The bubble burst: Near the end of the last decade, there was an Information Technology "bubble" fueled by speculation in Internet technology and startups. When it ended, late in 2000, investment fever shifted to the housing market.
As housing prices increased astronomically, more and more investors rushed into the housing market. There was a widely held belief that owning a home was a safe investment because if the owner got in trouble they could either refinance or sell their house for a profit. In many areas of the country, particularly along the Atlantic and Pacific coasts, vast areas were overbuilt. Many investors purchased houses they could not afford lured by "sub-prime" mortgages.
In 2007, the housing bubble burst as prices fell and defaults grew. If this had only affected homeowners, developers, and mortgage lenders, we would be suffering from our "father's recession." But the impact was systemic.
The banking system failed: The consequences of the collapse of the housing market spread throughout the financial community. In March of 2008, the Bear Stearns investment bank teetered on the edge of collapse and was forced into a merger with the J.P. Morgan bank. On September 15th, the Lehman Brothers investment bank filed for bankruptcy, causing a global financial panic. On September 18th, then Secretary of the Treasury Paulson presented an outline of a bank bailout plan to Congressional leaders. On October 3rd, Congress authorized $700 billion to shore up banks.
Coinciding with the housing bubble was spectacular growth in the financial services sector, particularly in non-standard banking activities the so-called "shadow" banking system. When these failed, they dragged down the conventional banking system, which stopped lending money. This produced a recession that looked like "your grandfather's recession," the Great Depression. Unfortunately, there was a significant difference: the impact was truly worldwide.
There were global consequences: The Great Depression affected the Americas and Europe, but had a limited impact on the Far East and none at all on Russia. The current recession is global. Paul Krugman notes, "A large part of the increase in financial globalization actually came from the investments of highly leveraged financial institutions which were making various sorts of risky cross-border bets. And when things went wrong in the United States, these cross-border investments... [drove] fresh rounds of crises overseas."
Because this is a worldwide financial emergency, global trade has stopped and many developing countries have currency crises. Krugman likens this to "the recession that followed the Panic of 1873... [that] lasted more than five years" our great-great-grandfather's recession.
How bad is it? The most obvious indication of the recession are housing starts at their lowest level in fifty years and the plunge in auto sales, but there is over-capacity throughout the market. As a result, most sectors of the economy are slowing down; last quarter the US economy shrank at a 3.8 percent annual rate. The national unemployment rate is 7.6 percent and rising; some analysts predict is will pass the 10 percent mark next quarter. Consumer confidence is at a record low. By year-end, credit card default rates are expected to reach a record 11 percent. Every day the financial press brings more bad news.
Lurking behind over-capacity is daunting problem: businesses do not have the necessary access to credit. They can't get money to make a payroll, expand facilities, or to ship product overseas. Despite an infusion of Federal capital, most banks aren't lending because they are buried under a mountain of debt.
What needs to be done? Three challenges face the economy: spending, credit, and confidence. In his February 24th speech, President Obama addressed each of these topics. The American Recovery and Reinvestment Act aims to stimulate spending. It's a good first step, but there may need to be an additional stimulus bill.
On February 10th, Treasury Secretary Geithner described his "Financial Stability Plan," which will inject further capital into banks in order to get them to lend funds to businesses and consumers.
President Obama's speech was well received. Polls indicate Americans have confidence that their new President is doing all he can to end the emergency.
How long will it take? It will take at least a quarter for the efforts of the Obama Administration to bear fruit. Therefore, look for the second quarter of 2009 to be worse than this quarter unemployment will rise and the economy will continue to shrink. On February 24th, Federal Reserve Chairman Bernanke told Congress that 2010 could be a year of recovery if Obama's efforts bear fruit. That's a realistic assessment. Meanwhile, look for the balance of 2009 to be grim.