The Current Economic Problem (Abridged Version)

In my first post of actual content, I figured that I would summarzie the current economic situation and explain what caused the whole mess.

If you trace the problem back to it's source you'll find that, interestingly enough, the Federal Reserve Bank was the main cause of this entire situation. Before I explain specifically how the Fed accidentally destroyed our economy, there are some basic things you need to know about economics and how the Fed works.

The job of the Fed is to attempt to keep the economy of the US in a pattern of sustained growth. They don't want the economy to grow too fast, and they obviously don't want it to shrink. They try to accomplish this by manipulating interest rates (which affects loan and mortgage interest, among other things). If the economy is growing too fast, the Fed raises interest rates to combat rising inflation. If the economy is shrinking, the Fed lowers interest rates to combat the recession. Raising interest rates makes the economy slow down, lowering the rates makes the economy speed up.

Here's where the problem starts: In 2001, the US suffered a very small, unimportant recession. Since the economy was in a recession, the Fed decided to lower the interest rates... a lot. At the beginning of the year, the Fed's target rate was 6%. By the end of 2001, that rate was slashed down to only 1.25%. In November of 2002, it was just .75%, making it extremely easy for businesses and individuals to get loans. Can you think of something else that started around that time? That's right, this lowering of interest rates is what created the famous housing bubble. It became so easy for people to get a mortgage that the housing market exploded with activity, increasing home prices by easily 200%. Due partly to the low interest rates, people were purchasing houses that they couldn't afford, with the hopes that the prices would just continue to increase. All of these bad mortgages were rolled into big packages called Mortgage-Backed Securities and sold to investors by the lending institutions Fannie Mae and Freddie Mac. The Fed eventually realized that the housing bubble was going to burst, so from 2003 to 2006 the Fed raised interest rates up to 6.25% in an attempt to slow down the growth of home prices. This is where another problem started, though; the Fed was too late in realizing the problem. House prices were still well beyond the Fed's control when the housing bubble finally burst, sending Fannie Mae and Freddie Mac into bankruptcy and creating the new recession that we are in today. Now the Fed's target interest rate is at a historic low of .25% and the end is still not in sight.

To summarize: the Fed lowered the interest rate too low and kept it there too long, creating the housing bubble. After that, they raised the interest rate too high, and they didn't raise it soon enough, causing the financial crisis. Yes, the Fed, the people who are supposed to keep this kind of thing from happening, are the ones who put us in this terrible situation.

Should we have let Fannie Mae and Freddie Mac just go out of business instead of letting the government buy them? And what about the stimulus plan? Or the Cap-and-Trade law? Check back later for posts about those issues and more :).

Sources: Financial Crisis Story - http://www.brookings.edu/papers/2008/11_orgins_crisis_baily_litan.aspx
Data on Target Interest Rates -http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html