Consumption drops because of recession; How did we get here?

The current status of the economy

The current economic problems were caused when the banks were caught lending to customers who couldn't pay. The result was that banks have lots large amounts of money, many have failed and more will fail. But the financial sector is beginning to figure out how much trouble they are in and how to deal with it. Unfortunately, to get this far they stopped almost all lending.

Since the economy depended on consumers to buy goods and services, but at the same time families have not had an increase in real income since 1970, the only way consumers have been able to buy is by (1) spending savings or (2) home equity, or by (3) borrowing money. Savings disappeared decades ago, and the housing bust that created the financial crisis also stopped most home equity loans. The money simply isn't there to spend. Then the banks lost so much money as the housing bust swept through them they stopped lending, both to consumers and the producers.

Producers have bought fewer goods to stock for Christmas because the banks have not been lending. At the same time, the businesses have not increased hiring for Christmas as much as usual. This, combined with the layoffs that have been constant all of 2008 have reduced consumer income sharply, so they have decided to do what sensible people do when money is short and the possibility of lay-offs is high. They have decided not to consume as much. Here is the latest report on consumer activity:

The panic on Wall Street has eased in the last few weeks, and banks have become somewhat more willing to make loans. But in those same few weeks, American households appear to have fallen into their own defensive crouch.

Suddenly, our consumer society is doing a lot less consuming. The numbers are pretty incredible. Sales of new vehicles have dropped 32 percent in the third quarter. Consumer spending appears likely to fall next year for the first time since 1980 and perhaps by the largest amount since 1942.

With Wall Street edging back from the brink, this crisis of consumer confidence has become the No. 1 short-term issue for the economy. Nobody doubts that families need to start saving more than they saved over the last two decades. But if they change their behavior too quickly, it could be very painful.

Let's not forget that anticipated consumption is what drives investment spending. Consumption is the key to total Gross Domestic Product.

Right now the banks don't anticipate an increase in consumption, so they want to hold on to the money given them by the Bush administration in the bail-out plan instead of lending it out. See the paradox in that behavior? In an economy in which the only source of money for consumers to spend is borrowing, the banks fear reduced consumption so they don't want to lend.

The lack of bank lending leads to less money for producers to operate their business, including hiring workers, so they cut back on employment. Consumers either being laid off or seeing those around them laid off want to save money instead of spending it, and at the same time the banks are cutting back on lending so there is less money to be borrowed for spending.

Every individual and organization in that economic system is doing what seems safest for them in a time of high uncertainty, and the result is that the overall economy is getting worse faster than before. Since the economy is getting worse, everyone is doing more of what makes it get worse.

How did we reach this point?

Welcome to the free market with unregulated financial institutions. Four key factors which led to this are

1. No increase in worker real wage since 1970 - Workers have been increasing productivity more than anywhere else in the world, leading to fewer workers producing more goods and services. But the increased profits from that increased productivity have flowed to a few very wealthy families instead of being shared by the workers to create the goods and services. The wealthy invest the money they don't need to live on, so consumption suffers. Consumption - the key to the economy - can only be pumped up by lending money to spend or by creating bubbles to create fake wealth that consumers can spend.


2. Unrealistically low interest rate creating financial bubbles - Low The Federal Reserve under Alan Greenspan and the bankers lowered interest rates to the level of inflation in order to keep the economy going. That happened first to create the Dot Com boom, and then after Bush was elected Greenspan again lowered interest rates to create the Housing boom. Consumer lending was also pushed up by the deluge of credit cards the banks have been pushing onto anyone who would take them for two decades now. Greenspan also encourages banks to create "innovative" new lending products to reach new potential consumers and get them buying homes and consumer goods.
   • New ways to transfer risk - A part of the innovative financial products included insurance instruments such as Credit Default Swaps (CDS). By buying a CDS the investor who bought part of a bundle of loans was able to transfer the risk of default to the seller of the CDS. However, the lack of regulation meant that anyone with a good name could buy the risk of default - that is, sell a CDS. AIG sold a lot of them, and the investors assumed that AIG was so big that if they had to pay off, they would be able to. Had CDS been a regulated insurance product, the seller would have been required to hold reserves in case they had to pay off a whole lot of them at once. CDS were specifically designed to avoid being regulated as insurance. That's why they were called "swaps" instead of default insurance. AIG sold so many CDS and held no reserves to back them that it has caused the collapse of AIG as they find they cannot pay off all the defaults they have insured.


3. Lack of regulation of bank lending and borrowing processes - Based on the erroneous assumption that banks would lend carefully and protect themselves from default, Alan Greenspan refused to regulate the sloppy mortgage lending practices during the housing bubble, while the banks, enamored with the higher fees available with newer financial products such as Adjustable Rate Mortgages and subprime mortgages, were ready to lend to anyone with a pulse who could sign their name. The individuals actually originating the mortgages got the fee up front, the banks did so also, and the loans were packaged anonymously in great bundles to be sold to investors.
   
   The investors represented very wealthy individuals and pension plans. The wealthy individuals were given lower taxes so that the money they were getting from increased labor productivity created a massive market for these bundles of mortgages created with the new types of lending. The rating agencies only got paid for saying the bundles of mortgages were top financial grade, so everyone was happy as long as home prices went up. Naturally the rating agencies, paid to say the investments were high quality, did not bother to spend the time and money required to learn what the real underlying risks involved were, and there was no government regulator with responsibility for oversight of the process except possibly the Federal Reserve, who did not do so because the ideology of market fundamentalism says such investigations by government are both unnecessary and a burden on banks and investors. Of course, the entire market depended on interest rates which were too low to continue rising.
   
   Immediately after Bush was reelected in 2004 Alan Greenspan and the Fed started raising interest rates. They increased interest rates a quarter percentage point per month for 17 months, killing the housing bubble - which Greenspan had said did not exist. The collapse of the housing bubble then place great strain on the investment banks which were buying and selling the bundles of mortgages as well as bundles of other kinds of debt.


4. The collapse of the over-leveraged investment banks - A major aspect of the deregulation was to stop regulating the amount of leveraging investment banks did in order to buy bundles of loans and mortgage loans. The less of its own money a bank uses to buy an investment, the greater the profit possible - but the reverse is also true. If instead of paying more than the borrowed money costs, the investment pays less, the leverage will make the losses greater. When an investment defaults and can no longer pay back the amount invested, the leverage multiplies the loss by the degree of leverage. Bear Stearnes was leveraged at a rate of 30 to 1 when it collapsed, as were the other investments banks which have since disappeared.
   
   Under regulated banking depository banks which took in government insured deposits could not use leverage beyond the conservative level the regulators permitted. During booms this cuts into banking profits by limiting leverages profits, but during busts it prevents the bank from going broke because of leveraged losses.
   
   A major intent of the Glass-Steagall Act passed in 1933 had been to prevent depository banks whose funds were based on government insured deposits from accepting the risk of high leverage ratios. When the government insures deposits, the bank could then leverage the investments it takes on, sharply increasing profits but also sharply increasing the risk of failure. The bankers then keep the profits when the investments succeed, but pass the losses that result from failure off to the tax payers who have to pay off the insured deposits the banks lost in bad leveraged loans.
   
   When Senator Phil Gramm, then Chairman of the Senate Banking Committee, passed the Gramm-Leach-Bliley Act in 1999 the depository banks were allowed to buy or merge with unregulated investment banks. This permitted the depository banks to take on the much greater risks involved in high leverage ratios. Note that the repeal of Glass-Steagall was a party line Republican vote. Here is what Wikipedia says about passage of the Gramm-Leach-Bliley Act. It was passed

   ...on a party-line vote of 54 (53 Republicans and 1 Democrat) to 44 (all Democrats) and on a 343-86 vote in a different form in the House of Representatives, before being resolved by a joint conference committee; the conference report was approved by both houses of Congress (Senate: 90-8-1, House: 362-57-15) and signed by President Bill Clinton

The Primary cause of the recession is the conservative market fundamentalist ideology

Market fundamentalism is the faith-based belief that markets themselves can maintain a stable economy and do best in an environment of deregulation by a small government. The small government should not tax to provide more than minimal government services.

Unfortunately, market fundamentalism is wrong. Economic markets and the economy they facilitate do not work reliably without appropriate government regulation. The idea that unregulated markets can create and maintain a modern economy has been repeatedly demonstrated to be false.

Here's what the Reagan Revolution has done to the American economy to lead to the current economic downturn. First The Reagan administration worked to destroy effective unions, which resulted in shifting of all profits from increased worker productivity to the wealthy, Second the conservatives restructured the economy to promote the removal of risk from large corporations and acted to pass it on to consumers and workers. Third conservatives manipulated the economy by lowering interest rates to where we have a series of booms and busts. This was the cause of both the Dot Com bubble and the Housing Bubble.Fourth conservatives happily exported higher paying middle class production jobs to lower cost labor areas as though the only cost under control of managers was labor. They also encouraged the growth of financial jobs to replace them. This has resulted in hollowing out the American economy in much the same way as the British economy was hollowed out - financialized - in the late 19th century. Finally The conservatives have spent three decades deregulating the financial economy so that the lending processes themselves are no longer reliable; they have also encouraged banks to take on too much risk by permitting extreme levels of leverage. All of these practices were recognized as highly economically dangerous in the 1930's and were regulated against to prevent another Great Depression. Profit-seeking conservatives who were not even alive during the 1930's considered such dangers nonexistent and skirted the regulations before finally removing them entirely in the name of their market fundamentalism ideology.

Additional problems have been caused the new and "innovative" financial products which transfer risk from the original lender so that it appears that investors can receive high returns of the type associated with high risk investments while someone else bears the risk of default. But the investors cannot be entirely blamed for this. They have found it necessary to search for alternative higher rate-of-return investments because the Federal Reserve has been holding interest rates at levels so low that investors could get little return above the rate of inflation. A related problem is that there are larger sums of money to be invested, since the profits from increased worker productivity have been being siphoned off into investment funds instead paid to workers who would use them for consumption. Greater sums of investment money required the investors to compete with each other for secure high-return investments. This also created the market for new "innovative" financial instruments. Those "innovative" financial instruments could be sold as secure high-return investments because no one really knew how much risk they included. They had never been tested in declining markets. The sale of derivatives to transfer risk simply added to the general ignorance of what risk the investors were taking because no one really knows who bears the risk. Shifting the risk to the seller of CDS adds to the possibility of the risk of failure of the seller of the CDS to the risk of default on the original loans in the loan packages the investor buys.

As the Bush/Paulson bail-out plan has demonstrated, that unknown financial risk has been ultimately been borne by the American taxpayers. The resulting weakened unstable economy has created the current truly nasty recession we are entering, a recession which will be borne by all of us.

This isn't all of the problems that brought us into the harshest recession since the Great Depression, but is it a lot of them. The shift of the risk of bad health onto the individual instead of considering health care a human right is another problem with many economic consequences, one caused by conservative ideology and its refusal to permit the only institution large enough to deal with the health care crisis - government - to do so. Another major problem is the escalating price of education and the strange way society makes students bear the total cost of their own education through loans that now frequently last a lifetime. This discussion is a fast description of where we are right now and the reason why consumers have stopped much of their consumption. The consumers are individually acting very reasonably, but the pull-back on consumption will rapidly make the economic downturn worse.

That's a thumbnail description of why economy is headed down right now. There is no way of telling where or when the bottom will be. The only institution large enough to possibly deal with the current economic downturn is government, and no one in government or out of it knows what is going to happen next or what to do about it.

The next two or more years are going to be a rough ride for a lot of people in America and around the world. The conservative ideology of free market fundamentalism is directly responsible for most of the problem.