Question

a. Based on the functions of the banking system, give reasons why governments bail out banks during an economic crisis?

b. Is the World heading for a recession? Explain the conditions under which the world can be classified as being in a recession as COVID-19 persists. Explain linking the pandemic to the various stages of a recession

Answer 1

a. Based on the functions of the banking system, give reasons why governments bail out banks during an economic crisis?

Ans:

Bailout is a general term for extending financial support to a company or a country facing a potential bankruptcy threat. It can take the form of loans, cash, bonds, or stock purchases. A bailout may or may not require reimbursement and is often accompanied by greater government oversee and regulations.

The reason for bailout is to support an industry that may be affecting millions of people internationally and could be on the verge of bankruptcy due to prolonged financial crises.

Description: Bailout policies come in various forms, the most common being direct loans or guarantees of third-party (private) loans to the rescued entity. These direct loans are often on terms favouring the entity being rescued. Sometimes even direct subsidies are provided to the parties concerned. Stock purchases are also not uncommon.

The government or the financing body places strict requirements such as restructuring of organisation, no dividend payment to shareholders, change of management and in some cases a cap on salaries of executives till a stipulated time period or the repayment of dues. This may also be followed by a temporary relaxation of rules that may impact the accounts of the rescued entity.

Bailouts have several advantages. First, they ensure continued survival of the entity being rescued under difficult economic circumstances. Secondly, a complete collapse of the financial system can be avoided, when industries too big to fail start to crumble. The government in these cases steps in to avoid the insolvency of institutions that are needed for the smooth functioning of the overall markets.

Bailouts also have their disadvantages. Anticipated bailouts encourage a moral hazard by allowing not only promoters but also other stakeholders (customers, lenders, suppliers) to take higher-than-recommended risks in financial transactions. This happens because they start counting on a bailout when things go wrong.

Reasons why governments bail out banks during an economic crisis

1. The government holds significant responsibility for the credit crisis. Firstly, the US government distorted the market to encourage poorer individuals to take out large mortgages and buy houses. When a few of these people (predictably) failed to pay off the mortgage, this began the chain of events that led to the crisis. Furthermore, governments around the world failed in their duty to regulate and oversee the banking industry. Since the government has responsibility for the crisis, the government should pay to support the companies affected by it.

2. Supporting the banks helps the rest of the economy. Financial institutions provide the loans that businesses need to open up, innovate, and invest. With the banks afraid of risk and lacking cash, banks have little capacity to lend money. Without those loans, the pace of growth in the global economy slows substantially, and may even go into reverse. Furthermore, economic growth requires businesses and individuals to be confident enough in the economy to make investments. When the government shows that it is willing to support the economy, investors will have more confidence and economic growth increases.

3. Banks collapsing also hurts individual citizens. Many pension plans and retirement savings have money invested in financial stocks. Bankruptcy destroys those investments, meaning less money for pensioners and retirees. In such circumstances, the government should step in to ensure the survival of major financial institutions.

4. The global economy is at risk of a much more severe collapse without an injection of government money. Without bailouts, bankruptcy of these institutions is likely, and that has the direct effect of putting at risk those assets that the bank manages. Mortgages, investments and savings which are insured and managed by banks are at risk of losing a substantial portion of their value, which would destroy significant amounts of global wealth.

5. Governments are not just giving financial institutions the money. Instead, they are generally exchanging the money for shares in the company. This has two positive effects. Firstly, the government as a shareholder and partial-owner can direct the company to act in the interests of the nation, and to avoid overly risky investments. Secondly, in future the government can sell those shares and recover some (potentially all) of the costs of the bailout.

b. Is the World heading for a recession? Explain the conditions under which the world can be classified as being in a recession as COVID-19 persists. Explain linking the pandemic to the various stages of a recession

Ans

Yes

The spread of the COVID-19 epidemic and the resulting public health lock-downs in the economy in 2020 are an example of the type of economic shock that can precipitate a recession according to Real Business Cycle Theory. It may also be the case that other underling economic trends are at work leading toward a recession, and an economic shock just triggers the tipping point into a downturn.

A recession is a macroeconomic term that refers to a significant decline in general economic activity in a designated region. It had been typically recognized as two consecutive quarters of economic decline, as reflected by GDP in conjunction with monthly indicators such as a rise in unemployment. However, the National Bureau of Economic Research (NBER), which officially declares recessions, says the two consecutive quarters of decline in real GDP are not how it is defined anymore. The NBER defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

Recessions are visible in industrial production, employment, real income, and wholesale-retail trade. The working definition of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP), although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession, and uses more frequently reported monthly data to make its decision, so quarterly declines in GDP do not always align with the decision to declare a recession.

Since the Industrial Revolution, the long-term macroeconomic trend in most countries has been economic growth. Along with this long-term growth, however, have been short-term fluctuations when major macroeconomic indicators have shown slowdowns or even outright declining performance, over time frames of six months up to several years, before returning to their long-term growth trend. These short-term declines are known as recessions.

Recession is a normal, albeit unpleasant, part of the business cycle. Recessions are characterized by a rash of business failures and often bank failures, slow or negative growth in production, and elevated unemployment. The economic pain caused by recessions, though temporary, can have major effects that alter an economy. This can occur due to structural shifts in the economy as vulnerable or obsolete firms, industries, or technologies fail and are swept away; dramatic policy responses by government and monetary authorities, which can literally rewrite the rules for businesses; or social and political upheaval resulting from widespread unemployment and economic distress.

For investors, one of the best strategies to have during a recession is to invest in companies with low debt, good cash flow, and strong balance sheets. Conversely, avoid companies that are highly leveraged, cyclical, or speculative.

There is no single way to predict how and when a recession will occur. Aside from two consecutive quarters of GDP decline, economists assess several metrics to determine whether a recession is imminent or already taking place. According to many economists, there are some generally accepted predictors that when they occur together may point to a possible recession.

First, are leading indicators that historically show changes in their trends and growth rates before corresponding shifts in macroeconomic trends. These include the ISM Purchasing Managers Index, the Conference Board Leading Economic Index, the OECD Composite Leading Indicator, and the Treasury yield curve. These are critically important to investors and business decision makers because they can give advance warning of a recession. Second, are officially published data series from various government agencies that represent key sectors of the economy, such as housing starts and capital goods new orders data published by the U.S. Census. Changes in these data may slightly lead or move simultaneously with the onset of recession, in part because they are used to calculate the components of GDP, which will ultimately be used to to define when a recession begins. Last are lagging indicators that can be used to confirm an economy’s shift into recession after it has begun, such as a rise in unemployment rates.

Numerous economic theories attempt to explain why and how the economy might fall off of its long-term growth trend and into a period of temporary recession. These theories can be broadly categorized as based on real economic factors, financial factors, or psychological factors, with some theories that bridge the gaps between these.

Some economists believe that real changes and structural shifts in industries best explain when and how economic recessions occur. For example, a sudden, sustained spike in oil prices due to a geopolitical crisis might simultaneously raise costs across many industries or a revolutionary new technology might rapidly make entire industries obsolete, in either case triggering a widespread recession.

The spread of the COVID-19 epidemic and the resulting public health lock-downs in the economy in 2020 are an example of the type of economic shock that can precipitate a recession according to Real Business Cycle Theory. It may also be the case that other underling economic trends are at work leading toward a recession, and an economic shock just triggers the tipping point into a downturn.

Some theories explain recessions as dependent on financial factors. These usually focus on either the overexpansion of credit and financial risk during the good economic times preceding the recession, or the contraction of money and credit at the onset of recessions, or both. Monetarism, which blames recessions on insufficient growth in money supply, is a good example of this type of theory. Austrian Business Cycle Theory bridges the gap between real and monetary factors by exploring the links between credit, interest rates, the time horizon of market participants’ production and consumption plans, and the structure of relationships between specific kinds of productive capital goods.

Psychology-based theories of recession tend to look at the excessive exuberance of the preceding boom time or the deep pessimism of the recessionary environment as explaining why recessions can occur and even persist. Keynesian economics falls squarely in this category, as it points out that once a recession begins, for whatever reason, the gloomy “animal spirits” of investors can become a self-fulfilling prophecy of curtailed investment spending based on market pessimism, which then leads to decreased incomes that decrease consumption spending. Minskyite theories look for the cause of recessions in the speculative euphoria of financial markets and the formation of financial bubbles based on debt which inevitably burst, combining psychological and financial factors.

Before the pandemic, there were signs of recession. The US yield curve inverted in mid-2019, usually indicative of a forthcoming recession.Starting in March 2020, job loss was rapid. About 16 million jobs were lost in the United States in the three weeks ending on 4 April.Unemployment claims reached a record high, with 3.3 million claims made in the week ending on 21 March. (The previous record had been 700,000 from 1982.)On 8 May, the Bureau of Labor Statistics reported a U-3 unemployment (official unemployment) figure of 14.7%, the highest level recorded since 1941, with U-6 unemployment (total unemployed plus marginally attached and part time underemployed workers) reaching 22.8%.Restaurant patronage fell sharply across the country,and major airlines reduced their operations on a large scale.

The Big Three car manufacturers all halted production. In April, construction of new homes dropped by 30%, reaching the lowest level in five years.

The St. Louis Fed Financial Stress Index increased sharply from below zero to 5.8 during March 2020. The United States Department of Commerce reported that consumer spending fell by 7.5 percent during the month of March 2020. It was the largest monthly drop since record keeping began in 1959. As a result, the country's gross domestic product reduced at a rate of 4.8 percent during the first quarter of 2020.

The largest economic stimulus legislation in American history, a $2 trillion package called the CARES Act, was signed into law on 27 March 2020.

The Congressional Budget Office reported in May 2020 that:

• The unemployment rate increased from 3.5% in February to 14.7% in April, representing a decline of more than 25 million people employed, plus another 8 million persons that exited the labor force.
• Job declines were focused on industries that rely on "in-person interactions" such as retail, education, health services, leisure and hospitality. For example, 8 of the 17 million leisure and hospitality jobs were lost in March and April.
• The economic impact was expected to hit smaller and newer businesses harder, as they typically have less financial cushion.
• Real (inflation-adjusted) consumer spending fell 17% from February to April, as social distancing reached its peak. In April, car and light truck sales were 49% below the late 2019 monthly average. Mortgage applications fell 30% in April 2020 versus April 2019.
• Real GDP was forecast to fall at a nearly 38% annual rate in the second quarter, or 11.2% versus the prior quarter, with a return to positive quarter-to-quarter growth of 5.0% in Q3 and 2.5% in Q4 2020. However, real GDP was not expected to regain its Q4 2019 level until 2022 or later.
• The unemployment rate was forecast to average 11.5% in 2020 and 9.3% in 2021.

In June 2020, economic analyst Jim Cramer said that the response to the coronavirus recession has led to the biggest transfer of wealth to the ultra-wealthy in modern history.