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Causes and Consequences of Globally Financial Recession

Executive Summary
The global outlook
The world economy is entering into a recession

The world economy is mired in the worst financial crisis since the Great Depression.
What first appeared as a sub-prime mortgage crack in the United States housing market
during the summer of 2007 began widening during 2008 into deeper fissures across the
global financial landscape and ended with the collapse of major banking institutions,
precipitous falls on stock markets across the world and a credit freeze. These financial
shockwaves have now triggered a full-fledged economic crisis, with most advanced
countries already in recession and the outlook for emerging and other developing
economies deteriorating rapidly, including those with a recent history of strong economic
performance. In the baseline scenario of the United Nations forecast, world gross product
is expected to slow to a meagre 1.0 per cent in 2009, a sharp deceleration from the 2.5 per
cent growth estimated for 2008 and well below the more robust growth of previous years.
At the projected rate of global growth, world income per capita will fall in 2009. Output
in developed countries is expected to decline by 0.5 per cent in 2009. Growth in the
economies in transition is expected to slow to 4.8 per cent in 2009, down 6.9 per cent in
2008, while output growth in the developing countries would slow from 5.9 per cent in
2008 to 4.6 per cent in 2009.

The world economy could fall into recession in 2009

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Given the great uncertainty prevailing today, however, a more pessimistic scenario is
entirely possible. If the global credit squeeze is prolonged and confidence in the financial
sector is not restored quickly, the developed countries would enter into a deep recession
in 2009, with their combined gross domestic product (GDP) falling by 1.5 per cent;
economic growth in developing countries would slow to 2.7 per cent, dangerously low in
terms of their ability to sustain poverty reduction efforts and maintain social and political
stability. In this pessimistic scenario, the size of the global economy would actually
decline in 2009—an occurrence not witnessed since the 1930s. To stave off the risk of a
deep and global recession, World Economic Situation and Prospects (WESP) 2009
recommends the implementation of massive, internationally coordinated fiscal stimulus
packages that are coherent and mutually reinforcing and aligned with sustainable
development goals. These should be effected in addition to the liquidity and
recapitalization measures already undertaken by countries in response to the economic
crisis. Under a more optimistic scenario—factoring in an effective fiscal stimulus of
between 1.5 and 2 per cent of GDP by the major economies, as well as further interstate
cuts WESP forecasts that, in 2009, the developed economies could post a 0.2 per cent rate
of growth, and growth in the developing world would be slightly over 5 per cent.

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Introduction:
It was never meant to happen again, but the world economy is now mired in the most
severe financial crisis since the Great Depression. In little over a year, the mid-2007
subprime mortgage debacle in the United States of America has developed into a global
financial crisis and started to move the global economy into a recession. Aggressive
monetary policy action in the United States and massive liquidity injections by the central
banks of the major developed countries were unable to avert this crisis. Several major
financial institutions in the United States and Europe have failed, and stock market and
commodity prices have collapsed and become highly volatile. Interbank lending in most
developed countries has come to a virtual standstill, and the spread between the interest
rate on inter bank loans and treasury bills has surged to the highest level in decades.
Retail businesses and industrial firms, both large and small, are finding it increasingly
difficult to obtain credit as banks have become reluctant to lend, even to long-time
customers. In October 2008, the financial crisis escalated further with sharp falls on stock
markets in both developed and emerging economies. Many countries experienced their
worst ever weekly sell off in equity markets. The current crisis, which started in the
housing and financial sectors, has now led to a strong fall in aggregate demand. There are
indications that this fall could be larger than in any period since the Great Depression. A
successful policy package should address both the financial crisis and the fall in
aggregate demand, and thus, should have two components: one, aimed at getting the
financial system back to health; the other, aimed at increasing aggregate demand. There
are obvious interactions and synergies between the two. Financial measures, from
recapitalization to asset purchases, have important implications for credit flows and
aggregate demand. Measures to support aggregate demand, for example by helping
homeowners and improving the housing market, have clear implications for the health of
financial institutions. Nevertheless, our focus in this note will be primarily on measures
aimed at sustaining aggregate demand (Financial measures have been, and will be, the
subject of other notes.

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Recession:
What is an Economic Recession? This occurs when there is a significant decline in the
economy which usually lasts for months. This is visible in terms of consumer spending,
employment, industrial production, real income and wholesale trade. A technical
indicator of this is 2 consecutive quarters of negative growth which is measured by the
countrys GDP or gross domestic product. Experts say that an economic recession is
normal because it is part of the business cycle and things usually improve within 16 to 18
months. During the business cycle, there is a period of recovery, expansion, slowdown
and then recession. During recovery, the GDP of a country starts to move up. When the
GDP grows robustly, this is the time that it expands. When consumers are not buying that
much, this is when you have a slowdown. Because there is weaker demand, you have a
recession. The last economic recession occurred in 2000 and 2001 which featured three
quarters of negative growth followed by three positive quarters then five more quarters of
sub par growth. Experts say that the same trend will happen right now. One solution that
the government usually does is lower interest rates to help stimulate the economy. Just
last year, the Federal government slashed interest rates three times towards the end of the
third and fourth quarter year so that overnight loans between banks could be borrowed at
4.25% which happens to be its lowest in the past 2 years. What makes the economic
recession different from what occurred after the Second World War is that this one is
caused by falling home values and a crisis of confidence among fixed income investors.
Despite the fact that the country has endured this time and again for over 50 years, there
is still no way to predict when it will happen. Some use the stock market as an indicator.
Others use the inverted yield curve which uses yields on a 10 year and three month
Treasury securities and the Feds overnight funds rate. The unemployment rate is also
another which happens to be one of the things that make up the index of leading
indicators. There are people in the Bush administration who do want to call it an
economic recession because this will make people panic but there are others who are
brave enough to admit that it is here. Since it is going to be some time before the
economy recovers again, everyone is advised to stay calm, save up and look for long term
investments worth going into. Apart from the war in Iraq, the economy is going to be one
of the critical issues that both candidates have to address as they are campaigning for the
highest post in the land. Whoever wins, they have to find a way to reduce the
unemployment rate, help people save their homes and a lot of other things that affect the
average American household. An economic recession lasts months at a time. If it should
continue for a much longer period, then this is called a depression which is something
that the world and not only the US experienced at the end of the First World War. This
lasted for up to 4 years that many hope will never happen again. Most experts agree that
it is only an "official economic recession" when GDP growth is negative for two
consecutive quarters or more. For all practical purposes though, a recession starts when
there are several quarters of slowing but still positive growth. The first quarter of
negative growth in a recession cycle is often followed by positive growth for several
quarters,and then another quarter of negative growth.

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This definition is somewhat unpopular with many economists as it does not take into
consideration changes in other economic variables such as current unemployment rates or
consumer confidence and spending levels. The official agency in charge of declaring that
the economy is in a state of recession is the National Bureau of Economic Research.
NBER's defines recession as a "significant decline in economic activity lasting more than
a few months". For this reason, the official designation of recession may not come until
after we have been in one for a substantial amount of time. It is actually quite natural for
countries to experience mild economic recessions. This is a built-in factor of a societies
economic cycle as spending and consumption are going to increase and decrease along
with prices. Rarely, experiencing many of these factors simultaneously can evoke deep
economic recession or depression.

Is is as simple as ....."The economy is doing lousy?". Actually, yes it is. Of course, there
is that technical definition used by the economists and the scholars; Many(non
economists and scholars) are now referring to it as an economic collapse. This occurs
when there is a significant decline in the economy which usually lasts for months. This is
visible in terms of consumer spending, employment, industrial production, real income
and wholesale trade. A technical indicator of this is 2 consecutive quarters or six months
of negative growth which is measured by the country’s GDP or gross domestic product.
For the National Bureau of Economic Research (NBER), “recession is a significant
decline in economic activity lasting more than a few months”. An economic recession
cycle typically lasts 16 to 18 months, and the last time the United States was technically
in a recession was during 2000-2001. Any recession which only lasts a short time(10-12
months), is instead typically referred to as an "economic recession "Make no mistake, we
are now in an economic recession

Officially, a recession is period when the Gross Domestic Product (GDP) growth is
negative for at least two quarters or more. This can cause troublesome economic changes
such as rising unemployment, falling stock prices, and stagnating business activity.

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Understanding the Causes of Economic Recession:

It can be difficult to predict the causes of economic recession. However, many


economists believe the Index of Leading Indicators may be a useful tool for determining
when a recession is coming. Factors in this measurement of the country’s financial health
include:

 Weekly hours worked by manufacturing workers on average


 Average number of initial applications for unemployment insurance claims
 S&P 500-stock index
 Inflation-adjusted monetary supply
 Spread between long and short interest rates
 Pessimistic consumer sentiment
 Amount of manufacturer orders for consumer goods and materials
 Speed of delivery of new merchandise to vendors from suppliers
 New orders for capital goods unrelated to defense
 Number of new building permits for residential buildings

The Index of Leading Indicators is not foolproof, however. Although it predicted each of
the seven recessions between 1959 and 2001, it also forecasted five recessions that failed
to materialize.

Many people believe that recessions are a natural part of the capitalist economic system.
In fact, there are those who think recessions help “clean the fat” from businesses that are
failing to operate within their means. By this logic, recessions help pave the way for
periods of economic expansion.

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What Causes an Economic Recession:

What causes recessions to happen? There are complex reasons as well as simple reasons
why economic recessions happen. John Maynard Keynes states that there are “animal
spirits” which exist as driving elements for a recession. “Animal spirits” could be
confidence, uncertainty, and pessimism. These “animal spirits” prevent objectivity and
quantitative thinking. An example where these “animal spirits” taking over, is when
consumers lose interest in products, services and outputs. On the eve of an economic
recession, there will be overproduction. Supply will exceed the demands for products and
services. This typically pushes companies to increase prices and consumers consequently
lose confidence and retract their purchasing of non-essential products. A good example of
this "animal spirits" element driving a recession was the psychological impact that the
events of the September 11, 2001 attacks on consumers across the nation. This period of
time was the last period in which our country was immersed in a recession. Some
economists suggest that recession may not only be caused by events that have large or
huge impact on the people. Events that hurt particular companies or industries can also
cause recession. Major innovations or change in a price of a major component needed in
the completion of the product can have dramatic effects on some firms. These may cause
reduction of workers or production. Over consumption can also be a cause of recession.
Spending more that what is necessary may often lead to recession and, sometimes to
poverty. An example of this is the extraordinary expenditure of the United States for the
Iraq war. Economists are saying that the United States should be more careful with their
consumption in the future, as resources that would have otherwise found their way into
our mainstream economy instead went overseas in the form of war spending.
Government economic policies can be used to avoid economic recession. But failure to
provide good economic policies can lead to recession, and strong thoughtful policies
accompanied by careful execution can lead to an economic boom. Another issue is that
the policymakers themselves are not attentive enough to see clearly the increasing signs
of inflation or the early onset of a recession. Policymakers often times regard the onset of
recession as just a slow economic growth that will correct itself. However, like in our
current situation, failure to address the economic warning signs leads to more significant
economic turmoil(ie...our current economic collapse). Economic recession is not just a
problem in theUnited States . The United Nations sounded an alarm that there might be a
global economic recession as early as January 2008. According to United Nations, world
economic growth for 2008 is estimated to be at just 3.4 percent, continuing to trend
downward since 2006 (3.9 percent) and 2007 (3.7 percent). The bursting of the housing
market bubble in the United States and the unfolding credit crisis in other countries are
two of the major factors responsible for the world's global recession. Currently, Latvia,
Estonia and Lithuania are all at risk of falling into economic recession due to the current
global credit crisis. To summarize, economic recession can be brought about by external
as well as internal economic shocks and widening imbalances in the economy. We are

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currently in the middle of this economic cycle and it will take good policy, patience, and
flawless execution by the incoming administration to start our march towards
normalization.

Experts say that an economic recession is normal because it is part of the business cycle
and things usually improve within 16 to 18 months. During the business cycle, there is a
period of recovery, expansion, slowdown and then recession. During recovery, the GDP
of a country starts to move up. When the GDP grows robustly, this is the time that it
expands. When consumers are not buying that much, this is when you have a slowdown.
Because there is weaker demand, you have a recession. The last economic recession
occurred in 2000 and 2001 which featured three quarters of negative growth followed by
three positive quarters then five more quarters of sub par growth. Experts say that the
same trend will happen right now. One solution that the government usually does is lower
interest rates to help stimulate the economy. Just last year, the Federal government
slashed interest rates three times towards the end of the third and fourth quarter year so
that overnight loans between banks could be borrowed at 4.25% which happens to be its
lowest in the past 2 years.

What makes the economic recession different from what occurred after the Second
World War is that this one is caused by falling home values and a crisis of confidence
among fixed income investors. So when someone tries to get an economist to provide a
"recession definition", it is more difficult than you may think. Events differ from period
to period and from economic cycle to economic cycle. Despite the fact that the country
has endured this time and again for over 50 years, there is still no way to predict when it
will happen. Some use the stock market as an indicator. Others use the inverted yield
curve which uses yields on a 10 year and three month Treasury securities and the Fed’s
overnight fund’s rate. The unemployment rate is also another which happens to be one of
the things that make up the index of leading indicators. There are people in the Bush
administration who do want to call it an economic recession because this will make
people panic but there are others who are brave enough to admit that it is here. Since it is
going to be some time before the economy recovers again, everyone is advised to stay
calm, save up and look for long term investments worth going into. Apart from
the war in Iraq, the economy is going to be one of the critical issues that both candidates
have to address as they are campaigning for the highest post in the land. Whoever wins,
they have to find a way to reduce the unemployment rate, help people save their homes
and a lot of other things that affect the average American household.

An economic recession lasts months at a time. If it should continue for a much longer
period, then this is called a depression which is something that the world and not only the
US experienced at the end of the First World War. This lasted for up to 4 years that many
hope will never happen again. That would be our definition of an economic windfall.
Federal Reserve is responsible for maintaining an ideal balance between money supply,
interest rates, and inflation. When The Federal Reserve loses balance in this equation, the
economy is forced to correct itself. The Feds monetary policy of injecting tremendous

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amounts of money supply into the money market has kept interest rates lower while
inflation continues to rise. Inflation refers to a general rise in the prices of goods and
services over a period of time. The higher the rate of inflation, the smaller the percentage
of goods and services that can be purchased with the same amount of money.Inflation can
happen for reasons as varied as increased production costs, higher energy costs.

In an inflationary environment, people tend to cut out leisure spending, reduce overall
spending and begin to save more. As individuals and businesses curtail expenditures in an
effort to trim costs, this causes GDP to decline. Unemployment rates rise because
companies lay off workers to cut costs. It is these combined factors that cause the
economy to fall into a recession.

These circumstances coupled with relaxed policies in lending practices making it


extremely easy to borrow money can result in unsustainable economic activity and the
economy coming to a near halt. It is also said that recession can be caused by factors that
stunt short term growth in the economy, such as spiking oil prices or war. However, these
are mostly short term in nature and tend to correct themselves in a quicker manner than
the full blown recessions that have occurred in the past.

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Few of the significant symptoms of an economic recession are:

 The rate of job loss becomes far too alarming


 Many businesses across all sectors suffer a serious decline in sales turnover and their
profits shrink
 Borrowers default on repayment of loans and credit card liabilities
 Banking system breaks down as borrowers are not in a position to repay loans
 Prices of food, fuel and other essential commodities shoot up
 Companies offer voluntary retirement programs to reduce their workforce and cut
wages
 People foreclose their fixed-term deposits, and sell off other assets to meet their day-
to-day expenses.

Apart from some simple causes, there can also be a few complex reasons why economic
recessions occur. One primary reason is when consumers lose interest and cease buying
products. Prior to an economic recession, there will usually be an overproduction of
goods causing supply to exceed the demand. This will drive companies to increase prices,
which in turn causes consumers to lose confidence and decide to decrease spending.
Certain events that harm specific industries could spur a recession, such as what is
currently happening to the banking, credit and mortgage industries. Over consumption or
excess buying may also be another reason for a recession. Spending more than what is
necessary can lead to debt. Debt can affect the amount people have in savings and their
disposable income.

Wrong economic policies pursued by a government can have detrimental effects. If not
zealously monitored, these policies could cause the economy to boom and then bust and
lead to inflation. The steadily escalating oil prices have a cascading effect and severely
impacts the economy. When the policy makers do not pay attention and fail to address the
increasing inflation at the beginning of a recession, more and more economic disasters
follow and spread world wide. Over the years, economists have suggested a number of
strategies to help an economy to recover from a recessionary phase. The strategy to be
adopted may vary depending on the type of economic system followed by a nation's
policy makers. While some may favor deficit spending to restart economic growth, others
may recommend tax cuts and a few may prefer non-intervention by the government in the
market forces of the economy. The only heartening feature is most economic recessions
are brief and time-bound.

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Economic Recession History:


This year, the United States has entered, again, into an economic-recession. Although
the National Bureau of Economic Research still has not release any formal announcement
regarding this, American people are starting to experience an economic slowdown and a
downturn in their financial and personal life. This is not be the first time that the United
States has experienced an economic recession. According to economists, since 1854, the
United States has encountered 32 cycles of expansions and contractions (boom and bust).
There would be and average of 17 months of contraction an 38 months of expansion.
However, since 1980 there have been only eight periods of negative economic growth
over one quarter or more.

There were three periods considered to be recessions:

January- July 1980 and July 1981- November 1982: two years in total
July 1990- March 1991: eight months
November 2001- November 2002: twelve months

The longest record for an American economic boom was 37 quarters during 1991 until
2000.

The first economic recession happened in 1819. It greatly affected the new nation. After
the War of 1812, the American economy was experiencing monetary strains. In 1814,
during the term of President Madison, he allowed a replacement of a national bank. This
enabled the post-war economy to boom. Although in 1817, there were some financial
irregularities and irresponsibility. Americans started buying extravagant amounts of
western lands- more than they could afford. The government started selling the land on
credit.

In 1819, the government started to demand payment on the loans. During this time, the
economy started to slow down. The market growth could no longer be sustained, and the
demand for American products started to wane. This led to a wave of bankruptcies and
foreclosures. Land owners found themselves unable to pay their government debts and
debts in the banks, leading to the repossessing of the land.

After the 1817 recession, another recession in 1837 followed. With this recession, in just
two months time, the economic decline accumulated to nearly $100,000,000 in value.
There were reportedly 343 banks that closed (out of the 850 banks). In addition, 62
banks reported partial failure.

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There were also recessions that occured in 1857, 1873, 1893 and 1907. The 1907
economic recession was a significant financial crisis. Nearly 50 percent of the stock
market fell from its peak in 1906. It's primary cause was a retraction of loans by some
banks that began in New York City and soon spread across the entire country. The 1907
recession was the fourth recession in just 34 years.

The post-World War I recession hit not only the United States but much of the countries
globally. The pre-war economy was showing fast economic growth. As a matter of fact,
the decade before the war, the world economy was growing record high. After the war,
the global economy stated to decline. The sharpest or worst decline was during 1921. the
recession was a result of the end of wartime production along with the return of the
troops without any employment. Global production was also affected by the war,
especially those countries whose industries were shattered by the war.

What followed was known as the Great Depression. It occurred from 1929 until 1939. It
is the most dramatic, worldwide economic landslide that has ever been experienced. It
affected not only industrialized countries but also nations who relied on exporting their
raw materials. It was the largest and most important global economic depressions
in world history.

Five recessions in the United States followed the Great Depression. We experienced
economic recessions in 1953, 1957, early in the 1980s, early during 1990s and early
2000.

The early 2000 economic recession was not felt only in the United States, but was
experienced in most Western Countries. The European Union was mostly affected during
2000 and 2001. The United States was affected most significantly 2002 and 2003.

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Over All Recession Periods:

Name Dates Duration Causes


The effects of the deflation of the Bank of England crossed the
Atlantic Ocean to North America and disrupted commercial and
real estate markets in the United States and the Caribbean.
Panic of 1797 1797–1800 3 years
Britain's economy was greatly affected by developing
disflationary repercussions because it was fighting France in the
French Revolutionary Wars at the time.
The Embargo Act of 1807 was passed by the United States
Congress under President Thomas Jefferson. It devastated
Depression of 1807 1807–1814 7 years
shipping-related industries. The Federalists fought the embargo
and allowed smuggling to take place in New England.
The first major financial crisis in the United States featured
widespread foreclosures, bank failures, unemployment, and a
Panic of 1819 1819–1824 5 years
slump in agriculture and manufacturing. It also marked the end
of the economic expansion that followed the War of 1812.
A sharp downturn in the American economy was caused by
bank failures and lack of confidence in the paper currency.
Panic of 1837 1837–1843 6 years
Speculation markets were greatly affected when American
banks stopped payment in specie (gold and silver coinage).
Failure of the Ohio Life Insurance and Trust Company burst a
European speculative bubble in United States railroads and
caused a loss of confidence in American banks. Over 5,000
Panic of 1857 1857–1860 3 years
businesses failed within the first year of the Panic, and
unemployment was accompanied by protest meetings in urban
areas.
Economic problems in Europe prompted the failure of the Jay
Cooke & Company, the largest bank in the United States, which
Panic of 1873 1873–1879 6 years burst the post-Civil War speculative bubble. The Coinage Act of
1873 also contributed by immediately depressing the price of
silver, which hurt North American mining interests.
The collapse of the Vienna Stock Exchange caused a depression
that spread throughout the world. It is important to note that
Long Depression 1873–1896 23 years during this period, the global industrial production greatly
increased. In the United States, for example, industrial output
increased fourfold.
Failure of the United States Reading Railroad and withdrawal of
European investment led to a stock market and banking
Panic of 1893 1893–1896 3 years
collapse. This Panic was also precipitated in part by a run on the
gold supply.
A run on Knickerbocker Trust Company deposits on October
Panic of 1907 1907–1908 1 year 22, 1907 set events in motion that would lead to a severe
monetary contraction.

Post-World War I 1918–1921 3 years Severe hyperinflation in Europe took place over production in
recession North America. It was a brief but very sharp recession and was
caused by the end of wartime production, along with an influx

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of labor from returning troops. This in turn caused high


unemployment.
Stock markets crashed worldwide, and a banking collapse took
place in the United States. This sparked a global downturn,
Great Depression 1929–1939 10 years
including a second, more minor recession in the United States,
the Recession of 1937.
1 year After a post-Korean War inflationary period, more funds were
transferred into national security. The Federal Reserve changed
Recession of 1953 1953–1954
monetary policy to be more restrictive in 1952 due to fears of
1 further inflation.
Monetary policy was tightened during the two years preceding
1957, followed by an easing of policy at the end of 1957. The
Recession of 1957 1957–1958 1 year budget balance resulted in a change in budget surplus of 0.8% of
GDP in 1957 to a budget deficit of 0.6% of GDP in 1958, and
then to 2.6% of GDP in 1959.
A quadrupling of oil prices by OPEC coupled with high
1973 oil crisis 1973–1975 2 years government spending due to the Vietnam War led to stagflation
in the United States.
The Iranian Revolution sharply increased the price of oil around
the world in 1979, causing the 1979 energy crisis. This was
caused by the new regime in power in Iran, which exported oil
at inconsistent intervals and at a lower volume, forcing prices to
Early 1980s recession 1980–1982 2 years go up. Tight monetary policy in the United States to control
inflation led to another recession. The changes were made
largely because of inflation that was carried over from the
previous decade due to the 1973 oil crisis and the 1979 energy
crisis.
Industrial production and manufacturing-trade sales decreased in
Early 1990s recession 1990–1991 1 year
early 1991.
The collapse of the dot-com bubble, the September 11th attacks,
Early 2000s recession 2001–2003 2 years and accounting scandals contributed to a relatively mild
contraction in the North American economy.
The collapse of the housing market led to bank collapses in the
US and Europe, causing the amount of available credit to be
sharply curtailed. (Note: this period, as of December 10, 2008,
does not yet meet the "classic" definition of recession, i.e. two
consecutive periods of negative economic growth. Rather, the
Economic crisis of 2008 2007–present ongoing
crisis has been identified as a recession by the National Bureau
of Economic Research who say that the U.S. has been in
recession since December of 2007. Future revisions of prior
quarter numbers may bring the classic and modern definitions of
recession into alignment for this time period.)

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Effects of a Recession:
An economic recession can usually be spotted before it happens. There is a tendency to
see the economic landscape changing in quarters preceding the actual onset. While the
growth in GDP will still be present, it will show signs of sputtering and you will see
higher levels of unemployment, decline in housing prices, decline in the stock market,
and business expansion plans being put on hold. When the economy sees extended
periods of economic recession, the economy can be referred to as being in an economic
depression.

About the only good thing about a recession is that it will cure inflation. The balancing
act the Federal Reserve must pursue is to slow economic growth enough to prevent
inflation without triggering a recession. Currently, it must do this without the help of
fiscal policy, which is generally trying to stimulate the economy as much as possible
through lowering taxes, spending on social programs and ignoring current account
deficits.

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Reasons for U.S Financial Crises:


In good times, financial markets embrace capitalism. In bad times, financial markets re-
discover socialism. Currently, the US Federal Reserve is engaged in a dangerous strategy
to look after its Wall Street friends. The origins of the current credit crisis lie in a loose
monetary policy and excessive capital flows that were turbo-charged by "financial
engineering" techniques used by banks. Borrowing bought more borrowing, fuelling
price increases in financial assets -- debt, equity, property, infrastructure. In recent
months, major banks have reported losses of around $45 billion on their investments. Up
to $1 trillion of assets are also on their way back onto bank balance sheets as complex
off-balance sheet structures (collateralised debt obligations, conduits issuing asset-backed
commercial paper and structured investment vehicles) are unwound. The major
regulatory response has been cuts in the US Fed funds rate (0.75 per cent per annum) and
the discount rate. In recent weeks, the differential between inter-bank rates and the
central bank targeted rates has widened to levels not seen since August. This points to
further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with
above-target inflation levels resulting from high oil prices, higher food prices, increasing
cost pressures in emerging economies such as China and the potential inflationary effect
of a weaker dollar.

The US central bank's strategy is clear. The current credit problems require a substantial
reduction in the level of borrowings and leverage in the global financial system. Asset
prices ramped up by excessive debt need to adjust. The adjustment can take place via a
"crash". This would be de-stabilising and would wreak further havoc on already
weakened banks.

Alternatively, the de-leveraging and price adjustment can be achieved by creating


inflation through a loose monetary policy. If asset prices remain at current levels, higher
inflation allows values to fall in real terms. Higher inflation also reduces the value of
borrowings that must be paid back allowing the required reduction in leverage.

Between January 1960 and December 1974, the Dow Jones Industrial Average was
substantially unchanged. This is despite significant periodic rallies during the "go-go
years". If inflation averaged 5 per cent per annum, then the value of the market (ignoring
dividends) lost around half (50 per cent) of its value in real (inflation-adjusted) terms.

The Fed strategy also assists affected banks. The large writedowns in risky assets and the
expected re-intermediation of assets mean that some banks need large infusions of
capital. Given recent performance and subdued profit outlook, it would be difficult for
them to raise this capital at acceptable prices.

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Lower short-term interest rates allow banks to borrow cheaply. The money can be used to
purchase government bonds that provide higher returns than the cost of borrowing. This
generates profits for the bank without the banks having to hold capital against their assets
(banks generally are not required to hold capital against government securities). The
profits help re-capitalise the bank.

An added benefit is that the US government can fund its deficit by selling its debt to the
banks. This would be handy if foreign demand for US Treasuries decreases in response to
the weaker dollar. The Bank of Japan used the same strategy to re-capitalise the loss-
making Japanese banks after the collapse of the "bubble economy" in 1989.

Higher inflation expectations are already evident in higher gold prices, the steeper US
yield curve (long-term rates are higher than short-term rates) and the weaker dollar.

Foreign investors, especially large sovereign investment funds, are switching from
financial assets (bonds) to "real" assets (companies with real businesses) reflecting higher
inflationary expectations.

The strategy is dangerous. Inflation can lead to a significant transfer of wealth from
investors to borrowers. Inflation once embedded in the economy distorts economic
activity such as investment and savings. The experience of the late 1970s and early 1980s
highlights the difficulties in recapturing the inflation beast once uncaged.

Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to
stratospheric levels to squeeze inflation out of the financial system.

The strategy may also not work. The cuts in rate do not appear to have had the desired
effect in improving market liquidity conditions. Default risk concerns continue to inhibit
lending and other routine financial transactions. Lower rates may set off further bubbles,
for example, in equities and emerging markets. Asset prices may fall sharply anyway. In
fairness to Ben Bernanke, he has limited policy alternatives available.

Central bankers have stated that "errant" banks and investors will not be "bailed out".
Actual actions suggest otherwise. Banks have played their "nuclear" option well. The
spectre of "systemic risk", whether real or not, is one a central banker cannot ignore. The
strategy has attracted little scrutiny or comment despite being implemented by unelected
officials with public money and without any transparent political debate.

In a 1998 speech during the Asian financial crisis, Lawrence Summers, then Deputy
Secretary of the US Treasury, preached the merits of American-style "transparency and
disclosure". A new term, "crony capitalism", was coined to describe the cozy relationship
between Asian governments' regulators and the private sector. It seems that crony
capitalism is not exclusive to emerging markets.

Banks continue to privatise gains and socialise losses. Socialism on Wall Street will
prevail, once again.

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Reasons for Global Recession:


The biggest problem with economic turmoil is; it creates fear and panic amongst general
people. Rumors are thick and they fly, resulting into even more fear amongst the
households about their savings and hard earned income. Economic problem of 2008 is of
gigantic proportions. If we look closely at the problem, we find few fundamental causes.
Foremost among them is, complacent regulatory norms in USA. USA has enjoyed
sustainable economic development with cushion of low inflation rates over last two
decades. This resulted into complete ignorance of essential business cycle of economy.
The first signs of this problem were visible 20 months ago when America was struggling
with excess liquidity in the market. That was an ample sign of coming of real estate
bubble and asset price inflation. Another responsible factor is cushion enjoyed by private
and investment banks. Taking their cue from good economic condition, most of these
high flying banks took higher risks. Most of their business deals were highly leveraged
transactions. The kind of risk undertaken by investment banks proved to be their nemesis
as they failed to gather enough capital to support their risky investments. Third
responsible factor is size of investment banks. Many of them witnessed huge growth
when economy was on the rise. They made huge profits based on their high risk
propensity ventures. These FIs (financial institutions) also contributed heavily to US
corporate profits. Another important reason was failure of top echelons of management
to provide sense of direction to their dealmakers. Greed took over and the rest is history.
However, USA has started taking serious policy decisions to control the worsening
situation. The $ 700 billion bailout package was first step in helping the doomed
institutions. Apart from that, taking over of AIG, orchestrating Bear Stearns’ merger with
JP Morgan, taking control of Fannie Mae and Freddie Mac, merging Merrill Lynch with
Bank of America are other crucial steps. Though, all these steps won’t prove to be of
much help in the short term. It is being said that, it will take another one year to stabilize
the market and credit flow.
These days the most talked about news is the current financial crisis that has engulfed the
world economy. Every day the main headline of all newspapers is about our falling share
markets, decreasing industrial growth and the overall negative mood of the economy.
For many people an economic depression has already arrived whereas for some it is just
round the corner. In my opinion the depression has already arrived and it has started
showing its effect on India.
So what has caused this major economic upheaval in the world? What is the cause of
falling share markets the world over and bankruptcy of major banks? In this article, I
shall try to explain the reasons for recent economic depression for all those who find it
difficult to understand the complex economics lingo and are looking for a simple
explanation.

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It all Started in United State.:


In order to understand what is now happening in the world economy, we need to go a
little back in past and understand what was happening in the housing sector of America
for past many years. In US, a boom in the housing sector was driving the economy to a
new level. A combination of low interest rates and large inflows of foreign funds helped
to create easy credit conditions where it became quite easy for people to take home loans.
As more and more people took home loans, the demands for property increased and
fueled the home prices further. As there was enough money to lend to potential
borrowers, the loan agencies started to widen their loan disbursement reach and relaxed
the loan conditions.

The loan agents were asked to find more potential home buyers in lieu of huge bonus and
incentives. Since it was a good time and property prices were soaring, the only aim of
most lending institutions and mortgage firms was to give loans to as many potential
customers as possible. Since almost everybody was driving by the greed factor during
that housing boom period, the common sense practice of checking the customer’s
repaying capacity was also ignored in many cases. As a result, many people with low
income & bad credit history or those who come under the NINJA (No Income, No Job,
No Assets) category were given housing loans in disregard to all principles of financial
prudence. These types of loans were known as sub-prime loans as those were are not part
of prime loan market (as the repaying capacity of the borrowers was doubtful).

Since the demands for homes were at an all time high, many homeowners used the
increased property value to refinance their homes with lower interest rates and take out
second mortgages against the added value (of home) to use the funds for consumer
spending. The lending companies also lured the borrowers with attractive loan conditions
where for an initial period the interest rates were low (known as adjustable rate
mortgage (ARM). However, despite knowing that the interest rates would increase after
an initial period, many sub-prime borrowers opted for them in the hope that as a result of
soaring housing prices they would be able to quickly refinance at more favorable terms.

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The American Housing Crisis: An Economic Analysis


Outlining Causative Factors:
The recent economic recession in the United States of America has left many wondering
why. This study reveals the underlying economic causes of the buildup and
corresponding collapse of the United States housing market during the last decade, an
understanding of these root problems can prevent future economic disasters of the same
nature.

The specific causes outlined in this report go further into detail than simply blaming a
market bubble as the sole foundation for the catastrophe. The assumption that this entire
phenomenon was caused solely by speculative bubble would lead investigators to believe
that a bubble has been present in the United States housing market since 1997, which is
disproven in this study. In order to accomplish this task, various housing market models
were manipulated and a plethora comprehensive data analysis was completed on statistics
affecting the American housing market. The two housing models included a fundamental
value of homes model and a housing stock flow model, the two are used most frequently
by real estate economists, while the data consisting of such things as mortgage rates, risk
free interest rates (6 Month T Bill Rates), rent rates as well as inflation. The models with
appropriate data were manipulated and analyzed in an attempt to explain the strong
fluctuation in housing prices as the result of changing underlying asset values as well as
increasing demand while including the possibility that speculation occurred in the market.
This analysis discovered that the causative factors for this catastrophe included: a.
mislead consumer expectations: home buyers historically have been allowed to base
future price appreciation expectations on the short term appreciation rates of the previous
two years, which in turn led to the creation of two different speculative bubbles present in

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the market over the last decade, b. poor monetary and fiscal policies taken within the
nation: a combination of capital gains tax removal from home sales and historically low
interest rates led to short term house price gains that extended home price gains via
increased consumer price expectations, c. deceptive mortgage market actions taken by
private firms over the last several years: the collapse of the housing market has extended
to the macro economy not only because of affected consumer confidence, but because
firms involved in the mortgage market took fraudulent actions over the last several years
that created a strong link between home prices and several fixed income securities owned
by several institutions tied to private equity markets. The larger implication of these
findings is that the guidelines expressed for the national mortgage market by its father,
President Franklin D. Roosevelt, need to be strictly adhered to in order to guarantee
maximum

performance and minimum economic suffering, and these guidelines explain that
mortgage loans within the United States are of a similar structure, similar term and have
similar qualification requirements.

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Bubble that Burst:


However, as the saying goes, “No boom lasts forever”, the housing bubble was to burst
eventually. Overbuilding of houses during the boom period finally led to a surplus
inventory of homes, causing home prices to decline beginning from the summer of 2006.
Once housing prices started depreciating in many parts of the U.S., refinancing became
more difficult. Home owners, who were expecting to get a refinance on the basis of
increased home prices, found themselves unable to re-finance and began to default on
loans as their loans reset to higher interest rates and payment amounts.

In the US, an estimated 8.8 million homeowners - nearly 10.8% of total homeowners -
had zero or negative equity as of March 2008, meaning their homes are worth less than
their mortgage. This provided an incentive to “walk away” from the home than to pay the
mortgage.

Foreclosures ( i.e. the legal proceedings initiated by a creditor to repossess the property
for loan that is in default ) accelerated in the United States in late 2006. During 2007,
nearly 1.3 million U.S. housing properties were subject to foreclosure activity.
Increasing foreclosure rates and unwillingness of many homeowners to sell their homes
at reduced market prices significantly increased the supply of housing inventory
available. Sales volume (units) of new homes dropped by 26.4% in 2007 as compare to
2006. Further, a record nearly four million unsold existing homes were for sale including
nearly 2.9 million that were vacant. This excess supply of home inventory placed
significant downward pressure on prices. As prices declined, more homeowners were at
risk of default and foreclosure.

Now you must be wondering how this housing boom and its subsequent decline is related
to current economic depression? After all it appears to be a local problem of America.

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What complicated the matter?…


Unfortunately, this problem was not as straightforward as it appears. Had it remained a
matter between the lenders (who disbursed risky loans) and unreliable borrowers (who
took loans and then got defaulted) then probably it would remain a local problem of
America. However, this was not the case. Let us understand what complicated the
problem.

For original lenders these subprime loans were very lucrative part of their investment
portfolio as they were expected to yield a very high return in view of the increasing home
prices. Since, the interest rate charged on subprime loans was about 2% higher than the
interest on prime loans (owing to their risky nature); lenders were confidant that they
would get a handsome return on their investment. In case a sub-prime borrower continued
to pay his loans installment, the lender would get higher interest on the loans. And in case
a sub-prime borrower could not pay his loan and defaulted, the lender would have the
option to sell his home (on a high market price) and recovered his loan amount. In both
the situations the Sub-prime loans were excellent investment options as long as the
housing market was booming. Just at this point, the things started complicating.

With stock markets booming and the system flush with liquidity, many big fund investors
like hedge funds and mutual funds saw subprime loan portfolios as attractive investment
opportunities. Hence, they bought such portfolios from the original lenders. This in turn
meant the lenders had fresh funds to lend. The subprime loan market thus became a fast
growing segment. Major (American and European) investment banks and institutions
heavily bought these loans (known as Mortgage Backed Securities, MBS) to diversify
their investment portfolios. Most of these loans were brought as parts of CDOs
(Collateralized Debt Obligations). CDOs are just like mutual funds with two significant
differences. First unlike mutual funds, in CDOs all investors do not assume the risk
equally and each participatory group has different risk profiles. Secondly, in contrast to
mutual funds which normally buy shares and bonds, CDOs usually buy securities that are
backed by loans (just like the MBS of subprime loans.)

Owing to heavy buying of Mortgage Backed Securities (MBS) of subprime loans by


major American and European Banks, the problem, which was to remain within the
confines of US propagated into the word’s financial markets. Ideally, the MBS were a
very attractive option as long as home prices were soaring in US. However, when the
home prices started declining, the attractive investments in Subprime loans become risky
and unprofitable.

As the home prices started declining in the US, sub-prime borrowers found themselves in
a messy situation. Their house prices were decreasing and the loan interest on these
houses was soaring. As they could not manage a second mortgage on their home, it
became very difficult for them to pay the higher interest rate. As a result many of them
opted to default on their home loans and vacated the house. However, as the home prices

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were falling rapidly, the lending companies, which were hoping to sell them and recover
the loan amount, found them in a situation where loan amount exceeded the total cost of
the house. Eventually, there remained no option but to write off losses on these loans.

The problem got worsened as the Mortgage Backed Securities (MBS), which by that time
had become parts of CDOs of giant investments banks of US & Europe, lost their value.
Falling prices of CDOs dented banks’ investment portfolios and these losses destroyed
banks’ capital. The complexity of these instruments and their wide spread to major
International banks created a situation where no one was too sure either about how big
these losses were or which banks had been hit the hardest.

Mayhem in the banks:


The effects of these losses were huge. Global banks and brokerages have had to write off
an estimated $512 billion in subprime losses so far, with the largest hits taken by
Citigroup ($55.1 billion) and Merrill Lynch ($52.2 billion). A little over half of these
losses, or $260 billion, have been suffered by US-based firms, $227 billion by European
firms and a relatively modest $24 billion by Asian ones.

Despite efforts by the US Federal Reserve to offer some financial assistance to the
beleaguered financial sector, it has led to the collapse of Bear Sterns, one of the world’s
largest investment banks and securities trading firm. Bear Sterns was bought out by JP
Morgan Chase with some help from the US Federal Bank (The central Bank of America
just like RBI in India)

The crisis has also seen Lehman Brothers - the fourth largest investment bank in the US
and the one which had survived every major upheaval for the past 158 years - file for
bankruptcy. Merrill Lynch has been bought out by Bank of America. Freddie Mac and
Fannie Mae, two giant mortgage companies of US, have effectively been nationalized to
prevent them from going under. Reports suggest that insurance major AIG (American
Insurance Group) is also under severe pressure and has so far taken over $82.9 billion so
far to tide over the crisis.

From this point, a chain reaction of panic started. Since banks and other financial
institutes are like backbone for other major industries and provide them with investment
capital and loans, a loss in the net capital of banks meant a serious detriment in their
capacity to disburse loans for various businesses and industries. This presented a serious
cash crunch situation for companies who needed cash for performing their business
activities. Now it became extremely difficult for them to raise money from banks.

What is worse is the fact that the losses suffered by banks in the subprime mess have
directly affected their money market the world over.

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Now what is a money market?


Money Market is actually an inter-bank market where banks borrow and lend money
among themselves to meet short-term need for funds. Banks usually never hold the exact
amount of cash that they need to disburse as credit. The ‘inter-bank’ market performs this
critical role of bringing cash-surplus and cash-deficit banks together and lubricates the
process of credit delivery to companies (for working capital and capacity creation) and
consumers (for buying cars, white goods etc). As the housing loan crisis intensified,
banks grew increasingly suspicious about each other’s solvency and ability to honour
commitments. The inter-bank market shrank as a result and this began to hurt the flow of
funds to the ‘real’ economy. Panic begets panic and as the loan market went into a
tailspin, it sucked other markets into its centrifuge.

The liquidity crunch in the banks has resulted in a tight situation where it has become
extremely difficult even for top companies to take loans for their needs. A sense of
disbelief and extreme precaution is prevailing in the banking sectors. The global
investment community has become extremely risk-averse. They are pulling out of assets
that are even remotely considered risky and buying things traditionally considered safe-
gold, government bonds and bank deposits (in banks that are still considered solvent).

As such this financial crisis is the culmination of the above mentioned problems in the
global banking system. Inter-bank markets across the world have frozen over. The
meltdown in stock markets across the world is a victim of this contagion.

Governments and central banks (like Fed in US) are trying every trick in the book to
stabilize the markets. They have pumped hundreds of billions of dollars into their money
markets to try and unfreeze their inter-bank and credit markets. Large financial entities
have been nationalized. The US government has set aside $700 billion to buy the ‘toxic’
assets like CDOs that sparked off the crisis. Central banks have got together to co-
ordinate cuts in interest rates. None of this has stabilized the global markets so far.
However, it is hoped that proper monitoring and controlling of the money market will
eventually control the situation.

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How it has affected India?


In the age of globalization, no country can remains isolated from the fluctuations of
world economy. Heavy losses suffered by major International Banks is going to affect all
countries of the world as these financial institutes have their investment interest in almost
all countries. As of now India is facing heat on three grounds: (1) Our Share Markets are
falling everyday, (2) Rupee is weakening against dollars and (3) Our banks are facing
severe crash crunch resulting in shortage of liquidity in the market.

Actually all the above three problems are interconnected and have their roots in the
above-mentioned global crisis.

For the last two years, our stock market was touching new heights thanks to heavy
investments by Foreign Institutional Investors (FIIs). However, when the parent
companies of these investors (based mainly in US and Europe) found themselves in a
severe credit crunch as a result of sub-prime mess, the only option left with these
investors was to withdraw their money from Indian Stock Markets to meet liabilities at
home. FIIs were the main buyers of Indian Stocks and their exit from the market is
certain to wreak havoc in the market. FIIs who were on a buying spree last year, are
now in the mood of selling their stocks in India. As a result our Share Markets are
touching new lows everyday. Since, the money, which FIIs get after selling their stocks,
needs to be converted into dollars before they can sent it home, the demands for dollars
has suddenly increased. As more and more FIIs are buying dollars, the rupee is loosing its
strength against dollar. As long as demands for dollars remain high, the rupee will keep
loosing its strength against dollar. The current financial crisis has also started directly
affecting Indian Industries. For the past few years, the two most preferred method of
raising money by the companies were Stock Markets and external borrowings on low
interest rates. Stock Markets are bleeding everyday and it is not possible to raise money
there. Regarding external borrowing from world markets, this option has also become
difficult. In the last fiscal year alone, India borrowed $29 billion from foreign lenders and
got $34 billion of foreign direct investment. A global recession has hurt external demand.
International lenders who have become extremely risk aversive can limit access to
international capital. If that happens, both India’s financial markets and the real economy
will be hurt in the process. Suddenly, the 9% growth target does not seem that ‘doable’
any more; we should be happy to clock 7% this fiscal year and the next.

However, one positive point in favor of India is the fact that Indian Banks are more or
less secured from the ill-effects of sub-prime mess. A glance at Indian banks’ balance
sheets would show that their exposure to complex instruments like CDOs is almost nil. In
India, still the major banking operations are in the hands of Public Sector Banks who
exercise extreme cautions in disbursing loans to needy people/companies. As a result, we
are not likely to see a repeat of sub-prime crisis in India. Though there have been a
presence of big US/European Banks in India and even some Indian banks (like ICICI)
have some foreign subsidiary with stake in the sub-prime losses, there presence is

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miniscule as compare to the overall size of Indian banking industry. So at least on this
major front we need not worry much.

However, a global depression is likely to result in a fall in demand of all types of


consumer goods. In 2007-08, India sold 13.5% of its goods to foreign buyers. A fall in
demand is likely to affect the growth rate this year. Our export may get affected badly.

A negative atmosphere, shortage of cash, fall in demands, reducing growth rate and
uncertainties in the market are some of the most visible aspects of an economic
depression. What started as a small matter of sub-prime loan defaulters has now become
a subject of global discussion and has engulfed the global economy scenario

Greed of some woes of billions:


If you think about this with a cool mind, you will find that the underlying cause of this
depression is the greed of those who failed to anticipate the consequence of their actions.
On a more ideological front, it is high time to have a rethink on the very idea of free
markets and capitalism. I think the time has come to evolve a capitalism where
everything works under a broad regulatory framework and we do not see a repeat of this
condition where greed of some people can affect the lives of billions.

So here concludes my attempt to explain the current economic crisis which has started to
affect the lives of all of us. The above explanation is very simple and by no means it
presents an accurate picture (i.e the one that includes all the micro/macro factors) of the
crisis. However, I hope that it must have given you a broad idea of the reasons behind
current economic depression. Feel free to post your comments on this issue.

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Stock market and Recessions:

Some recessions have been anticipated by stock market declines. In Stocks for the Long
Run, Siegel mentions that since 1948, ten recessions were preceded by a stock market
decline, by a lead time of 0 to 13 months (average 5.7 months). It should be noted that ten
stock market declines of greater than 10% in the DJIA were not followed by a
recession[14].

The real-estate market also usually weakens before a recession[15]. However real-estate
declines can last much longer than recessions[citation needed].

Since the business cycle is very hard to predict, Siegel argues that it is not possible to
take advantage of economic cycles for timing investments. Even the National Bureau of
Economic Research (NBER) takes a few months to determine if a peak or trough has
occurred in the US[16].

During an economic decline, high yield stocks such as FMCG, pharmaceuticals, and
tobacco tend to hold up better[17]. However when the economy starts to recover and the
bottom of the market has passed (sometimes identified on charts as a MACD [18]),
growth stocks tend to recover faster. There is significant disagreement about how health
care and utilities tend to recover[19]. Diversifying one's portfolio into international stocks
may provide some safety; however, economies that are closely correlated with that of the
U.S. may also be affected by a recession in the U.S.[20].

There is a view termed the halfway rule [21] according to which investors start
discounting an economic recovery about halfway through a recession. In the 16 U.S.
recessions since 1919, the average length has been 13 months, although the recent
recessions have been shorter. Thus if the 2008 recession is an average one, the downturn
in the stock market should bottom around November 2008. However some economists
fear that this recession may last longer.

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Benefits of Economic Recession:

Many people think that an economic recession is bad. Although that’s partially true, there
are definite profits to the situation if you know where to look.

While the economic system is in recession, it will not be long before you will get a
repayment from the Internal Revenue Service or IRS. This may be a sum of money from
$300 to $1,200 which is the government’s way of helping the economic system. A similar
thing will occur in the UK to.

If you are inquisitive about how much of a good deal you will get, calculate for this using
the economic stimulus tax calculator. This is reasoned to be a rebate so if you did not get
it this year, you should in 2009. This was done when the economic system was in
recession in 2000 but most of the checks went out when the economy was already
regaining a year later.

During an economic recession, the bulk of bonds, shares and stocks are devaluated. This
means it is deal to buy them right now so try for it if you have the cash! But before you
advance on a shopping frenzy, find out which company’s shares will do rise after the
economy regains. With that in mind, it will be easy to determine which ones you ought to
invest in. It’s likewise possible to buy houses when the prices have gone to an all time
low and wait for prices to rise and realise a profit from them too in both the UK and
USA.

One answer that may curb the economic recession is for the Federal Reserve System and
Bank of England to lower rates of interest. This means that as long as you’ve a good
credit ratings, you’ll be able to borrow money from the bank.

As a consumer, an economic recession makes for tax breaks. What happens is that you
don’t have to pay the IRS that much this year because of a deduction for private mortgage
insurance which happens to be a propagation of the sales tax write off and also a boost in
the alternative minimum tax immunity amount.

If you’re still working, an economic recession may also increase pension account limits.
You can do this by using your rebate check to turbocharge your retirement savings and
investing this in a Roth or Traditional IRA. Some people have decided to invest it in both.
The limit is likely to be raise in the UK also.

Should your gross income be $100,000 and below, you can now roll over your 401(k)
direct into a Roth IRA without having your funds experience a Rollover Traditional IRA
first. But if your income is above $100,000, just wait until 2010 when the income limit
vanishes so that you too can invest this into your retirement savings account.

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There are people who say that an economic recession is also good for the environment
because the consumer will be forced to cut costs. People will more probable trade in their
sports utility vehicles or SUV’s for more fuel efficient transport. This in turn will contract
the number of carbon gases that are released into the air. Regrettably, industries won’t be
capable of doing the same.

Rather than going to the store to purchase something they like, more people will order
and leverage the equivalent items online thus increasing business online and not tempting
them to over spend by visiting the shops full of temptaion. The same holds true for
advertisement because it is much cheaper to do this online that hoardings, magazines or
newspapers.

There are benefits to an economic recession if you are savvy, even if many of us see that
nothing good comes to the fore. The only consolation is that it’s only temporary and the
economy should regain at some point in 2009. You can if your are careful benefit from
this difficult time

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Islamic System as an Alternative:


Islam provides humanity with solutions to problems created by imperfect man-made
political systems and moral values. Islam is a Divinely-ordained social framework that
should guide humanity to peace and tranquillity in all aspects of life. It is neither
capitalistic nor socialistic, but a wholly different system. According to noted Islamic
jurist and thinker Muhammad Baqir as-Sadr, the ills stemming from man’s
oppressiveness in the economic realm of life persist in the form of an inequitable
distribution of economic resources on the one hand and from inefficient utilisation of
these resources, which result in underdevelopment of economic resources and their
waste. Sadr specifies three components of the Islamic solution:

1. Cessation of the various forms of oppression manifest in the unjust distribution of


economic resources;
2. Disciplining of human nature to achieve control of the instinct of self-love; and
3. Utilisation of economic resources to satisfy the needs of all humanity.

A just social system is one that allows all people to benefit from economic wealth. The
Islamic economic system, accordingly, is based upon this criterion. It is only through the
ethical control of all the community’s resources by society that the common need of
social security is guaranteed and the essential economic rights of the individual are
insured. Accordingly, the legitimate Islamic government has the responsibility to make
long term plans for serving the common good and overcoming instabilities of the market.

Islam recognises differences of income between people, and does not outlaw private
enterprise, but strives to create an equitable standard of living. To realise such a
socio-economic condition, Islam, although it specifies fixed taxes to be collected from
prosperous people, establishes a social and moral mechanism. A lavish and extravagant
style of living is totally discouraged in Islam. Islam also forbids waste in production and
consumption in order to direct the resources of the economy to produce commodities that
satisfy the needs of all people and bring about social equity. The Islamic State also has
the authority to regulate wages and prices so as to overcome the selfishness and greed of
those who possess economic wealth and insure an equitable standard of living for all
people. In sum, the major goal of the Islamic State is the prosperity of all citizens.

Confirmation of this solution is beginning to come from the most secular economic
sources. Marcus Noland, for instance, is a Senior Fellow at the Peterson Institute for
International Economics — a private US research institution. Empirical research
(research based on observation and experiment rather than just abstract theory) by Noland
leads him to flatly deny the proposition ‘that Islam is inimical to growth’. He stresses: ‘If
anything, the opposite appears to be true’. In other words, Islam’s just economic and
finance system, according to this secular economist, is a source of economic growth and
prosperity.

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Contemporary writings of Muslim economists demonstrate the stability of the Islamic


(profit-sharing) financial system, compared to the rib’a based capitalist economy. The
Islamic system functions smoothly and possesses long-lasting economic equilibrium
since Islam’s profit-sharing mechanism enables the economy to efficiently absorb any
possible shocks to its asset position. But debt financing, speculation, money creation and
other evils are absolute essentials of capitalism; instability is acknowledged by even
renowned secular economists to be built into capitalism. One very significant school of
secular economists the (Post-Keynesians) regards that interest (rib’a) constitutes one of
the main causes of financial instability, which leads to recession or stagflation. Keynes
himself demonstrated that systematic instability and financial crises are inherent
characteristics of modern capitalist economy. Instability and cfrises in economies result
from securing the means of production through debt-creation. There can be no question
that Islamic finance is the sole method of finance suitable to humanity at large.

A modern capitalist economy is based on a pervasive system of short-term financing of


long-term capital assets. Debt is repaid when it is due, by the creation of new debt;
refinancing is a continuous process, if the expectation of future cash flows and interest
rates remains optimistic. When these indicators go into reverse gear, then refinancing
becomes very difficult and attempts to acquire cash would bring the asset values below
their original prices or even below their current cost of reproduction. This can cause the
whole investment process to cease and bring down income and employment. The
relationship between cash receipts and payment commitments determines the course of
investment and thus, employment, output and profits. Many secular economists seem to
agree that debt financing is the major destabilising factor of investment in capitalist
economy.

Rib’a:
Rib’a (or usury) has been prohibited in all three Abrahamic religions (Islam, Christianity,
and Judaism). This prohibition was subsequently abandoned in both Christianity and
Judaism. Rib’a is risk-less gain. It occurs when extra liability is created in a financial or
business transaction, in excess of the produce available and that does not exist.

Rib’a was prohibited by Almighty Allah precisely to prevent the creation of ‘extra
liability’. This extra liability does not exist physically, and only creates scarcity of the
produce in the society and unjust accumulation of the produce in few hands. Rib’a has a
power to get hold of assets or properties of individuals, enterprises, and nations
deceitfully. This is both unjust and against nature. Almighty Allah banned Rib’a very
strictly to stop this criminal action. Nature is the limit in Islam; any thing not natural is
prohibited, stopped, and declared illegal.

Islam permits increase in capital through trade and, at the same time, it blocks the way for
anyone who tries to increase his capital through lending on interest (Rib’a) — whether it
is at a low or a high rate. Allah Almighty says :

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[4:29] O you who believe, do not consume your property among yourselves
wrongfully, but let there be trade by mutual consent.

Almighty Allah has allowed everything that is natural but given its strict judgment to stop
any behaviour, agreement, and practice that is not natural. The basic rule of economics is
that to maintain economic equilibrium (stability) in a society, the supply side should be
equal to the demand. If the demand is more than the supply a shortage will occur.
Creating an extra liability means creating an extra demand without increasing equal
supply, this will start a never-ending mechanism of perpetually increasing the shortage of
that produce in the society.
The strict prohibition of Interest in Islam is due to its deep concern for the economic,
moral, and social welfare of humanity. Dependence on interest discourages people from
working or trading to earn money and the value of work and trade is reduced. A dynamic
is introduced into society such that some people tend to shy away from useful economic
activity such as running a business or risking money in trade, or in industry. Further,
usury discourages people from doing good to one another and lend out of goodwill.

A society that encourages interest on lending will require needy people to pay back more
than they borrowed, which quite often is a source of huge (and unpayable) burden. If
interest is allowed, the rich (who are most likely to be lenders) will exploit the poor (the
borrowers). As a result, the rich becomes richer and the poor becomes poorer.

Islam’s prohibition of rib’a naturally eliminates the pure debt market as a means of
conducting business and income generating mechanisms. If rib’a is abolished and the
terms of financing are linked to the anticipated profit rate, which varies with its
movements, the chaotic condition that makes the investment the unstable factor in
macroeconomic components could be brought under control. The alternative method of
Islamic financial system channels capital resources into productive investments. These
investments can generate a stream of returns that repay the cost of the investment capital.
There is an underlying sound economic rationale in the revealed wisdom regarding the
difference between prohibited rib’a and profitable trade.

Capitalism is a ruthless, rapacious system. Billions of the world poor suffer in mere
recessions, yet capitalism’s defenders cynically and dispassionately view recessions. The
noted secular economist John Kenneth Galbraith, for instance, comments: ‘Few can
believe that suffering, especially by others, is in vain. Anything that is disagreeable must
surely have beneficial economic effects’. Former US President Ronald Reagan remarks:
‘Recession is when a neighbour loses his job. Depression is when you lose yours’. Islam
is the only rational, sane and humane alternative to this Satanic madness.

The fallout of a new US recession could be immense — affecting even new growth
economies such as China, for instance. The Chinese economy is currently experiencing
real growth, based on its successful exportation of cheap but excellent manufactured
goods, especially to the United States. Chinese industry accrues massive amounts of
dollars from this trade, which it then lends back to the US. Everything depends upon the

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continued ability of the US, its consumers and its companies to spend more than they
actually earn. But, if the US heads into recession, as the US Federal Reserve last year
hinted it might, this would have a major impact on China. This, in turn, would hit the
economies of Japan and Germany, which sell machinery to China, and countries such as
Australia providing raw materials to China. Unemployment, possibly combined with a
credit squeeze and/or sharp rise in unemployment, could occur globally.

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