We're not in a garden-variety recession, which is usually caused by a shortage of liquidity and is easily fixed by the central bank relaxing interest rates to circulate more money into the economy.
The economic crisis today is the result of a major collapse in the global financial system - specifically, the 'shadow banking' system that developed in the past couple of decades outside financial regulations and grew massive, on the order of many trillions of dollars.
Because investments in these 'shadow banking' institutions were unregulated, there was very little fiduciary oversight and firms made some very risky investments, e.g. in collateralized debt obligations on securities made up of blocks of subprime mortgages.
They were also very highly leveraged, which means every dollar invested was multiplied by 20 or 30 dollars borrowed; and their so-called insurance - credit default swaps, which are essentially bets on whether a mortgage-backed security will fail - was itself an unsustainable bubble of highly leveraged risk.
The whole edifice formed because neoliberal governments refused to extend financial regulations into this new sector, and it persisted as long as it did only as long as house prices, driven by a combination of strong sales from extremely low real interest rates and a general relaxation of fiduciary responsibility in mortgage lending, continued to rise.
Between the tremendous run-up in oil prices between 1999 and 2008 and the fact that by 2007/8, everyone who could remotely afford a house (and many who clearly could not) already had one, the mania was doomed to stall eventually.
Since real median incomes actually declined and nearly all the growth in the US economy during 2002-2007 was in home construction, automobile and furniture sales, and growth in private health care spending, there was no 'real' economy or savings to fall back on once the housing boom stalled.
The result was a perfect storm:
Rising foreclosure rates resulted in a glut of houses on the market, which depressed house prices further, made it harder for people whose incomes had stagnated to keep spending, and threw more people out of work. That, in turn, fed back into more foreclosures.
The turnaround was so fast and hard that the shadow banking institutions that had so much money invested in CDOs on subprime mortgages were shocked - SHOCKED - to discover that their investments were suddenly worthless, as panicked investors carried out what amounted to a bank run to extract their money before their investments became worthless.
(Again, with traditional banking regulation, banks are offered deposit insurance in exchange for regulation. With deposit insurance, people will no longer panic and rush to withdraw their money on the rumour of insolvency, thus creating a self-fulfilling prophecy. It creates a very strong measure of financial security and stability by preventing the panicked herd mentality of unregulated markets.)
Of course, since the funds were so highly leveraged, there was absolutely no way they could pay back their investors, and so they just collapsed spectacularly.
Since so much of the real economy was now financed through these shadow banking institutions, they destroyed trillions of dollars in real money, money that was no longer available to invest elsewhere. Outside of Canada, many legitimate, otherwise solvent institutions were brought down in the panic.
Investors were suddenly afraid to put their money anywhere, and financial institutions were afraid to extend capital to each other any more. This so-called credit crunch ground the rest of the economy to a halt, reversing GDP growth and forcing losses and layoffs in unrelated industries. That, of course, only fed back into the spiral of declining property values, falling consumer spending and investor panic.
The last hurrah was investors desperately throwing their money into commodities as a supposedly safe parking spot. Of course, the high and rising commodities values - particularly oil - were due to the sustained strong demand growth of the housing bubble - a growth that abruptly reversed in summer 2008 when oil prices skyrocketed to $147/barrel and then suddenly collapsed when the economy gave up the ghost.
Because the recession is caused by a general collapse in the financial sector - a collapse, I should point out here, that was preventable if only our governments had had the fortitude and good sense to extend the successful regulation of the banking sector to these new de facto banks - we're in serious danger now of falling into a liquidity trap, a situation in which interest rates are already so low that central banks can't lower them any more, yet investors still refuse to invest and instead keep their money parked in low-risk, short-term investments and bank accounts.
The problem with liquidity traps is that banks can't reduce the nominal interest rate to less than zero, so they can't reduce rates enough to trigger new spending.
Economists from Milton Friedman through John Maynard Keynes are broadly agreed that the way out of a liquidity trap is for the government to step in very aggressively and act as both the banker and builder of last resort, dumping money into infrastructure projects and giving loans directly to businesses.
Unfortunately, the lesson of Japan's liquidity trap since the early 1990s is that sometimes even this isn't enough to kickstart the economy. Paul Krugman makes an unconventional case that if banks can't reduce the nominal interest rate below zero, the answer is for the government to create an inflationary expectation to achieve a negative real interest rate. In other words, the central bank would need to abandon its normal policy of maintaining price stability (inflation in the 1-3 percent range) and deliberately try to raise the inflation rate significantly.
(Austrians, of course, take the stance that a liquidity trap is punishment for central bank policy and government interference in the free market. They recommend sitting back and letting the economy flush all those bad investments out of its system, somewhat akin to the way doctors used to bleed people when they had fevers.)
In summary, people are right to worry. No one knows if this will actually turn into a Depression (and anyone who tells you otherwise is just guessing), but we are definitely back in the realm of the economic forces that produced the Great Depression of 1929-39.
If we don't carefuly apply the lessons learned after early attempts to 'bleed out' the bad investments spectacularly failed, we may once again find our economy stuck in a long, downward spiral that normal macroeconomic policy can't seem to reverse.
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