Romer's Recession

Our current economic situation cannot be blamed on one specific event, person, or administration. Where we are now is the result of mismanagement and imperfect information in nearly every facet of the American economy. This repression/recession has been a long time coming, and it could have been easily prevented had we been a little more educated about what was going on.

Starting in 1982, the economy experienced huge growth that showed no signs of stopping. Washington benefited from this growth just as much as the rest of us, so policies were made that encouraged this unprecedented growth and prosperity. This merging of financial and government interests was our first step towards disaster. Government policies leaned further and further towards deregulation (see Clinton years). Newer, more complex financial instruments were created. China and India were developing into economic super powers, and fast. Their new wealth poured into the U.S., making capital even easier to get. People trusted Wall Street; they thought their money was safe in these complicated schemes. Banks gained more power and influence over the government. The line separating commercial and investment banks blurred, a move that hadn't been allowed since before the Great Depression. Aggressive lending practices gave people the ability to live far above their means.

One of the best examples of this was shown through the housing market. Banks gave people mortgages on houses they couldn’t afford, and then sold the debt away to other investors. Buying mortgage debt was considered a "safe" investment, because whenever someone couldn't pay their mortgage, they would just sell the house, which would have already increased in value. Investors wanted to buy more mortgage debt because it was a (seemingly) risk-free way to make a profit. Banks started giving sub-prime mortgages in order to meet the demand of the investors. When people began defaulting on their mortgages, banks put those houses up for sale. More people were defaulting, and more houses were on the market, so supply of houses shifted right, causing house prices to decrease. People who couldn't make their mortgage payments no longer had an easy out. They couldn't sell their house for a profit anymore because their house wasn't as valuable. Investors were left with worthless CDOs, banks were left with worthless houses, and homeowners lost their houses. The entire credit market froze.

The failure or near failure of America's major investment banks followed the credit freeze. These banks had been household names for decades, but without money coming in from mortgage payments, they didn't stand a chance. Lehman Brothers failed, while Fannie Mae and Freddie Mac had to be bailed out by the government. Americans had put their savings and their confidence into these institutions, and now they were failing. We lost confidence in the financial system as a whole, which only added to the economic woes. With less confidence came less spending and less investment. The stock market plummeted, decreasing confidence even further.

What I've said so far makes the average American seem like a victim of the greedy bankers and investors of Wall Street. While some of that is true, average Americans need to shoulder the blame as well. When everything was going great, people thought they could live above their means forever and get away with it. People making $30,000 a year were buying $700,000 houses, just because they could. Everyone thought that they could get out whenever they needed to and pass on the debt to someone else. Interest rates were extremely low, and money was cheap. Why not buy a new car/house/boat when you were practically being given the money to do so? Average Americans got greedy, Wall Street got greedy, even the government was greedy.

Right now, we are not in a great place economically. Consumer confidence has not been restored, unemployment is still increasing, and the stock market is iffy. Businesses keep closing down and housing prices remain low. Other nations no longer want to invest in the U.S. economy because they think we'll lose their money, and who can blame them?

Resources courtesy of Parke

Parke sent this to me via email, and I'm impressed with both.

Recession 101 points you to five other resources Bankling was too lazy or tired to do the work itself. Included among the five links is the Visual Guide to the banking crisis that Roday so loves. You can even watch that one in HD... which I so love.

Parke's second source was a flow chart which I found particularly useful.

That said, though, you all are still being too financially focused in what I'm reading so far. Think of the financial crisis as a mirror which reflects other fundamental flaws!

Sumerth's ultra-liberal version of reality

It seems like only yesterday that the United States was once the world's greatest economy. A nation of growth and progress, the U.S. continued to dominate the world economy, producing advancing technology and helping other nations who strove to follow its path. Yet, currently the United States is in a serious recession. The economy continues to falter as GDP declines, and unemployment sky rockets. Currently the GDP of the United States according to the last BEA release shows real GDP at -6.3%. This is expected to continue to fall for the next year or so. Unemployment, another indicator which shows us that our nation is in a recession, has gone up to 8.5%. Roughly double of what it was during the economic boom of the 1990s. Inflation has also increased; according to the BLS release in February the CPI rose 0.5%, showing that price levels continue to rise. There were many players who played a key role in the responsibility economic mess our of our once great nation.

Let's start early, all the way to 1982 when Ronald Reagan was president. Reagan an economic genius, helped spur the economy into a long twenty-nine year period of economic growth. He did this by implanting his idea of supply side economics where instead of trying to increase the demand or the consumption of products (who's effects are good yet not perfect: increase in GDP but higher levels of inflation) he tried to increase supply (whose effects are almost perfect: increase in GDP along with a slow decrease in price levels). Reagan's economic plan coined famously as Reaganomics helped the supply side of the economy or the entrepreneurship of the economy in two major ways. One, Reagan lowered the costs of business by reducing the power of labor unions in companies. Reagan’s war on Unions started in 1981 when he fired 13,000 air traffic control workers and destroyed their union, this was the start of the demise of the labor union movement. All though I usually drift to the extreme left of the political spectrum I must admit that this plan worked. Soon wages became flat and production went up due to the lowered cost of dealing with Unions.

The second step in Reagan's plan of shifting supply was to deregulate various public industries, most notably telecommunications, transportation and financial services. The deregulation of these industries boosted competiveness, investment, as well as opening new industries thus increasing overall production of the economy. Thirdly, Reagan helped simplify our tax system into 5 simple progressive tax brackets. This along with tax cuts targeted for the wealthy led to increased investment and more production. These economic principles were followed by the next two presidents, Bush Senior and Clinton. Clinton especially was lucky enough to have the explosion of the internet to encompass his similar Reaganomics policies. If you disagree with me just take look at the numbers, a net increase in employment of 16 million, and an average increase in GDP of 3.4% a year. Yet what does this have to do with economic recession today? Let's take a look at the housing crisis and we'll see an amazing connection.

During the economic that twenty nine year economic boom, a series of government placed economic policies led to the demise of the housing market. One of the many was the extremely low interest rates which allowed more people to take out loans for homes. Here the Federal Reserve tried to artificially move demand thus creating a fake boom to match the increase in supply and causing the prices for all goods and services, mainly houses, to go up. So if anybody wanted to buy a home they would have to pay more for it. Thus with housing prices going up, sub-prime lenders made loans to people who could not afford them allowing for these lenders to make a short term profit in this artificial boom. Soon the value of these loans went down due to increased interest rates (causing housing prices to decrease) as well as banks not covering the difference when people could not meet their loans due to decreasing housing prices. Yet why was this shift artificial? Since the Federal Reserve kept the rate at which they lend money so low the supply of funds (money they lend) kept shifting right. This put downward pressure on the price to borrow money leading to all capital resources to flow into the housing market.

Along with this government backed companies such as Fannie Mae and Freddy Mac bought up these loans or mortgages and combined them to sell to investors as mortgage backed securities further complicating the process. Finally in 2007 when this housing bubble exploded, the entire economy felt it’s after shock.

Now how did this affect the banking industry? Remember as the value of homes went up (due to low interest rates), sub-prime lenders made loans to earn short term profits. Soon Wall Street heard of this and banks began to invest heavily into the mortgage backed securities that Fannie Mae and Freddy Mac were selling. When the housing bubble burst, banks such as Citigroup, Bank of America, and Bear Stearns collapsed as well due to the heavy losses in their investment of mortgage backed securities. Hedge Funds especially took a hard hit to the housing market since they invested a minimum of 7 billion dollars in mortgage backed securities. Also insurance companies such as AIG, began selling credit default swaps (paying banks when mortgages defaulted) to various investment banks. This soon put these companies in quite a mess. To go along with this banks needed to stop lending in order to stay in business. This credit crunch soon affected many other industries who had nothing to do with the housing market. Since many industries were not receiving any form of investment, companies began to cut cost. Soon prices for many goods and services shot up leading to various people reducing in expenditures. With this decrease in expenditures companies were losing profit and began to lay off jobs. With unemployment peaking at 9% and rising along with declining GDP due to decreased investment as well as consumption the United States was about to enter a long recession.

In a nutshell there were many key factors which led to the demise of the economy, the 29 year inflationary boom, irresponsible actions by the Federal Reserve, and greedy lenders and investors. And no, it was not all George Bush’s fault, take it from a true liberal. I’m not trying to lay the blame on any of these factors but instead pointing out how we should try to fix the problem. You cannot make good decisions without understanding your mistakes.

Carried Away- The Thexton Version of the Causes of the Recession

This economic crisis is our own fault. We could go around for days blaming it on the banks, Regan, the housing bubble, the government, etc. but that wouldn't be fair. We as Americans have been so privileged and have usually been at the top of whatever we do and we are used to being able to get what we want. Whether we admit it or not, we are greedy. We always want more; the newest model, the prettiest, the 'coolest' of whatever it is that we are buying. Do we really need all of this? No. As we learned in science class, the three things needed for survival are: food, water, shelter. We have gotten greedy and tried to buy everything that we wanted and made stupid decisions in the process. These stupid decisions I am referring to involve buying things (houses especially) that we knew we did not have enough money or credit to buy. Also, we took out loans of heinous amounts and couldn’t pay them back, which left banks with no money to lend out, which was a big part of the bank failures. We didn’t know any better. We wanted to get what we wanted when we wanted but didn’t know how it would affect us in the long run or the economy because we didn’t know how the economy worked. Anna Quindlen put it nicely when she said, "you can't proceed knowledgeably, in terms of personal finance or political judgment, in an area you don't really know much about."

The current economic situation is deeper than a recession but not deep enough to be classified as a depression, or a "repression" as Anna Quindlen put it. The unemployment rate is at 8.5%, the inflation rate is 0.24% for Feb. '09, and the GDP growth rate was -6.3% for the 4th Q 2008. None of these numbers are close to what they should be for a "3-way happy place" or equilibrium. The targeted range for unemployment is somewhere between 4.5% and 5.5%, the ideal range for inflation is 1% - 2%, and the intended range for GDP growth is between 2% and 4%. Let's start with the banks and housing bubble, not because it is the biggest cause, but because the media gives it the most attention. We know that those who work for the media are most likely NOT economists but we still believe them when they say, "oh this is all the banks' fault…oh this crisis is all because of Bush (or Obama)…oh this economy is going down the drains because of x, y, and z…" Why do we believe whatever bull crap the media gives us? It’s because we don’t know enough about the situation ourselves... but on to the banks and housing market. You could say it started with Regan and his supply-side economics and deregulation of the private sector. Both of these tactics could have been very successful in the short and long run if only there had been perfect information and transparency. The deregulation led to excessive freedom and power in the banking system and housing market. "Arrogant traders around the world [and in local banks] were playing a high-stakes game they didn’t understand" and the people they were dealing with, who didn't understand either, were hurt. Banks gave out loans to people who couldn't afford them and they weren't paid back. This led to people buying houses that they knew they couldn’t afford and taking out more loans to pay the mortgages. This leads to the mortgage-backed security (MBS) issue, where banks packaged multiple mortgages up, sold them to higher risk investors and the investors then put them into the stock market and/or hedge funds. The FED kept interest rates at about 1% during this bubble, and the banks kept buying MBSs because they thought they were going to keep making boatloads of money. When the markets went down, the MBSs went down with them. This meant that banks didn't get that money back and that the average American with too big a mortgage from too big a house on his plate couldn't pay the bank back. Banks then proceeded to give sub-prime loans with adjustable mortgages to people with faulty loans, but once the interest rate sky-rocketed, "Joe-the-Plumber" could no longer pay his loans back. Homes went into foreclosure because the money people had invested in the stock market was ‘gone’, their adjustable interest rates went way up, and the banks were out of loanable funds because of the above reasons and more. This was the bubble bursting which led to tons of foreclosures and to the failure of banks for reasons above as well.

Simon Johnson, in his essay "The Quiet Coup," uses the metaphor of an oligarchy to explain who is at fault. "An oligarchy takes control of the nation. The oligarchs get carried away and build an empire on mountains of debt. The whole thing comes crashing down." In our current situation, a case could be made that the oligarchs were those at the very top of the ladder, the elites, the members of Wall Street who got rich wasting the average American’s money. Johnson says that when the market started to collapse, "the elites did what all elites do…they took care of their own." They were selfish and greedy and only saved what they needed to in order to return to their previous spending and splurging habits. Now this is not to say that they are the only ones to blame, because we are not placing blame here. The "average Americans" (i.e. those not in the top 1%-5% of the spectrum in this case) made some stupid decisions as well. They either chose to not educate themselves on this matter or were never given the opportunity (ragging on the education system to come in a later segment). But if you don't know anything about what you're doing, you’re probably going to end up doing something stupid (see above paragraphs for unpaid loans).

Harrison Claud's Causes of the Recession

When examining our current economic situation, you could point many fingers, lay blame in many ways, or try to pin the problem in one specific area, but it's just not that simple. There isn't just one person to blame, one corporation to blame, one governmental policy. It is a concoction of different mistakes made by different sectors of our country, all coalescing into the biggest financial meltdown of at least my generation. Which is something my generation is not used to, because my entire lifetime, and specifically dating back to about 1982, the U.S. economy was a shining beacon in the world market, and enjoyed the most prosperous time any country experienced in the contemporary world. During this period, however, mistakes were made that would eventually lead us into the recession we are experiencing today, and this blog post will attempt to delve into some of those issues, though of course no essay anywhere will be able to give the full story.

One ingredient that was a key part in this stew of disaster that goes unnoticed and unrealized by most people is just how much our foreign policies and relations have had an effect on our economic condition. Events such as the Iraq war, the Vietnam war, the Korean war, nuclear scares like the Cold War, and other foreign crises have been huge parts of the United States history. And in order for these wars to happen, or for the United States to extend its touch into far-reaching sectors of the world, our government had to shell out some major cash. Through this, the national debt went through the roof, and it also created a sense of distrust in the government by many parts of society (see George W. Bush). This meant that a lot of people decreased their consumption.

Another period during recent history that aided to this recession was the Reagan Era. During this time, many changes were made to the financial sector of the United States. Reagan was a big proponent in supply-side economics, and that the private sector should control the national level, and played a big role as far as the deregulation of the private sector. Debt exploded from 900 billion dollars before Reagan's tenure to 2.8 trillion dollars after his tenure. If transparency and perfect information of the government and Federal reserve had been available to the public, "Reaganomics" may have been wildly successful in the long run. The capitalist nature of our America, however, made this impossible, making "Reaganomics" a lot like crack. During his presidency, it was great, because America was high on crack, but a few years later, we took a look in the mirror and realized, "Oh my God, I'm addicted to crack. This is a bad situation."

Probably the reason for the recession that has gotten the most attention by the media would be the collapse of the housing market, and the subprime mortgage fiasco. After years of monetary inflation on the part of the Federal Reserve (an institution that created a 1% interest rate from 2002-2004, even dipping below 0% in 2003) families with bad credit and low income, who didn’t qualify for "prime" mortgages, applied for mortgages with insanely low down-payment and low interest. The housing demand rose to ridiculous levels, with money easily flowing from the Federal Reserve to the banks. The banks were more than willing to lend to the people, as they continued to make profits from an simulated "boom" created by the government. Credit was given by the government, through both fiscal and monetary policy, controlling prices, artificially raising demand, and as the government removed what it injected into the system, the demand returned to normal, and there was an inevitable "bust," with a glut of supply hurting prices, and misleading consumers. The government also sponsored companies such as Fannie Mae and Freddie Mac to buy mortgages given by banks and sell them as "mortgage backed securities," throwing leaves onto the blaze already created by the government. When everything came to the forefront, and the reality of what was happening set in, the housing market crashed, and we see the effects on our own economy.

So who is to blame for that? The people looking for nicer houses than they could afford, and buying them anyway? Or the banks that allowed these malfeasances to occur? Well, the banks are certainly at fault, for they invested a lot of money into these "mortgage backed securities," and as prices of houses rose and rose, these securities gave banks a guaranteed return-- something they would be stupid to stop investing in, right? Wrong. Banks that you’ve no doubt continued to hear about in the news such as Bank of America, Bear Stearns and Citigroup were key players in this securities market, and as the housing market crashed, all of the investments these banks had made were destroyed, sending the banks into (IRONY) bankruptcy. AIG, a huge insurance company, had to pay investment banks when these mortgages defaulted, and as this market for mortgage backed securities died, AIG was shattered. A 85 million dollar bailout was issued to AIG, which was AFTER investment banks like Lehman Brothers collapsed, all of which created a huge scare in the market. Unemployment began to rise, and the US growth became no more. Currently, the unemployment rate is still high, and continues to rise. Investment has shrunk, household debt is up to 100% , national debt is 350% of the GDP, a big change in 160% in 1980.

So who is to blame? The answer is of course, everybody. The everyday American people got greedy, and wanted things that they couldn't afford. The American corporations got greedy, and wanted money that wasn’t real. Ideas such as the stimulus package will help, but the American people need to get confidence back in the American system. Even then, how can we stop our country from repeating the same mistakes? Is it simply human nature to be greedy, to try to find loopholes and tricks to get money without actually earning it? That's what really scares me about this recession. Probably the reason for the recession that has gotten the most attention by the media would be the collapse of the housing market, and the subprime mortgage fiasco. After years of monetary inflation on the part of the Federal Reserve (an institution that created a 1% interest rate from 2002-2004, even dipping below 0% in 2003) families with bad credit and low income, who didn’t qualify for “prime� mortgages, applied for mortgages with insanely low down-payment and low interest. The housing demand rose to ridiculous levels, with money easily flowing from the Federal Reserve. The banks were more than willing to lend to the people, as they continued to make profits from an simulated “boom� created by the government. Credit was given by the government, through both fiscal and monetary policy, controlling prices, artificially raising demand, and as the government removed what it injected into the system, the demand returned to normal, and there was an inevitable “bust�, with a glut of supply hurting prices, and misleading consumers. The government also sponsored companies such as Fannie Mae and Freddie Mac to buy mortgages given by banks and sell them as “mortgage backed securities�, throwing leaves onto the blaze already created by the government. When everything came to the forefront, and the reality of what was happening set in, the housing market crashed, and we see the effects on our own economy. So who is to blame for that? The people looking for nicer houses than they could afford, and buying them anyway? Or the banks that allowed these malfeasances to occur? Well, the banks are certainly at fault, for they invested a lot of money into these “mortgage backed securities�, and as prices of houses rose and rose, these securities gave banks a guaranteed return. Something they would be stupid to stop investing in, right? Wrong. Banks that you’ve no doubt continued to hear about in the news such as Bank of America, Bear Stearns and Citigroup were key players in this securities market, and as the housing market crashed, all of the investments these banks had made were destroyed, sending the banks into (IRONY) bankruptcy. AIG, a huge insurance company, had to pay investment banks when these mortgages defaulted, and as this market for mortgage backed securities died, AIG was shattered. A 85 million dollar bailout was issued to AIG, which was AFTER investment banks like Lehman Brothers collapsed, all of which created a huge scare in the market. Unemployment began to rise, and the US growth became no more. Currently, the unemployment rate is still high, and continues to rise. Investment has shrunk, household debt is up to 100%, national debt is 350% of the GDP, a big change in 160% in 1980. So who is to blame? The answer is of course, everybody. The everyday American people got greedy, and wanted things that they couldn’t afford. The American corporations got greedy, and wanted money that wasn’t real. Ideas such as the stimulus package will help, but the American people need to get confidence back in the American system. Even then, how can we stop our country from repeating the same mistakes? Is it simply human nature to be greedy, to try to find loopholes and tricks to get money without actually earning it? That's what really scares me about this recession.

The Recession-- According to Ellis

In 2006 our economy was in full throttle; the stock market was climbing, innovation was greater than ever before in the United States, and all seemed to be going well. That is, until, as said by Time magazine’s Kurt Andersen, "we started gambling (and winning!)" – our economy went downhill from there. Banks were forced to foreclose, the prices of houses plummeted, and Americans found themselves either in debt or unemployed – or maybe both. But how did our economy go from such a prosperous era to an 'economic crisis'?
In the past few years, the values and prices of housing increased dramatically. Housing was not only growing in price but also in size, increasing by half its original size. The stock market was booming; people were bringing home more money than ever – so why not buy a nicer, larger house? "We started living large," as said by Andersen, "literally as well as figuratively."
Another factor of American’s having more spending money was the FED's efforts to stimulate the demand in the economy after September 11th. They lowered interest rates, to stimulate borrowing and spending and to promote growth. By doing this, there was more money to be spent – and over production. People were buying new houses, buying new cars, and utilizing new innovations – such as the internet, to purchase laptops and iPods – most likely rarely paying in cash under any circumstance.
With this promotion for growth, our economy became demand induced – with the ability to spend more. People wanted to live larger than ever before – maybe because there was more to purchase or invest in than ever before; this is when we turned to the banks. Americans looked to the banks for assistance in purchasing their dream home or their new Lexus – and the banks granted them mortgages and/or loans. Not only did this ultimately put Americans in potentially great debt, but the banks were in a situation as well. Many banks gave loans to unqualified people, meaning that some people were unable to pay back these loans which caused the banks a lot of trouble and loss.
With people easily being granted loans for mortgages, there was an increased demand for housing. Naturally, because the demand increased, the supply increased. More houses were built everywhere and because loans were so easy to come by, affordable housing was created – which did not necessarily seem like a bad idea at the time, but many of the loans utilized for mortgages were unable to be paid back to the bank.
But the banks seemed to balance out their losses from bad loans by investing in the housing market. Prices were still high. Therefore, the banks began investing in Mortgage-Backed Securities. These securities were highly profitable as long as the prices of housing remained sustainable. Banks invested in these and were profiting from them left and right. Unemployment was low, banks were prosperous, Americans had more money than ever (and spending more than ever too) – but all aspects of everything good in our economy, seemed to disappear.
The FED's plan to synthetically stimulate the demand completely backfired; it caused a great flow of money – which resulted in overspending in every category possible. Due to false assumptions on continued growth in the economy, consumers were in debt. The prices and values of the housing market declined steadily due to the overproduction of housing – and the easy process of receiving loans. But as the economy began to slow down, the loans were not being paid back – by the unqualified people they were granted to in the first place. Banks lost money and could not continue lending at the same levels as before.

Some more sources courtesy of Rachel

Rachel's post below draws on some good sources beyond what I've already posted. The first deals with the widening income data I mentioned Friday in A Period.

The second source shows equity index data since the 1980s. Can you say "profits income?"

Final source she used is a look at house prices in Ireland. The parallels are scary and since this is a global recession. It makes great sense to consider this, especially since many people overlook the international components at work here.

Long Run Aggregate Supply... Think about it...

How We Got Here

(Sorry for editoralizing a bit too much in this, Mr. Wedge.)


So as we try to figure out how exactly we arrived at our current economic situation, it’s useful to have some perspective. From 1982 to 2007, the United States enjoyed the most prosperous, sustained period of growth in any place in the history of the world. And that’s not hyperbole- there is literally no period in recorded history in which a nation has produced so much innovation (everything from personal computers to ipods to life saving pharmaceuticals,) wealth (a consistently rising standard of living for all classes, one unrivaled by any other country in the world,) and social progress (as we moved increasingly further away from our shameful past towards a more egalitarian society in which the intellectual resources of all sexes, races, and ethnic groups are employed.) If there has ever been an Age of Abundance, this was (and hopefully, still is) it.

What unleashed this explosion of growth? Mostly, it can be explained concisely: relatively unfettered free markets produce the greatest wealth for societies that employ them. To that end, the 82-07 period saw huge reductions in taxes on labor income, capital gains, and business profits, rapid expansion of trade, and the deregulation of several key sectors of the American economy (transportation, energy, telecommunications, and yes, financial services.) The result was a quarter century of booming growth and job creation, interrupted by just two short contractions (in the relatively shallow recessions of 1991 and 2001.) The power of the free market to produce wealth and combat social prejudices is unmatched.
So with all of that said, we get back to our current recession, the worst since the 1981-1983 slump, or possibly even the 1973-1975 stagflation disaster. Some are laying the blame at the feet of the free market. The causes are far more complex than that. I will grant, however, that rising inequity perhaps drove average people to make irrational decisions that they wouldn't have made in different circumstances. On the other hand, some feel that this recession shows that the strong growth we experienced from 82-07 is unsustainable. I say that's BS. There's no reason we can't continue to have prosperity in the 21st century. While excessive debt did fuel some of the boom of the last few years, to say that debt was the only cause is misleading.

The most clear cause(s) of the recession is a series of perverse incentives put in place by government actions. It is almost universally agreed that the Federal Reserve policy of keeping interest rates at 1% during the 2002-2004 period was a catalyst for the housing bubble, which itself is at the root of the current malaise (at one point in 2003, real interest rates were actually below zero.) As first explained by the Austrian School of economists, an infusion of credit from the government (whether through monetary policy or fiscal stimulus) distorts decisions by producers and consumers by manipulating price signals, leading to poor decisions with negative consequences. In other words, when the government tries to artificially raise demand, it does just that- artificially (and temporarily) raising it. When the government cash is withdrawn, as it must be eventually, the demand returns to its natural level, leaving an excess supply that depresses prices and hurts the overall economy- the bust following the boom. Prices communicate to producers how much they should make of something, or how to best allocate scarce resources. When the government messes with prices, a misallocation of resources results. In this case, housing demand soared to unsustainable levels because of the easy money flowing from the Fed. People who couldn’t truly afford houses got mortgages from banks, who were happy to lend to these people as long as they could continue to make profits from the artificial boom; this was the so called "sub-prime" mortgage market. The government also encouraged this kind of irresponsible behavior through "affordable housing" programs such as the Community Reinvestment Act, as well as the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which bought up mortgages issued by banks and sold them as mortgage backed securities (MBS), providing further fuel for the unsustainable cycle. Also, long term social trends did played a part. Americans became increasingly willing to go into debt during the the last few decades, as household debt as a percentage of household income soared during the 90s and 2000s. Because many middle class people felt that the best way to enhance their income was purchasing an appreciating asset, they went heavily into debt to buy houses, reasoning that the increase in the value of their home would allow them to pay off the debt. A federal government that engaged in near constant deficit spending was really a reflection of a culture of debt that pervaded average American's own decisions. When the housing bubble finally burst, leaving an oversupply of housing on the market (the result of the misallocation of resources,) it had ripple effects throughout the entire national economy, while also doing serious damge to many people's financial plans.

You may ask yourself, if the housing market’s collapse is one of the main causes of the economic crisis, why am I hearing so much about banks? This brings up one of the key facets of the crisis- the banking industry’s collective unhedged bet on housing. What I mean by this is this: because the prices of houses seemed to be rising without any end in sight, banks began to invest heavily in mortgage-backed securities (sort of like a stock, but tied to the value of a house) in great number. It was like an automatic profit: as prices climbed ever higher, MBS became like guaranteed returns. What company wouldn’t get in on this? Banks like Citigroup, Bank of America, and Bear Stearns got involved in these securities, and bundled them into complex financial instruments called derivatives that I won’t even pretend to understand. But the idea is, these banks followed the perverse incentives put in place for them by the Fed and the GSEs, Fannie and Freddie (who facilitated these MBSs for the banks) and bet big on housing. When the bubble inevitably burst, these bank’s investments in housing were wiped out, dragging the banks down with them. Even though foreclosure rates weren’t extremely high (roughly between 1 % and 2 % during 2007 and 2008,) the value of MBS were so completely laced throughout the entire financial system that the major banks could not withstand the fall in prices that resulted from this relatively modest wave of foreclosures. In order to survive, these banks were forced to clamp down on their lending- hence, the "credit crunch." Since credit is the key engine for investment and consumption in a functioning economy, this contraction of lending sent a shockwave throughout the entire economy. In March, the Fed stepped in to save Bear Stearns with a $30 billion guarantee. Bailout season had begun. In September, the venerable investment bank Lehman Brothers collapsed, and the government couldn't legally step in to save it at that point. Soon after, the insurance giant AIG was given a $85 billion bailout from the government. Becuase AIG had heavily sold credit-default swaps (meaning they had to pay, say, Goldman Sachs when a mortgage defaulted,) they were ripped apart by the collapse of the MBS market. This one-two punch of the Lehman bankruptcy and AIG bailout heavily spooked the market, which began its nosedive. Unemployment began rising, and growth, already flat for most of 2008, completely screeched to a halt. The crisis had begun in earnest.
Some have tried to say deregulation allowed these banks to make these risky decisions. However, the 1999 deregulation of the financial industry (The Gramm-Leach-Bliley Act) merely broke the wall between investment banks and commercial banks. Banks could always invest in housing, and the G-L-B law had nothing to do with these banks’ bad decisions. In fact, the banks that got in the most trouble, like Bear Sterns and Lehman Brothers, didn’t even take advantage of the law: they were stand-alone investment banks, without any commercial banking aspects. The one "deregulation" that did cause serious harm was the SEC’s decision in 2004 to reduce capital requirements for banks. This led to the wild over-leveraging (meaning the ratio of a firm’s debt to capital base) of many Wall Street firms. 30-to-1 leverage is simply unsustainable for anyone. Fannie and Freddie, meanwhile, continued to pour fuel on the fire; because the government implicitly guaranteed their losses, the duo were allowed to engage in wildly reckless behavior, without full thought about the consequences. Fan and Fred never even had reasonable capital requirements in the first place.

Needless to say, there are other causes of the recession, and my explanations are very simplified. However, they go a long way towards showing how we got to where we are today. Too much easy money, too much debt (for consumers and companies,) too much leverage, the Fed sharpening the edges of the business cycle, Fannie Mae and Freddie Mac indirectly subsidizing risky behavior, bank loans to unreliable borrowers, "mark-to-market" accounting regulations that forced banks to write down temporarily illiquid assets as worth zero (and thus diminishing their capital base, and by extension, curtailing their lending activity,) and the SEC being asleep at the wheel all helped cause the crisis. Also, as real wages flattened out over the last few years (although real household income rose steadily,) many people turned to investment, rather than wages, for income. In a sense, many people began speculating on their homes, hoping to supplement their income which was not growing through wages. It’s a complex and multi-layered situation that requires considerable scrutiny to even partially understand, which is why it is important to look back on what truly happened.