Unable to understand that rapid interest rate moves create shocks to the market, resulting in distortions in supply and demand, the Fed dealt with the bursting of the housing bubble by lowering interest rates rapidly, this time to next to nothing. This response was intended to stimulate the economy. In 2001, the rate decreases were also intended to stimulate the economy, but they mainly stimulated one sector. The Fed's goal with the most recent round of drastic rate cuts is to stimulate lending. The rate cuts came when the scope of the crisis was just becoming apparent. The rapid reaction this time was met with skepticism from markets. Where before there was at least one strong sector in which to invest excess capital, this time there were none. Worse, the mistakes of the past few years had put banks in a position where they could not reasonably lend out their money. Many bank executives simply did not trust their lenders and tightened restrictions severely. The result of this was a credit crunch, as the liquidity the Fed was trying to inject into the banking system was either being used to cover losses on subprime loans and collateralized debt obligations or was simply not lent.
The Money Supply and Savings Rates
The money supply typically refers to the total amount of money in the economy at a point in time. The money supply (M2) consists of money that is readily available for spending (M1) plus money in savings deposits, time deposits and individual money market accounts. The objective of the Fed's interest rate decreases was to ensure sufficient money supply in the economy. For the most part, that strategy worked. While money supply growth was slow, it only receded once, during August 2008 (Federal Reserve, 2009). Yet, growth in the money supply did not equate to growth in the economy.
One of the contributors to M2 of course are savings accounts. In April 2008, the savings rate was zero. Americans, buoyed by a surging stock market, still with high real estate values, and not yet fully aware of the impending financial crisis, were spending as much as they made. Low savings rates were also reflected in high rates of consumer spending. With the onset of the crisis, this changed.
Investors, once confident about the future, had that confidence shaken by the realization that not only was the housing market bust but that the stock markets were set to tank, and quickly. Consumers began to save. As the subprime crisis blossomed into the global financial crisis, savings rates only increased, such that by May 2009, just one year after the savings rate hit zero, it was at 6.9% (Miller & Sider, 2009). While this is likely good for the overall economy, particularly in China's savings rates come down, it is bad for businesses that rely on consumer spending.
Consumer spending is the largest component of the Gross Domestic Product. Although some dispute the inclusion of certain components such as health care programs that should be included as government spending, consumer spending is considered to be roughly 70% of the GDP (Mandel, 2009). Even without government health care funding, consumer spending is the largest portion of the GDP. It also provides 60% of total employment in the U.S. economy (Toossi, 2002).
During the real estate bubble and stock market increase, savings rates dropped while consumer spending increased. This increase fueled substantial profits, which fueled strong stock markets. Consumer spending, however, has gone into a tailspin as a result of the lingering effects of the subprime crisis. In addition to the aforementioned increase in the savings rate, consumer spending has been hampered by the lack of credit. Despite the Fed's efforts and the efforts of Congress to inject liquidity into the banking system, consumer spending remains suppressed.
The intensity of the subprime crisis is ultimately dependent on consumer spending. With the category accounting for 60% of domestic employment, job losses were inevitable as consumer spending fell. However, as unemployment increases, consumer spending should fall further. This cycle perpetuates recession. With savings rates still increasing and consumer spending still suppressed, it is expected that unemployment will remain high for the foreseeable future as well.
With consumer spending suppressed, the federal government took the view that the best way to improve aggregate demand was injecting money into the economy. The stimulus package was signed into and law monies were pumped into the economy over the subsequent months. The third quarter spike in GDP has been attributed to the stimulus package.
The main test for the stimulus, however, is not the short-term surge in GDP, but whether that stimulus promotes spending growth on the part of consumers, which in turn would allow businesses to start making investments again. Government spending, therefore, is being used as a catalyst to prop up the ailing economy.
Insufficient time has elapsed from the stimulus to make this determination. However, the impact of this stimulus relates to a pair of factors. The first is the savings rates. With a higher than usual savings rate, some of the stimulus from the government will go into private savings. The other factor is business investment. Although the economy as a whole performed well as a result of the stimulus package, individual businesses are unlikely to have seen a substantial positive impact. Thus, they are unlikely to make the decision to invest strictly based on the stimulus provided by government. This situation is compounded by the credit environment, which remains tight.
The subprime crisis has caused by high volatility in liquidity in both the U.S. And overseas economies. This liquidity, which was above its equilibrium point as the Fed suppressed interest rates in order to stimulate economic growth, was put to poor use in the subprime mortgage market.
The housing bubble burst, again as a direct result of interest rate policy, which constricted money supply and reduced demand for new homes. The move also forced many into foreclosure. The risk was spread throughout the financial system, causing a credit crunch. As credit dried up, so did consumer spending. Savings rates increased by the GDP began to decrease.
Ultimately, responsibility for the crisis falls to the Federal Reserve. They managed the money supply poorly, injecting too much liquidity into the system too quickly, and then removing that liquidity from the system just as quickly. The markets reacted poorly to this volatility, at which point a multitude of macroeconomic factors lend support to the emerging recession -- increase savings, decreased spending, decreased business investment and lower aggregate demand as the global impacts of the crisis affected exports.
Knowledge @ Wharton: Inside the Subprime Crisis website, various pages. (2008). Wharton School of Business. Retrieved December 2, 2009 from http://knowledge.wharton.upenn.edu/special_sections/subprime/
Bureau of Economic Analysis. (2009). Gross domestic product: Third quarter 2009. BEA. Retrieved December 2, 2009 from http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
Shiller, R. (2005). Origin of the Term. Irrational Exuberance. Retrieved December 2, 2009 from http://www.irrationalexuberance.com/definition.htm
Boeri, T. & Guiso, L. (2007). Subprime crisis: Greenspan's legacy. Vox EU. Retrieved December 2, 2009 from http://www.voxeu.org/index.php?q=node/488
Chomsisengphet, S. & Pennington-Cross, A. (2006). The evolution of the subprime mortgage market. Federal Reserve Bank of St. Louis. Retrieved December 2, 2009 from http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf
Federal Reserve Statistical Release. (2009). Money stock measures. Federal Reserve. Retrieved December 2, 2009 from http://www.federalreserve.gov/releases/h6/Current/
Miller, R. & Sider, A. (2009). Surging U.S. savings rate reduces dependence on China. Bloomberg. Retrieved December 2, 2009 from http://www.bloomberg.com/apps/news?pid=20601103&sid=aMl2N_xsMPT4
Mandel, M. (2009). Consumer spending is *not* 70% of GDP. Business Week. Retrieved December 2, 2009 from http://www.businessweek.com/the_thread/economicsunbound/archives/2009/08/the_retail-impo.html
Toossi, M. (2002). Consumer spending: An engine for U.S. job growth. Monthly Labor Review. November 2002.