Economic Downturn: Description, Triggers, and Consequences
The economic structure inherently follows a cyclical pattern. This cycle involves periods of expansion, which are then followed by contractions referred to as recessions. These recessionary phases are acknowledged to occur when there's a substantial reduction in economic activity across various sectors of an economy that persists beyond a few months. Indicators of a recession include noticeable declines in the real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales.
While the majority of recessions last less than 18 months, the Great Recession was more intense than usual. As one of the most serious economic crises since the Great Depression, it gained the title of the Great Recession.
This severe recession left a profound impact on economic sectors, particularly finance, banking, and housing.
What is it?
What was the Great Recession?
The Great Recession, also known as the financial crisis or the subprime mortgage crisis, refers to the global economic downturn that spanned from 2007 to 2009. The U.S. formally entered a recession in December 2007, marking the start of the downturn that continued until June 2009. Lasting for approximately 18 months, it marked the longest recession since the Great Depression. During this period, the U.S. GDP decreased by 4.3%, marking the largest decrease since the Great Depression.
The effects of the Great Recession reverberated beyond 2009. The U.S. GDP, stock market, unemployment, and household income took years to recover to their pre-recession levels. Several European countries faced defaults on their national debts between 2010 and 2014.
Causes
Causes of the Great Recession
A 2011 report by the bipartisan Financial Crisis Inquiry Commission pinpointed several contributing factors to the Great Recession, including:
1. Lack of regulation in the financial industry by the government
In the years leading up to the financial crisis, the government rolled back regulations in the financial sector. The Financial Services Modernization Act of 1999 allowed banks to invest deposits in derivative securities - financial instruments that derive their value from other securities and thus have more price volatility.
The Commodity Futures Modernization Act of 2000 exempted these financial derivatives from regulatory oversight, enabling financial institutions to use a variety of new and risky financial instruments without regulatory scrutiny.
2. Assuming excessive risk by financial firms
Not only did banks concentrate on risky, profitable derivative securities, but they also used leverage to purchase more of these securities than they could afford.
These financial institutions attempted to offset the risk they had assumed by purchasing a type of derivative called a credit default swap (CDS) as insurance. In turn, CDS providers, such as insurance company AIG, assumed too much risk and lacked the financial resources to meet their CDS and other insurance commitments when the housing market collapsed.
3. Excessive borrowing by consumers and corporations
During the pre-recession housing boom, mortgage lenders loosened their approval standards to approve more loans, even to borrowers with questionable credit and mortgages for 100% or more of a home's value. Many homebuyers maximized their purchasing power, opting for the most expensive homes they could afford. The national mortgage debt increased almost doubled from 2001 to 2007, and the average mortgage debt per household increased by more than 63%.
Financial firms also took on excessive levels of debt. The Financial Crisis Inquiry Commission noted that, by one measure, their leverage ratios were as high as 40 to 1, meaning that for every $40 in assets, there was only $1 in capital to cover potential losses. A 3% decrease in asset values could wipe out the entire company.
4. Limited understanding and response by lawmakers
Lawmakers and government agencies struggled to grasp the changes in the financial industry prior to the financial crisis due to a lack of oversight. The U.S. government failed to understand that the collapse of the housing market threatened the entire financial system, leading to an initial failure by Congress to pass a financial rescue package. It wasn't until the stock market crashed and stock markets worldwide teetered on the brink of collapse that Congress approved legislation to inject emergency funds into the U.S. financial sector.
The legislative body in the U.S., Congress, enacted two significant financial laws in notable instances. In the early days of October 2008, they approved the Troubled Asset Relief Program (TARP), giving the Treasury Department direct authority to distribute funds to banks. The subsequent event occurred in February 2009, when Congress passed the American Recovery and Reinvestment Act, which was an economic stimulus package worth $787 billion. This package decreased taxes and disbursed funds for various projects, such as infrastructure development.
Another significant legislation, the Dodd-Frank Act, was enacted in 2010. This law aimed to restore the power of the government to regulate the financial sector, reversing many aspects of the Financial Services Modernization Act of 1999. The 1999 act, which repealed some provisions from the 1933 Glass-Steagall Act, had contributed to the Great Recession by liberalizing some Depression-era regulations.
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Recovery
Recovering from the Great Recession
By the second quarter of 2009, a mix of the Federal Reserve's fiscal stimulus and congressional spending managed to halt the economic downturn. The U.S. economy started expanding again in the next quarter.
It wasn't until the second quarter of 2011 that U.S. GDP regained its pre-recession peak. The Dow Jones Industrial Average (DJIA) -- which suffered a 50% loss between August 2007 and March 2009 -- took until March 2013 to return to its previous high. Unemployment rates remained above 5% until 2015, while average household income lagged behind its pre-recession level until 2016.
One positive outcome from the Great Recession was that it strengthened the global financial system in numerous ways. Governments also developed strategies for navigating future recessions.
Article Written by Matt DiLallo has no position in the stocks mentioned. Our Website has no position in the stocks mentioned. Our Website has a disclosure policy.
The Great Recession, which began in 2007 and ended in 2009, significantly affected various sectors, including finance and banking. During this period, many financial institutions faced financial difficulty due to a lack of regulation, excessive risk-taking, and excessive borrowing. As a result, multiple regulatory measures were implemented to strengthen the financial system and prevent similar crises in the future.
Investors should be mindful of the lessons learned from the Great Recession and consider risks associated with investing in derivative securities, financial derivatives, and highly leveraged financial firms. While the financial industry has undergone significant reforms, it's essential to stay informed about current regulations and legislations to make well-informed investment decisions.
