Just about anybody could answer this question now, but do you understand the why and if this is different than previous recessions or depressions? The following research will lay out answers, in simple terms, to several different questions you may have such as; What has happened to the economy and why are so many people losing jobs; Why have home prices and the housing market dropped so low; Why were gas prices so high before and so low now; What is going on with the stock market; What is going to happen to the economy and when will the economy recover?
Keep in mind the following explanations are not full explanations, as there are so many factors involved in what is happening now that it would be nearly impossible to list them all here, rather I will focus on some of the major issues.
In order to answer what has happened to the economy and before we get more specific, we need to get a basic understanding of the nature of economies in general. This paragraph will help lay the grounds for a discussion that will focus on what is happening in the US and how it affects the world economy.
The US is a country, like many other industrial powers, with money being ultimately governed through a central bank. The central banks, like the Federal Reserve in the US, govern monetary policy, meaning they are responsible for maintaining the money supply among various other duties like setting interest rates. Think of the central bank as the parent of all the banks in the country, whether they are private or public, the banks follow the lead of their parent in setting rates. The parent sets the guidelines, but that does not mean their children always follow them, as in many cases they are free to act on their own within the rules of the law. The Federal Reserve in the US, a private institution, acts as a financial representative of the lawmakers.
Having provided this background, hopefully you can see already where the problems may arise in this system. That’s not to say you won’t have these same problems or worse using some other sort of monetary policy, however, this conversation is focused on our US and global Economy and what has happened to it as a result of central banks, and poor lending practices. Two possible things of many that could cause issues with a central bank would be the fact that they can create pricing bubbles based upon their lending rates to banks, and the banks could in turn create lending schemes that may lead to their own demise. Naturally, this system creates booms and busts, because of the nature of supply and demand.
Think of a bubble as an artificial increase in prices due to increased demand. Everyone and their brother wanted to buy a house in the late 90’s and up until the mid 2000’s, because lending practices were so lackadaisical. When everyone was competing to buy the same houses, something had to give, and that was price. Prices were driven up to unreasonable levels, considering most of the people buying the houses wouldn’t be able to maintain payments, thus they wouldn’t be able to keep the value of the houses so high. The good guys that were qualified to make payments severely overpaid too, because truly non-qualified buyers were able to spend money on credit they didn’t have to payback or couldn’t afford when their adjustable rate mortgages ballooned. Basically, there was a bunch of people banking on the price continuing to rise, when at some point the collapse was inevitable.
For example, recently lending practices have came back in line with being more reasonable, as it was determined previous lending practices were leading to too many defaults and banks were paying the price when their customers couldn’t pay their bills.
So, maybe you can start to see where I’m going with this; We we’re living at unmaintainable levels in the past with regards to housing, jobs, etc. Now, when this housing bubble popped, and prices had to come back down to more reasonable levels, reasonable people could afford, it sent a ripple affect throughout the entire economy. Suddenly, large banks were deemed grossly overvalued, and their stocks plummeted. The stock market was over 14,000 at its all time high in October of 2007. Soon after all hell would break loose as fear gripped investors and they began to perpetuate the problem by pulling their money out of companies and investing in the government. Most of these people had legitimate fears, however, they only compounded the problem by pulling their money out. As you’ve seen, companies that no longer have capital to invest in their companies, will stop creating additional work, and will be forced to downsize to accommodate their new forced direction. This truly has a downward spiral affect similar to an exaggerated boom, the difference being the economy shrinks back disproportionately.
Instead of smoother cycles in the economy, we see massive spikes in both directions until the economy stabilizes and people start putting their money back in to the markets – allowing capital spending to continue in companies and jobs to be created once again.
The cost of gasoline/oil in the US saw a similar bubble, where expectations on demand were unreasonable, and speculators bid the price up to unmaintainable levels. When reality set in, in under 6 months the price had dropped by 2/3.
Currently, the market is so shaky in part simply because people are not spending because of fear, not investing because of fear, and they are creating their own mess. Eventually, people will come back to their senses when sentiment turns around, and the market will once again explode and shoot up to levels it won’t be able to maintain, to drop once again. In order to be a good investor, you need to recognize the signs that the market is turning one way or another.
If history is any indicator this economy will recover by the end of 2009 or shortly thereafter. Do your part and spread knowledge to combat these irrational fears and help your portfolio get back on track. Check out more of my articles to help you understand this sometimes complicated world of accounting and finance.