A Challenge to Voters

If you are planning on voting in the 2010 midterm election, which you should be, please pay close attention to the following important bulletin.

First, do not vote out an incumbent merely based upon your disgust with the current state of the economy. I will agree that the economy remains in tatters, but blaming politicians for it does nothing to address the reasons behind the sluggish economy.

Congressional Democrats did not cause the economic crisis. Neither did President George W. Bush. In fact, the former President, along with President Obama, Congressional Democratic leadership, and members from both parties have undertaken many efforts to combat the recession (and members from both parties have opposed these efforts).

Recessions are hard to escape from, so even with the soundest policy decisions the economy should not be expected to suddenly rebound. As such, irrationally blaming the government when you lose your job is shortsighted. On the other hand, holding the government accountable for its handling of economic policy is good citizenship. The key is that policy, not the unpredictable swings of the fiscal cycle, is what the government has control over and is thus responsible for.

To help you analyze the economic policy that Congress has passed since the fall of 2008, I present a brief voter guide.

Causes of the Recession

The years leading up to the recession were marked by a housing bubble: an over-inflation of home prices. Mortgage brokers eager to make sales offered adjustable rate home mortgages with low introductory teaser rates, to people who provided little or no down payment and did not have the income to afford the homes—so called subprime mortgages.

The mortgages were then transformed into mortgage backed securities and sold to investors. This encouraged morally unsound decisions on the part of brokers because they had an incentive to make risky loans to boost their commissions, but did not stand to lose if the loans went into default.

Just like a Ponzi scheme, when the constantly increasing stream of homeowners feeding into the system turned into a trickle, the entire system came crashing down. At first, the new homeowners could afford their payments, but when the rates started to go up, some could not afford them.

However, the constant flow of new home buyers caused home prices to continue to rise, so those who could not make their payments could use the equity in their homes to make the payments or could sell the home and pay off the mortgage. Either way, the financial institution holding the mortgage got the money. Eventually, home prices were so high that the amount of people entering the market slowed and prices started to decline. With the decline in prices, home equity could not be used to cover payments and selling the home could not recoup the value of the mortgage. These subprime loans then went into default.

As loans were defaulted on, banks started to issue fewer loans further decreasing housing demand and lowering prices. These effects combined in a feedback loop to cause many mortgage defaults and a downward spiral in home prices. Thus the bubble burst.

The collapse of the housing market soon expanded to an economy-wide recession. The mortgage backed securities dropped significantly in value as the mortgages went into default, so any financial institution that had bought them faced heavy losses. Investors in these financial firms panicked and withdrew funds en mass, similar to the bank runs of the Great Depression, although this time it affected non-depository investment banks.

With investors leaving, many of these financial firms teetered on the edge of collapse. When The Lehman Brothers went bankrupt in the fall of 2008, investor panic increased from a stream to a torrent.

The significance on the greater economy is that credit dried up. With so many financial firms losing large amounts of capital both from the mortgage defaults and the subsequent investor panic, the firms greatly restricted lending. Not only were they afraid to make risky loans, but even stopped making loans usually considered to be safe because of their deficient capital reserves.

Many businesses, especially small businesses, could no longer obtain loans to cover their regular expenditures such as payroll. Without these loans the businesses could not cover short term costs and thus had to lay off employees or shut down. As workers lost their jobs, they cut back on purchases, reducing consumer spending. This in turn caused businesses to lay off more workers and led to something resembling the collapse of the economy.

Next time, we’ll examine what the government has done to address this complicated problem. Stay tuned, and go vote!