How the credit crisis is effecting the broad economy

This is the second part of my previous post on the coming recession. This offers an explanation of some of the the mechanics of the problem.

Why is the mortgage crisis such a major threat to the economy? How many people have bought homes with risky mortgages anyway? What about all the people who haven't moved and aren't speculators trying to turn a fast buck on the housing bubble?

Unfortunately, the mortgage lenders made lots of money just for selling new mortgages. There was a major push to get people who already owned their home free and clear to refinance. Read that article. So the problem is a lot more widespread than appears obvious.

The next question is, can't the economy deal with a set of isolated credit failures in the mortgage market? Read this article to see what a run-on-the-bank (or in this case, the investment fund) means. Counties in Florida are pulling their money out of the state investment fund for fear that it will go under and they will lose their total investment. But to pay back the investing counties what they had in the fund, the fund is having to sell its own investments, even if they are currently losing money but are expected to later recover. So the institutions the fund had invested in face the same withdrawal problem as the fund that is having to repay its investors.

So the total amount of money invested is literally shrinking as nervous investors pull their investments out in order to protect their money. The institutions that are having to pay back investors become more shaky, causing more investors to withdraw their investments to avoid loss of money. Some of those institutions will not be able to repay all their investors at once and will become insolvent. Anyone still having funds invested in those institutions will then lose that money.

If only a few institutions become insolvent at once, it is possible to sell the good investments they had to other institutions and repay the original investors who want to withdraw their money. But if a lot go bad all at once, there is no one to help bail out the failing institutions and a lot of money gets lost. Wealth literally disappears, because it cannot be converted to cash fast enough.

That's the danger the U.S. may face next year. The Federal Reserve may put extra money into the economy, but that is an inflationary action. So the risk for the economy is a worse recession versus stagflation.

Again, I am not predicting that this will happen. I am just describing a very possible scenario that could well accompany the recession we all now know is coming.