INTRODUCTION

Recession is a contraction phase of the business cycle, or "a period of reduced

economic activity”. The U.S. based National Bureau of Economic Research

(NBER) defines a recession more broadly 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. A sustained recession may become a Depression.

Some business & investment glossaries add to the general definition a rule of

thumb that recessions are often indicated by two consecutive quarters of negative

growth (or contraction) of Gross Domestic Product (GDP).A recession has many

attributes that can occur simultaneously and can include declines in coincident

measures of overall economic activity such as employment, investment, and

corporate profits. Recessions are the result of falling demand and may be

associated with falling prices (deflation), or sharply rising prices (inflation) or a

combination of rising prices and stagnant economic growth (stagflation). A severe

or prolonged recession is referred to as an Economic Depression. Although the

distinction between a recession and a depression is not clearly defined, it is often

said that a decline in GDP of more than 10% constitutes a depression. A

devastating breakdown of an economy (essentially, a severe depression, or

hyperinflation, depending on the circumstances) is called economic collapse.

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Causes of Recession:

• Currency Crisis

• Inflation

• National Debt

• Speculation

• Wars

• Sub-Prime Loans

Effects of Recession:

• Bankruptcies

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• Banks lend less money

• Deflation

• Reduced Sales

• Stock market Crash

• Unemployment

WHAT DOES THIS CRISIS ABOUT ?

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When Harshad Mehta and Ketan Parekh used money from the

debt markets to play up stocks , they took the markets and few

players down with them .When large investment banks use money

from the wholesale debt markets for nearly a decade ,and go belly

up when their favorite bet crash , they can bring whole nation to

its knees, and this is what precisely happened with U.S.

INVESTMENT BANKS

After the crisis of 1930s, the Glass Steagall Act was promulgated ,

separating commercial banks that accepted public deposits from

investment banks that specialized in advisory and broking business.

Investment Banks spearheaded most of what we now know as

components of modern financial system i.e. capital market funding of

businesses , innovative financial products, structures for reviving and

expanding businesses and so on . They were also large brokers and

dealers in Equity, Debt and Derivative.

UNHEALTHY COMPETITION

In 1999 ,the Glass Steagall Act was discarded . Deposit taking banks

were allowed to indulge in financial advisory and compete with

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investment banks .Competition cut into the margins of investment

banks .As a result their trading desk become bigger, and their

intellectual prowess was used in creating new products and

structures and selling them off to clients. The size of their trading

book doubled to $15 trillion since 1999.

ENGINEERING

The most important condition for investment banks , when it used

to borrow money to buy assets , was that return from trading assets

was higher than the borrowing rate .In early 2000s fund procuring

was no problem since federal reserve rates was at lower levels. But

the assets still carried risk. So investment banks bought only those

assets that were liquid and easy to sell off in the market .Where

the asset was not liquid, it was made liquid through financial

engineering.

LAYERING

For example, a 15-year home loan made by a bank ,is not liquid .

But the cash flows due from the loan can be repackaged and sold

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off to another entity like mortgaged backed securities. Investment

banks would create new structures with these cash flows,

rearranging them into collateralized debt obligations, and sell them

off to others. They can also repack their risk into newer

instruments like credit default swaps . The risk on the original home

loan is now spread across four different Balance sheets. This

exercise was expected to reduce the risk of the original loan,

enabling a fast growth in all the products that were engineered.

LEVERAGING

Since the interest rates were low, and housing prices were going

up, all participants extended themselves .Household borrowed more

than they needed, banks lend more than they could, investment

banks held and traded too much of the structured products and

investors bought more and more in the hope of profit. This

extension created sub prime loans, where household could borrow

even if they had no income, no paper , no credit rating or payment

record. They only needed to use the money to buy the house,

whose prices went up.

BUBBLE BUILDING

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As everyone books blew out of proportion, the bubble burst. When

housing prices crashed, the domino effect came into play. Across

the balance sheet that the loans were spread into, all values

dropped. And panicky investment banks try to sell off what they

held, and found that market had become illiquid. When they wanted

to borrow to keep the assets ,the rates had moved up and money

was not available. They began to sell in panic what they had, and

prices only dropped further.

AND FINALLY BUBBLE BUST

Investment banks now faced a situation where the assets they held

were worth less than the amount they had borrowed. So ,they went

around asking for capital .At the peak of the boom, many of them

had $40 of borrowings for every dollar of capital. Now when the

value of assets fell off to say $20 or less,there was no money to repay

the borrowing ,unless they got equity capital .Equity capital was not

forthcoming because the value of the assets was dropping day by day.

The result: they simply went belly up.

AFTER EFFECTS

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Since fear of failure grip the markets credit has dried out .As

value of assets held by large players has shrunk, the market itself

has shrunk. Money is difficult to get. Loan is new bad word and

no one wants to lend money to fund risky assets. Safe heavens like

money market funds have began to lose value, and investors are

holding back funds worsening the liquidity crunch. And the result ,

investment banks came crashing down. Two of the four pillars of

U.S financial System , Lehman Brothers and Merrill Lynch have filed

for bankruptcy with losses running over to $8 billion, while the

other two Goldman Sachs and Morgan Stanley have given up their

status of investment banks to much regulated commercial banks.

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ANOTHER DEPRESSION IN THE MAKING-

REASONS FOR U.S. FINANCIAL COLLAPSE

The total credit market debt in US is $51 trillion(2007-08) versus

our $14.3 trillion GDP(2007-08). Debt as a percentage of GDP is now

356% versus 260% during the of the 1930’s. This massive buildup

of leverage has just begun to unwind showing false prosperity. The

huge Mansions, luxury cars, high tech gadgets, granite kitchens

homes, and exotic vacations were purchased with debt. These

“assets” are depreciating rapidly and consumers and companies are

desperately selling assets to pay down the debt that is strangling

them. Real median household income in the U.S. is $50,233 today.

It was $50,577 in 2000 when George Bush took office. The

government has added over $4 trillion to the national debt during

this time. This proves that most people in this country have not

been able to generate enough income to keep up with inflation. And

this is using the fake CPI numbers put out by the government.

Using inflation rates in the real world would make the situation

more dire for the average household. The only way people have

been able to maintain their lifestyle has been to borrow against

their house and run up their credit cards. That is a phony

improvement in lifestyle. The country has been living a lie for the

last twenty years. It is now time to pay the piper.

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The top 20% of households showed real increases in income. The

bottom 50% lost income during the Bush years, with the bottom

20% losing 6% of income over this time frame. No wonder there is

so much anger in the country regarding this bailout for the top 1%.

Fifty million households make less today than they made 8 years

ago. The criminal CEOs on Wall Street collected $30 million annual

salaries while their companies have lost $500 billion in the last

year. The average American is living paycheck to paycheck and

can’t maintain a lifestyle without borrowing. The unwinding of this

unbelievable debt load could lead to the next great Depression.

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TODAY’S ENVIRONMENT V/S CONDITIONS THAT

EXISTED IN THE 1920’S

1. Expansion of the money supply by the

Federal Reserve

THEN

The Great Depression was mainly caused by the expansion of the

money supply by the Federal Reserve in the 1920’s that led to an

unsustainable credit driven boom. The artificially low interest rates

led to over investment in textiles, farming and autos. In 1927 the

government lowered rates yet again leading to a speculative frenzy

leading up to the Great Crash. By the time the Federal Reserve

belatedly tightened in 1929, it was far too late and, in the Austrian

view, a Depression was inevitable. The artificial interference in the

economy was a disaster prior to the Depression, and government

efforts to prop up the economy after the crash of 1929 only made

things worse. According to Murray Rothbard, government intervention

delayed the market's adjustment and made the road to complete

recovery more difficult.

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NOW

Alan Greenspan(US Fed Reserve Chairman) reduced interest rates to

1% for over a year in 2003. This act led to a speculative frenzy

in real estate, $3 trillion of equity withdrawal by consumers and

tremendous over consumption built upon a foundation of debt. This

speculative frenzy was exacerbated by the “Masters of the Universe”

on Wall Street with their CDOs, MBSs, and other magic potions

that made bad loans appear good. The Bush administration’s decision

to not enforce any existing oversight of the banks also contributed

greatly to the current situation. Realistically, the current conditions

are worse than they were prior to the Great Depression based on

the speculation that has occurred in the last eight years in stocks

and real estate.

2. Excessive use of debt which led to a false prosperity

THEN

By 1929, the richest 1% owned 40% of the nation’s wealth. By

1929, more than half of all Americans were living below a

minimum subsistence level. Those with means were taking advantage

of low interest rates by using margin to invest in stocks. The

margin requirement was only 10%, so you could buy $10,000 worth

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of stock for $1,000 and borrow the rest. With artificially low

interest rates and a booming economy, companies extrapolated the

good times and invested in huge expansions. During the 1920s there

were 1,200 mergers that swallowed up more than 6,000 companies.

By 1929, only 200 mega-corporations controlled over half of all

American industry.

NOW

Today, the richest 1% own 21% of the nation’s wealth. The bottom

50% has experienced a 4% drop in real disposable income in the

last eight years. During the dot.com boom of 1998 – 2000, small

investors used massive amounts of margin debt to speculate in

companies with no earnings. When this bubble collapsed, a lesson

should have been learned that would last a lifetime. Instead, Alan

Greenspan lowered interest rates to 1% and encouraged everyone to

take out an Adjustable Rate Mortgage. The speculation in real estate

reached phenomenal heights by 2005. The downside of that

speculation is now only half finished. Home prices did not fall on

a national level during the Great Depression. In the last ten years,

there have been hundreds of mergers, particularly in the financial

industry. The repeal of the Glass-Steagall Act in 1999, spearheaded

by Senator Phil Gramm, allowed the massive consolidation In the

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industry. This is why our financial institutions have become too big

to fail and are on the brink of collapsing the world economy.

3. Government responding with tighter credit, higher taxes

and higher tariffs

THEN

Ben Bernanke , a self proclaimed expert on the Great Depression,

concluded that missteps by the Federal Reserve in 1930 and 1931

resulted in the financial crisis becoming a Depression. After the

stock market crashed, speculators began selling dollars for gold in

1931. This caused the value of the dollar to plummet. The Federal

Reserve raised rates and reduced the money supply by 30% to try

and prop up the dollar. Investors began to withdraw their dollars

from banks, and banks began to fail. By the end of 1932, 9,000

banks failed. People hid their cash under their mattresses. Bank

deposits were uninsured, so when banks failed, people lost their life

savings and businesses failed. Panic and fear gripped the nation.

The remaining banks hoarded their cash, refusing to make loans to

businesses. Treasury Secretary Andrew Mellon declared, “Liquidate

labor, liquidate stocks, liquidate real estate, values will be adjusted,

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and enterprising people will pick up the wreck from less competent

people.”

The failure to stimulate the economy with increases in the money

supply was a huge mistake. The United States had the flexibility to

stimulate the economy. At that point in history the U.S . was the

biggest creditor in the world, with a trade surplus of $638 million .

Instead of stimulating the money supply, the government attempted

to protect American businesses by passing the Smoot-Hawley Tariff

in June 1930. This bill increased taxes on imports which led to

retaliation by other countries and contributed greatly to the

worldwide downturn. World trade declined 67% by 1933. Herbert

Hoover increased the top tax rate from 25% to 63% in 1932 . The

worst year of the Depression was reached in 1932 with GNP

declining 13.4% and unemployment reaching 23.6%.

.NOW

In this current financial crisis no one can accuse the Federal Reserve or the

Administration of not responding with injecting liquidity into the system or

reducing interest rates sufficiently. The discount rate has been reduced from 4.75%

to 2% in the past year. The Federal Reserve has increased their balance sheet by

over $1 trillion in the last 9 months. The government has committed in excess of

$1.3 trillion of taxpayer money to keep the financial system from imploding. The

question that has yet to be answered is whether these actions are just pushing on a

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string. Are the current conditions so extreme that we are destined for a severe

recession or possible Depression? The country has a national debt of $9.6 trillion,

annual deficits of $600 billion, unfunded future liabilities of $53 trillion, a trade

deficit of $600 billion, inflation of 6%, two wars costing $12 billion per month,

and a weak currency. Therefore, we have not entered this extremely dangerous

period with strong economic fundamentals.. The next administration could easily

make policy mistakes which would cause a second Great Depression.

RESCUE PLAN OF THE U.S GOVERNMENT

BANK BAILOUT

A bailout is nothing but infusion of required funds for the purpose

of ensuring that the bank is able to meet its various commitments.

This can be done by either giving a loan to the bank or by taking

equity capital in the bank. Banks that are facing losses on some part

of the portfolio will find infusion of cash useful in conducting

their activities properly. This will ensure that there is also some

confidence in the financial system as stability is established in

Banking system.

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IMPACT OF US RECESSION ON INDIAN ECONOMY

India is w orld’s second highes t

p o p u lated country. R ich at Human R es ource……B ut s tuck by th e

r eces s ion of U.S . economy. R eas ons being the decline of foreig n

in v es tment, S haken trus t of F oreign Ins titut ional Inves tors (F II’s ) ,

I n f lation, Depreciat ion in the value of R upee ( v/s dollar).I n

r ef er ence to that”, F inance M inis ter P. C hidambaram s aid “Th e

g lo b al s low dow n w ill have an indirect effect on the Indian

eco n o my ( Sour ce: The F inancial Expres s ).

This lead to a rapid fall in the employment and FICCI in The

Financial Express stated that , “in the next ten days or so about 25

to 30 percent employees are likely to lose jobs in seven sectors

including aviation, information technology, steel, financial services,

real estate, cement and construction”

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This further became the reason of fall in the growth of the

country. The Finance Minister projected the growth for the financial

year 2008-2009 to at 7%.

Which as per the World Economic Outlook, October 2008 is projected

at 6.9%

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 CONCLUSION

Fall in real estate prices triggered by sub prime crises led US

economy grippling down and as they say , “When US sneezes entire

world catches cold”, it bought entire world with it with world stock

markets plunging faster than one could even blink his eyes

A flourishing Economy is dream of all but currently The Darker

side of the Coin is that we are on verge of the black-hole of

inflation, depreciating value of rupee, poor liquidity in banking

system , fall in employment opportunities.

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Stringent actions have been taken to save the economy from the

repercussions of the U.S. economy’s crash down. RBI (Reserve Bank

of India) has already took up corrective measure for example: a

decrease in REPO rate by 1.5 % and this lead to fall in market rate

of credit, in turn liquidity in the economy is enhanced. The finance

minister has announced many times via media that people should

not sell securities in panic.

Thus U.S. Depression is a situation emerged due to the shortcomings

of the economic planning and lack of institutional measures to keep

a check on sub-prime loans and advances. US being the leader of

the world economy has a major impact on Indian economy. But

India is domestic consumption and investment driven economy and

exports play an important role, can face this period of adversities.

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 BIBLIOGRAPHY

The following journals and sites have been cited for reference and

facts mentioned there in the project report.

 The Financial Express ( 31 0ctober 2008 )

 www.TheHindu.com

 www.Wikipedia.org

 World Economic Output report, October 2008 (www.finfacts.com ,

www.imf.org )

 www.google.com

 www.yahoo.com

 The Times of India (17- 18 October 2008 )

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