Recession 2008

What exactly caused the current economic recession? It was not a single incident or a specific action by any one regulatory body. Instead it was a sequence of events that triggered the economic downfall. Let us start with Sept 11, 2001.

1. US was attacked by terrorists on Sept 11, 2001. This was a serious blow not only to US but also to the world economy. In the US, the stock markets remained closed for the next 6 days after the attack. There was huge uncertainty spreading across the globe. People everywhere put a break on their discretionary spending. Businesses investment slowed dramatically.
2. The central banks of the world decided to act with the most powerful tool that they have in their belt. They reduced the interest rates. In US the rate was reduced all the way to zero. This made borrowing easier for businesses and consumers. Slowly money started flowing to lenders and then to consumers triggering a consumption based economic growth across the developed nations.
3. During the same time, Chinese and other Asian economies experienced very impressive real growth, mainly due to increased demand for products from US and other developed countries. Also globalization allowed companies in developed countries to move their manufacturing and service jobs to lower cost countries. This gave great opportunities for countries like China and India. The saving rate in these countries started to move up.
4. However the governments and entrepreneurs of these developing nations did not have much faith in their local currencies. The only stable investments that they could think of were the currencies and treasury notes of the developed countries. More and more money started flooding into US and European countries.
5. With more money coming in the governments and people of the developed countries consumed more and more on credit. Their economies seemed to grow mainly driven by higher consumption (It is true to some extend that the Chinese were funding Americans to buy Chinese goods...)
6. This would have been the time when the central banks of the world needed to act again and tighten the money flow by increasing the interest rate. This did not happen this time. In America, the Fed under Greenspan decided not to end the party in the middle of a presidential election and two wars.
7. With free money all around, the banks started devising new ways to utilize them and maximize their profit. They soon found ways to lend money to anybody, however bad their credit history, and still make a lot of money. They discovered CDO, a credit default swaps, where by lenders can package a loan and sell it to investors. This allowed them to pocket the profit the same time they wrote the loan.
8. The CDOs were promoted everywhere as the low risk investment. Many of the businesses including the investment banks like Lehman invested heavily in these CDOs.
9. The New Bush administration considered financial regulations as an intrusion to economic progress and decided against introducing any regulations against all these new mortgage backed securities. They believed the banks and Wall Street would regulate themselves and do the right thing. They also promoted home ownerships among minorities and low income families. Demand for homes started to outstrip the supply. Everybody saw their home prices shooting off the roof. Soon US and other parts of the world were in a clear housing bubble.
10. Like all bubbles, the housing bubble had to break. People realized such high home prices can not be sustained on a weak economic foundation. Soon the market value of the houses in many parts of the country started to fall below their loan amount. These home owners had no other alternatives but to walk away leaving the home keys with their lenders. As a result the CDOs started losing their value and whoever held it started realizing the risk associated. The mad rush to the gate began.
11. Major banks like Lehman had to write off a large part of their assets held in CDOs as worthless assets which eventually resulted in their crash. Many other banks who      held on to sub prime loans in their books also were in big troubles. Banks in US and other countries started to fail. Lending slowed. Credit for consumers and even businesses became difficult to come through. This resulted in the chain reaction of business cutting payroll, reduced consumer confidence, lower spending, and finally shrinking the overall economy.

Now is recession that bad? It is clearly an effective medicine to increase saving and improve production. It may taste bitter when forced on us but it is still the only medicine that works… Anyway that is a topic of discussion another time.