CONTENT 1. INTRODUCTION 3 2. MONETARY AND FISCAL POLICIES OF THE USA 3 3. REASONS FOR CONTRADICTORY CONSEQUENCES 5 4. IMPACT ON THE BANKING SYSTEM 7 5. IMPACT ON CITIBANK 8 6. RECOMMENDATIONS 9 7. CONSEQUENCES 10 8. REFERENCES 11 ? EXECUTIVE SUMMARY The global economic downturn, the sub-prime mortgage fiasco, investment bank collapses, falling shares and home prices, and tight credit pushed the United States into a recession by end 2007.
In response to which the Federal Reserve, Treasury, and Securities and Exchange Commission responded with unprecedented , monetary policy expansion, fiscal stimulus and financial institutional bailouts intended to create employment, promote investments and combat slumping consumer spending. However these policies have had useful as well as contradictory results in their outcomes. The following report discusses various monetary and fiscal policies, reasons for the contradictory consequences ,impact of these policies on the banking sector for e. . how banks started hoarding and investing money in securities instead of lending out to businesses, and how Citibank in particular has been impacted. The report concludes with a number of recommendations to address the challenges of debt management, dismal unemployment rate and the crisis of the banking sector. 1 INTRODUCTION The global economic downturn, the sub-prime mortgage fiasco, investment bank collapses, falling shares and home prices, and tight credit pushed the United States into a recession by end 2007. National Bureau of Economic Research ). Figure 1 United States GDP Growth Source : CIA World Book Fact Sheet As shown in figure 1,the GDP rate started to deteriorate in 2007 ,and by Jan 2009 it had slumped to -6. 40 . Unemployment rate also reached a staggering 10% thus forcing Government and the central banks Federal Reserve to respond with unprecedented , monetary policy expansion, fiscal stimulus and financial institutional bailouts intended to create employment, promote investments and combat slumping consumer spending as discussed below. MONETARY AND FISCAL POLICIES 1) Economic Stimulus Act of 2008-. This stimulus package, projected at $152 for 2008 was passed in February 2008. It includes tax rebates for American Low and middle income households, tax stimulus for businesses to invest, and an increase in the size of home mortgage loans that the Federal Housing Administration (FHA) can insure and that the government sponsored enterprises Fannies Mae and Freddie Mac can purchase. 2)Troubled Asset Relief programme –
In order to address the subprime mortgage crisis, one of the first and most significant monetary measure was TARP. Congress allowed the United States of the Treasury Department to inject $700 billion dollars into banking industry to buy illiquid, difficult-to-value assets from banks and other financial institutions so that they could start lending again. 3) American Recovery and Reinvestment Act of 2009- In January 2009 the US Congress passed and President Barack OBAMA signed a bill providing an additional $787 billion fiscal stimulus to be used over 10 years.
It contained a number of spending and tax measures to inject more aggregate demand and to increase consumer spending thereby boosting employment and the economy. The Act includes federal tax cuts, expansion of unemployment benefits and other social welfare provisions , and domestic spending in education, health care, and infrastructure, including the energy sector. A detailed composition of the package is as presented below. 4. )Operational Procedures to Influence the Federal Funds Rate Monetary Policy Changes in 2008/2009
Thus against the backdrop of further deteriorating economy and the market On December 16, , the FOMC established a target range for the federal funds rate of 0 to . 25 percent, the lowest target for overnight fed funds trading in U. S. history as seen in the figure above and keeping it unchanged throughout year 2009. Figure 2 United States Interest Rate 3. REASONS FOR THE CONTRADICTORY CONSEQUENCES 1)Huge Deficits With America pumping in massive amounts of money in the economy ,USA’s national debt has increased to a whopping $1. 2 trillion in 2009, a $960 billion increase from the 2008 deficit, representing 12. 3% of gross domestic product, the largest share since World World . As a result dollar has dropped against the emerging-market counterparts. The high level of debt and continuing large trade deficits have raised concerns regarding inflation and the value of the dollar relative to other currencies, as well as its place as the primary reserve currency. Secondly, many of the foreign holders of U. S. debt are investing more in their own economies.
Over time, diminished demand for U. S. Treasuries will increase interest rates, thus slowing the economy Furthermore, this diminishing demand is putting downward pressure on the dollar. That’s because dollars, and dollar denominated Treasury Securities, are becoming less desirable, so their value declines. As the dollar goes down, foreign holders get paid back in currency that is worth less, which further decreases demand. The bottom line is that the large Federal debt is having a slowing effect on the U. S. economy. 2. Liquidity Trap
As short-term policy rates for the various central banks have moved close to zero in America, the conventional open-market operations purchases of short-term government debt by the central bank seem to be loosing traction. Consequently a liquidity trap is believed to be setting up. (Paul Krugman,2010)The situation is being compared to that of Japanese economy where despite the near zero – interest rates ,the economy fell into a prolonged stagflation. 3. Unemployment Rate Unemployment insurance benefits have given people incentives to work less.
Its been found that many people have delayed going back to work just because such package pays them for not working. This had led to a lower unemployment rate. Thus unemployment remains twice as high as it was before the housing crash. Also another micro policy of an increase in the minimum wage has negatively impacted hiring teenage workers leading to a increase in teen unemployment rate. Hardly enough jobs are being created to keep pace with the growth in the population of working-age adults, let alone put unemployed back to work.
Thus to conclude unemployment benefits have adversely affected the unemployment rate. The figure below shows a steady rise in the unemployment rate from year 2008 to 2010. Figure 3. United States Unemployment Rate Source : UNITED STATES DEPARTMENT OF LABOUR 4) Other effects. There were lot of controversies as well regarding the efficient use of TARP funds. Taxpayers were concerned that their money would not be used wisely, although the Treasury did suggest that , it could sell the toxic assets it held at a profit once the economy stabilized.
The hefty executive bonuses paid by banks which received TARP funds did also create furore. It later on make government rush through a program which would monitor and restrict salaries and bonuses for institutions receiving TARP funds. While several institutions paid back the funds they received in a timely fashion, many others dragged their heels, and economists suggested that the government was subsidizing the American economy at taxpayer expense. Commercial real estate still is staggering today as homeowner defaults and foreclosures continue at a rapid pace.
Credit problems still linger for businesses. Meanwhile, inflation is likely to remain dismal, reflecting the lagged effects of financial restraint and economic slack. Citi analysts believe that limited private credit demand is likely to limit risks of upward cyclical pressures on interest rates. However, the lack of a fiscal exit strategy, amid an eroding long-run deficit outlook, poses a threat of crowding-out pressures as recovery matures. Thus the financial system still remains vulnerable to the crisis conditions that TARP and other fiscal and monetary policies were meant to fix. . IMPACT OF POLICIES ON THE BANKING INDUSTRY TARP was the most important measure taken by the United States government in 2008 to address the crises of banking sector industry. Under this $245 billion invested in U. S. banks. It allowed the United States Department of the Treasury to purchase or insure up to $700 Billion of difficult to purchase illiquid, difficult – to- value assets from banks and other financial institutions. Another goal of TARP was to encourage banks to resume lending again at levels seen before the crisis, interbanking and to consumers and businesses.
However contrary to the governments goals of encouraging banks to resume lending again, the banks started hoarding cash for the future unforeseen losses from troubled assets. Resulting from the Fed’s near-zero interest-rate policy, it actually led to vast transfers of wealth to banks from investors. It allowed them to earn fat profits on the spread between what they paid for their deposits and what they got on their loans. These margins were especially rich on credit cards, given their current average rate of 14 percent and up.
It has also allowed the banks to keep bad loans valued on their books at unrealistic levels , making banks more reluctant to lend. And so the shrinkage of the banking system has continues. As Hank Paulson, the former Treasury and previous executive of Goldman Sachs , told the Financial Crisis Inquiry Commission that 2,000-3,000 banks should have held the government capital for three to five years. Instead, a few hundred banks rushed to repay because of the associated restrictions on pay levels and the political atmosphere.
Taking one of the most drastic steps , President Barack Obama announced that executives of finance firms taking government bailouts would have their annual salaries limited to 500,000 dollars. Thus with such deep restrictions banks started facing high attrition rate by these top executives.. Such turned out to be disincentives for financial firms to reach out for aid, which just prolonged the recovery for the sector and the economy. Thus If the investments had been broader and for longer, that would have done far more than any stimulus programme to get the economy going again. IMPACT ON CITIBANK Citibank, one of the hardest-hit banks during the financial crisis, received $45 billion in bailout money. That was one of the largest rescues by the government. Treasury invested $25 billion in October 2008 and another $20 billion November 2008. In turn, $25 billion worth of preferred shares were converted into common shares in early 2009, entitling the government about a 34% ownership stake in the bank. However it was not easy for the bank to cope up with consequences that followed.
With the United states government taking a stake in citibank,citigroup’s shares dropped 40 % on news. On June 1, 2009, it was announced that Citigroup Inc. would be removed from the Dow Jones Industrial Average effective June 8, 2009 due to significant government ownership. The government obtained wide powers over banking operations as well. As a condition of the bailout, Citigroup’s dividend payment had been reduced to a mere 1 cent a share. Another major impact of the policy on Citibank was the cap on executive pay . On Feb. , the administration announced a salary cap of $500,000 for top executives at companies that received the largest amounts of money under the $700 billion federal bailout. Thus Citibank , in lines of Bank of America decided to buy back $20 billion in preferred shares held by Treasury because of its investments under TARP at the cost of increasing it total cost of capital. Citigroup decided to issue $17 billion of new shares when its share price is below $4/share, instead of paying an 8% interest rate on $20 billion in preferred shares.
Citigroup’s cost of equity is certainly more than 8%, thus it just increased its overall cost of capital. The stock price fell by 6 % as according to shareholders , the dilution they suffered (because new shares were issued) will more than compensate for the fact that Citi no longer has to pay dividends to Treasury. On the other hand, according to the treasury Department it raised $6. 2 billion from the sale of 1. 5 billion shares of Citigroup stock it received as part of the government’s rescue of the bank. The government sold the shares at a profit as it seeks to recoup the costs of the $700 billion financial bailout.
Thus paying back the bailout money has only made Citibank weaker. The risk that Citigroup will come back for a future bailout has infact gone up. .6 RECOMMENDATIONS Although the government and the treasury have taken a number of steps to stabilize U. S. markets and the banking system, including injecting billions of dollars in financial institutions, it still needs to address a number of critical issues like the increasing huge debts,unemloyment rate,and executive compensation cap,dividend payments ,and the repurchase of stock by companies.
Although restrictions on the form of compensation in financial institutions are justified, such as requiring them to be distributed in restricted stock that vests over several years (which is already standard practice at some banks, such as Goldman Sachs) and making bonuses in good years subject to conditions in not so good years. However these restrictions should apply to all financial institutions, not just some of them therwise, such situations arise where Bank of America made unwise financial decisions because it had to hire a new CEO or Citibank , decided to buy back $20 billion in preferred shares held by Treasury because of its investments under TARP at the cost of increasing it total cost of capital. Government also needs work with the bank regulators to establish a systematic means of determining and reporting in a timely manner whether financial institutions’ activities are generally consistent with the purposes of policies and help ensure an appropriate level of accountability and transparency. CONCLUSION Although the government and treasury were able to help stabilize economy to some extent, the monetary and fiscal policies taken by the US government have also had contradictory results both in their as well as their usefulness for the American economy. With the government pumping in billions in these policies USA’s national debt has increased to a whopping $1. 42 trillion in 2009 . Thus debt management remains a major challenge for the government. Inflation rate remains dismal. As discussed above, unemployment benefits have adversely affected the unemployment rate.
It has also, as noted in the report above, delayed, not prevented, the day that banks will have to deal with toxic assets. Thus the government needs to consider various implications these policies have had on each industry and on the overall economy in order to address the roots of the issues to facilitate rapid recovery of the economy 8 REFERENCES Federal Reserve Available at : http://www. federalreserve. gov/bankinforeg/default. htm (accessed on 2 June 2010) NewYork Times Available at : http://krugman. blogs. nytimes. om/2010/03/17/how-much-of-the-world-is-in-a-liquidity-trap/ (Accessed on 2 June 2010) CITIBANK Available at : http://www. citibank. com/ipb/europe/pdfs/monthly_1003. pdf (Accessed on 2 June 2010) YAHOO FINANCE Available at : http://finance. yahoo. com/news/Treasury-gets-62-billion-from-apf-2653586322. html? x=0&. v=4 (Accessed on 2 June 2010) CIA THE WORLD BOOK FACT Available at : https://www. cia. gov/library/publications/the-world-factbook/geos/us. html (Accessed on 2 June 2010) UNITED STATES DEPARTMENT OF LABOUR Available at : http://www. bls. gov/data/ (Accessed on 2 June 2010)