8 Questions About the Current State of the Economy

Over the last few months as the subprime lending situation has grown increasingly worrisome, a lot of people have written to me asking some very fundamental questions about what’s going on. I’ve decided to collect all of these responses into a single post.

Please note that this is not a be-all end-all explanation of how the United States economy works, nor does it capture all of the nuances. This is intended as a layman’s explanation so that an individual can hear a news report in the mainstream media about the Federal Reserve or about the subprime crisis and know generally what’s going on. It’s also based on my own understanding of macroeconomics and a ton of research I’ve done lately – I don’t claim that it’s infallible, and I’m quite sure that someone will correct or expand on a detail or two in the comments.

So, let’s dig in.

The Federal Reserve and The Subprime Crisis

1. What is the Federal Reserve? What do they do?
The Federal Reserve (sometimes called the Fed) refers to the central banking system of the United States. It basically serves as the interface between the government and private banks, like Bank of America or Citibank or your local bank.

In the words of the Federal Reserve Act, the law that authorizes the existence of the Federal Reserve, the purpose of the Federal Reserve is:

To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

The primary reason the Federal Reserve was created was to avoid banking panics. Banking panics are pretty familiar to anyone who has ever heard stories of the Great Depression, when all of the customers of a bank would line up and try to take out all of their deposits at once. If the bank didn’t have that much cash on hand – and often it wouldn’t – the bank would be forced to close and simply not return deposits to investors. This caused some serious mistrust of the banking industry, for obvious reasons – I can say, for example, that my grandfather still refused to use a bank as late as the 1980s because he was so jilted by banking panics in the 1930s.

The recent mess with Bear Stearns was a near-miss of a banking panic, for example.

2. What power does the Federal Reserve have to stop such panics?
The Federal Reserve has several powers that they can use to prevent such panics from ever happening again.

First, they control the money supply. If a bank is about to run out of money because the customers are demanding all of their money, the Federal Reserve can print more money (they can print less money, too). This has a bad effect over the long run (I’ll talk about that later), but over the short run, it can keep a bank afloat and maintains the trust that people have in putting their money into banks.

Second, they control the federal funds rate. The federal funds rate is the interest rate that private banks can charge other banks on short term loans, usually overnight loans. Although the actual process is somewhat more complicated, it essentially works like this: Bank A and Bank B are both operating in the same town. Bank B has several customers wanting to make withdrawals today and they don’t have enough cash just sitting there to cover all the withdrawals. So Bank B asks Bank A for a quick overnight loan so that the withdrawals can be covered. The interest rate on that loan is (more or less) determined by the Federal Reserve and is known as the federal funds rate.

More or less? The actual truth is that the Federal Reserve itself lends out money at a slightly higher rate, called the discount rate. Any bank can borrow from the Federal Reserve at the discount rate, which means that it’s the default rate that banks can get for those quick overnight loans. Other banks will compete with that rate on the open market by offering a lower rate if they think it’s worthwhile, and the Federal Reserve uses a big bag of tricks to encourage banks to lend among themselves at a rate very close to the lower federal funds rate.

The Federal Reserve has a lot of other powers, too, but those are among the biggest.

3. Why does it matter when the federal funds rate goes up or down?
As a general rule of thumb, a lower federal funds rate means that it’s much easier for banks to carry on their normal business. They can lend with more confidence, knowing that if the depositors come around wanting withdrawals, they can borrow the money back pretty cheap. A higher rate means that banks are more cautious about lending money.

As a result, the Federal Reserve usually cuts their rates when the economy is starting to look weak (encouraging more loans) and usually raises the rates when the economy is starting to look strong (encouraging more conservative loans).

4. Why would the Fed ever want to raise rates if it makes the economy worse?
Think about your own life – one year, you might buy a car and a new living room set, but then you won’t buy anything over the next few years. This is probably affected by a lot of things – your feelings about how secure you are in your job, how the economy is doing in general, and so on. If you lose your job, for instance, you’re not going to be buying a new car.

The reverse of this is true, too. When people are buying, companies are doing well – they’re hiring more people and posting great earnings reports. However, when people stop buying, companies usually have to tighten their belts.

This creates a cycle, something that happens in any economy. It goes up, it goes down.

If the Federal Reserve just dropped rates to the floor, the economy would take off like a rocket and we’d have several years of a booming economy. After that, though, we’d be in a 1929 position all over again – many years of exuberance would leave a lot of consumers content with their big purchases and a lot of companies with overvalued stock prices as a result of that exuberance. In other words, a crash.

In order to prevent such a crash, the Federal Reserve moves to slow things down when they start really rolling along. They do that by raising the interest rates, so that companies can’t borrow money quite so easily and thus can’t quite run as efficiently as they might otherwise run. It protects us (theoretically) from another Great Depression.

5. What is a subprime mortgage?
First of all, let’s look at what a “prime” mortgage is. A “prime” mortgage is one that a bank is willing to offer to someone that they view as being trustworthy and highly likely to repay the mortgage without difficulty – someone with a steady, high income and a good credit rating. The term “prime” actually refers to the prime lending rate, which is an interest rate that most banks agree upon to use (yes, another different interest rate). The prime lending rate is usually close to 3% higher than the federal funds rate – right now, the federal funds rate is 2.25% and, thus, the prime rate is 5.25%. If you’re a trustworthy borrower, that 5.25% rate is approximately (not exactly in any way, shape, or form, but a guideline) what you should get on a mortgage right now.

Subprime mortgages are those offered to people who are deemed not as trustworthy, usually people with a less reliable income or a lower credit rating. These are people who are pretty likely to repay, but it’s not quite as clear cut. In order to help make up for that increased risk, many banks offered all sorts of special loans to these borrowers, usually at higher interest rates. ARMs were one particular option – they would have a great interest rate at first, but would adjust to a very high interest rate over time.

In order to sell more mortgages, many companies started offering these “subprime” loans quite easily, often loaning higher amounts to people at low income levels. For example, I was able to get a prime mortgage for a little less than double my family’s annual income, but I could have received a subprime loan for about four and a half times my family’s annual income.

6. How is that a bad thing?
The emergence of subprime mortgages had several effects. First of all, it increased the number of people who could buy homes very quickly, and it also increased the amount of money that people could get to buy homes. That meant there were a flood of potential home buyers in the late 1990s to mid 2000s. This caused the prices on the homes to rise – if there’s an increase in demand, the supply’s going to change to match that. (I’m simplifying a bit here, I know.)

Eventually, though, tons of new homes were being built, which increased the supply. Also, people were now sitting in subprime mortgages that were adjusting to rates that they couldn’t afford, so they were either not able to keep their house or they were walking away from them.

So, now you have two problems: the housing market is in bad shape because supply is higher and demand is lower, and there are people out there holding onto mortgages that are now very difficult for them to pay.

7. How does this affect big banks?
At this point, a lot of people are simply walking away from their subprime mortgages – they’re not paying the bills and letting the bank take their house. They have monthly payments that are too high for them to cover and thus they’re simply being foreclosed on for failure to pay their mortgage. Other owners are realizing that their houses are now worth less than they paid for them and, in some cases, the house is worth less than what they still owe on their mortgage, so some of these people are simply walking away, too, and letting the bank foreclose on their houses.

A big bank would much rather have a mortgage with a nice fat interest rate on it than a house with a low value on it. Every time a person walks away from a mortgage, the bank is force into trading that mortgage for that lower-value house. When you hear about subprime lending losses, this is where the losses start at.

The big problem is that these losses multiply. Whenever a person walks away from a mortgage, that loss doesn’t just affect whatever company actually holds the mortgage. It also affects everyone who is invested in that mortgage holder, and that’s a lot of people. That’s because home mortgages were previously seen as a rock-solid investment for investors, and thus a lot of different investment firms would invest their money in home mortgages, seeing it as being a very stable place for their money. Suddenly, that most stable of places is looking pretty risky and coughing up losses.

That’s how Bear Stearns got into trouble. They had a lot of their money invested in supposedly stable mortgages, but when people started walking away from those mortgages, suddenly Bear’s most stable investments were losing money pretty quickly. If that’s coupled with an investment in the stock market – a risky investment that’s also down right now – all of a bank’s investments could be losing money rapidly.

This creates a domino effect. Suddenly, banks stop trusting each other. If all of the other banks are losing money like gangbusters, why would you want to give that bank an overnight loan? It’s not really very safe to do so, so many banks become very hesitant to loan out a dime to each other. That’s very bad. It’s those overnight loans that make it possible for banks to conduct business – to lend money to entrepreneurs and companies and individuals who need the cash to keep their businesses and lives going. This is the so-called “credit crunch” that you keep hearing about on the news.

This, coupled with a long series of foreign policy initiatives not liked by most of the rest of the world, is also why the dollar is losing value against the rest of the currencies in the world. Think about it – from the eyes of someone outside of America, would you rather own a Euro – backed by nations that aren’t in a foreign policy fiasco and aren’t dealing with this subprime mess (at least not directly) – or a dollar, which comes from a nation with these problems? I know which one I would probably view as being more stable, and I’m an American.

8. What’s next?
In response to all of this, the Federal Reserve has been cutting the federal funds rate like crazy to encourage banks to lend money to each other. They’ve also made it much easier for banks to borrow money from the Federal Reserve at that discount rate mentioned above – they’re letting banks borrow the money for up to ninety days and have made more money available in this fashion than ever before. In other words, the Federal Reserve is trying to stabilize this mess.

What does it mean for you? It means that most investments are pretty awful at the moment – over the long haul, they’ll probably rebound as this crisis works itself out. Inflation is going up because the Federal Reserve is pumping money into the economy right now (those “discount rate” loans) – that’s why you’re paying higher prices at the grocery store, because with more dollars out there, an individual dollar is worth less than it used to be. Housing prices will certainly drop in the near future as all of this flushes out – that’s why it’s probably a good time to buy a house over the next few years.

Thankfully, banks are learning from this. It’s not a path they want to go down again, because this has been very dangerous for their business. It’s almost hard to get a prime mortgage now, and actual subprime mortgages are very hard to find.

My suggestion is be patient. If you’re investing for the long haul, now is as good a time as any to buy most investments, but if you’re looking at the short term, it’ll be pretty bumpy. If you’re looking to buy a house and have good credit, now’s a great time to start looking. Otherwise, now’s a great time to build up an emergency fund and use other tactics that are appropriate for any downturn in the economy.

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  1. Vered says:

    We are long-term investors. We pretty much plan to ride it out and wait for the next bull market. It’s still difficult for me to buy stocks when the market is bumpy, even though I do realize that this is a great time to buy at bargain prices.

  2. mitchell says:

    i think that i enjoyed this explanation of whats happening with the subprime markets. it has some rough language, but its a stick-figure cartoon and lays it out in terms most anyone can understand.

  3. Tim says:

    I knew most of this information at a general level, but have never seen it written out quite so clearly. Well done!

  4. zach says:

    Good post Trent, really good intro into a very complex situation.

  5. Jon says:

    @Trent,

    “that’s why you’re paying higher prices at the grocery store, because with more dollars out there, an individual dollar is worth less than it used to be.”

    Might be worthwhile to mention that there is more going on there than just inflation at work. Issues such as high oil prices, and probably more notably the government’s ever present desire to subsidize ethanol also has a huge impact on grocery store prices.

  6. Kris says:

    Monster post, Trent. I was wobbly on a few details of the subprime meltdown, but this makes it much more understandable. Will definitely be forwarding.

  7. tambo says:

    My question is about home selling. We’re good borrowers with great scores, and I’m confident we won’t have trouble purchasing a home, however my husband recently received a promotion that’s leaving us with 2 options. Long commute (90 miles, one way, which he’s currently doing) or sell our house and move. We want to sell, and we’ve priced our home about 12% below actual market value (as per market analysis provided by our Realtor), but the slow housing market worries me greatly. We’ve been on the market about a month now and have had several repeat-viewings, but no offers.

    Do you have any insights on the issues faced by home sellers? Everyone seems to talk about the buyers and the trouble getting loans – which of course is part of the seller’s problem – but are there other factors involved? What can a seller do, if anything, to get a buyer?

  8. Dave says:

    I believe the abundance of dollars and skyrocketing crude oil price are steering us towards some of the nastiest inflation we’ve seen since Carter. (Has the prime rate ever been higher than Jimmy’s 21.5% in 1980?)

  9. esteban says:

    I just bought Vanguard VTSMX yesterday. I chose not to go with VEIEX for fears of too much risk. In the state of the economy right now, was this a mistake? Was buying local biased and dumb?

    I’ve never invested before, I’m 24 years old and getting married in a few months. Was investing in a falling stock market a good or bad buy (assuming I hold for at least 2-3 years)?

  10. jaushwa says:

    Great Post Trent! I was a little fuzzy about what has been happening lately but you filled in what was missing. Thanks

  11. margo says:

    Nice. Timely, straightforward, and a good summary/intro for people who aren’t up to speed.

  12. Brent says:

    Very well stated

  13. ted says:

    Fed doesn’t print money. Treasury does. Fed increases or decreases money supply through open market purchases. So, if the Fed sells bonds, they contract the money supply, if they purchase bonds, they increase the money supply.

  14. Andy says:

    I am certainly no economist, but it just seems odd that we are in trouble because of easy lending, and the fix is even easier lending. Does this set us up for even more hurt in the future?

  15. luvleftovers says:

    So, is this a good time for me to put some of my 401k money into REITs? I’ve been thinking about doing that since they are low now. Real Estate will bounce back eventually and I have about 20 years…

  16. Trent Hamm Trent says:

    “Fed doesn’t print money. Treasury does. Fed increases or decreases money supply through open market purchases. So, if the Fed sells bonds, they contract the money supply, if they purchase bonds, they increase the money supply.”

    That’s a good clarification, ted. The fed doesn’t print the money, they just have a lot of power over the money flow. It’s kind of like looking at your faucet – the Fed is the tap itself, not the source of the water.

  17. Trent Hamm Trent says:

    “I am certainly no economist, but it just seems odd that we are in trouble because of easy lending, and the fix is even easier lending. Does this set us up for even more hurt in the future?”

    I think it’s a matter of “we’re trying to prevent a crash right now and we’ll look at a long term solution later.”

  18. Jesse says:

    “My suggestion is be patient. If you’re investing for the long haul, now is as good a time as any to buy most investments, but if you’re looking at the short term, it’ll be pretty bumpy.”

    So true, it is basically a sale for those who are in it for many years to come.

    “the Federal Reserve is trying to stabilize this mess”

    This is where is gets kind of messy. The truth of the matter is what the fed is doing right now is helping no one except for some of the big banks. Lower interest rates = faster inflation = things cost more. These rate cuts are causing a much longer term problem than a small correction/recession is as far as the country as a whole goes. Inflation is much greater threat to the country than a small recession. Bailing out the banks who made subprime loans and the minority of people who took those loans (less than 4%!!!) is NOT the way to fix things.

  19. I did a 3 part series a while back about the Fed, and this subject is my passion. Well written post Trent. The key point is this is still all short-term market conditions. Your investment strategy should not change.

    Andy, there is a difference between EASY money and CHEAP money. Cheap money stimulates growth. It’s easy money that got us in this situation.

    Luvleftovers, whenever you ask about a good “time” it is a question of market timing. Don’t try to pick the right time to go into REITs, just diversify into them when you’re ready. Depending on risk tolerance, you should avoid having more than 5% of your portfolio in REITs. Since most of us are or will be homeowners, you have enough invested in real estate that way.

  20. Michelle says:

    How long do you think we have to buy a house before prices start going up again and we missed the boat? I am looking for something in the next 2 years, saving up a large down payment in the meantime. My credit and income is good, I live in Scottsdale/Phoenix. Any thoughts?

  21. Jon says:

    “I am certainly no economist, but it just seems odd that we are in trouble because of easy lending, and the fix is even easier lending. Does this set us up for even more hurt in the future?”

    It’s not really about easier lending to individuals. In fact, many interest rates offered by banks right now are actually higher than 6 months ago. Banks may be lending to each other, but are more cautious to lend to individuals.

  22. Jeremy says:

    Great post Trent, thanks for the concise info.

    @ esteban:
    I think you made a good decision with VTSMX for 2 reasons: the market is down so its on sale, but will eventually bounce back up. Also, the dollar is weak so your getting even more bang for your buck when you buy US. make that 3 reasons: Trent loves that fund as well. Just don’t get anxious if it goes down a bit, feel confident it will eventually bounce back, investments are for the long term, otherwise they’re just a gamble.

    VEIEX will probably keep doing well too, so if you continue to have more money to invest and want to diversify, you can put some in there too. I just had one of my clients buy some in fact, but I am beginning to transition them from foreign to domestic. Just remember 2 of the keys to success are diversifying and sticking to your plan then not bailing because of market hiccups.

  23. Marcus Murphy says:

    Right now we are not in a period of inflation due to an increase in the money supply.

    http://www.forecasts.org/m2.htm

    Right now there is inflation due to a stagnant economy or what is referred to as “stagflation”. With our Gross Domestic Product (a measure of our output in dollars) being stagnant or contracting (i.e. a recession), this causes the ‘amount’ of spending to go down (a lowered demand), which causes the supply to ‘shift’ and cause a price increase. This is what is known as “supply shock”.

    Look at the graph here:
    http://content.answers.com/main/content/wp/en/9/9e/Economics_supply_shock.png

  24. kent says:

    Disclaimer: Wrote this very fast and did not proofread.

    Very good post, Trent. This statement you had “They’ve also made it much easier for banks to borrow money from the Federal Reserve at that discount rate mentioned above”, is so essential if this thing is to work itself out. The Federal Reserve is taking steps to solve this CREDIT ( not stock market) crisis that we have never seen before. One of the big things they have done is open up the discount window to the investment banks, among other things. This is a VERY big deal! ( much bigger then them lowering the interest rates). Who really borrows money at 2.25%? Not me! The problem is NO ONE can get loans! Anyways, by the I-banks being able to go to to the discount window they can essentially take out a low interest loan from the government and loan it out. Are they going to lend it out or keep it? Let’s rememeber, the Banks ( except Goldman ; )) screwed up big time — by investing in CDO’s, being over-levered, etc. They have written down/lossed $230 Billion! and they will probably will continue to lose more as housing prices continue to decline, so they need this money badly! as well as other $ they are raising…Let’s hope they lend it out, we do not want another Japan!

    Are the banks learning from this??? let’s hope! but seems to me, that when the banks find something that is making them tons of $, they do it until they have hit a brick wall and then oops!

    With that said, long-term VALUE investors are good shape! Go Shopping!

  25. Jesse says:

    @Michelle:

    Truth be told you have a while, we haven’t yet hit the rock bottom because even though most ARMs have readjusted, there are a lot of those subprimes that are barely hanging on. After all the foreclosures are said and done (many of which are house flippers who got caught with their pants down) there will still be a “recovery” period. It also depends on your area of the country…I am not sure about phoenix area but two opposite examples: my area (fort collins colorado) is basically unaffected by the current situation due to growth restrictions and the area. Prices have changed very little. Other parts of the country (hello California) have home prices all over the map.

    Long story short: dont be worried about “missing the bus” if you are saving and plan to buy in the next couple years just make sure you have enough of a down payment to where you aren’t paying PMI, get a good fixed loan (watch for rates, this will make a huge difference in the “true” cost of your home) and you will come out happy ;)

  26. luvleftovers says:

    The Weakonimist: Thanks. I don’t own a home and probably will never have enough money for one (unless I can find a Sugar Daddy ;)! ). My portfolio is quite diversified, but since my plan’s REIT has dropped so much I was considering putting 5-10% in. I think I’ll take your advise and put in 5 for at least the next year or two, then let it sit until close to retirement.

  27. Saving Freak says:

    Ethanol is a huge factor in the prices we are seeing at the grocery store. All the meats are dependant on corn and the government is artificially raising the price with the ethanol subsidies. Good old government getting in the way again.

  28. KMunoz says:

    As someone with no background whatsoever in economics (just started a macro class yesterday, actually!), I think this was an awesome post. A very nice breakdown of what is going on in terms that are easy to understand. This could be seen as the answer to all the “stupid” questions you were afraid of asking. Thanks, Trent!

  29. esteban says:

    @ Jeremy:

    Thanks for the response! I was really glad to read your opinion as it is what I was thinking (but friends keep saying that the US will keep going down). It might go lower but hopefully years from now that won’t matter one bit.

    By the way, I’ll copy your comment into my monthly budget so I can better explain to my future wife why it is that we are investing, instead of just saving. :)

  30. Credit says:

    This is a really well written and important post.

  31. trb says:

    @Jesse #16
    “The truth of the matter is what the fed is doing right now is helping no one except for some of the big banks. Lower interest rates = faster inflation = things cost more. These rate cuts are causing a much longer term problem than a small correction/recession is as far as the country as a whole goes.”

    I’m with you on this comment. But I still think the Fed is doing the right thing – with their actions, we’re in a small recession. Without them, it might be a big one. And that’s good for no one.

    I am upset that my savings are worth less now than they were, and that some people who made dumb decisions are getting bailed out. Even more upset that some banks which made dumb decisions are getting bailed out, while still giving their executives major bonuses, etc. Even so, I’m grateful someone’s trying to keep things more or less stable.

  32. Sandeep Goswami says:

    Great post Trent!

    You couldnt have made it any simpler for a layman to understand the current state of the economy and the reasons behind it.

    Thanks
    Sandeep

  33. #4) Excellent prospective Trent, I’ve tried to explain this to people before, sometimes without much success. I’m going to expain it to them your way in the future.

  34. esteban says:

    Remember online savings accounts at 6%?

    Their at around 3% now.. glad I enjoyed a few months of high yield from those lol.

  35. Andy says:

    Fair enough. Thanks for the clarifications Trent, Weakonomist and Jon.

  36. @trb: Jesse is right. The recession idea was unavoidable (regular economic cycle) but the inflation *is* avoidable if the Fed was willing to do as all the other central banks across the world have done and actually *raised* the rates. In case you haven’t heard of “stagflation” it’s when recession meets inflation, and can take up to a decade to recover from. Here in the US we had stagflation in the 70s. Some folks point to Japan in the 90s as another example.

  37. Fred says:

    It seems then that the definition of a subprime loan is not necessarily based on the person to whom it was given, but rather the pricing of the loan.

    The credit risk of the people getting subprime loans was not THAT bad, but people across the credit spectrum were overextended due to the attractive up-front pricing. So, when the housing market began to cool, there was nowhere to turn for credit.

  38. Miranda says:

    A great post!

    I agree with #34. Since I don’t get into the consumer debt, interest is actually my friend. My cash investments have not been benefiting from all these interest rate cuts.

    I do want to point out that while a recession may not be that desirable, periods of a down economy are natural. All these steps we’ve been taking in the last couple of decades to change the natural economic cycle — this fear of recession — actually serve to make the economy as a whole more unstable in the long run. The last economic stimulus a few years ago set the stage for the current problem.

    Constant growth is unsustainable, and a lot of the time the “powers that be” seem to be always trying to stimulate growth, rather than letting the economic cycle take its natural course.

  39. Scott says:

    The only “hitch” to all of this is crude oil. When fed cuts rate crude goes up. Why? Because crude is bought with USD. The lower its value the stronger other currencies are and the more oil they can get with their money after conversion. Cutting rates now only hurt us more.

  40. Jesse says:

    Debt Free Revolution is spot on: Japan IS a perfect example. They could have had a few fairly painful years and had their problems over with. Instead they ended up with a full decade of pain because they were in such a nasty stagflation trap. The Fed raising rates right now wouldn’t send us into a early 1900s style depression – for reasons beyond the scope of this comment box (read my blog I guess) but it might save us from a nasty cycle of stagflation.

  41. gr8whyte says:

    The Fed’s funded by banks, not by taxpayers, so it’s unclear to me where its loyalty lies but it does enjoy a .gov domain.

    I understand why the Fed had to bail out Bear Stearns but don’t understand the long term ramifications of opening up the Fed discount window that’s funded by taxpayers to privately-held investment banks whose clients include the very rich and large private institutions. Of course, no moral hazard here.

    The Fed had been warned by several entities (Center for Responsible Lending for one) of questionable lending practices during the housing bubble as they were happening in real time but the Fed declined to intervene or regulate. The Fed’s performance clearly needs improvement.

    Re. investing, if you’ve plenty of cash, go ahead. If not, I suggest holding off for a while to make sure stagflation isn’t in the offing. Some say it’s coming if not here already.

  42. Subwo says:

    Trent, you should look further into the Federal Reserve and how it was formed. We are in debt as a nation to the centeral bank since 1913 when our country was sold out with the Federal Reserve Act. Congress and the president can change it with the stroke of a pen by taking back our ability as a country to manage our own money without being in debt to private bankers. A good Google video to watch is ” Money as Debt”.

  43. Laura H. says:

    Maybe this is a silly question, but I have read that the figure on foreclosure is about one in one hundred, and that about one in ten is in danger of foreclosure.

    The question on my mind is: how over-extended are America’s banks on additional fronts? A *person* who lived responsibly could take a one percent cut in pay without blinking. A ten percent cut would be harder, but not endanger an entire lifestyle, except in the case of those who have been living so far beyond their means that the next late check means eviction or vehicle repossession that makes it impossible to get to work. While Countryside mortgage can’t quite move back in with Mom and Dad, how did it get to the point where we are now at national crisis?

    And why try to stave off recession? Aren’t periods of slow economic growth part of the cycle? We’ve got systems in place so no-one needs to starve or freeze to death. From a lay point of view, it makes about as much sense as trying to stave off winter in Chicago— buy some metaphorical boots, hunker down, and keep the roads clear, don’t build bonfires so you can keep running through the sprinkler…

  44. Laura H. says:

    I mean the above even with the “domino effect,” sorry.

  45. myla says:

    Trent — great information given in a language that even those with “non financial” savvy can understand Thanks.

  46. Justin says:

    Wow. Great post… I can’t wait to read some of your soon to be published works! You really are a good writer.

  47. Carrie says:

    Great post. So many people are confised… especially about what subprime is. Not so much a loan product but instead a borrower! Thanks for a clean and easy to understand explaination.

  48. Jessica says:

    Thanks for the post, Trent! Very helpful, but I’d like to toss in my two cents (hard-earned and hard to part with! ;])… From my discussions with others (more like me listening to people who appear to be well-informed), part of the reason we’re in this mess is because the creation of the Fed did away with the gold standard (I think I have that right – please correct me if not). That we can’t bring a dollar or ten dollar bill into a bank anymore and say, “I want this gold,” now is what I’ve understood to be part of the problem, because there are more dollars in circulation than the gold they’re worth. Thus, inflation and (eventually) a tanking dollar.

  49. 144mph says:

    Wow, I’ve got to disagree with the majority here. I think this post was horrible. Waaaay oversimplified and boiled down to pretty much meaningless terms. I know it’s tough to put these complex concepts in simple terms that people can understand, and what people need to realize is that they’re never going to get a one page document which fully explains the horrible mess that is currently unfolding with the financial markets.

    To reduce it all down so much and never come across with the fundamental fact that the Fed is E-V-I-L with big bold flashing capital letters is a huge disservice to readers. The fact of the matter is that the Fed is definitely not some sort of benevolent entity which is trying to help people with money. The thought that the Fed is somehow trying to shepherd the US to financial solvency is ridiculous. Drawing from your analysis of the Born to Buy book, it would be similar to thinking that Toucan Sam is really interested in making sure that kids eat a healthy, balanced breakfast. Absurd!

    Banks, the Federal Reserve, Corporations, and every grifter on the street are out to rob people blind in the name of profit. Walking into the buzz saw blindfolded is not the right approach here.

  50. Tresaca says:

    Great post Trent!
    I also believe that it is important to be
    patient during this rocky economy.

    It is more important to prepare yourself to
    weather the storms brewing now or in the future
    by building your emergency fund and creating
    other income streams instead of only depending on
    a job.

  51. Marcy says:

    Part of what was left out–maybe on purpose ’cause it gets complicated– is the mess with derivatives. They are tied up with the mortgage and sub-prime mess. It’s not just that people are defaulting on iffy loans, but that loans are packaged up and sold as investments as a bundle, so the iffy ones are “hidden” in the bundle. When sub-prime loans are sold as bundles, they take the best (least questionable) ones and sell them for one rate, and the less trustworthy one for a higher rate because there is more risk with them. These bundles have been sold and resold, but right now because nobody knows what’s really in them and how risky they might really be, the usual sources of money-investors, often from oil nations, are drying up and nobody wants to buy them–and if banks, etc. can’t sell the product, like any other business, they have no money to make more product–in this case loans.So the Fed can lower rates to encourage banks to work with each other, but the trust level is in the tank and there’s few out there that can afford the risk. Therefore, the low prime interest rate isn’t being passed on to the consumer.

  52. Marcus Murphy says:

    Here is a great article in the latest (April 10th) print edition of “The Economist” that talks a bit about the recession:

    http://www.economist.com/opinion/displaystory.cfm?story_id=11016333

  53. occasional reader says:

    This was a very clear and easy to understand explanation – thanks for putting this together.

  54. Roger says:

    Excellent article about the state of our economy.

    I’d like to see more posts like this concerning the state of our economy.

  55. Karl says:

    @Trent,

    Great post. I’m actually able to connect the dots now. Thanks!

    Could you please expand more on the following statement.
    “that’s why you’re paying higher prices at the grocery store, because with more dollars out there, an individual dollar is worth less than it used to be.”

    I don’t understand how could my money be worth less just because there is more of the dollars out there…

    Thanks.

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