Economic Stimulus: Part 2 – How We Got Here

Recessions and depressions have triggers. They also have fundamentals. They are always the result of some excess. They are the practical, ironic, and perhaps divine response to academic arguments that markets are efficient and reflect in prices all known facts.

Some recessions are triggered by disasters – natural or man-made. Normal recessions are about reducing excess inventory. When one company cuts back production because its inventories are too high a few people temporarily lose some wages. When many companies cut back at the same time it’s called a recession.

Excess inventories build up because of excessive optimism by some critical mass of producers. When the critical mass cuts production their suppliers see reductions in demand and therefore instant excess inventories. Of course, they respond by cutting production as well.

The current recession is different. It’s not about excess inventory it’s about excess debt. It was triggered by rising interest rates resetting upward the monthly payments of certain classes of mortgages. Fundamentally, far too many people bought homes they could not afford, financed by mortgages with terms that were absurd under any conditions save one – that of continuously and forever raising real estate values.

We should have known we were in trouble when “house flipping” turned into prime-time television entertainment; when 5-year interest only balloon mortgages were resurrected from the their 1930’s graves.

But when mortgages were written allowing borrower’s to “name their own” monthly payment for the first five years while tacking the unpaid interest onto the principle – sirens should have sounded - whistles should have blown.

But no – for fifteen years the nation was “charging it.” Personal credit card debt doubled, tripled, and then quadrupled. Home mortgage debt did the same. Corporate debt, especially bank and finance company debt led the way with banks borrowing cheap from Uncle Sam, lending dear to the public, and raking in leveraged profits for as long as the party lasted.

And government? Government was the cheerleader encouraging and enabling every additional dollar of debt – while simultaneously running up government spending and just “charging it.”

Congress eliminated the wall of separation between commercial banks and investment banks. Congress encouraged writing mortgages to “sub-prime” borrowers. The Federal Reserve reduced bank capital requirements and kept interest rates too low for too long. The FDIC waived premium payments from the bank’s for their deposit insurance. The regulators of Fanny Mae and Freddie Mac stood aside as the two government-sponsored lending agencies purchased and created bundles of high risk loans and called them AAA securities. Congress then stood aside refusing to consider tighter regulation of Fanny and Freddie.

Government enabled and encouraged the conditions that led to the recession but government did not cause the recession. Excessive optimism about real estate values and excessive debt serviced by insufficient income caused this recession

Links to Other Topics in the Special Report: Economic Stimulus