Page 1 Analysis of the Recent Economic Downturn

In 2007, strong growth in the third quarter lead most to believe that a recession had been avoided, however, this proved not to be the case. A decline in GDP growth is the cause of recessions. Typically, there will be a goldilocks economy or an irrational exuberance prior to a recession, followed by a market crash. Prior to the 2007 2009 recession, the housing market was going up. Everyone knew house values could only go up and behaved accordingly; banks lent too much money to consumers bought too much house. Once the market crashed, the stage was set for a recession. Many factors affecting the aggregate demand curve had declines. As mentioned, home equity declined, as well as the stock market. This decrease in wealth decreased consumption and consumer confidence leading to lower spending. As consumers cut back on spending, business confidence also fell with additional decreases in consumption and also investments. Additionally, foreign GDPs were also declining leading to a decrease in exports. The changes in these variables all caused a shift back in the aggregate demand curve, lowering the GDP. Attempting to counteract the recession, the Federal Reserve pumped money into the economy, increasing the nominal money supply. As the value of the dollar decreased, interest rates were kept low, allowing the exchange rate to remain favorable for exports. Additionally the government increased spending by way of stimulus packages for banks, automakers and tax rebates and incentives. These changes in variables caused the aggregate demand cure to shift out. However, the effect of the exchange rate, government spending and increases in the nominal money supply were small compared to the loss of wealth and confidence of both consumers and businesses. There were also changes in the aggregate supply curve; increased unemployment and lower wages, which lead to lower employment costs, and oil price increases both caused shortrun shifts down. Increases in efficiency shifted the long-run aggregate supply out. The overvalued housing market, compounded with the subprime credit financial crisis and loss of wealth were primary factors in the start of the 2007-2009 recession. During 2007, primary economic concerns were the housing slump and inflation. Bernanke believed that the mortgage problem was mainly with adjustable sub-prime mortgages. Rising home prices and demand by Wall Street for high-yield securities encouraged lowering of underwriting standards which led to more sub-prime mortgages. In addition, the downturn in the housing market was seen as necessary to correct the balance in the market. There was slower structural productivity growth, requiring more workers to increase output. Unemployment was

Page 2 Analysis of the Recent Economic Downturn

relatively low, between 4.5% - 5%, which would increase labor costs and prices leading to inflation. In the third quarter of 2007, the GDP increased by a 3.9% annual rate, seasonally adjusted, despite the large drop in residential investment which was offset by an increase in consumer spending and international trade due to an increase in exports. Expectations were that future growth would slow for the end of 2007 and continuing into 2008 as consumer confidence in October decreased and unemployment claims were increasing. However, overall, many forecasters thought a recession had been avoided and the nearly 4% growth in the third quarter, despite the large drop in the housing market, reinforced the belief that the economy was very resilient. As the US GDP declined, the global economy was also contracting. Indias 2008 fourth quarter GDP was lower than expected; Japans GDP contracted at a rate over 12% and in Europe and the UK GDPs fell at a 5.9% annual rate. As a result, exports plummeted in the fourth quarter of 2008 by an annual rate of 24%. This decrease in foreign GDP causes exports to decrease and the aggregate demand curve to shift back. Early in 2009 business confidence was also down. Even with the prospect of becoming more productive, employers were hesitant to invest in new equipment. In Vermont, Bradley Aldrich, the president of Forcier Aldrich & Associates Inc., would like to invest $30,000 in software which would save them $5,000 a year; however, in the poor economy they were reluctant to make that investment. Consumer spending was also down during 2008 and going into 2009. In the fourth quarter of 2008, consumer spending on non-durable goods declined at an annual rate of 9.2%. This hit retailers particularly hard since it was in their major holiday season. Coach Inc. not only laid off 150 employees and reduced prices, but scaled back new store openings. In addition, many companies cut pay in an attempt to prevent layoffs. In addition to the poor economy, uncertainty about potential costs of the health care expansion and environmental legislation has further decreased business confidence. This decline in business confidence lowers consumption and investments, shifting the aggregate demand curve back. In 2008, unemployment continued to rise sharply. By February 2009, over 600,000 new unemployment insurance claims were made each week. Unemployment did not reach its peak of 10% until October 2009. In addition to layoffs, employers also cut employees pay, with high

Page 3 Analysis of the Recent Economic Downturn

unemployment many workers had few choices and were forced to accept lower pay. Rising unemployment and lower employment costs resulted in a short-run shift down of the Aggregate Supply curve. Even as business confidence declined, productivity increased. At DAddario & Co, in Farmingdale, NY, 150 workers were laid off during the recession and many labor savings efficiencies were put into place. They estimate production could be increased by 15% to 20% without hiring additional workers. In the second quarter of 2009 productivity grew at an annual rate of 6.6%. Employers cut their work force faster than they cut production. In 2009, Federal Reserve staff noted that Businesses have been so aggressive in cutting labor input that productivity rose noticeably in the first half of the year. Even in service industries employers found ways to increase production; in Hawaii, Chip Bahouth, at the Sheraton Maui Resort & Spa reduced some service hours and increased the productivity of cleaning staff by storing cleaning solution on each floor, saving workers time in refilling their machines. Instead of deep cleaning 10 rooms a day, they were now able to clean 15. Productivity increases shifted the long term aggregate supply curve out. Consumer confidence also fell in 2008 and 2009. The large unemployment rate and the fear of unemployment contributed to the decline in consumer confidence. Personal savings rose to 5.7% of after-tax income in April, 2009 well up from the zero percent rate saved in April 2008. Even as personal income increased, personal consumption declined slightly. Just as the great depression changed consumer behavior, this recession has shocked consumers, who no longer view the economy and the world as stable, and savings increased. A decrease in consumer confidence decreases consumption and sifts the aggregate demand curve back. Not only has consumer confidence declined, but wealth declined as well. The housing market crash had decreased the home equity of consumers. Interest rates were down, but homeowners with high interest rates were not able to take advantage of the lower rates, due in part to increased underwriting requirements from the very tight credit because of the subprime crisis, and the lower home values which left many owners owing more than their houses was worth. Thus, homeowners no longer had home equity available for spending. In addition, consumers had decreased wealth from the stock market crash. The stock market crash not only lowered

Page 4 Analysis of the Recent Economic Downturn

consumer confidence, but increased consumer savings, further lowering spending. This decrease in wealth decreased consumption and shifted the aggregate demand curve further back. In 2009, despite official talk of the importance of a strong dollar, no action was taken to strengthen it and by October 2009 the dollar was down almost 12% against a basket of currencies from the beginning of the year. The weak dollar increased US exports and helped achieve a rebalancing of the global economy; the US exporting more and China exporting less. As the interest rates that the Treasury pays to borrow stayed down, stock prices maintained their value and the dollar decline was gradual and no action was taken on the weakening dollar. The Federal Reserve Chairman, Ben Bernanke, restated that once the recovery takes hold, interest rates will need to be raised; he gave no timeframe, this has yet to happen and rates remain extremely low. A decline in the dollar would increase exports and decrease imports, shifting the aggregate demand curve out, however higher fuel prices and a strong demand for imported autos offset this gain and the trade deficit was at its widest point since January. Higher oil prices in 2008 due to increased global demand were not only in part responsible for an increase of imports over exports, despite the favorable dollar exchange rate, but also shift the short-run aggregate supple curve down. Throughout the recession the Federal Reserve put new money into the economy. In 2008 and 2009, they had put about $800 billion of new money into the financial system and early in 2009 planned to create another trillion dollars. The Federal Reserve planed to buy not only mortgagebacked securities, $1.25 trillion, debt issued by the holders of those securities, Fannie Mae, Freddie Mac and Ginnie Mae, $200 billion, but also plans to buy up to $300 billion in long-term debt issued by the federal government. This increase in nominal money supply shifts the aggregate demand curve out. Government spending was increased in an effort to encourage spending. Credits of up to $8,000 were available for first-time home buyers and up to $6,500 for those who already owned homes. It was estimated that this pushed the average home price 5% higher than it would have been without the program. Automobile sales were temporarily increased by the cash for clunkers program. In addition, the government had multiple stimulus packages bailing out US automakers

Page 5 Analysis of the Recent Economic Downturn

and banks and investing in US businesses. This government spending shifted the demand curve out. By the time the recession was announced the GDP had been declining for about a year. Initially, some experts had believed that the economy was strong enough to weather the storm of the housing market crash and sub-prime crisis, however, other factors caused additional decreases in demand and a lengthy recession was underway. The loss of wealth in both home equity and the stock market had a major effect on consumer spending and confidence, both reducing demand and causing a decline in the GDP. Additionally, business confidence declined, lowering investment spending and causing businesses to cut labor forces further reducing consumption, consumer confidence and causing additional declines in the GDP. At first, declining exchange rates for the dollar kept exports high and kept the recession from deepening, however, a decline in foreign GDP and an increase in oil prices worsened the trade deficit and lowered the US GDP. Government spending and Federal Reserve policies of low interest rates and increased nominal money supply were not enough to stop the 2007-2009 recession, but they may have kept the recession from becoming even worse.

Page 6 Analysis of the Recent Economic Downturn

P AS09

AS07

P P

09 07

AD09 Y 09 Y 07 Yf 07

AD07 Yf 09 Y

Curve Variable AD09 Foreign GDP decreases Business confidence decreases Consumer confidence decreases Wealth decreases (home equity, stock market) Exchange rate -- dollar decreases Nominal Ms increases (FR policy) Government spending increases AS09 Employment costs decrease Prodcutivity, efficiency increase Oil price increases

Spending Compenent(s) exports decrease consumption and investiment decrease consumption decreases consumption decreases exports increase, imports decrease -------government increases ----------------------

Shift of Curve back back back back out out out short-run shift down long-run shift out short-run shift down

Page 7 Analysis of the Recent Economic Downturn

Sinking Dollar Aids Exports, but Trade Gap Grow, November 14, 2009 Economy in Worst Fall Since 82, February 28, 2009 Fed doesnt need a printing press to print its new money, March 21, 2009 Americans Get Even Thriftier as Fears Persist, June 2, 2009 More Firms Cut Pay to Save Jobs, June 9, 2009 Stimulus Fueled Much of Expansion, October 30, 2009 Employers Hold Off on Hiring, October 20, 2009 Piecing Together the Job-Picture Puzzle, March 12, 2012 US Stands By as Dollar Falls, October 9, 2009 GDPs 3.9% Surge May Be Tough to Match, November 1, 2007