor confidence and ability to borrow money. In March 2008, to avoid
bankruptcy, the venerable firm sold itself to JP. Morgan Chase for $10 per share.

6. 2008 Stock Market Crash:

 CDO debacle turned into a full-blown credit crisis by spring of 2008
 Since it was unclear where all these toxic securities were — given all the packaging and
repackaging — and whose balance sheets were harboring them, banks started charging
high interest rates to lend to other banks and institutions.
 Disastrous for Lehman Brothers – of the $600 billion in debt owed by the company, $400
billion was supposed to be covered by CDS. Unfortunately, by that point, the debt was
worth almost nothing. Lehman Brothers collapsed and declared bankruptcy on
September 15, 2008
 Panicked banks stopped lending almost completely and the entire global banking
system became short of funds.
 The stock market reacted sharply. From September 19, 2008 to October 10, 2008, the Dow
Jones Industrial Index went into free-fall, declining 3,600 points.
 Big financial institutions started dropping:
o Bank of America (BAC) announced it was buying Merril Lynch
o The FDIC seized Washington Mutual, the country's largest savings and loan,
transferring its assets to JPMorgan Chase
o Goldman Sachs and Morgan Stanley, the last two of the major still-intact
investment banks, converted to bank holding companies, the better to be able to
obtain federal bailout funding
 With the global economy declining, international trade and industrial production fell at
an even a faster rate than during the Great Depression of the 1930s. As consumer and
business confidence was shattered, companies started massive layoffs and
unemployment skyrocketed globally.

Aftermath of the Great Recession:

1. An activist Fed:
 Interest rates were at 5.25% in 2007. But by the end of 2008, the Fed slashed them to zero.
  Two key programs launched to provide emergency assistance, which prevented the
recession from converting into a decade-long affair, like the Great Depression:
o Troubled Asset Relief Program (TARP): This initiative helped stabilize the economy by
having the government purchase up to $700 billion in toxic assets, with most of the
money used to bail out troubled banks.
o The American Recovery and Reinvestment Act (ARRA): A stimulus package enacted in
2009, ARRA implemented a series of tax cuts, government spending mandates, loan
guarantees, and unemployment benefits to help kickstart the economy.

2. Financial regulation and reform:

 In 2010, President Obama signed the Dodd-Frank Act into law, which aimed at
reforming regulation of the financial industry
 Ability for the government to take control of banks seen to be fiscally unsound,
regulation of the over-the-counter derivatives market, including credit default swaps,
and a requirement for banks to set aside more capital reserves as a cushion
 Volcker Rule, which curbed banks proprietary trading for their own accounts and
limited their dealings with hedge funds and private equity funds, among other steps.

3. Hobbling of a generation:
 Millennials have decreased savings and heavy student loan debts
 Reluctance to buy homes and overall less wealth than previous generations at a
comparable age
 A 2019 Country Financial survey revealed that half (50%) of Millennials rate their level
of financial security as fair or poor, compared to 44% of Americans overall.

Fiscal and Monetary Response: Great Depression Vs. Great Recession

Similarities:

1. During both, the U.S. economy suffered a steep output decline that followed a long
economic expansion marked by financial excesses. Other aspects of economic activity—
especially employment, consumer durable spending, housing, and business investment
—fell sharply, and there were large declines in the capital positions and resiliency of
most financial firms that survived
2. Both crises were triggered and amplified by financial and monetary turmoil exacerbated,
in the case of the Great Depression, by an incipient deflation – the stock market lost
roughly half of its inflation-adjusted value by the trough in both episodes, while risk
premiums in corporate yields versus Treasuries similarly widened.
3. Each reflected a correction of earlier financial excesses that financial regulation was
inadequate to either prevent or make the financial system sufficiently resilient to
subsequent corrections.
4. Another, less well recognized commonality of the great downturns was high rates of
mortgage foreclosures rooted in earlier, unsustainable lending practices.
Differences:

 The unprecedented crisis of 2008 posed a very serious threat to the global economy, but
it did not produce results anywhere near as bad as those of the Great Depression, which
created a high of 25% unemployment. During the Great Recession, the unemployment
rate’s peak was 8.5%.

 Response to panics:
o After Lehman Brothers went bankrupt in September 2008 and set markets all
over the world into a panic, the Federal Reserve Open Market Committee
drastically lowered its short-term overnight federal funds rate to 0.25%, injecting
badly needed liquidity into the banking system. It was the exact opposite of what
the young Federal Reserve did in the wake of the 1929 crash and the approaching
depression.
o In early 1930s, Fed and other central banks worldwide, raised interest rates in
response to the panic. The thinking at the time was that this would tamp down
on speculation in the wake of the 1929 stock market crash.

 Misguided tightening:
o The 1930s Depression can largely be blamed on misguided tightening of
monetary policy when economic demand was already plummeting. Banks were
failing everywhere, due to lack of liquidity, and taking people’s savings with
them. But the 1930s crisis also has to be put into the context of drastically
differing fiscal policy responses.
o In 1932, Roosevelt’s fiscal policy response to the depression was to announce a
pathbreaking group of legislative initiatives he called the New Deal, a policy of
drastically increasing demand in the economy.
o The New Deal was seen as too radical when it was introduced, certainly too
radical at a time when capitalists everywhere still feared the rise of Bolshevism.

 Fiscal response differences:

o Ultimately it was World II that pulled the United States out of the Great
Depression: differences between the fiscal response in the 1930s and the actions
taken in the financial crisis could not have been starker. Largely believed at the
time that the market would readjust itself and nothing needs to be done. The
weaker businesses will be rooted out and only the stronger ones would survive
o It was clear to U.S. economic policymakers that a giant fiscal package was going
to be needed if markets and the banking system were to be calmed
o At the time of the financial crisis, this came in the form of TARP in which a huge
amount of $700 billion were injected into the economy

Effects of the Great Recession on the Pakistani Economy

State of Pakistani Economy Prior to the Recession:

 Pakistan’s economy was in a dire macroeconomic state.

 The macroeconomic mismanagement of several years since 2005-06 often characterized as
the era of ‘twin’ deficits of current account (CA) and fiscal balance was only exacerbated
immensely by the arrival of another ‘twin’ shock, this time external, in terms of the global
fuel and food price surges of 2007 and early 2008.
 A fiscal surplus of 3.7% of GDP in FY03 turned into a deficit of 2.3% of GDP in FY04, which
was the start of an adverse trend of annual fiscal deficits. Again, a CA surplus of 4.9% of
GDP of FY03 turned into a deficit in FY05 and joined the above negative trend
 Global fuel prices increased 300% between January 2007 and January 2008, while world food
prices surged 175% between January 2006 and January 2008.
 Pakistan has a significant dependence on imported oil (almost 50% of its energy needs) to
meet the needs of its transportation sector and other modern sectors of its economy. During
2006-2008, Pakistan imported 0.28 to 0.33 million barrels of oil/day (Pakistan imports 80%
of its crude oil) and, more broadly, during the same period, energy imports comprised
almost 25% to 33% of Pakistan’s Total Merchandise Imports. The oil import bill almost
tripled from 2004-05 to 2007-08 as it rose from $4.7 billion to $11.4 billion during this time
period.
 Due to dependence on energy imports, inflation rates in Pakistan spiked in 2008. Inflation in
Pakistan increased from 7.8% in 2007 to 12% in 2008, rising to 20.8% by 2009. In contrast, in
India, the inflation figures from 2007 to 2008 were 4.7% to 8.7%; in Bangladesh, they were
7.2% to 9.9% and in Sri Lanka, they increased from 15.8% to 22.6%.
 Since Pakistan also imported 9.5% of its food in 2006-07, the food inflation in Pakistan rose
to 17.5% in 2008, surpassing the overall inflation rate of 12%.
 Net imports of fuel and food translated into worsening Current Account as well as fiscal
balance for Pakistan – Pakistan’s year-over-year International Reserves dropped by almost
5%.

Observed Impact on important macroeconomic variables for Pakistan due to the global financial crisis:

 Pakistan’s real GDP declined by 4.9% in 2009 as compared to 2007, whereas, for the same
time period, Bangladesh’s growth rate decline, which was relatively the smallest, amounted
to only 0.5%.
 Pakistan’s precarious outcome has been due to an unfortunate confluence of pre-crisis
vulnerability due to terms-of-trade shock, political instability and geo-political trauma on
account of terrorism related security concerns. As a result, Pakistan witnessed a sharp
decline in economic growth from an average of 7.3% during 2004-07 to 4.1% in 2008, which
further decelerated to 1.9% in 2009, as the security environment deteriorated even more.
 Pakistan’s CA deficit, which was already at a relatively high level of 4.8% of GDP in 2007
almost doubled in 2008 and was slow to recover
 Trade Balance deficit reflects a longer-term trend (that goes as far back as 2004-05) of slow
growth or declines in exports without concomitant declines in imports, thus widening Trade
Balance deficits.
 In FY09, full brunt of the global financial crisis was felt. Consequently, Foreign Direct
Investment (FDI) as a representative of Capital Inflows declined, as did Foreign Exchange
Reserves (bottomed out in FY08).
 One ‘bright’ spot was worker’s remittances which stayed up and are expected to play the
role of an increasingly important source of foreign capital inflows in the future.
 Inflation rate soared not only due to monetization of ever-growing fiscal deficit by direct
borrowing from the central bank but also because of the unusual global price surge in fuel
and food prices during 2007 and early 2008.
 The fiscal deficits rose to 7.6% of GDP in FY08 from 4.4% of GDP in FY07 due primarily to
government’s subsidy programs to prevent the full pass-through effect of rising import
prices of fuel and food to reach domestic consumers. As a result, the month-on-month
headline CPI inflation surged to 25.3% by August 2008 compared to 6.5% in August 2007.
 Domestic currencies depreciated in most of the South Asian countries on account of outflow
of capital due to the global financial crisis. Most significantly, Pakistani rupee depreciated
by almost 25% in 2009 as compared to Indian currency that depreciated by approximately
14% in 2008.