the precipice: a simple economics lesson part one

precipice- a situation of great peril

Over the last six months, I have been asked on multiple occassions to explain to people what is going on in the economy. At last, I've decided to give it a shot. This post is probably going to be long and for most of you, boring. However, I feel that if you have any interest in your future in a capitalistic economy, you should at least read a little bit of it. So here goes....

I believe that it is wise to say that problems occuring in recessions stem from problems occuring in past recessions. Economics is defined as the science of attempting to maximize your utility from a limited amount of goods. Naturally, the fact that we have a limited amount of goods brings about the problem of how to best allocate these resources. The simple introduction to our current crisis stems from the last recession that occured at the beginning of the 21st century. That recession was fueled by the overheating of the market due to the introduction of names such as Apple, Microsoft, and IBM to every household in America. For almost five years traders ran these companies' stock prices up to absurd levels. Upon realizing this, a huge technology driven sell off began. That, coupled with the destruction that 9/11 caused our economy, launched the country into a recession. The Fed chairman at the time, Alan Greenspan, decided that the best way to get the economy going again was to lower the federal funds rate(interest rates is misleading, because the fed funds rate is one of many important interest rates). The reason he decided to do that is because there is a very observable correlation between the federal funds rate and investing/saving. When the federal funds rate drops, people tend to save less because they are getting lower returns on their money than they would have beforehand. Therefore, any person acting rationally will move their money from savings to investments because of the decreasing returns from savings. The lowering of the federal funds rate is the easiest way the Federal Reserve can influence the macro, or entire, economy. Greenspan felt that the economy was in such poor shape that he lowered the rates 17 times straight! You might ask why once or twice was enough and there are two basic answers to this. First, the obvious answer is that he has to lower them in small enough percentages that he doesn't bring shock to the market. Imagine what would happen if you were earning 7% on your savings account one day and you wake up the next to be told that it is only earning 1% now. Not only would you be incredibly pissed, but you would be very afraid that the banking system may not survive. The second reason is that it takes time for the economy to respond to the stimulus. Imagine that you get strep throat and require medicine to get rid of it. Although the medicine begins working almost instantly, it takes time for you to see any results from it. The same holds true for interest rates. It is generally believed that it takes about six months for us to see the effects of a single rate cut. However, when we do see them, the results are generally incredibly positive. About a year and a half after 9/11, the American economy began to climb out of the recession thanks in part to those cuts. You have to remember though, these rate cuts began to have very unforseen consequences. For one, mortgage brokers were willing to give anyone with any sort of income a loan to get a house that the brokers knew they would not be able to afford in the future. Why did the brokers do this? It's simple really: they got a commission every time someone signed on the dotted line. The general belief is that most of the dealers knew that what they were doing was wrong, yet they continued to do so. It's one thing to take a stand when you know that what you are doing could legitimately make a difference. However, when you're talking about a couple extra hundred thousand that would have been lost(had these dealers acted prudently), you really aren't talking about that much. With the easy availability of these mortgages, the price of homes skyrocked in a short period of time. In late 2005 all the rage was up and businesses and individuals alike realized that they had been gravely fooled. The Federal Reserve had begun to raise interest rates again, translating into increased payments per month for an individual home owner. As people realized they could not afford the payments, default rates began to rise almost overnight. As businesses realized that these people weren't going to pay, they quickly tried to pawn off these obligations on others. The most common technique was to package these mortgages together and try to sell them to investment banks in the US or to foreigners.

This ends our lesson for today, namely because my head is pounding and the Rays look like they're trying to be the third team to lose to the Sox despite being one game from ending the series. I'll continue the lesson with my next post, but until then, enjoy.


mh