Understanding the Financial Crisis and the Recession

This is pretty accurate of the financial crisis, which is a beast on its own.

I would nitpick what said one person said in +Ian Pottinger‘s thread (found here: http://bit.ly/nNUjHP) , though. The financial crisis is actually over. It doesn’t have anything to do with this recession we’re currently in. The current recession was partly caused by the financial crisis, but the bailout which alluded to stemmed that tide. The bailout actually did work. It may have not been the best idea in the long-term, but the long-term effects can potentially be remedied with the right regulations to minimize excessive risk taking.

The long-term problem is that if the banks and investors get bailed out once, they’ll expect it again – giving them incentive to be riskier. Riskiness is not necessarily a bad thing. As a matter of fact, taking risk is how you make money in a capitalist economy. Every entrepreneur is taking risk; every new business owner is taking risk; every investor is taking risk. So risk isn’t a bad thing. The problem is what kind of risk you’re taking and what you’re playing with. The risks being taken that led up to the financial crisis were, depending on your perspective, bad or corrupt.

The video made obvious why that risk was corrupt. It was corrupted in order to make more money. Sub-prime mortgages were offered in order to make more and more money. Mortgage companies saw a huge return by selling off more houses, thinking that their money will never stop coming in. The mortgage companies believed that even if some home buyers default, they’d be able to cover it because the money was coming in smoothly. They were able to take more risk (with sub-primes) because Wall Street was able to package their mortgages and sell them off as CDOs – and the mortgage companies started getting a steady commission. This allowed for more risk taking and sub-prime mortgages with even fewer strings, allowing them to offer more lucrative deals to people who should have never been offered a home. It seemed like a steal to those home buyers.

Sounds corrupt, right? Yeah… but here’s the thing: from the perspective of Wall Street and the mortgage companies, there was no housing bubble. As a matter of fact, if you look at some of the numbers, there actually wasn’t a housing bubble. This is why, depending on your perspective, what happened wasn’t due to corruption, but it was just bad luck because you couldn’t see the forest for the trees. In a way, the reason you couldn’t see the forest was because the trees were so huge. The trees I’m talking about is land.

OK, so a bit about supply and demand and housing starts.

Nobody was screwing all that much more than normal 18 years before the 2000s hit. People were more interested in leopard print and flocks of seagulls during the 80s than, say, the sex hungry and orgiastic parents of the Baby Boomers. Population had grown steadily, but it didn’t boom. So when the 2000s hit, population wasn’t booming.

Housing starts are just that: new homes. You take an undeveloped plot of land around a town, suburb or city with under-developed suburbs and you create new homes on it: housing starts! Society wants housing starts if there’s demand for new homes – due to population growth through kids moving out of their parent’s homes or increased immigration. Since there wasn’t a population boom since the 80s (no thanks to Billy Idol making with the sexy music), you’d think we wouldn’t really need to build a lot of new homes.

If there weren’t a lot of new homes, then why was there a housing bubble? There wasn’t one because of building new homes (see Matt Yglesias: http://bit.ly/qDZ5Pe).

At the height of the “boom” we were adding units about as quickly as we were adding them in the late 1970s… If the Federal Reserve was trying to engineer a homebuilding boom it didn’t really work.

fredgraph8

What there was, in fact, was a rise in the price of homes, just like the video said. More specifically, there was a rise in the price of land (see Yglesias again: http://bit.ly/mSbOrk).

This prompted several correspondents to write that their may not have been an unprecedented boom in new starts, but I need to consider the boom in home sizes. Again, though, while home sizes certainly increased they didn’t increase at any kind of unusual rate. The Census Bureau has convenient data going back to the 1970s…

home-size

…Nobody would look at this and say to themselves ‘omg, housing boom!’ This was a boom:

fredgraph9

That, however, was a boom in the price of houses (or more precisely land), not the construction of houses.

Now, there was an increase in the construction of homes, but not necessarily out of the ordinary. Homes were being reconstructed in order to make them even fancier and more attractive to home buyers. Remember all those TV shows about remodeling homes to turn them over for a profit? Yeah, that. Those shows were practically advertisements for the housing industry.

So: no population boom, no new housing starts … There was no supply and demand problem. There were no excessive number of newly built homes to create an over-supply, leading investors, bankers, Wall Street and mortgage companies to believe that there wasn’t any kind of bubble and that the prices of houses were genuinely going up. Looking at those numbers, you wouldn’t think there was a bubble, either.

But there was. It wasn’t a housing bubble, it was a credit bubble. In a way, this was almost like a ponzi scheme: you had to keep on selling new homes over and over again in order to keep the scheme going. When sub-prime mortgage borrowers started defaulting (That no down payment, no payments for a year thing? Yeah, that year ended. “Pay up!), there was no way that the mortgage companies were going to find any new people to sell homes to in order to keep getting that nice, steady flow of money. So they started freaking out. And they stopped selling because there was no one left to sell to because everyone who would have bought a home is now indebted with a huge mortgage that’s now due and they can’t turn their home investment. Without that steady roll over, everything stopped.

WindowsLiveWriterCashCollateralizeddebtobligationCDO_117AAimage_4No new home sales and people defaulting led to no continuous rise in prices, leading to fewer home sales and mortgage companies freaking out. Their steady stream of money started getting skinny because Wall Street was seeing those mortgages default and their CDOs starting to stink. Instead of the Risky tranche of the CDOs looking risky, the medium-risk (“Okay”) tranche started looking like the Risky. Then the Safe tranche began looking like the original Risky tranche. No money going in.

Boom. Investors weren’t getting their returns, mortgage companies weren’t getting their returns. Investors lost their shirt, mortgage companies lost their shirts. Wall Street started seeing their liabilities stay firm and no money was coming in.

Then comes the government, freaking out. They think, “bailout?” Wall Street gets excited, thinking they were going to be saved. Nope, said Congress. So then Lehman Brothers happened. They crashed, big time. The bankers freak out, seeing the sky falling, and then Congress freaked out, seeing their jobs and country club memberships imploding. Bailout time.

So Wall Street got their bailout. Financial crisis averted. End of story.

No, that’s not the end of the story.

That’s actually just the beginning. LOL…

Did I leave anything out? Oh yeah, the investors and the home owners! Some of the investors lost their shirts. Wall Street didn’t necessarily pay them back, now did they? Some, yes. Others, no. The home owners? They still owe. That’s where the “Where’s my bailout!?” thing came about.

Tea Party time.

rick_santelliWhat started out as a small movement to protest the government ended up becoming a national movement after “in a broadcast from the floor of the Chicago Mercantile Exchange, CNBC Business News editor Rick Santelli criticized the government plan to refinance mortgages (wikipedia: http://bit.ly/nFfTBS)”. It’s kind of funny, Santelli was bitching about Obama’s “Homeowners Affordability and Stability Plan”, which was effectively a $275 billion bailout for homeowners and Fannie and Freddie Mac – answering the “Where’s my bailout” crowd. Fannie/Freddie are GSEs (government-sponsored enterprises) which are semi-public/semi-private and are publicly traded. They’re in the business of securing mortgages in order to boost home sales.

The thing is, Santelli is one of those people who believes that bailing out anyone was a bad idea. I don’t know if he thought bailing out the banks was a bad idea (they had already gotten their baillout by then), but he sure thought that the losers who bought homes they shouldn’t have bought should lose their homes instead of getting bailed out.

481901058_eCQds-MSo, silly Tea Party movement cheers him on. They agreed: Obama’s plan to bail out homeowners was morally unacceptable. Never mind that bank bailout. Remember! What happened during the “housing bubble” wasn’t corruption, it was just bad luck. They were victims of people buying homes – these fraudsters who said they could pay their mortgages but really couldn’t. Those subprime bastards!

Right. So Obama’s a bad guy, the GSEs (Fannie/Freddie) were bad guys (They got blamed for the “housing bubble”, the argument being that the federal government forced them and the mortgage companies to make subprime mortgages to give homes to poor people.), and the idea of bailing out the homeowners was morally corrupt.

The Tea Party movement exploded and that’s, well, history I’m not going to rehash here.

The current recession

recessionSo here we are. The people are indebted because credit was easy and some made purchases they should have never made. Others made purchases that were good ideas for their personal financial liquidity at the time, but they got stuck with their debt even after they lost their jobs due to the financial crisis. A lot of people are indebted, keeping their ability and willingness to buy goods and invest what money they would have had from keeping aggregate demand up. So demand has been down since the financial crisis because everyone’s out of money and indebted. Everyone is saving their money instead of spending it.

Recession time!

Wait, is this the same recession or a new one? Yes, it’s a new one. That financial crisis was fixed, remember? No, it’s not actually a new recession, it’s the same one, but it’s also a different one. They rolled into each other.

What happened was 2008 happened. At a time when there was a huge demand for money in the US (so people could pay their debts), that money didn’t suddenly appear. The banks were out of money, no lending was happening, so no money was turning over. The people’s debts weren’t getting paid, banks weren’t getting their money, so lending was tight. That means the demand for money was there.

Federal_ReserveThe Federal Reserve controls the supply of money. They print money by releasing it into the economy through different financial instruments. They can lower the interest rate they charge banks whenever banks borrow money from the Fed to in turn lend elsewhere (the Fed gets paid back through those interest payments). The Fed can also increase the money supply by lowering the amount of money banks are legally required (determined by the Fed) to hold in their vaults (digital money these days), which means banks have more money to lend. The Fed can also buy bonds (like Treasuries) in order to make the Treasury bond rates go up (higher demand for bonds [the Fed’s buying of the bonds acts like demand going up when you look at the numbers], meaning the Fed makes it less lucrative for investors to buy bonds. The Fed doesn’t buy bonds from the Federal government to increase the money supply – they buy it from bond holders (investors) for a higher return than the Treasury bond rate at the time. That means bond holders get a great deal by selling to the Fed (The Fed buys these bonds with money it magically created out of thin air – money which they will “get back” later when they increase interest rates years later to make up the difference; this is how the Fed funds itself even when they buy billions in bonds.).

repealthefedSo the Fed increases the supply of money by temporarily lowering interest rates, lowering the amount of money banks are required to have at all times, and buying bonds. Buying bonds with the money it created out of thin air is pretty much like counterfeiting money, but that money is legitimate. This, by the way, is why there are people who want to abolish the Federal Reserve. They believe it to be printing money out of nowhere, causing inflation. They do have a point, but that’s because they think there is some kind of intrinsic value in money, as if you can do something other than buy things with money. (You can wipe your ass with money and burn it to protect you from the cold, but it’s nothing but a tool to exchange for other goods. This is why money has no intrinsic value. No intrinsic value makes these anti-Fed people’s arguments bull crap.) They do have a bit of a point: printing money can increase inflation, which destroys wealth (and makes people on fixed incomes have to pay higher prices) but the act of printing money by itself doesn’t necessarily increase inflation. Inflation is an increase in the general price of goods. Printing money can lead to increased demand for goods, which increases the prices of goods because more people are bargaining for the same number of goods, leading them to offer higher prices for them.

The thing is that printing money doesn’t necessarily lead to inflation. Not when demand is below trend. When demand is down, printing money does boost sales but it doesn’t necessarily increase prices because demand doesn’t butt up against supply.

I’m getting off track. That was just an aside to give hard money advocates (anti-fiat currency) something with which to get hard-ons and yell about.

In 2008, there was a big demand for money so everyone – home buyers, companies seeing demand go down even though they expanded, investors – could pay off their debt and cover their liabilities. The Federal Reserve might have seen that demand for money, or maybe it didn’t. We don’t know. What we do know is that the Federal Reserve didn’t answer that demand for money with an increased supply of money.

Interest rates were already super low. Federal Reserve chairman Greenspan kept it at around 1% for most of his tenure in the 2000s to boost demand to recover from recessions due to the tech bubble bursting. His successor, Bernanke, lowered interest rates but it wasn’t anywhere near enough. They were afraid that lowering interest rates and increasing the supply of money would have led to inflation.

Except they had it all backwards. Low interest rates doesn’t mean that money is loose (too much money in an economy), it means that money is actually tight (not enough money to meet demand for money). See Scott Sumner (http://bit.ly/oyQ2Vo) about this.

If interest rates are low, that’s because the demand for money is high. This works backwards from common sense – if there’s a high demand for money and there’s a low supply of it, wouldn’t the price of borrowing from the Fed increase just like normal inflation? Nah… that’s the prices of goods, not the price of money. The Fed creates money, remember? When banks demand money from the Fed, the Fed can lower rates to boost demand. If demand doesn’t increase, that means there isn’t enough money in the economy to create that demand. So the Fed needs to lower interest rates again. And again, until that demand goes up.

But they were afraid of inflation. The Federal Reserve governors shouldn’t have. Because the demand for money was HUGE! and it was even bigger than they could have imagined it.

Money was tight in the 2nd and 3rd quarter of 2008 because the Federal Reserve was worried about inflation. Stupid…

money-supplyScott Sumner (same link above):

But didn’t the monetary base increase sharply? Yes, but this is also misleading for two reasons. During periods of deflation and near-zero rates, there is a much higher demand for non-interest bearing cash and bank reserves. In addition, last October 6th [2008] the Fed began paying interest on reserves, which caused banks to hoard bank reserves.

Remember that legal requirement for banks to hold money I mentioned above? Those are called bank reserves. The Fed started paying interest on those bank reserves, meaning the banks were making money on not lending. This lowered the supply of money in the economy (If a bank holds money, it’s not going anywhere, is it? If it’s not going anywhere, it’s taken out of the supply of money in an economy.)

So the Fed did this in fear of inflation. They saw a demand for money and said, “Shut up, whiners!” because they feared the consequences (inflation).

i-m-like_obama_i_want_changeExcept that led to no one paying off their debts. And not paying off those debts meant less money was circulating through the economy. What money people did have was being saved to pay off those debts instead of buying goods. So demand for goods went down, and even more people lost their jobs.

We originally thought that GDP (gross domestic product, or “the market value of all final goods and services produced in a country in a given period” [wikipedia: http://bit.ly/nx9uBd]) dropped about a few percent, which is a huge loss of economic value by itself. We thought this was how bad the economy was at the time that Obama and Co. were thinking up the Recovery Act.

Boy, were they wrong! 😀

From Scott Sumner (http://bit.ly/pyhqj2):

First the BEA said NGDP fell about 2% between 2008:2 and 2009:2. Then last year the figures were revised sharply lower, especially for 2008:3, which showed that the recession got much worse before Lehman. NGDP fell 3% between 2008:2 and 2009:2. Now we have another revision, and the fall is nearly 4%!

So we now have a nice three year data set. NGDP fell nearly 4% from 2008:2 to 2009:2, and has risen at a tad over 4% a year for the next two years. We are up by only 4.1% in 3 years, that’s a little over 1% per year. In other words, per capita NGDP has barely risen in 3 years! To maintain full employment everyone would have had to go nearly three years without a pay rise.

Now I’ve got to revise my papers. I’ve been saying NGDP fell 8% below trend during the contraction, actually it was 9%.

So we originally thought that NGDP fell about 2% between 2nd Quarter 2008 and 2nd Quarter 2009 (one year), which would have been before Obama won the election and got into office.

Then, years later, we find out that instead of just 2%, it actually fell 9-fricking-percent.

And we are 11% below trend over the three year period.

Even though we had that 9-fricking-percent drop in GDP, Republicans fought to keep any recovery efforts to a minimum, Obama didn’t fight for a bigger recovery effort, and the Federal Reserve has been held back by the Republican/Conservative inflation hawks who are unwilling to do what’s necessary to fix this serious fall in nominal GDP – which means this whole thing is a 100% monetary problem that only the Federal Reserve can fix. When you have no fiscal (federal spending and tax policy) recourse, you’re left with only monetary (Federal Reserve supply of money) policy.

If the Fed hadn’t kept money tight, that second recession wouldn’t have happened. We’d have recovered by now and I could be watching cartoons instead of writing this damn book.

Well, the fight was over 2% GDP drop, at the time. We didn’t know it was 9-fricking-percent until earlier this year. I imagine if we knew at the time just how bad it was, Obama and Co. would have asked for a bigger Recovery Act instead of the ~$800 it ended up getting. We don’t know what Republicans would have said if they knew. Since they’ve been politically motivated to crush Obama, they would have probably been popping the champagne of 2012 electoral victory in the floor of Congress back in 2009.

outputgapSo… here we are. The recession we are in is a different one, but caused by the last one and the Federal Reserve’s reservations on increasing the money supply. And now we have political gridlock and the Federal Reserve is being conservative with its monetary stimulus because of fear of inflation by some (idiots) and fear of begging the anti-Federal Reserve crowd (Ron Paul and Co finally managed to convince the idiots in Congress to investigate the Fed, Republicans have been throwing stones at the Fed, Rick Perry threatened to kill Bernanke for treason, etc.).

And we still have crappy economic growth (LOL!) and a serious unemployment problem. The Federal Reserve’s primary objectives are stabilizing prices (making sure prices don’t go up too much above or below their preferred normal rate [2%] increase) and maximizing employment (by making sure demand doesn’t go too far below normal by managing the money supply). They have been failing at both of those jobs because we’ve been seeing dis-inflation* (prices going down due to a lack of demand) and we are not anywhere near the maximum of employment.

Sucks to be us.

* There’s something to be said here as well. Inflation hawks will point to one price index to argue that prices have been going up, but that price index (CPI) includes the price of food and energy, which naturally fluctuates up and down. There’s a different index, Core CPI, which ignores the price of food and energy in order to get a better understanding of inflation. The prices of goods, minus the highly varying prices of food and energy, tell us what inflation looks like in goods which don’t vary in prices so easily. This gives us a longer-run picture of inflation. If we only pay attention to CPI, including food and energy, we can be mistaken to think inflation is high (because of, for example, high oil prices, which go up and down; or drought), or low (because of, for example, Monsantos’ genetically modified oranges made the production of oranges increase by 1000%!).

OK, I’ve said enough.

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