Finance On Wheels

What are the Causes of the Economic Recession?

The current global economic crisis has caused many countries to formally declare that they are in recession. This means that the country’s gross domestic product has fallen to a negative value for two consecutive quarters of year. The slowing down of an economy is felt when businesses cease to expand, employment rate decreases and unemployment rate rises, and prices of housing decline.

A recession is not an unnatural occurrence in the business cycle, as the world has gone through several recessions in the course of its history. Each has its own underlying cause but one common factor is that it is always preceded by a period of a boom in the stock market, called irrational exuberance. To cite an example, an economic boom occurred in 1999 when many people bought computers and software to ensure that their systems were Y2K compliant. This led to the rise in stock prices of information technology companies and investors became only too willing to put their money into any kind of hi-tech corporation, without even ascertaining first if there was a potential for profit or not. This irrational exuberance was called the dot.com bubble and it burst when the year 2000 came and it became obvious that computer sales would decrease. Investors sold off their stocks as quickly as possible and prices plummeted, along with the value of the technology companies and many of them became bankrupt.

One of the main cause of the current recession started way before its effects were felt. In 2004, the United States economy experienced a boom and the Federal Reserve kept interest rates low. Due to the low rates, investors bought homes to resell at a profit. This created a housing bubble and debt and many non-investors also took advantage of low interest rates to buy homes they could scarcely afford. In 2006, interest rates started to rise and the prices of housing declined. This caught many home purchasers by surprise as they realized that the value of the houses that they bought was less than the mortgage they had to pay. These houses were then foreclosed by their owners. The foreclosures, in turn, caused many banks and hedge funds to panic, since they had invested in mortgage-related securities and were losing money. As a result, banks stopped lending to each other because the houses that used to be accepted as collateral were now considered as toxic loans. Several financial institutions and banks became bankrupt; the most prominent of which are AIG, Bear Stearns, Freddie Mac and Fannie Mae. The government had to intervene and conduct a bailout in order to stop, albeit momentarily, the devastating effects of the crisis.
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