Given that our physical infrastructure, human capital, and intellectual property were the same before the crash as after – what precisely was lost in the crash? Wasn’t productive capacity undamaged?
Why couldn’t the government in theory have simply hit a reset button and forced things back to normal operation?
It was mainly property values, which are by definition, speculative/relative, right?
People’s willingness to pay prices at a certain level. The only reason you have a house that’s worth $300,000 is because people (including you) have reason to believe somebody would pay that much for it. If nobody is willing to offer more than $150,000 for that house, that’s its new value and you just lost $150,000 in assets.
We lost many newspapers during this period. While news continued to be reported online, it was gathered by a shrinking number of investigative reporters and we’re all a little dumber for it.
Was our human capital the same before and after the crash? Lots of qualified workers (blue and white collar) lost their jobs during the recession and many never made it back. In fact, a significant number of individuals, especially those in the older age categories, never returned to the employment ranks.
Confidence.
You’re right - everything material was the same, before and during. What was lacking was people willing to spend money.
Look, a “good” economy is one where money is moving around. It doesn’t really matter where; homes, wages, government infrastructure - all move money from one place to another. Work is done, things bought, things produced. People are hired to make things, sell things, keep track of things.
In a recession/depression, people hunker down. They don’t buy houses, employers don’t hire and may lay workers off. What it takes to get out of the bad times is for someone to spend money in an environment where most folks are not, on a large scale.
Very good explanation. Very good.
Can I take a hyperbolic step forward?
It would seem that what we need to do then, is open all of our coastal cities open to drunken sailors from foreign navies. We can then take all of this $$$ we earn and funnel it into the interior 40+ states of this fine union…
There are as many answers to this as their are schools of economic thought (i.e. many), because what you are asking is in essence: what causes a recession?
I will give you an oversimplified version of the answer from two major schools of thought (which contradict each other):
“Animal spirits.” This viewpoint, often attributed to Keynes, suggests the recession occurs pretty much just because people freak out. They get afraid to spend money, for any number of reasons, whatever creates a mob mood. When they don’t spend money, products don’t move. When products don’t move, producers have to cut back on expenses, like wages. So wages fall, unemployment rises, and the people who were freaking out say See? I was right! and then people who were calm start to get worried – the effect snowballs and things get worse. The process only stops when people stop panicking, either because they tire themselves out, because the worst never materializes, or because government intervention reassures people.
“Delusions of wealth.” This viewpoint, often called the “Austrian school,” suggests the recession is actually the healthy response of the economy to the misallocation of capital that occured during a previous period of ebullience – the preceding boom. During a boom, when prices of assets (e.g. homes or stock) and investments (stock, business loans, mortgage loans, IPOs) are soaring, people get carelessly enthusiastic. They stop thinking about the fundamental value of the asset or probably return on the investment, and just take note of the soaring price. They assume they’ll make money not by some organic process of appreciation, e.g. the company producing something valuable, the highway being completed and improving the desirability of this property, et cetera, but just by finding someone later to sell the asset/investment to at a higher price. Usually called “the greater fool” model of investing: Sure, I may be a fool, but as long as I can sell this to a greater fool at a higher price, I win.
But sooner or later this party has to end, because you run out of greater fools, and the underlying assets or investments turn out not to be worth what’s invested in them. The capital that is invested in them is not performing – not creating any real value, and consequently not returning any real value. Worse, capital tied up in nonperforming bubble assets is not available to genuine investments that return real value. For example, every $1 invested in Twitter stock, assuming it will someday turn a profit, is unavailable to, say, some scruffy inventor who has an idea for a better solar cell. So…you get into a situation where real economic growth slackens or stalls, although the GDP may still soar on the basis of the increasing nominal value of these bogus investments, which hides the problem for a while, maybe quite a while. Nevertheless, usually at some point people wise up, and start pulling capital out of the nonperforming assets. When that happens, you quite naturally get a crash. The price of these bubbly assets implodes (i.e. real estate prices take a tumble, or the stock and bond prices fall, et cetera). This is often magnified by the fact that many people borrowed money to buy the assets in the first place – e.g. took out 3% down FHA loans to buy real estate, or borrowed on margin to buy stock. When the asset prices drops, these people get wiped out, which pushes the price further. You get a rapid disinvestment of capital, which starves businesses, particularly those that were bogus in the first place (Solyndra), and unemployment jumps up. The Austrians describes this as a necessary “creative destruction” in which all kinds of businesses that had no real justification for existing are destroyed, jobs which created less value than their salaries disappear, and profits and value that was purely paper and unjustified by the underlying economic reality vanish, turning loads of people poor – or perhaps making them suddenly realize they’re poor when they fantasized they were rich.
From this point of view, what’s “lost” in the recession is the delusion that things are going swimmingly according to some old stupid scheme, and what is gained is, hopefully, some measure of caution and wisdom about the next cycle of investment.
The two viewpoints lead to diametrically opposing prescriptions for action. The first suggest the government should, at all costs, try to restore the enthusiasm of the previous boomtime, because without the return of the “animal spirits” the economy will never recover. The second suggests this is the worst possible action of the government, because it prolongs – perhaps for years and years – the period of cold-water-in-the-face readjustment of perceptions to match reality. They say you can’t cure a hangover with “hair of the dog” (more booze).
The two schools debate passionately over the unusually long recessions, e.g. this one and the Great Depression. The first says the length is caused by timidity – the government fails to act vigorously enough to counter gloom and excess pessimism. The second says the length is caused by exactly the opposite, a lack of caution – by too much ill-advised meddling by government that drags out the necessary reallocation of jobs and capital.
For example, when real estate crashes, the first school suggests government should do something to prop up prices, e.g. lower interest rates on mortgage loans, allow people to refinance even when their equity is zero (or negative), subsidize purchases through low or zero money down loans, et cetera. This will restore confidence and the market will zoom back up again.
The second school says this is nuts. They say the problem is simply that the real estate is not worth what was paid for it, and you can’t escape that fact (or rather, the longer you persist in trying to escape that fact, the worse will be the final reckoning). They say the right thing to do is allow those who are going to lose their money to lose it as fast as possible, so that they can get on with their lives, readjust expectations, do something else to restore their fortunes, having written off dumb real estate investments one hopes. Meanwhile, the asset (a house) falls to a price that is actually reasonable, and someone who should be able to buy it (but couldn’t before because of its outrageous price) gets to buy it and this time will keep it, because it isn’t beyond his means.
Economics and social psychology being as murky ill-defined non-empirical subjects as they are, I don’t think any honest person not in the grips of ideology can say for sure certain which of these is closer to the truth, if indeed either is.
Over the last 7 years, prices have gone up slightly but wages for have been flat for people who aren’t in the top 1%. So for us in the 99%, purchasing power has gone down. Hence, the vast majority of people have less disposable income. If you own a business, that means your customers have less to spend and they’re more cautious about spending it on non-essentials.
Now, if your business caters to the top 1%, whose wealth has actually increased in the last 7 years, then maybe you have plenty of customers and everything is great. But that’s not enough to get the economy moving. A healthy middle class means customers with money, and customers with money is what creates jobs. The middle class is what’s been… well, I won’t say “destroyed” but certainly “damaged”.
Quick note - I am not an economist, nor even particularly well-read in the subject. I suspect Carl Pham is.
That said, I don’t see the two schools he mentions as being diametrically opposed, really. It does depend on the particulars of the economic downturn, and can morph from one school’s thought to another.
In the most recent Great Recession, for example. Housing prices went through the roof due to rampant speculation, well beyond the point of absurdity. So far, see the “Austrian School”. The bubble grew beyond sustainability, and some sort of correction was inevitable. The thing is, people realized things had gone too far, and the real estate market crumbled. The “animal spirits” of the time turned to stampede, as everybody got out - causing all the banks who held bad paper to suffer and some of them to fail. This fed on itself, until nobody was spending.
What’s to be done? Some of column A, some from B. The government steps in and announces the solvency of federal sources of funding, and props up some of the banks. In the meantime, the cost of housing drops somewhat nearer to sanity.
Again, I’m not an economist.
True. People need to realize that the distribution of wealth can be as important as the amount of wealth. As galen ubal noted, a healthy economy needs to have money moving around within it.
Producers need customers. And for a lot of products, there’s a maximum amount any individual customer will buy. So you’re generally better off having a hundred customers that can afford to buy one of your products then ten customers who can afford to buy ten of your products. To illustrate that point, imagine you own a pizzeria - nobody is likely to buy ten pizzas even if they can afford it. The same is true for DVD players, novels, and helicopters.
I assume you mean 2008.
Basically, our system runs on credit. People take out mortgages, car loans, use credit cards, etc. Businesses big and small run on lines of credit. Almost all businesses are ship now, bill at end of month. All that stuff on store shelves - bill is due in 30 or 60 days, but goods are there now. The overwhelming factor in all this is the trust that generally, 99% of these debts will be paid.
What happened was the bubble in real estate. People bought, and were lent mortgages, on the assumption that rising house values would allow them to make good on the mortgage, or sell at a profit if the monthly cost got too high. The money made was ploughed back into more housing and mortgages. People with oney to lend, thought “this is a good idea”, lent money at higher interest rates or mostly, bought mortgage bonds from people who had lent mortgages.
When people with mortgages started defaulting, it cascaded. The bonds were worthless, since the mortgages weren’t being paid. The banks that had put their depositors’ money into worthless bonds were closing, so people were losing their deposits (beyond the FDIC limit). This had cascade effects too, businesses that needed the bank’s line of credit to operate, couldn’t operate. If they looked for another bank to work with - the other banks didn’t have more money to lend, as their loan capacity was shrinking due to bad debts. People didn’t get paid, so they couldn’t pay loans either. With so many banks in trouble, who could trust the other bank? A cashier’s cheque drawn on A to pay a debt to bank B - would A have the hard cash to honor that? Should B take a cheque drawn on A? You pay your credit card at the bank - but does the bank have enough money to pass on to the credit card company, and hence the merchants? Because the bank has so many bad debts, it can’t make new car loans. Besides, if your employer maybe can’t pay you, At one point there were parking lots full of unsold Mercedes on both coasts; Detroit could not sell any cars because nobody could get a loan.
And so on…
This is what was lost in the recession - the trust that banks, people, and businesses generally were solvent enough to be given credit. If not for the pump priming of the Fed, the result would have been a cash-on-the-barrel society. That would have crashed the economy even harder than it did. What would your life be like if everything, including a car, had to be cash? Now imagine you can’t even trust the bank with those savings…
What happens in a large diversified economy such as the US is that there is a certain amount of money an economy needs to prosper. This amount changes constantly as circumstances change, people are constantly creating new money or taking money out of the economy when they take loans and create new things. When there is not enough money the price of money goes up. When the price of money goes up the price of everything else goes down. Labor is one of those things whose price goes down. Since wages can not go down easily because of psychology what happens is that instead of everyone losing 5% of their wages, the wages of 5% of the workers go to nothing. The economy as a whole slows down while resources are reallocated. Eventually either the proper amount of money is provided to the economy and people are hired or the economy adjusts to the new price level.
Let me just observe that the “Austrian school” has been predicting for the last 7 years that the US government credit would collapse, that interest rates and inflation would soar out of control. What has actually happened are very modest inflation and rock bottom, near zero, interest rates. Some prediction.
What the Austrian school cannot even retrodict is why the economy continued its flight into terrain when Hoover followed their prescription for 3 1/2 years after the 1929 collapse. Then things very slowly improved under the Keynsian medicine until Roosevelt put the screws on after the 1936 election and there was a second wave. Things didn’t really get better until the full steam ahead government spending to finance the war. After the war, high income tax rates (up to 91%) brought the accumulated debt down to a safer range and the economy boomed. Pure Keynsianism.
Others have offered good answers, but I’d like to add to them expected returns on investment. People thought they were buying securities which were low risk and would pay out X amount over the years to come. Many of these securities were worth little or nothing as the mortgages backing them failed, went into default and repossession.
Other people bought houses and other real estate thinking they would be able to sell it later for more than they bought it for. As the real estate market crashed, they were not able to.
Yet others bought stock in companies like Bear Stearns or AIG, believing it would rise in value, but wound up selling for just a few percent of what they paid for it. Bonds too, for that matter.
In general that’s the same as “loss of confidence” and some of the other answers above.
No government bailout was ever going to be large enough to keep the bubble of securities and real estate value higher than below the crisis. As it was, government bailouts to keep some banking and auto industries in operation and out of bankruptcy were a major political fight and the cause of anger that lingers on even now, 7 years later.
Two large automakers.
Carl Pham, that was a great restatement of the question and a great answer. If I can jump in on one tiny point. You seem to suggest that rising values of investments adds to GDP although you don’t actually say this. It’s not true that rising asset prices adds to GDP. GDP measures the output of the economy – goods and services produced. There is no increase to GDP if Twitter stock goes up in value, and there is no drop if it goes down because there is no new good or service.
As I’m sure you realize, there is some linkage between rising asset prices and GDP, and maybe that’s what you were really saying. GDP doesn’t increase because my home goes up in value. But, if homes in my neighborhood go up in value, a builder may see that he can make money buying up old, worn-out homes and building shiny new ones on the lots. This construction activity does add to GDP and “helps the economy.” Similarly, homeowners in my neighborhood may use their rising home values to get home equity loans and renovate. This adds to GDP too.
This construction and renovation stops if home prices fall and the builder can no longer build houses for less than he can sell them or the homeowner can no longer tap equity to finance renovations. That drop-off in activity contributes to the recession.
Similarly with Twitter, there is no GDP effect if Twitter stock goes up. But, when Twitter stock goes up, venture capital investors may look for similar companies to invest in. They may invest money in other venture-stage companies (like Snapchat) and allow that new company to hire employees and offer services that add to GDP. This source of job creation and GDP drops if stock prices fall and investors don’t want to put money into those kinds of companies anymore.
The OP has a huge hidden assumption in the word “normal.” “Normal” doesn’t exist, especially when applied to the value of things. Nothing has intrinsic value. Value is always relative to current conditions. To use some broad examples, the value of a stock is the consideration of the company’s future worth; that number may go wildly up or down based upon assumptions that may or may not be rational. The value of a house is the price at which somebody in the future might pay for it; that value may rise enormously in a Vegas suburb and fall precipitously in Detroit (at one time and do the reverse at another time). The value of human capital is what people will pay for its services; many doctors in Iraq who were forced out of the country wound up driving cabs in NYC because their English was poor.
Bubbles happen because people overestimate future value. When the bubble breaks, people underestimate future value. The Austrian school itself makes an assumption: that the market is rational and that bubble breaking can return to a rational valuation. That normally does not happen. It is irrational at the top and irrational at the bottom. It’s true, as Carl Pham says, that “businesses that had no real justification for existing are destroyed, jobs which created less value than their salaries disappear, and profits and value that was purely paper and unjustified by the underlying economic reality vanish.” It’s also true that good businesses are destroyed and so are valuable jobs. A flood can damage well-built buildings alongside shoddy ones.
The remedies for recession are not entirely clear. Time does heal: the stock markets is back to previous heights, joblessness is back to previous lows. But these are averages spread across the entire economy. The same companies do not have the same values; the same people do not have the same jobs, which may not exist exist. We are at normal, according to the OP, but that is illusory. There is no “normal.” Nobody could snap a finger and get us to here.
Government intervened in an attempt to make the process of the past seven years less painful to people who were not involved in creating the flood, considering that to be a superior alternative to doing nothing. That created inequities of its own. Some people, like the banks who allowed unqualified people to take out mortgages and the rating agencies which allowed the banks to sell these shoddy mortgages as if their were prime property, mostly had no real consequences, while some people, like those who were dependent on consumer spending, did suffer. Whether a better set of inequities could have happened we’ll never know.
But the answer to the OP on what was lost is “value.” You can’t assume it away. It is critical to any economy.
I think you could argue, as is implied by several posts above, that while, say, infrastructure is the same as it was, during the recession it was not upgraded in any significant ways, and what was “lost” was improvement. In the absence of funding or workers, streets, bridges and other aspects of infrastructure continued to deteriorate so that we are now waaaay behind in any upgrades, inhancements or improvements. I think that’s a loss.
Let’s take this a few more steps.
You have a house worth $300,000 and a mortgage for $275,000. Then something happens – you lose your job, have an unexpected expense, whatever. You can’t make your monthly mortgage payment.
So you decide to downsize to something more affordable. You put your house on the market. But surprise, no one will offer $300,000, or $275,000, or even $200,000, but the monthly payments keep coming due. You forfeit the house back to the lender and file bankruptcy.
Now your lender is stuck with a house they lent $275,000 on, and they can’t sell it for anything near that price, either. They cut back on new loans. And going bankrupt means you can’t pay your home improvement loan, or your car loan, or your credit cards, or your medical bills. So everyone who lent you money for those suffers as well.
Of course, you also can’t afford to buy new furniture or a TV or even new clothes. So all the companies who make… and sell… and finance those things don’t make money, either. The stronger businesses cut back, lay off employees, don’t give raises, don’t upgrade their equipment and hoard what cash they have. The weaker businesses fail altogether.
Now multiply that by a few thousand lenders and a few million consumers and you can see how everything snowballs.
[QUOTE=Robert163]
It would seem that what we need to do then, is open all of our coastal cities open to drunken sailors from foreign navies. We can then take all of this $$$ we earn and funnel it into the interior 40+ states of this fine union…
[/Quote]
Didn’t Greece try this?