Cause of Great Recession?

This post is the second of a series covering an event that is going to strike the world economy over the next year or so. Inflation and deflation was the first posting in this series giving a definition of several economic terms for readers. Now, I am going to discuss what is the root cause of our current economic issues often referred to as the Great Recession. The link gives the Wikipedia explanation to our protracted downturn, but, I would not put too much faith in the details. The basic reason why our economy is having problems comes from excessive amounts of debt.

Debt is the result of credit. It is the lifeblood of an economy. Businesses are able to open and expand quickly with access to capital through credit. Consumers can purchase big ticket items such as homes or cars. These two examples would take years for most people to save enough money to execute these tasks without credit. In most cases, it would never be done. Credit expansion is good as long as it is limited to the point debtors can pay back their creditors. It becomes a problem when the debts are NOT paid back. We all know of the family who buys an enormous house, several vehicles and other items they can not afford. We never talk about the creditors taking back possessions.

Reading over several sources, the accumulated private and public debt of the USA is on the order of $54 to $59 trillion. Yes, that is a "t". In comparison, the gross domestic product (annual economic output) of the US is on the order of $14.5 trillion. We may ask, in what forms are the debt? I do not have an exact breakdown, but the main sources are:

• Federal, state and local government
• Housing
• Automobile
• Corporations
• Student loans
• Credit card.

This list is not exhaustive, but covers the biggest categories. Most are familiar with mortgages, auto loans, student loans and credit cards. The debt not familiar to most people are bonds. BondsIOUs issued by either governments or corporations to borrow money.

The government accumulation of debt is obvious. Taxes were cut over the last couple of decades as no one wants to pay while politicians refused to cut spending. Governments issued massive amounts of bonds to keep the social spending going. Debt was accumulated to keep people happy. The amount of debt issued by governments before 2007 was not that significant though. It does contribute to the overall problem now as the amount grows quickly. We will discuss this in the next installment why.

Large amounts of private debt is much more a problem. If everyone (businesses included) spend a significant amount of their earnings on repaying debt, there is not much left over to purchase new items or the demand within an economy decreases. In effect, the money was already spent on items consumer already own or past events. It becomes an even bigger issue if consumers can not keep up payments and default on the debt. This would limit the ability of an economy to grow. The US economy is based upon ~70 % consumer spending by the simple fact that we are not longer a major manufacturer. If consumer spending decreases, the economy contracts and the result is a recession. During normal economic cycles, this occurs every ~8.5 years or so which can be expected. Normal recessions last 6 to 9 months typically with a turn around caused by credit/economic growth.

The Great Recession is different. The number of jobs have not returned with the official unemployment rate U3 at ~9.6 % and true unemployment U6 is at 16.5 %. In a nut shell, U6 is all of the people who want to work but cannot find full time employment. 1 in 6 currently fit into this category folks! This is not your daddy's recession. It all comes back to excessive amounts of debt.

How did we accumulate this amount of debt? It has to due with a new financial innovation that began to appear in the '90s known as securitization. I will simplify this complex phenomenon for laymen. Securitization is the process in which banks take loans on their balance sheets and place them into new structured securities. These new securities are then sold to other investors who make money off of the payments from within the investment vehicles. Banks then remove the loans and risk from their balance sheets. The risk is passed onto the investors within the securities. The result is banks passed on loan default risk to others while in the past banks held onto the loan portfolio (risk). Final results of these new instruments were a credit explosion since the banks had greater incentives to make risky loans. Too much debt was then accumulated over a small time frame outpacing the economic realities underlying the loans.

Next post we will talk about where this is going to lead us.