Is History Repeating Itself?
Updated: Feb 2
Is America relying on the economic policies implemented during Global Financial Crisis to combat COVID-19?
Written by: Sumair Jalan
The Global Financial Crisis (GFC) began in the United States in 2007 as the subprime mortgage crisis due to the collapse of the US housing market. According to Sargunam, Kumar & Mary (2016), “a situation in which the financial assets suddenly lose a large part of their nominal value” is known as a financial crisis. The systemic financial crisis led to the failure of numerous investment and commercial banks, insurance companies, and mortgage lenders. It led to a technical recession in the US. By early 2009, American households experienced a fall in their net worth by about “$17 trillion in inflation-adjusted terms,” a loss of 26 percent since its peak in mid 2007. (Duignan, 2019).
The unemployment rate climbed to 10% as 7.5 million people were retrenched. The crisis propagated globally, which resulted in a severe contraction of liquidity in global financial markets. When this crisis had a severe impact across the world, it was termed as a Global Financial Crisis (Sargunam et al., 2016). It sparked the “Great Recession” and the global economy contracted by 2% in 2009 as 52 countries experienced a decline in per capita income. The Great Recession (2007-09) was the worst economic downturn since the Great Depression in 1929.
The novel Coronavirus disease (COVID-19) is another such global phenomenon to disrupt the global economy. The economic downturn inflicted by it is more acute. As per IMF reports, the global economy will shrink by 3% this year (Jones, Palumbo & Brown, 2020). This decline would be the worst since the Great Depression (Jones et al., 2020).
Major economic similarities
Monetary policy is a demand-side policy implemented by monetary authorities to ensure price stability. The US Federal Reserve (Fed) implemented expansionary monetary policy by reducing interest rates significantly before the GFC. The lower yields led to excessive leverage by banks as they wanted to maintain profitability. The lending standards fell as banks provided loans to investors with poor or no credit rating. These high-risk loans were called subprime mortgage loans. (Boshkoska & Lazaroski, 2018). These bad mortgage loans were securitized into collateral debt obligations (CDO). These financial instruments reduced the perceived risks on balance sheets by paying the credit agencies for manipulating their rating. The artificial manipulation of credit ratings led to asymmetric information for the investors as the risk associated with such securities was unknown. (Boshkoska & Lazaroski, 2018).
Besides, the outbreak of the COVID-19 crisis interrupted trade activities due to the impositions of the travel bans and lockdowns globally. With the cases soaring and the vaccines yet to get approval, there is great uncertainty regarding the extent of the economic impact of the pandemic. The World Pandemic Uncertainty Index (WPUI) quantifies the uncertainty associated with COVID-19 and compares it with previous pandemics and epidemics (Ahir, Bloom & Furceri, 2020). The index of Global Economic Policy Uncertainty (GEPU) is a weighted average of national EPU indices for more than 20 countries. The WPUI and index of GEPU have reached record levels this year (Strauss-Kahn, 2020) (Figure 1).
Figure 1: World Pandemic Uncertainty Index and Global Economic Policy Index
Source: Atlantic Council
The advent of both crises led to stock exchanges of major economies crashing. In both cases, the resulting global recessions have been classified as the worst since the Great Depression. Figure 2 highlights the similar trajectory of the S&P 500 index post the collapse of Lehmann Brothers and the historical peak of COVID-19 cases in the US. In both instances, the index was considered overvalued.
Figure 2: US Stock Exchange 2008-2020 during GFC (Sept. 2008) and COVID-19 (Feb. 2020)
Source: Atlantic Council
Major economic differences
Although GFC and COVID-19 disrupted the global economy, the fundamental cause of each crisis is distinct. An endogenous financial shock in terms of systematic banking crisis had a direct impact on the real economy and led to the GFC. It affected the demand side first. In contrast COVID-19 was an exogenous public health crisis. The resulting Draconian containment efforts, including lockdowns and travel bans, produced a shock to the global supply chain. It led to a supply shock and then a demand shock. Therefore, GFC had a primary impact on the real economy in contrast to COVID-19 which had a secondary effect.
The demand shock adversely affected aggregate demand (AD) and led to the decline of global real GDP and price levels (deflation). Conversely, the supply shock negatively impacted aggregate supply (AS) and reduced global real GDP and increased the price levels (stagflation). While both cases led to a contraction of global real GDP, the impact on the price levels in the countries depends on the relative strengths of the movement of AD and AS curves.
Severity of adverse economic impact
Although both the crises led to a global recession, the contraction of global economic activity due to COVID-19 was more acute. Figure 3 portrays the severity of the COVID-19 recession as more than twice that of the recession associated with the GFC 2007-09 (Kose & Sugawara, 2020). It is considered the deepest recession since 1945-46 (Kose & Sugawara, 2020).
Figure 3: All global recessions since 1870 measured as % of real GDP
Source: World Economic Forum
Global Financial Crisis
The policies implemented during the GFC had three distinct objectives:
· Improve the macroeconomic environment
· Induce financial stability
· Effectuate structural repair
The Fed implemented an expansionary monetary policy that reduced interest rare by fifty basis points (bps) (Arner, 2009). The interbank interest rate or the fed funds rate was close to zero. Quantitative easing was in effect as the Fed bought government bonds and mortgage-backed securities. It caused Fed’s total assets to skyrocket from $900 billion to $4.5 trillion (Schulze, 2017). As per Arner (2009), Fed drastically increased the liquidity of dollars in the market by lending out large amounts of money to the world’s major central banks and other institutions that could not borrow in financial markets.
The US government implemented expansionary fiscal policy through tax cuts and increased expenditure to “stimulate demand and support employment throughout the economy.” (Arner, 2009). In the United States, the American Recovery and Reinvestment Act was passed in 2009, which led to the creation of a $787 billion stimulus and relief program to combat the adverse economic impact of the financial crisis (Duignan, 2019). They guaranteed deposits and bank bonds to raise the confidence of investors in the financial markets. They also purchased ownership stakes in some banks and financial firms to prevent bankruptcies that could have worsened the financial crisis. (Arner, 2009).
To mitigate risks to the financial system as a whole, the US implemented macroprudential policies. These are regulatory tools that can be used to increase the resilience of the financial system to shocks (Nier, 2016). These included requirements for cash on hand and capital and imposed restrictions on loans such as “caps on loan-to-value and debt-to-income ratios” (Nier, 2016). These policies were implemented by regulators to strengthen their oversight of banks and other financial institutions. The regulations required banks to closely assess the risk of the loans they issue. They must operate with lower leverage and are prohibited to make short term loans to fund the loans they make to their customers. Duignan (2019) reported that in 2010 the US government implemented the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which instituted banking regulations to prevent another financial crisis. It formed a Consumer Financial Protection Bureau that was responsible for regulating subprime mortgage loans and other forms of consumer credit (Duignan, 2019).
The US learned from its mistakes during the GFC. The Fed’s policy response to the adverse economic impacts of COVID-19 was quick and effectively coordinated. Within 100 days of the pandemic, it implemented a tested crisis toolkit. The monetary and fiscal policies were implemented to not only combat the demand and supply shocks but also directed towards disease containment and mitigation.
The Fed implemented an expansionary monetary policy by reducing the interest rate to 0-25 BPS (ECLAC, 2020). It initiated a quantitative easing program that increased Fed’s Treasury securities by US $500 billion and agency mortgages backed securities by US$ 200 billion (ECLAC, 2020). As a result, its balance sheet expanded to US$ 7.17 trillion by June 2020 (ECLAC, 2020). Figure 4 highlights the accelerated and effective response to mitigate the adverse economic ramifications of COVID-19.
Figure 4: Comparison of the changes in Fed funds rate during GFC and COVID-19 (%)
Source: Economic Commission for Latin America and the Caribbean
The implementation of fiscal policy has also been at an unprecedented speed. During GFC, it took over 500 days for the measures to take effect. In contrast, the Fed implemented three policy measures in response to COVID-19 in March 2020 alone (Figure 5).
Figure 5: Total funds sanctioned by US States Congress, 2008-2009 and 2020 (Billions of dollars)
Source: Economic Commission for Latin America and the Caribbean
The Paycheck Protection Program and Health Care Enhancement Act were passed in April 2020. The US government had to increase capital injections by US$ 484 billion towards coronavirus relief efforts (ECLAC, 2020). This involved:
· Additional US$ 322 billion in funding for PPP kits
· Disaster loans and grants for small enterprises worth US$ 60 billion (the Economic Injury Disaster Loan fund)
· US $100 billion for hospitals and coronavirus testing
With the expiration of fiscal support from the US government looming and no vaccines in effect, the real test for the US economy begins now. If past performance is an indicator of future performance, then history might repeat itself with the post-pandemic years. Therefore, the policymakers should continue to engineer policies to prevent the economy from shrinking to a level and experiencing a delayed recovery as it did during the GFC.
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