What Went Wrong With the Economy?

I have just seen yet another attack ad berating McCain for saying “the fundamentals of the economy are strong”, and for believing that we are in a “mental recession” and that we are a “nation of whiners.”

First of all, it was Phil Gramm who said, “You’ve heard of mental depression; this is a mental recession,” and, “we have sort of become a nation of whiners, you just hear this constant whining, complaining about a loss of competitiveness, America in decline.”  While Gramm is admittedly one of McCain’s campaign co chairs, McCain never said that he agrees with Phil on everything. McCain has since changed his line and continues to say, with everyone else, that the economy is just plain DOOMED.

Secondly, McCain is right. The fundamentals of the economy are strong, and were it not for the irrational market that we’re in, we would be doing just fine. Of course, an irrational market can do a lot of damage.

The economic crisis started because of low interest rates, which were originally in place because the tech stock bubble burst, continued because of 9/11 and then because of the light recession in the early 2000’s.  All of this served to keep interest rates low for an extended period of time. Low interest rates mean cheap money, and cheap money means more borrowing, as cheap money makes it easy to borrow.

Cheap money also means new investors.

New investors leaves an open market for someone to provide something to invest in, and because of the easy borrowing, Frannie Mae and Freddie Mac, among others, could provide just that. Fannie and Freddie bought mortgage loans from banks and packaged them into mortgage backed securities, because you can trade or buy a mortgage backed security, but not a given person’s mortgage. This provided a way for investors to capitalize on the housing market.

This, along with speculation that housing prices would keep increasing, led to the housing bubble. However, before it was known as a bubble, it was just a booming home market. This meant that everyone wanted houses, as they saw how fast their value accumulated. Consequently, the percentage of homeowners jumped from 64 percent, the usual average, to an all time peak of 69 percent in 2004. Unfortunately, the usual average of homeowners is what people can actually afford. The jump meant that people were buying homes way above their pay grade.

Subprime mortgages (or mortgages made to borrowers with poor credit ratings) also got bundled into mortgage backed securities. As these were much riskier investments, there was a much larger opportunity for gain. The bonds were rated, so people knew exactly how likely it was that their investment would fail, and how much money they stood to make if it didn’t.

Some investors, noting the high likelihood of failure, bought credit default swaps, which are essentially insurance policies that guarantee that an investment is safe. If the investment fails, the policy pays the loss…or doesn’t. AIG, the largest issuer of credit default swaps in the world, went bankrupt, because it didn’t have enough money to pay for all of the policies it had issued. You could call it a ‘run on the credit default swaps’ because as mortgage backed securities started to go toxic, everyone was suddenly interest on getting out of their housing market investments. Democrats enjoy pointing out that the credit default swaps were completely unregulated.

Now, here’s why the fundamentals of the economy are strong. Not every single person’s mortgage within a mortgage backed security foreclosed. The problem is that no one knows exactly how many did foreclose. In a rational market, where people weren’t so darned scared, people would think to themselves, hmm let’s say about 15% foreclosed, and the value of the securities would drop by 15%. In an irrational market like this one everyone panics and decides that all of the loans are toxic and the value drops to 0. If investors would calm down and think, the market would be fine. As they haven’t…

We have a credit crunch. And that is the real problem with today’s market. Businesses pay people with short term loans, or commercial paper. When they can’t get that, people walk out. Our economy runs of commercial paper, and with all of the panic, banks don’t want to lend to each other. So yes, the recession is mental. If people calm down, the crisis will end.

Short version:

  1. Low interest rates –>  heavy investing and heavy borrowing
  2. Extra borrowing and low regulation –> extra subprime mortgages
  3. Extra subprime mortgages and speculation –> housing bubble
  4. Housing bubble starts to burst –> Homes are worth less than loans –> more foreclosures
  5. More foreclosures –> mortgages back securities fail –> Credit default swaps are collected –> banks fail
  6. Banks fail –> Crisis of Confidence –> banks won’t lend to other banks
  7. Banks won’t lend to other banks –> Credit Crunch
  8. Credit Crunch –> Stock market falls –> Crisis of Confidence
  9. Repeat 6-8 –> Negative feedback loop, “rolling crisis”

And that is what went wrong with our economy. However, this doesn’t mean that you should try to act is rational in an irrational market and keep buying. If everyone else keeps acting irrational, you could get screwed. And that’s why we’re going to be stuck for a while. No one wants to act rationally because if they’re alone, then they’ll end up worse off. We’ll just have to wait for the market to bottom out.

I’d like to thank BBC Research for assisting me with this post.


2 Responses to What Went Wrong With the Economy?

  1. Clyde says:

    great explanation. i love the points 1 to 9. i’ll cross post lost tonight.

  2. elwoodin says:

    I too love the points 1-9. I coulldn’t have said this better.


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