US Economy and Gross Domestic Product Decline

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This paper discusses the current state of the US economy and outlines some of the problems that have caused the GDP to face a decline in recent times. The paper then goes on to explore what policies are being used to alleviate the problems of a slowdown and suggests plausible solutions to the US problems.

The US economy, an engine for the world’s economies, is showing signs of a downturn in economic activity. The housing sector and as a result the sub-prime debt market has suffered in recent time. Global giants such as Citibank have written off losses worth $18 billion in terms of bad sub-prime debt. However, if these two sectors were the only ones facing a downturn matters could have been easily controllable. But other problems such as the rising energy prices and the subsequent increases in the costs of production, along with unemployment levels rising to 5% from 4.4% in March 2007, the US economy is in a crisis.

There are three main problems with the US economy. These are the housing sector slump, the capital market issues, and the rising energy prices.

The sub-prime market issues are the main factor belying the housing industry slump. Before discussing the housing industry it is important to clarify the role of the sub-prime markets. Sub-prime lenders loan out money to borrowers who are not very creditworthy and as a result of this, the lenders charge the borrowers a higher interest rate. Houses that cannot be sold on the primary market are sold in the sub-prime mortgages industry.

Thus, due to over-building, the prices of houses fell and the houses could not be resold without significant price reductions. In 2007, due to the inability of many subprime borrowers to pay back these loans, many foreclosures took place. This led to a downturn in the housing market, which in turn has led to a slowdown in the construction industry.

The capital market also has suffered as a result of the housing sector’s weaknesses. As banks suffered huge losses due to the sub-prime losses, credit became tighter and investors had little money to invest. Also as property prices went down, people did not have a property to secure their loans, and investments in the capital market lowered. Due to this credit crunch, interest rates rose further fueling the decline in investments.

The effect of the capital market slowdown and the housing sector decline, coupled with rising energy prices has worsened the USA’s economic conditions even further. Rising energy prices have led to price hikes and increases in the costs of production which in turn has further curtailed aggregate demand in the economy leading to a situation, many economists think, that will give way to a recession.

To counter the worsening situation the Fed and the congress have each introduces measures that might hold the economy from going into recession.

Congress has introduced a two-pronged policy to curtail the onslaught of a recession. Congress has introduced a spending stimulus package worth $150 billion. Companies have been offered increased tax deductions if they invest in certain industries. This tax-cut incentive provided to companies is worth $50 billion. The rest of the $100 billion is to be distributed among people who earn less than $75,00 and to people who do not contribute at all to federal taxes. Each person, including children, will receive $300 in households earning less than $75,000 a year. Families who do not contribute to federal income taxes will also get $300 checks issued by the government.

This policy measure has been introduced alongside the Fed’s interest rate reduction of ¾ of 1%. Thus the government has tried to boost spending so that people have additional income to spend and that demand is created in the economy to bring it out of the downturn.

The policies introduced by the government; however, might not be the solution that suits the needs of the economy. The capital market is far too complex to respond immediately to an interest rate cut. There are areas where there is little or vague regulation such as the credit-default swap market. The credit default works like an insurance policy in case the bond does not pay. With the sub-prime market in a bad shape, the companies who have invested huge amounts in the credit-default swap market (the industry is worth $45 trillion) will face huge losses that cannot be countered with the measures that the government has initiated.

Therefore the solutions that could work for the USA in these times of financial trouble are that instead of giving money to people, loans could be provided to the banks at low-interest rates to counter the bad subprime debts. This would also give banks enough lending power which would automatically introduce spending power into the hands of the people. Also, there will be a lag in the fiscal policy to work, because people might not get the money until it’s too late and then they might save the money rather than spend it. Another possibility is that they might use it to pay back the loans they took, which would again not work in the intended direction.

According to David Wyss in the Businessweek article-You Call This a Recession,

“The cuts did help stop the stock market slide, and can make the recession shorter and shallower, but, in our view, it is too late for monetary policy to prevent the recession.”

An element of injustice also arises in this case, where blatant partiality being displayed by the government in an election year. This is because although all taxpayers are suffering from the recession the government is only giving money to those who contribute little or nothing to taxes. This could aggravate the taxpayers who are contributing towards taxes but are now watching their money go into the hands of those who are not paying taxes at all. Another thing to note here is that if rich or middle-class people are given the money they will spend on buying luxury items while if given to the poor income groups, the money might be used to buy commodities the demand for which is fairly stable and won’t impact the GDP as much as expenditure in the other industries can.

Another measure that the government could have taken is to try and regularize the credit default swap market and fix a ceiling for the amount that can be invested by a company in derivatives and subprime debt. This will serve to stabilize the market and there won’t be a downward spiral in all related industries with one incident.

The US economy is bound to slow down as the fiscal and monetary policy measures taken by the fed and the congress respectively will take effect after a time lag. The first few months are expected to be bleak with the economy showing signs of an upward trend in the middle of the year. However, the end of the year is going to be tough again as the stimulus provided by the government gets used.

Another outlook for the USA is that it can look to the emerging markets for an export-driven increase in demand. The economies of emerging markets such as India and China will not suffer as much as they previously would have with the decrease in US consumer spending. The reason for this is the decoupling effect. This effect implies that as China and India are increasingly depending on domestic demand, their reliance on consumer spending in the US is decreasing and as a result, the downturn in the US economy will not have as powerful an effect as it would have on these economies.

Therefore the USA should look towards diversification and more long-term-oriented policies to hold recession from continuing for a longer duration.

References

Gross Daniel ‘The U.S. Economy Faces the Guillotine’, Newsweek, 2008.

Wyss David, ‘You Call This a Recession?’ Businessweek, 2008.

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US Economy and Gross Domestic Product Decline

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