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The Economic Crisis 101

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I am not an expert, and I appreciate that the understanding of any economy is essentially ideological in perspective. With that said, I thought this short piece would help some people understand the present economic situation and offer room for their own further investigation. It's like a short piece answering the question: "Why is their a crisis?" and for this reason, I thought it best to put this in the "Ask the Librarian" section rather than the political. If that is an error, please accept my apologies and do with this post as is fitting.

In the late 1990s, the economy expanded thanks to the Internet and high tech boom. Investors made money which led others to float new company stock. Prices went up until they reached unrealistic levels and the market crashed. To address the crisis, interest rates were lowered. This made it cheaper to borrow money and help pay off debts. Because money was cheaper to borrow, people started buying things. Houses were popular purchases, because it is not the cost of a home that is as important, as how much must be paid on it each month. House prices rose while mortgage loans became easier.

In the late 1990s and early 2000s, across the USA and the EU, you could buy a house for up to 10% down and sometimes less. You didn't need a million €s to buy a million € house, just a €100,000, and many banks let you borrow that. People started making fortunes overnight as they bought and sold houses for a profit, some before they were even built. Home prices shot up and, because the house I'm living in is worth more, why not take out another loan and buy a new car, holiday, fix up my kitchen? The future buyer of my house will eventually pay off that loan when I sell! It's like free money.

The banks also got creative. They offered exotic loans with little or no money down. Many people opted for ARMs (Adjustable Rate Mortgages) that gave a low interest rate for the first five years before rising. Banks relaxed further rules for loan approval and they cut up mortgages (debt creations) and repackaged them as derivatives. Investors could invest in these debts, they could buy them, which were based on homes which historically always go up and are secured by bricks and mortar and land.

Then home prices stalled. They didn't drop, they just stopped ballooning. Many home owners feared they would lose their profit (not their house, just the money they’d made over the last five to ten years). Suddenly, millions of home owners put their homes on the market. The market was flooded with supply but demand was drying up. Then came the margin calls. Banks said pay the ARM interest rates etc or its foreclosure. Millions of people couldn't afford to do this.

If you are a bank handing out loans, your income depends on how many loans you can make. What happened to them after that is not your problem, because the banks can securitize these loans – they can sell them. Since the values kept rising on the loans and defaults were very, very low, debt agencies thought these were safe packages. Between 2000 and 2004, households in the EU and the USA took on trillions of euros and dollars in mortgages and about a half of these mortgages were financed by European banks who bought the securitized debts. This is one reason why European banks are in trouble.

During the 1990s, investment banks were freed from the amount of debt they could create. With very little of their own money, they could create a lot more money in relation to the actual capital they possessed in reserve. When the crash happened, the mortgages and other loans the bank had created began to look very risky because it looks like the banks may not get the money back. Those who had lent money to the banks panicked and wanted their money, but the banks didn’t have it all. This is a liquidity problem. If the banks also hold assets which are worth less than their liabilities this is a solvency crisis. Today, there is a general spreading of solvency crisis in which the value of assets is gradually falling.

In 2007 & 2008, tax payers across the world subsidized the banks. Taxes were given to banks to buy their debts. This is very significant. The effort to blame government for the crisis typically opposes something called government with something called the market and assumes an independence which government does not have. Its decisions reflect power and the interests of particularly powerful fractions of capital. What fractions of capital are dominant explains what government proposes to do. In this case, they helped bail out the banks.

Due to unstable market confidence, banks are loaning less and people are borrowing less. This means that people are buying less, so people start cutting back on investment, on wages, on employees. Salaries and wages are held down. This causes less purchasing power and more pressure on the economy. People don't invest where other people have borrowed more than they can repay and the overall consequence is that people lose jobs.

The features which have driven the American and European economy over the last two decades and fueled the two great bubbles have been the high tech-Internet of the 1990s, and the housing boom of the present decade. Other key elements is the expansion on military spending, the general tendency towards stagnation in basic infrastructure such as education, health care, the increment in flexible working contracts, and the repackaging of pension and retirement schemes. Finally, another significant feature is the remarkable rise in debt which funds much contemporary consumption. Across Europe and America, household indebtedness has risen from about 50 percent of average GDP in 1980, to about 100 percent in 2007. It is not just bankers' greed which produced the crisis. It is the effort to use debt to overcome the tendency of stagnation in the economy. It is a structural issue. An economy which cannot grow without resorting to a large buildup of debt that seems to be the problem here.

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Posted (edited)

This is awesome, I'm glad there's another economics fan here.

Have you read my housing bubble thread? ;)

http://academy.galilean-library.org/showthread.php?t=7781

Edit: I'll respond more fully later. At work. :thumbdown:

In the late 1990s and early 2000s, across the USA and the EU, you could buy a house for up to 10% down and sometimes less. You didn't need a million €s to buy a million € house, just a €100,000, and many banks let you borrow that. People started making fortunes overnight as they bought and sold houses for a profit, some before they were even built. Home prices shot up and, because the house I'm living in is worth more, why not take out another loan and buy a new car, holiday, fix up my kitchen? The future buyer of my house will eventually pay off that loan when I sell! It's like free money.

Another thing about this. You can take a second loan on your home. Basically you just end up having 2 mortgages secured by the same home. The way it works I believe, is you convert some of the liabilities on your home to equity over time as you pay off your bills, correct? But as you gain more equity, a bank may feel comfortable giving you yet another loan based on the equity you're building on your home. If you look at it from a balance sheet perspective, you're just converting equity back in liabilities.

I think the main type people got (in the US at least) was the home equity line of credit, so people basically just turned their house into a credit card. The interest rates were relatively low since the liabilities were secured by the value of the home, unlike a credit card which isn't secured by squat.

Interest payments on these loans were also tax deductible because the IRS considers your personal home an investment, and certain investment related expenses and interest payments are deductible.

By the way, have you heard of the new first time home buyer credit (I don't know if you live in the US heh)? The IRS is giving up to $8,000 (or 10% of the value of the home, take the lesser) for people who purchase a new home in 2009 up to April 30, 2010, you can either be a new homeowner, or you can be an existing homeowner that hasn't bought a new home since 2006 I believe (I forgot the exact rule).

The government is doing what it can to re-blow the bubble. :/

Edited by Michio

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Posted

The banks also got creative. They offered exotic loans with little or no money down. Many people opted for ARMs (Adjustable Rate Mortgages) that gave a low interest rate for the first five years before rising. Banks relaxed further rules for loan approval and they cut up mortgages (debt creations) and repackaged them as derivatives. Investors could invest in these debts, they could buy them, which were based on homes which historically always go up and are secured by bricks and mortar and land.

Then home prices stalled. They didn't drop, they just stopped ballooning. Many home owners feared they would lose their profit (not their house, just the money they’d made over the last five to ten years). Suddenly, millions of home owners put their homes on the market. The market was flooded with supply but demand was drying up. Then came the margin calls. Banks said pay the ARM interest rates etc or its foreclosure. Millions of people couldn't afford to do this.

Those ARMs also got popular just before the federal funds rate was relatively low.

Check this out: http://tradingeconomics.com/Economics/Interest-Rate.aspx?Symbol=USD

ARMs got popular around 2004-2005, when interest rates were relatively low, then they just climbed higher and higher as the federal reserve cut back liquidity. This caused banks, basically to receive less funding, which made loans, including ARMs, more dangerous. The high interest rates peaked out at the same time the teaser rates on ARMs expired for a lot of people, and that's when foreclosures started happening. And Adjustable Rate Mortgages adjust according to the interest rate environment.

And the derivatives banks created out of various mortgages started becoming worthless since they weren't generating positive investments. That's why the federal reserve is currently buying mortgage backed securities in an attempt to keep banks solvent. They've been doing this for over a year now, and that's been pretty controversial.

It is a structural issue. An economy which cannot grow without resorting to a large buildup of debt that seems to be the problem here.

We could argue about whether or not debt based economies are good, but that would easily be a 25 page thread, so I don't even want to approach that too much ...

We can grow without debt, the problem is it would slow down economic activity by an extreme amount. If you wanted to build a factory, imagine having to wait until you had 1 million dollars up front, instead of just say, paying a bank $50,000 as a down payment, then taking the rest as a loan and paying it off over time. Everyone benefits: a bank makes money, which it can then use to facilitate more healthy loans to build more factories, the factory gets built which provides jobs and useful products, etc.

I think the real problem is the growth imperative. Debt-based economies rely on continual growth, because if the economy deflated, there's all this outstanding debt that wouldn't get paid off which would cause defaults and wealth destruction. The universe is finite, but the stability of a debt-based economies depend on infinite growth. It's built into the definition of a debt-based economy that it will fail if a certain rate of growth is not met. There is a tendency toward disequilibrium.

The global ecosystem eventually regenerates, but the problem is we're moving WAY too fast, it cannot feed 7 billion people for much longer, and eventually we'll reach some sort of environmental breaking point. Political views don't matter, what matters is that all economic activity begins with the soil, the sun, and the water.

And that's the thing about an expanding financial sector. The whole point of the financial sector is to provide money to entrepreneurs who eventually, in some way, exploit the environment to provide useful products and services to the economy. If the financial sector grows too large, there are diminishing returns and the economy becomes unbalanced and inefficient, leading to wealth destruction. An economy will eat itself alive if the financial sector grows too large, and this is the problem with the U.S. economy, we're nothing but a financial sector that exports debt to places like China and Japan.

When bubbles pop, that means that a certain portion of the economy merely deflates in relation to everything else. So it's actually healthy that the U.S. going through a recession right now, because that's just the economy fixing itself to become more balanced. :)

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Posted

Thanks for all this, Michio! It's brilliant stuff and I really appreciate what you've done here. It's informative, extremely interesting (the link was unbelievable and I don't know how I missed it - I've been reading through the old sections so as not to repeat) and all adds well to this section. Michio, I've a few questions that arose, and I will try to think them through and throw them out to you - and others - in the political section before this weekend and see what you think. If you've got anything else, please post. I'm a complete dunce about all this stuff and I find it fascinating.

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