How did we get here?

When rogues like these (a sparrow cries)
To honours and employments rise,
I court no favour, ask no place,
For such preferment is disgrace.


In the decade which precedes us we have experienced all the outward signs and embellished pronouncements which so readily accompany a sustained boom. The policy has been a success, the economic philosophy has led to greatness and the wizards of finance and the titans of business have brought us glory unknown to other nations. And as the proportion of our economies which was made up of financial services grew we were encouraged to exalt the genius of these markets, and as the average person fell deeper and deeper into debt we were encouraged to believe that gains in housing and employment would render this fact unimportant.

Yet the bankers are now charlatans, the financiers are greedy opportunists and the governments subject to an unpredictable once-in-a-century event, well, they are apparently victims though that is hard to believe and harder to accept. The economists have offered little remorse or change in tone. It is true after all that economists can be wrong every day, while most people who rely on them can barely survive doing it once.

We are now encouraged to believe that some bankers made some bad loans and as long as key businesses and banks are not allowed to fail, as long as dramatic bank runs and stock market crashes are averted this will all go away. The theory seems to be that if we remove all dangerous implements and calm the markets down everyone will realise that things are fine. The abiding belief that has sustained us for so long can be characterised precisely so-- things are fine, and if anything goes wrong it is only because people are irrationally worried.

This article is the first in a series that will attempt to examine the causes of this crisis, its roots in theory and in practice, and how we might expect it to continue in the next few years. The mess we find ourselves in is vast and complicated and only be investigating many different realms can we hope to crystalise the truth and understand properly how all the myrriad events going on around us are all connected, and what that will mean for the future. So let's begin:

Since August of last year the crisis has been known to most as the "credit crunch", underlining the common conception that the economic drama which has unfolded week by week on our television screens has been, in fact, all about banks lending money. So how did we get here, what happened in August of last year, whose fault is all of this? To understand the answer to these questions it will be necessary to delve into one of the two main branches of macroeconomic policy; monetary policy.

In any economy monetary policy is a set of tools governing what we call the money supply. The money supply is a composite of the cash in circulation, deposits in banks and credit in use and takes into account the rate at money is spent or saved in the economy. This is because the same pound or dollar or euro will be passed from person to person many times in the course of a year, and so may be involved in many purchases and sales. As the money supply increases there are more units of currency in the system and each one loses some value. This in turn determines the price level of all goods and services in the economy.


Prices are the way that the economy determines the relative value of different goods via supply and demand. If more people want oranges than apples they will be willing to pay more to compete with other people in order to get hold of the limited supply of oranges and this will increase the price. Conversely apple sellers will have to offer discounts in order to tempt people to buy their apples, which are less popular. The prices of each determine a ratio of value, perhaps for every 3 apples people buy 4 oranges are also sold. In theory the value of these goods should be about the supply and the demand for them, not about the size of the money supply. This is why prices, wages and other values are adjusted for inflation and is the basis of the concept that inflation does not automatically change the real economy as the real value of each good remains intact. However there are a number of violations of this rule which are important in this crisis.


Let's imagine you want to buy a house. The price of the house should reflect its relative value in terms of supply and demand right? Well, not necessarily. If you think back to the last housing boom during the years prior to 2007, many people bought houses expecting the value to go up with time and this affected their decision to buy. Indeed many people began to look on the value of their house as their retirement plan or savings on which they could draw. This meant people spent more and saved less. People believed that the value gain in their houses was money they could rely on. And as a result of that many people bought houses hoping to see a gain, and quite a few bought them in order to rent them out and sell later.


In summary, normally in a market as prices go up people are more willing to sell and less willing to buy. A house is worth a certain amount to each person, if the price is a lot lower it's a bargain, and if it's a lot higher it isn't worth it. Similarly if you can sell something for a lot more you'll be much more eager to part with it, than if noone is willing to pay much for it. If prices rise some buyers will drop out at the same time more people will be interested in selling and this will create a market surplus. In order to sell their products vendors will have to discount and this will return the price to the normal level.


However because of the built in inflation expectation as prices went up many people were more tempted to buy in order to make a profit, and some were simply willing to risk it because they didn't want to be left out. Many bought houses hoping to make a gain and this amplified the increase in prices. And this effect was not isolated to consumers . . .


In order to buy a house most people need a mortgage, and as the prices went up banks were willing to lend with smaller deposits. Their reasoning was that if the person defaulted the value of the house would have gone up and they would still get their money back. At the peak of the boom many groups predicted continued 10% price growth in real estate each year. This was high enough that banks allowed smaller and small deposits, and as a result more and more people were able to buy at higher prices than would have otherwise have been possible, and this too helped prices continue to increase.


All of this served to create what most now agree was a bubble; an unsustainable increase in price. Eventually houses became unaffordable no matter how much banks were willing to lend and the bubble burst. People started defaulting, prices started getting lower, people started getting worried and trying to sell and banks became more aware of the risks and started requiring higher deposits and more proof of income (and so stopped lending, making things worse). The 'bubble' went into reverse, and as more and more people tried to sell and fewer and fewer were able to buy there was a massive suplus of houses on the market, creating more and more downwards pressure on house prices.

And that is one part of the problem. There were two more.


The second part of the problem is that this scenario was not just unfolding in housing. Consumers were using credit cards and then remortgaging their houses to pay them off, consumption was high and borrowing was an essential part of life for many in the west. This got so bad that the US savings rate became negative for some time. And with all this extra money people went to starbucks, went shopping, bought a new car when they didn't really need to, and so on. And the companies in turn borrowed money so they could capture all this demand. Starbucks expanded and build dozens of new stories, new shopping centres were errected and . . . General Motors didn't go bankrupt for a few more years, and as a result they were able to keep hiring and paying people. All this hiring and spending kept the economy going and helped sustain the boom.

Unfortunately that demand was based on credit, and when the housing bust began and employment started to shrink the consumer stopped spending money. Many people could no longer afford to go to starbucks on a whim, or go on a shopping spree, and they decided to buy reliable efficient cars and hold on to their old ones longer. The firms who had borrowed all this money in order to expand suddenly suffered a massive loss of business and started firing people. And those people having lost their jobs spent even less money. And so it went. Starbucks closed dozens of stores, shopping centres deteriorated and GM, well, it had to happen sooner or later.


The third part of the story is perhaps the one we've all seen play out the most dramatically. The financial system was overflowing with cash. The banks had borrowed money so as to lend it, the corporations has borrowed money so as to expand and the government had borrowed money . . well, out of a complete lack of fiscal discipline. And all of this money had to go somewhere. In investments there is an overall balance which exists. If stocks become a more attractive investment people take money out of bonds, and because of the way bonds work this increases their yield. Similarly as more people buy shares their price goes up and the ratio between their value and their price changes. As more and more money was flooded into investments shares became overpriced and bond yields became very low. In combination with an extremely ineffective rating system this led to more and more investment in riskier investments. The reason for this is because the higher the risk the higher a firm has to pay in order to get people to lend them money, same as anyone else. As yields went down investors started becoming more and more willing to risk money which they had borrowed cheaply from elsewhere.


The most famous debt of this type was based on complex financial manipulation of subprime mortgage debt, the so-called dodgy debts. These debts were viewed as safer than normal by the banks for two reasons: a) as already stated increasing prices insulated them from the risk of default, b) they were able to sell the debt to investors who were looking for a profit. As we all know by now they were not safe nor insulated and as prices went down the risk of holding or buying those debts went up rapidly, banks were desperate to sell them but noone wanted to buy them. Many people stopped being willing to lend to banks on a short term basis and this led to the commercial paper crisis which started the famed credit crunch. Banks wanted to build up savings so they could afford to survive the losses from their defaults so they stopped lending, and other people reacted the same way and stopped lending to the banks. Many groups-- such as northern rock-- who were reliant on that borrowed money and rapidly went from making large profits toward severe risk of bankruptcy.