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The Genesis of the Great Recession in Outline Form, not completely chronological

2013-01-30

Government policies encourage banks to finance more loans to buy houses
Govt implicitly guarantees debt of Fannie + Freddie
Mort loans are securitized and taken out of hands of local banks
Foreign investors buy securities based on mortgages, many of which are not secure
Loans are highly leveraged by securities firms and banks without govt control of leverage

Govt fails to monitor market conditions and restrict borrowing when it becomes excessive

Loans are made without verification of income, and many are fraudulent (up to one half)

Real wages are stagnant, forcing people to borrow to get things they want
Compensation for securities firms employees increases dramatically
More people get mortgages easily and demand for houses increases
House prices rise rapidly, creating a bubble of “collateral”
People borrow more money based on higher house “value” to buy things
Economy appears to be doing well based on false increases in house values

Credit and housing bubble ends because all who could buy houses have bought them
House prices decline, pricking bubble of collateral and drying up credit markets; average decline is about 30-40%
Unemployment increases dramatically, causing homeowners to default on mortgages
Securities lose value because they are short sold by prescient investors, which causes a stampede
Overleverage causes securities firms and banks to become insolvent
Foreclosure and renegotiation are inefficient due to securitization of mortgages (Mortgages were combined into packages and sold) and “underwater” mortgage loans (loan size exceeds house value)
Securities markets, facing uncertainty, are depressed for prolonged periods
Govt is forced to take over Fannie and Freddie, creating huge deficits buying up worthless securities
Govt does not apply strong policies to increase jobs, and high unemployment persists, depressing govt income from taxes and aggravating deficits

Shortsighted politicians focus on deficit and demand reductions in government spending, which if implemented will aggravate economic weakness and worsen deficit by reducing tax income

Some of these things occurred simultaneously, some occurred earlier, and some happened later.  They are not shown here in exact chronological order.

(The approach which was effective at the end of World War II should be re-used here: high, progressive income taxes and expansive government spending on projects that stimulate the economy.  The result was rapid economic growth, full employment, and dramatic reduction of the deficit as a percentage of gross domestic product.  Ironically, the debt only declined slightly in absolute figures, but the economy grew so rapidly that it became insignificant.  The USA was affected by unemployment due to returning soldiers and a huge war debt with a world economy shattered by war, but by using progressive tactics, it was able to grow out of the debt and enhance everyone’s standard of living.)

The mistake that the short sighted politicians make is in assuming that sovereign government debt is the same as household debt.  Sovereign debt can be sustained in large amounts if confidence in the government, private corporations, and the people can be maintained.  The debt, and the money supply, can be managed to prevent significant inflation while running a “current accounts deficit” , sustained by selling sovereign debt.  Confidence in the American dollar is currently high despite the fraught nature of our current government, and our sovereign debt is selling at very low interest rates.  We would be well advised, as an American government, to take advantage of the low rates and borrow money to stimulate our economy by careful government spending.  It is critically important for the government to provide money to people who will spend it immediately and not set any of it aside for savings.  This is what will stimulate the economy “from the bottom up.”

Spending by people who need to buy things immediately for their survival will most effectively prime the economy because the money will move rapidly from consumers to providers of goods and services.  Providers will then buy additional stock and invest in enlarging their places of business, and so on.  In addition, spending by construction companies will spread quickly into salaries and payments for materials.  Government “spending” on such items as tax credits or tax reductions will not be a good stimulant for the economy because the amounts involved are small and spread over large groups of people, many of whom do not need more money.

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