The Economic Crisis

            Over the past few months, we have seen a radical worsening of the economy. As the government continues to support banks in a hope to revive the lending market, the major US automakers are close to failing themselves. They now look to Washington to bail them out, labeling themselves as “too big to fail.” In this case, the automakers may have a more direct point than the banks seeing as they employ a large amount of individuals in the middle portion of America. Along with this, the ceasing of the credit markets have shown us just how leveraged the economy truly was. While banks struggle to stay solvent, many homeowners see the value of their housing decline rapidly. As companies begin to scale back their operations, unemployment has begun to rise rapidly, and consumer demand begins to fall. All these factors beg the question, How did we get here?

 

            The question of how did we get here is not easily answered and highly subjective. One factor was certainly the amount of leverage across society, but this is not unusual nor necessarily a bad thing. Typically leverage allows individuals to purchase today what they wouldn’t be able to for awhile. A house, for example, is purchased with debt today with future earnings being pledged typically as payment for the debt. Now certainly part of the problem was individuals purchasing houses with the idea that their price inflation would allow for then to sell in a couple years and make a profit, and when housing prices stopped climbing it created a large problem for these short term buyers. However, housing prices (along with company valuations and college education) moved much higher than seemed reasonable during the past few years. The reason for this, the same leverage that typically allows for individuals to responsibly pledge future earnings for the purchase of something today. These housing market often is a bidding market where in many cases the buyers ability to pay determines the sellers price. This works similarly for the purchase of companies, the price of the company gets set competitively mainly by how much the bidders can find to purchase the company with. In this case the cost of debt became a large determinant for the price of these assets.

 

            In this case, our typical fed policy, the setting of the feds fund rate, had a terrible consequence. While the fed used its typical tool to help provide liquidity for the market during times when the economy began to decline, it was causing a huge rise in the prices of these assets. When the base rate of the economy was lowered with providing a large amount of liquidity in the market, it began to lower the cost of borrowing, and consequently raise the value of these assets in a bidding market. This was the first facet that created the current market problems. The decline of this base rate provided a large amount of liquidity into the market at cheap rates, which gave bidders in the housing and LBO market a larger amount of cheaper capital to bid on these assets. While the Fed watched the CPI and other indicators of general inflation, it failed to recognize the inflation in these markets since we typically do not discuss “inflation” of housing prices or company valuation. This inflation, however, became a large portion of “wealth” in our society and was in many cases tied to our economic prosperity in the past 7 or so years. This was the first and more direct factor which created the seeds of this current crisis.

 

            The second factor, has been an ongoing problem and works similarly to the Fed’s fund rate in how it helped spur this crisis. This problem, which has been mentioned before by many different sources, is the wealth disparity which continues to this day. In America, our capitalist system has allowed for a consolidation of wealth in the upper tier. A majority of this wealth, since it is unnecessary for consumptions, is funneled back into the public markets as investment. This allowed for a huge amount of liquidity available for investment into the debt markets which were already bolstered by the Fed’s policy to cut rates. For example, the collateralized mortgage market was a pass-through created to allow for more liquidity in the home loan market. Public markets allowed for a simple mortgage loan to be packaged with other loans, statistically analyzed, and then financially restructured to meet the risk criteria of a broad range of investors. This allowed for a large amount of those invested funds from the top tier of America to be reinvested as loans for the middle to lower class in order that we could bolster demand in the housing market, and achieve the American Dream of home ownership. This also allows for a large amount of investment into hedge funds and private equity firms which offered attractive returns funded by the large amount of debt funds from the over saturated debt markets.

 

            The reasons for the wealth dispersion rely mainly on the way returns are allocated in society. Since we have been staunchly capitalist from the start, returns to capital (that is money invested in companies from capital owners) have always been highly attractive in order to spur investment. At the same time factors have continued to decrease returns to labor. Offshoring, immigrant labor, and technological innovation, have moved the returns earned in society towards the capital owners which often times are unfortunately the more wealthier individuals who have invested their large amounts of wealth back into the market. In economic theory, as labor earns lower returns, it should have less funds by which to demand products in society and so prices should decline. That is why often times offshoring and technological innovation are seen as creating economic wealth. They lower costs and allow for lower pricing for the general consumer. However, the larger returns to the capital owners have allowed for larger investments in debt. Essentially the lower to mid tier wage earners are being offered less equity earnings in terms of wages and jobs, and being supplied with the availability of debt in order to purchase items that would otherwise be out of their range. We have allowed for economic growth solely in terms of leveraging out the future “potential” earnings of the lower to mid tier wage earners. In this case, all possible future earnings have been captured by the upper tier in the form of debt (like mortgages and credit card debt).

 

            None of this was malicious or even wrong, it was just the way in which we viewed society and economics. Debt was great, it allowed for individuals to acquire today what they could never dream of without saving for decades. Fed policy was intelligent, insuring that markets had enough liquidity in order to operate efficiently. Many of those who earned fortunes were those capitalist who supplied our economies with the ability to grow and innovate. This was all fine as long as the system continued to operate, but the second things began to falter, the house of cards crumbled. We have now seen just how precariously the system was and how isolated failure could lead to system-wide collapse.