On March 12th 2020, the World Health Organisation declared the Covid-19 outbreak a pandemic, as the ruthless spread of the disease showed no sign of relenting. Governments from all over the world have responded in varying ways in a bid to save lives, the result of which has been an economic downturn not seen since the 2008 Global Financial Crisis.
One measure to ease the downward spiral has seen central banks imposing temporary stimulus measures as a way of counteracting this looming fear of recession and total economic collapse. But this isn’t the first time we’ve seen these measures having to be taken.
We’ve decided to take a look back at the 2008 Financial Crisis and the monetary measures the USA took and compare them with the measures the Federal Reserve is enforcing during this current epidemic. Could this look back into our history give us hope for our future? Or do we need to strap ourselves in and batten down the hatches?
What Caused the Financial Crisis?
Such a complex situation can rarely be explained by one single cause, but theories converge around deregulation in the financial industry that saw banks to engage in hedge fund trading with derivatives. Banks, as a result, demanded more mortgages to support the profitable sales of these derivatives.
In 2007, the subprime mortgage market in the US began to depreciate, unemployment was at its highest and homeowners were unable to repay their loans. This became an international crisis in September 2008 when Lehman Brothers, a huge risk-taking bank, collapsed. This created a huge panic throughout the world and rippled through the international markets, which we now know as the 2008 Financial Crisis.
How Did the USA Respond?
The Federal Reserve system, a collection of 12 regional federal reserve banks in the States, responded to these events in two major ways. These two steps were cutting interest rates and targeted assistance, and loan bailouts known as quantitative easing.
1. Interest Rate Cuts
This first response started in 2007 when the US first saw its markets deteriorating and subprime mortgage markets dwindling. In September the Fed cut the interest rates to 4.5%, a half percent decline. The advantage of cutting the rate that banks pay each other for overnight loans, or the federal fund rate, is boosting the economy. With low interest rates, more businesses and individuals are inclined to make new investments, buy properties, cars etc. At the same time, all these new investments boost employment as well as economic output.
In 2008, interest rates had reduced to as low as 2%. But cutting interest rates and excessive spending risks inflation. The Fed kept to the steady 2% as long as they possibly could even though the state of the economy was equally depressed. By December 2008 the economic situation had deteriorated further and the interest rate reached nearly 0%. This risked a surge of people taking out their money from their accounts and collapsing yet more banks in a scenario known as ‘zero bound’.
2. TARP and Quantitative Easing
In September 2008 when Lehman Brothers collapsed, the Fed encouraged congress to pass TARP to avoid any further costly bank closures. The Troubled Asset Relief Program consisted of a $700 billion bailout to target ailing financial institutions. The program allowed the United States Department of Treasury to purchase troubled assets, which in this case focused on the mortgage-backed securities of American banks which couldn’t be sold in the secondary mortgage markets.
Banks such as Goldman Sachs and Morgan Stanley were also allowed to be classified as bank holding companies to give them access to cheap overnight lending. The US also produced an “alphabet soup” of loan programs to aid the financial industry.
Quantitative easing is where a central bank, in this case the Federal Reserve, is allowed to purchase bonds, loans or other assets to increase liquidity in the financial markets and inject money into the economy. For the Fed to be able to purchase these “toxic assets”, they must create the money. Thus quantitative easing being often referred to as “printing money”. In 2008, the Fed added almost $2 trillion to the money supply. By increasing this money supply, its intention was to keep the country’s currency low and as a result the country’s stocks more attractive to foreign investors.
Did This Work?
It is regarded by most economists and financial journalists that the Fed’s handling of the financial crisis was a huge success. It is considered that the US was teetering on the edge of another disastrous scenario like the Great Depression, but due to the active response of the Fed they were pulled back into safety.
However, it is also noted that it took the better part of a decade before there was a reliable return of growth not only in the US but across Europe too, as a staggering estimation of over $10 trillion was lost in the process of the Financial Crisis. This article by John Cassidy in the New Yorker comments "The economic recovery that began, according to the National Bureau of Economic Research, in the summer of 2009 was weak and uneven. Growth in the G.D.P., wages, capital investment, and productivity continued to lag for most of the ensuing decade."
What Is the USA Doing In The Current Crisis?
As a result of the COVID-19 pandemic, the US Fed have resorted to many similar measures that employed during the 2008 crisis, including:
1. Interest Rate Cuts
The Fed have cut rates down to 0.25%. (In the UK this has been cut to 0.10%).
2. Quantitative Easing
They have added $2 trillion of liquidity to the banking system as well as purchasing over $1 trillion worth of mortgage-backed securities and treasury.
As well as this they have released another “alphabet soup” of programs and funding facility to aid the financial industry as well as to support businesses.
We can see a lot of the same actions from the 2008 financial crisis being replayed in today's pandemic. The questions are, will it work as it did the first-time round? With interest rates already nearly hitting zero bound this early in the game, where is there to go from here? Are the US and Europe in real danger of economic collapse and inflation with interest rates becoming so low? Is a decade until recovery looking to be a far-off fantasy?
If you're a trader and you know the answers to those, then you're in the right game. Good luck.