I’ve been watching the economy very closely recently, trying to make a few correct moves in my portfolio to slow down or negate this disaster.
But haven’t we all. I’m going to spend the next few days finishing watching the auto ‘bailout’, which although I am completely against, I feel may be necessary. To help explain why, I’d like to start at the beginning with this whole problem.
The government. That is the answer to the root cause of this economic downturn. I don’t mean to say that they haven’t tried to help or slow it; I simply mean that they gave it a decent start. From then on, there are a number of factors contributing to this downward spiral, contributed by many things.
To start, let’s look at what happen. The government pressured banks, with the housing industry booming, to write higher risk loans to families or people who arguably had no ability to repay these loans. While many people did have the means to repay, certain programs such as interest only loans and loans with variable interest rates made it possible to have the means one day, and not the next. The government pressures were brought on by the idealistic vision of everyone being eligible for home ownership. It remains a fact; some people just do not make enough money to own a home.
What you have to consider is the cascading effect of this decision. As people began to default on their loans, the banks, which lent against those collateralized debts, started to realize lost earnings. Their liquidity was compromised as they began to inherit houses. Since banks are required to keep 20% of their deposits on hand, they needed to cut back lending to retain their reserve deposits.
Here’s the cascade I feel like some people are missing. When the banks tighten lending, people are less likely to get lending and financing. So they start to pull their money from the stock market to both fund their everyday lives and develop some sense of security. In turn, companies begin to watch their value drop. To combat this they try to weather the financial storm by borrowing in the short term. But remember, the banks aren’t lending. So the market begins to drop. This destroys investor confidence, so people do two things. They stop spending and they pull their money out of the market (to stop losses) and more or less hide it.
The drop in consumer spending causes companies to report even more losses, and therefore scare more people out of the market.
So the government has stepped in, saying shame on you for these loans. However, they dumped money on the banks, to facilitate lending. If full lending returned, not only could corporate markets flow again, but consumer spending could return, and therefore investor confidence. That was the intended effect of the bailout. It will work, but the depth and time length of the crunch has entrenched itself so that it will take time to revive the loan market, as well as people’s confidence.
While there are many in depth factors that also contribute, (corporate paper markets, foreign currencies, media spin, etc) this guide was intended to generally inform anyone who is confused as to why the markets are spiraling down. It’s no longer because of a bank crisis, although the banks aren’t doing much lending. It has become a consumer and investor confidence problem.
Tags: banks, Economics, economy, interest rates, investor confidence
November 20th, 2008 at 4:24 pm
First off, I read your blog every time you update. I enjoy reading about important things from perspective other than that of my own.
I believe you have made very clear points in this past post, but only briefly mention, “[M]any in depth factors that also contribute…” I agree, but explaining just the governments’ faults leaves a lacuna of legitimacy in your analysis.
For example the severity of the 80’s Reagan tax cuts causing crowding out (I’m sure for anyone reading this blog, an explanation of the phenomenon of crowding out is not necessary), raising interest rates in the US, making US a more attractive place for foreign capital versus the rest of the world is not mentioned. Yes you call the government the problem, but I’m assuming it is implicit, in regards to your previous posts, that you mean the government has had too much of a intentional interventionist role? How would you respond to (above)?
What about the liquidity trap of Japan for the past ten or more years, they send their own central banks money right overseas to us, to be loaned? Do you see this liquidity trap happening in the US?
It may be possible, like Susan Strange states, more specifically expounded upon by Torben Iverson and Thomas Cusacks’ analyses of technological determinism in globalization, that states no longer have complete territorial control (i.e. capital flows are extremely difficult to monitor, let alone regulate) and therefore the government is not to blame. How can the government be to blame if globalization, specifically what Iverson and Cusack call technological determinism, causes these financial flows?
One aspect you have altogether not mentioned (again, I apologize, I know this, your post, was just a general introduction to the ‘financial crisis’ to those who are looking for some elementary explanation) is AIG’s role in the credit default swaps accompanying these mortgages.
This is not an excoriation of your blog, I just wanted to hear your opinion about such things. Thanks Matt!
November 21st, 2008 at 10:11 am
Excuse me, I meant to say that Geoffrey Garrett discussed Technological determinism and capital flows, not Iversen and Cusack.
November 22nd, 2008 at 2:43 pm
Thank you for explaining me about the economic situation facing our country right now. You’re the first person to explain this to me and now so many of questions have been answered. Thank you. As a student, I fear not being able to afford to go to school, and definitely lay off. What do you think of president Obama’s plans to solve the economic downfall? I hope he will provide everyone with health care and help with paying for college.
November 23rd, 2008 at 6:42 am
This is a very clear explanation of the background leading to the current situation. There is, of course, the obvious problem of individual responsibility. Many people incurred debt that stretched them to the limit and beyond. They did not keep reserves to enable them to do more than live paycheck to paycheck. They charged their credit cards to the limit, incurred huge mortgages at inflated house prices, and generally set themselves up for failure.
Unfortunately, when the dominoes started to fall, even those who had made what were apparently conservative credit decisions, also got caught.
The real estate brokers and those selling these loans took their profits at the time.
November 24th, 2008 at 4:58 pm
You must include those wrapping high risk mortgages into larger portfolios, the companies (AIG) selling mortgage backed securities on these portfolios, the entire market for an unreasonable assumption that housing prices in the US would never fall, the government for its Graham, Leach, Bliley act of 1997 in attenuating the Banking act of 1934 and further deregulation and lack of oversight, increased leveraging via increasingly obscure, theoretical, and speculative derivatives…if we are going to play the blame game here.
The worst is still yet to come (See my response in the forum for a discussion concerning GoldmanSachs’ recent reports concerning the drop in GDP just this quarter). Remember, only $250B are available for loans from the IMF and already Iceland, Turkey, Pakistan, Hungary and Ukraine are in line for loans totaling $62B. …What happens when some bigger, more troubled countries need loans?
November 25th, 2008 at 12:11 am
I meant to say that Geoffrey Garrett discussed Technological determinism and capital flows, not Iversen and Cusack.
November 25th, 2008 at 3:07 am
Very good points on all accounts. I believe, however, there is another contributing factor. Many of the large institutional investors were not only buying very high risk mortgage backed securities that they did not truly understand, but they were ignoring one of the most fundamental concepts of building a safe portfolio: Diversification. These investors had far too much invested in these securities, and thus when the crash of the housing market came, they had nowhere to go but down. The very fact that they were buying securities that they did not understand plays to the fact that the managers themselves should have done their research before investing such vast sums in something.
Now, I’m not necessarily saying that massive regulation is the answer, because that will only restrict the market, and we will forever protect the right of the Americans to make poor decisions (I blame alcohol), but we need to take a serious look at the process through which investment institutions are able to create new investment instruments. They were able to take very high risk mortgages, (CCC rated and sometimes) and package them together in such a way that the entire investment ended up with a rating of AA or higher. Something is wrong there.
November 14th, 2009 at 12:36 am
Detailed analysis about the present economic condition. I loved your blog.
November 15th, 2009 at 1:39 pm
A good article. We can understand all about the economy since 1 year
November 20th, 2009 at 2:12 am
It is a good article.We can see a brief history of the current economical situation.People like us can easily capture the details.
November 27th, 2009 at 7:05 am
I like this article very much. I have been read all your updates. Keep it up. thank you.