Why we’re in a recession

INTRODUCTION

The world finds itself in the midst of the Great Recession that came to full fruition in September 2008 with the collapse of Lehman Brothers. Many have asked this simple question – “how can this have happened?”

So why are we in this mess? Before proceeding with my explanation, I modestly offer to the reader my personal economic theorem:

“A free market economy is a theoretical construct that only works if, and only if all of the players in the economy are both honest and competent. Both elements must be present for an economy to function properly. As this ideal is impossible to achieve, an economy will habitually require government intervention.”

Let’s examine this statement in detail.

The Players

So who are the players in a modern economy? For the purposes of analyzing the financial sector that brought us into this mess, they consist of:

  • Lenders
  • Borrowers
  • Government

I assert that the financial crisis is a result of the following:

  • both individual Borrowers and institutional Lenders were incompetent (i.e., did not possess the intelligence or information required to make sound economic decisions); and
  • Government did not adequately intervene to implement controls (i.e., regulation) to offset potentially bad decisions made due to the incompetence of both groups.

Competence

Let’s examine the situation of the individual Borrower first. The average consumer in the U.S., the U.K. and the E.U. lacked the basic financial literacy required to make sound financial decisions with respect to obtaining credit. Had these consumers been educated through a mandatory curriculum of personal financial management in a public education system, we wouldn’t have seen the ridiculous run up of rampant overspending and overborrowing we’ve witnessed over the past decade.

Now, as any banker will tell you, how much you can borrow is determined by your income. Average per capita income has stagnated in most industrialized countries due to globalization. Many jobs that used to be in the manufacturing and service sectors of the industrialized nations have gone to regions such as China, India and Eastern Europe where labour is less expensive. Therefore, although banks are willing to lend you money initially, there will ultimately be a limit to how much you can borrow. Your income isn’t going up, and neither will your credit limit. So when you hit that ceiling, you’ll no longer be able to spend like you did before.

Now, imagine this scenario being played out for all of the 300 million Americans that have been driving the global economy during this past decade. During 2007 and 2008, each one of those American consumers became tapped out because they could no longer borrow any more money – each one of them had reached their credit limit. Consequently, they can no longer buy things, like homes for instance. The basic law of supply and demand states that as demand drops for a commodity, so does its price.

This is pretty much what happened to the American housing market starting in 2007, which led to a precipitous fall in the value of homes. Lenders were therefore hit with a double whammy: (a) the security for their mortgage loans dropped in value; and (b) their customers could no longer refinance their mortgages or service their mortgage payments. Consequently, the mortgages on the books of the institutional Lenders (and the financial derivatives created therefrom, purchased by institutional investors throughout the industrialized world) became almost worthless, leading to huge asset write-downs in their books, thus leading to the insolvency of many banks and other financial institutions throughout the industrialized world.

This leads me to discuss the role of the Lenders. The preceding analysis is based on common sense and could have easily been predicted, and should have been predicted, by anyone with the ability to think logically.

The fact that this scenario played out and caught the institutional Lenders by surprise demonstrates how incredibly incompetent the leaders of these institutions were. We have witnessed the consequences of their incompetence, with the bankruptcy of Lehman Brothers and Countrywide Financial and the U.S. Government bailout of AIG and other financial institutions. Had the U.S. Federal Reserve and Treasury Department not intervened (as well as their counterparts in the U.K. and Europe), things would have gotten considerably much worse.

Honesty

The lead up to the U.S. housing crisis was made much worse because of the dishonesty of many Borrowers and the mortgage brokers who facilitated the loans, particularly in the U.S. sub -prime market. By now, we’ve heard stories of people getting mortgages with no proof of income or assets (“Ninja” loans, meaning No Income No Job or Assets). My view is that the housing crisis and subsequent financial meltdown resulting therefrom would have been much less severe if Government regulations required Borrowers and mortgage brokers to document proof of income and assets before proceeding with a mortgage loan.

CONCLUSION

So long as modern economies consist of imperfect human beings, a truly free market economy with no government regulation or intervention can never work. It is inevitable that people will occasionally succumb to the fallacies of dishonesty and ignorance, which would lead to imperfect outcomes in a truly free market economy. We have seen the results of this in events leading up to the Great Recession of 2008.

Until human evolution brings us to a level where people are unable to act deceitfully and are able to make perfect decisions all of the time, government will unfortunately be required to play a role in our economy.

© Copyright Fong and Partners Inc 2010.

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