The economy is in the midst of a downward spiral or, to use less deceptive terminology, severe contraction. During the last three months of 2008, gross domestic product - the total value of all final goods and services produced in the United States - actually shrank at an annualized rate of 3.8 percent. Let's figure out what's causing the contraction, and next week we'll talk about how to fix it.
What got the ball rolling? "Mortgage-backed securities" have passed into common parlance, but what exactly are they, and why have they wreaked so much havoc? This story begins in the late 1990s with the passage of two pieces of legislation: one law repealing elements of the Glass-Steagall Act of 1933 and the other requiring the government to back home mortgages to low-income households.
The Glass-Steagall Act, among other things, set up firewalls between investment banks, insurance companies, regular banks and other financial institution. The repeal of this element of it in 1999 set off a wave of mergers as the financial industry consolidated. While not destructive in and of itself, the consolidation of the financial industry permitted the spread of the bad debt that now permeates the financial sector.
Meanwhile, in the early 2000s, to counteract the effects of the 2001 recession, Alan Greenspan and the Federal Reserve Bank dropped interest rates significantly. This easy money permitted the economy to climb out of the recession but also set off a spike in home investments and, consequently, home prices.
Housing prices rocketed for several years as people treated houses like investments, mortgaging them, buying them and then selling when house prices had climbed even further. Companies that existed merely to sell loans sprouted up - but because they did not hold the loans, they were insulated from the repercussions of poor loans. Meanwhile, the government was still providing incentives for low-income households to take out mortgages and purchase homes. And the financial system leveraged the mortgages, buying and selling securities whose value depended on consistent mortgage payments.
Now we fast-forward to early 2007 to see how this mix of financial speculation turned toxic. The first signs of trouble were in the subprime mortgage market: the market for loans to homeowners who probably wouldn't be able to pay back. Banks found that households to whom they had lent these subprime mortgages were suddenly defaulting. While it doesn't take a genius to realize you shouldn't loan to people who probably won't be able to pay you back, the people actually selling loans - mortgage originators - were insulated from the consequences of their decisions. As a result, banks' assets were suddenly worth less, and the securities they had backed with these mortgages were worth nothing.
But now, because of the Glass-Steagall Act's repeal, the financial industry had consolidated and traded these securities back and forth, leveraging them anew each time; the industry had immensely complicated the process. Suddenly, investment banks had no idea what their assets were worth: which securities were worthless, and which were valuable? Since no value was determinable, banks stopped lending to each other and to the rest of the economy.
What does all this have to do with the economy? Quite simple: an economic growth engine is driven by lending and borrowing - by the expectation of the creation of future wealth. But banks are no longer lending, and the collapse in home prices is still taking its toll on the balance sheets of these financial institutions. Banks are no longer sure who will be able to repay loans and who won't, and that is putting brakes on the economy.
And why should you care? Because, as college students, your job prospects are affected by the state of the economy. Because as responsible citizens, you need to put time and effort into understanding how the economy works and how it responds to government intervention. And because any major government deficit-spending scheme is going to come out of your and my wallets.
Next week: the effect of the financial collapse on the economy and the stimulus package.
Write to Neal at necoleman@bsu.edu
Read More
Three Air Jam teams take home the win
October 12, 2012Nineteen teams shimmied, shook and flipped for a sold out John R. Emens Auditorium on Thursday night during the 25th annual Air Jam.
Bill Clinton Speaks at North Central High School
October 12, 2012Former President's Speech Could Have Effect on State Senate Race
