What was the cause of the great recession
that started in 2008?
Some blame it all on greedy wall street bankers
and some on sub prime mortgage lenders.
Other's say it's what Canes called, animal
spirits.
What is clear is that the trigger for the
recession was the boom, and eventual bust,
of the housing market.
What caused this bust?
Why did so many home builders get it wrong
at the same time all across the country.
A simple answer, is that the home builders
responded to a false price signal in the economy.
That false signal was the interest rate, set
artificially low by the Federal Reserve.
The Federal Reserve began lowering interest
rates from 6.5% in late 2000, all the way
down to 1% in November of 2003, and held it
there until June of 2004.
These artificially low interest rates encouraged
consumers to buy houses and builders to produce
more houses.
However, the low interest rate was not an
accurate reflection of the true demand for
the houses in the market place.
At the same time, Congress amended the Community
Reinvestment Act, encouraging banks to offer
mortgages to lower income borrowers who would
ordinary not qualify for a loan.
In addition, the Federal Government required
Fannie Mai and Freddy Mac, the two now infamous
government sponsored lenders, to provide over
half their mortgages to low-income buyers.
These are known as the sub prime mortgages.
Essentially, this meant that banks and other
mortgage lenders were to told to relax there
lending standards, and provide mortgages to
people who couldn't really afford them.
Then, in July of 2004 the Fed began to increase
interest rates to counter the growing inflation.
By May of 2006, the higher interest rates
began to cause housing prices to fall.
Millions of homeowners soon found that they
owed more on their mortgages than their homes
were worth.
This led to a wave of foreclosures and defaults,
further depressing housing prices, and shrinking
the capital of financial institutions, who's
mortgage backed securities were now worth
much less.
This is all made much worst by a 2007 change
in the Federal accounting standards, which
required that these institutions write down
losses before they occur.
This is called Mark to Market Accounting.
This drastically reduced the capital of these
financial institutions and led to the collapse
of investments banks, such as Lehman Brothers.
The best analyses of the great recession,
focusing on the unattended consequences of
government intervention, is the Austrian Business
Cycle theory.
As developed by such economist's as Wudon
Framesi and Friedrich Hayek.
If you would like to know more about Austrian
Business Cycle theory, and this explanation
of this great recession, watch Lecture Number
9 of ECON 101.
