The Great Recession Causes & Prospects

What is the “Great Recession?” Decline of speculative markets in 2007 Bursting of the real estate bubble Decline in credit, even with cheap money Decline in circulating money Drop in production & job losses High unemployment Low growth & growing government debts As Morris argues, the stage was set long ago

Let’s go back to the beginning Consumption in the U.S. has been subsidized by low-cost imports from China Wages had more buying power & hardly grew After dot.com crash in 2000, Fed lowered interest rates This made money cheap Cheap money seeks to earn high returns Real estate looked good

So, where did this cheap money come from? Equity pulled out of houses financed consumption Consumers bought low-cost goods from China Dollars flowing to China used to buy Treasury bonds This is a “loan” to the U.S. at low interest rates Allowed U.S. to continue to consume Chinese goods Also permitted tax cuts & high military spending China grew, as did it dollar holdings

This shows how the money circulates in “Chimerica”

Economy grows via increases in consumption of goods & services Stagnant wages posed a problem for growth Real estate became focus of investment & cheap money Low interest rates & high growth in housing prices Homeowners could take out cheap equity loans to consume Speculators could realize high returns from flipping houses Both real & speculative economies were juiced

Mortgages used to be held by lenders Home buyer went to bank to borrow funds Bank held a lien on the house to secure loan Mortgage owned by bank But bank can only loan out 10x its deposits If it can sell mortgage, it gets new money to loan And it can further leverage its assets

When money is cheap, highly-secure mortgages don’t return much (4-5%) But they can return more if they are high-risk Sub-prime mortgages Lenders can borrow low and sell high (8-10%) To mitigate risk, they bundle them with low-risk mortgages These packages are sold to investors as CDOs “Collateralized Debt Obligations”

This is how a CDO works…

So investors, speculators, pension funds, hedge funds, banks, etc So investors, speculators, pension funds, hedge funds, banks, etc. bought CDOs The market in CDOs took off and their prices rose Value is linked both to interest paid and price of CDO Each CDO is made of layers of low- & high risk mortgages Combined return can be high But what happens if the high risk mortgages go bad? No one wants to buy them—so their “real” value is uncertain If there is no market, there is no price As assets, CDOs suddenly become worthless Banks don’t know how much money they have

The Great Recession is the result of a sudden collapse in the global money supply The “real” economy was supported by cheap money Speculative economy took up excess money supply Inflation & interest rates were low When securities markets froze up, paper had no clear value This made financial actors insolvent Money stopped moving

What happens next? Speculators continue to look for places to invest Investment in such markets does not create jobs Governments (UK) seek ways to reduce budget deficits They lay off large numbers of employees Consumption & wages are stagnant, so little growth Prices could begin to decline: deflation Even less consumer spending What is to be done?