Economics: The most important things in life are the least understood – Part Two


Are recessions a necessary part of a Capitalist economy?

What really happened in 2007? Why do we get hit every few years with these recessions?

A recession is defined as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales.” There is no definitive definition for the term Depression, though it generally involves either a decline in GDP of more than 10% or a recession lasting for two years or more.

To put things in perspective the Great Depression of 1929 saw a GDP decline of 26.7% and lasted 4 years and 7 months. The Great Recession of 2007 saw a GDP decline of 4.1% and lasted 1 year 6 month. However, it is the worst downturn in the economy since the Great Depression. The only time GDP dropped more in the last 75 years was at the end of World War II when government spending for the war effort ended.

The recession of 2007 was and still is terrible by many people’s standards, but things have been a lot worse in the past. Just, not in the recent past. So, are things in this country getting worse, or is this just part of the normal economic cycle; like the weather?

Some questions that you may be pondering these days are:

What caused this recession?

What is wrong with our economy that we keep having these problems; is this normal?

Will it happen again?

Isn’t there something we can do to prevent recessions from happening?

Some of the most heated debates around the country these days are centered on answering the questions above. If you ask 10 professional economists, you will likely get 10 different answers. Therefore, what is a reasonable person to do, and how can we ever hope to make an intelligent decision about which approach to back when it comes time to cast our vote?

To begin with, stop listening to people trying to tell you what to do. Get, as many of the facts as you can and decide for yourself what you feel the best approach would be.

What caused this recession?

Everywhere you look, someone is pointing the finger at someone else. It seems we have become a nation of finger pointers. It’s relatively easy to look at a sick patient and determine what is hurting at the moment. With a little effort, you can even determine what immediate thing may have caused that pain. It is considerably harder though to go back farther and look at the habits, daily activities, and long-term environment that may have been a factor in causing the current condition.

The reason so few people can agree who to point the finger at, is because it is the confluence of a number of things that went wrong to create the perfect storm. Really, it was several perfect storms that all came together to create a mega storm.

The immediate cause of the 2007 Recession was a failure in the mortgage-backed securities market. When investors suddenly became aware of the high level of foreclosures being experienced in these investments, they panicked, and could not sell them fast enough. Suddenly no one wanted to buy them, and everyone wanted to sell.  This creates a situation where you have a run on a security. The price drops through the floor.

So, why was this so devastating? We have had real estate bubbles before and it never created this kind of damage. The short answer; deregulation in the banking and financial services industry. Banks that used to be prohibited from investing their own assets in the market were now in with both feet. In addition, the creation of extremely complex investments were permitted that concealed the real risk of the investment to those would be investors. It is as if Wall Street was in the car sales business, slapping on a fresh coat of paint to cover up an old wreck, and sold it as a brand new vehicle. Many of the banks that failed were simply the victims of an unscrupulous Wall Street used car salesman. However, it is important to note that they never would have been put in that position if not for banking deregulation that let them do it.

Ok, we know why now, but why did all those mortgages start failing in the first place? If you applied for a mortgage 30 years ago like I did, you probably recall going through an agonizing process trying to qualify for the home of your dreams. Banks and mortgage companies had no problem drawing a solid line in the sand about how much house you could afford. They took great care to sell only mortgages where they felt relatively assured of getting their money back. That is because they were embarking on a long journey with the mortgagee of twenty or thirty years. They had a stake in selling only solid mortgages. In addition, they were constrained by law to require certain things of a person requesting a new mortgage. Plus, the average American was not living beyond their means, and able to save some of their surplus income.

Enter the new age of easy credit. Did anyone notice the explosion of credit cards on the market? Something happened in the last 30 years that has fundamentally altered the typical Americans financial habits. Where it used to be a sign of good credit worthiness to carry a credit card, suddenly everyone had one, then two, then four, five or more. People started living month-to-month paying for daily expenses with their credit cards. Some people even had to resort to taking out new cards to make payments to their old cards. People who did not have the financial maturity to handle credit suddenly started going off the deep end getting into debt.

During the eighties, while people were becoming consumer debtors, lending institutions starting figuring out they could make a lot of money in low quality loans called sub-prime, by charging higher interest rates and exorbitant fees. This of course led to the savings and loan crisis in the late eighties. However, did we learn anything from that? no! The political thinking at that time was that trying to regulate an industry created inefficiencies, so the solution of course is more deregulation. This practice was continued throughout the nineties as we saw the fall of one law after another designed to prevent the type of disaster we went through in 1929. Everyone thought we had evolved past the point of needing such antiquated regulations, that they are just stifling innovation and hurting profits.

Sub-Prime mortgages started becoming a larger and larger part of every mortgage portfolio, including Fannie Mae and Freddie Mac. Conventional wisdom had supply side economics winning the day. The solution to every economic problem was to control the money supply by easing credit. The thinking goes that by making it easier to borrow, money flowing into the system would create a prosperous economy. What they did not foresee was human nature. The sub-prime market was hugely profitable. They were now easily packaged into investments and sold off the highest bidder. There was no longer a long term relationship with your bank. Mortgages were a fire and forget industry. With the easing of credit to businesses, the number of companies chasing after the get rich quick sub-prime mortgage sales plan skyrocketed. Even the U.S. Postal service was granted a reprieve from going broke because of the large volume of junk mail being sent out soliciting mortgages. I personally remember getting four or five mailers soliciting mortgages every single day. Some companies even resorted to bait and switch tactics where they would lure someone in with a ridiculously attractive add, then switch them into something considerable uglier and more profitable.

Ok, so now, we know that deregulation of the banking and investment industry coupled with a policy of making credit easy to obtain created a situation where people could exorcise their natural inclination to make a quick buck. Why did anyone think those were good ideas, and where did such notions come from? In addition, more importantly, have we learned from our mistakes; deciding to do things differently?

As to where those notions come from, they are based on an idea of economic theory that began with a fella named Adam Smith who published ‘The Wealth of Nations’ back in 1776. This was to be the beginning of the Capitalist era. Smiths theory of Capitalism is known as the Classical model. For the first 140 years or so, there were no regulations controlling capitalism, and we had a very small government. The early years were experimental while we played with the notion of who should print and control currency. They were understandably rocky years, with the economy growing and contracting in fits. However, even after resolving the currency issues, the economy was still like a roller coaster ride. Quick spurts of growth were followed by sharp downturns and rough years. In fact the bad years were almost as numerous as the good years. See the chart below.

Many economists struggled with the problem of Recessionary cycles; what caused them? Hundreds of theories were put forth. One theory that would become known as the Neo-Classical model claimed that the cycles were just a normal part of the business cycle. This theory held that capitalist markets are the most efficient when they are unhindered. That any attempt to intervene in a natural cycle just exacerbates and prolongs the problem. This theory also believed that the downturns were usually a problem that interfered with supply. It was determined that demand for goods was irrelevant to the discussion, that all problems could be rectified by insuring industry was not impeded from creating a supply of goods. It was reasoned that if all variables involved in manufacture, including labor were kept flexible, then things would just naturally find equilibrium and become stable.

This theory states that in a down turn, the market can be restored by easing credit and lowering taxes so the companies are better equipped to create a supply of goods. The extra production would create jobs and lead to consumers able to buy the extra goods produced. Thus growth could be sustained.

An alternative to the Neo-Classical theory was put forth by John Maynard Keynes in 1936. He postulated that the cycles are actually caused by an interruption in demand. He stated that demand creates a need for supply, not the other way around. That for any number of reasons, potential buyers elect to withhold their dollars from purchasing; creating an initial panic or run on a market. Then, a contraction in manufacturing prolongs the downturn by paying fewer wages, which are needed to restore the market.

This theory states that in a down turn, the government should intervene with spending; creating the jobs that would be lost from industries contracting in order to bolster a demand for goods. This alone would not prevent recessions, but it would help them recover much quicker. Regulations on industry would help prevent the natural volatility in markets to bubble, and then burst. Controlling labor cost by holding wages steady during a downturn actually lent stability to the market preventing a self-feeding cycle downward with declining consumption. Therefore, unions were seen as a stabilizing factor in the economy.

If we are to evaluate the merits of each of the two theories above we need to look at how they actually behaved in practice. The Classical theory was king from 1776 until the late 1930. The Neo-Classical theory contains only minor revisions of detail about controlling money supply and came back into favor in 1980 and has ruled economic theory until the Recession of 2007. The Keynesian theory was in favor from 1936 until 1980.

The average period for a recession to run its course before and including the Great Depression in 1929 was 23 months. The average time between events was 4.1 years. So, you can see almost as much time was spent in a down turn as in a growing economy.

After Keynesian theory became popular until 1980, we have not had a depression. The average recession lasted only 11 months, with 10.1 years between events.

Since Neo-Classical theory was brought back, the average recession lasted 11.2 months with the last one lasting 16 months. The average time between recessions has dropped back down to 6 years.

As we now see, the practice of easing credit and deregulating of industry that began in the eighties and continued for 25 years led directly to the recession of 2007. Those policies had their birth at the inception of the Capitalist enlightenment in 1776. Once some inherent flaws were identified, remedies were enacted in the 1930’s that actually worked pretty well. Big business however hated anything that might constrain their ability to make a profit and fought tooth and nail until they finally got what they wanted in 1980 by bringing back the Classical model.

So, there you have the analysis. The key facts laid bare for your consumption. Only you can decide what to do now.

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4 responses to “Economics: The most important things in life are the least understood – Part Two

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