How Recessions Work

[dirtboy]

How Recessions Work from howstuffworks.com

This is a great read on what a recession is, how a nation gets into one and the means by which we exit one.

This is an especially important for people who spout doom and gloom at every opportunity to educated themselves on why things aren't so bad after all, considering that our government happens to be taking all the right steps to remedy this problem.

 

[Witling]

Well, I read the article. IMO, it's a bit long for the casual reader. But let's skip to the remedies part. The article says that there are two types of remedies; (1) Fiscal policy and (2) Monetary Policy.

Of the three choices under fiscal policy, the relevant choice is "spend more money." That fiscal remedy always assumed that the money would be spent in the country, thus providing workers with a paycheck. Think $87 billion here. Is that money being spent in this country. For quibblers, yes, a little will be spent in this country.

Monetary policy. The Fed (Federal Reserve Bank) has played just about all the cards it has in this deck. The rates that the Fed sets are at historic lows. Personally, I hope the monetary policy works because it's going to very ugly if it doesn't. However, personally, I think the economy will go up this next year and then down, down, down. I'd like to blame it on the Republicans but, IMO, it's a structural problem that neither political party has the courage to handle. Think of it as a large firecracker with a burning fuse. One administration hands it off to the next.

 

[ElFenix]

i don't think monetary policy actually works through the mechanisms that milton friedman thinks it does. i think it does work, because it does send a message. the economy is all bully and hot air anyway... if people think it will be good in the future or bad in the future they will plan accordingly, and if enough people plan in a certain manner that future will generally come about, barring some catastrophe (which, of course, really just changes peoples' expectation about the future)

 

[dirtboy]

Originally posted by: Whitling
However, personally, I think the economy will go up this next year and then down, down, down.

Is this just something you believe or is it something you have evidence to back up.

Not trying to start a war, just curious to know what the reasoning behind your words is, if it was more than just a hunch.

 

[rjain]

The stock bubble caused a bond bubble. This pushed interest rates amazingly low. When they go up, people will go bankrupt quickly, especially people who just bought and mortgaged houses. They'll have more debt because the equity value of their house just dropped. Could get ugly if it's not managed correctly. If you thought Fannie and Freddie were in trouble now, just wait...

 

[konichiwa]

Originally posted by: dirtboy

Originally posted by: Whitling
However, personally, I think the economy will go up this next year and then down, down, down.

Is this just something you believe or is it something you have evidence to back up.

Not trying to start a war, just curious to know what the reasoning behind your words is, if it was more than just a hunch.

Is economic forcasting ever anything more than a hunch? Rarely.

 

[dirtboy]

Originally posted by: rjain
This pushed interest rates amazingly low. When they go up, people will go bankrupt quickly, especially people who just bought and mortgaged houses.

How does a rise in interest rates cause people to go broke? Seeing how the rates have recently been at a 30 year low, that would lead me to believe that for the last 30 years we've been broke??

 

[Witling]

It's more than a hunch about the economy, but I to tell you how I came to this conclusion, I'd have to let you in on a dirty little family secret. One of my daughters married a Republican who is a serious level money manager. And I tell you truly, I could live with a Republican son-in-law, but this year he asked for a Yankee's cap for Christmas. It's possible to go too far, even if he is family.

 

[rjain]

Originally posted by: dirtboy

Originally posted by: rjain
This pushed interest rates amazingly low. When they go up, people will go bankrupt quickly, especially people who just bought and mortgaged houses.

How does a rise in interest rates cause people to go broke? Seeing how the rates have recently been at a 30 year low, that would lead me to believe that for the last 30 years we've been broke??

No, because they were high then. ...

The salient point is that people are leveraged out their wazoos. They've mortgaged their new houses or refinanced their existing mortgages. Also, there are plenty of new car loans, etc. People are ready for an economic rebound.

Any increase in interest rates will cause their house values to drop, and their debt-to-equity ratios will drop similarly. They've mortgaged a $300,000 house which is now worth $200,000 because of the change in interest rates. With Freddie and Fannie, a house these days is basically equivalent to a bond. In fact, mortgage bonds are called asset-backed securities. This change will have a major impact on their credit rating.

Of course, if their cash flow (salary) goes up to keep pace with the interest rate increases, everything will be fine. Fortunately, the most important basis for interest rates is inflation, which is caused by increases in demand for goods and services. This can only be caused by the fact that people have more money to spend. Where did this money come from? Their salaries (or other sources of income, of course).

The problems occur when the changes are sharp and drastic. People don't have enough time to adjust their financial plans to account for these changes. Also, wage increases and hiring occur very slowly, as there is much risk associated, especially with new hires, as it is so hard to fire someone and that person doesn't have a proven track record with you, so you don't know if you'll need to fire them. Therefore, it's not likely that wage increases will apply to most people.

If changes occur to the general economy based on those changes, then those people who didn't cause the change will suffer dramatically. I suppose this is why the government is so afraid of rapid inflation. It doesn't give time for the wealth increases to be spread out evenly.

 

[LunarRay]

Originally posted by: dirtboy

Originally posted by: rjain
This pushed interest rates amazingly low. When they go up, people will go bankrupt quickly, especially people who just bought and mortgaged houses.

How does a rise in interest rates cause people to go broke? Seeing how the rates have recently been at a 30 year low, that would lead me to believe that for the last 30 years we've been broke??

The price of a house is contingent upon the income of the individual... usually. The ratio of (I think) 40% earnings gets a monthly payment that affords a house given some down payment. If the mortgage is a fixed rate long term one... no problem (not exactly) but, if it is a ARM that ties to the Tbill or some indicator and the indicator goes up to the maximum that the ARM can adjust to, the mortgage payment can jump hundreds of $ and when it does this the Selling Price of that same house just lost a lot of potential buyers in its previous price range. So the 'comps' go down and the person in question has a home worth less than he bought it for. But, the bigger kicker is higher interest rates stiffles buying. This causes a slow down in the economy and jobs get lost and the payments must be made. This guys house has no equity so he says the heck with it and files for bankruptcy. Maybe he goes bowling.

 

[rjain]

Originally posted by: LunarRay

The price of a house is contingent upon the income of the individual... usually. The ratio of (I think) 40% earnings gets a monthly payment that affords a house given some down payment.

House prices still fluctuate with interest rates. If rates are low, everyone is buying houses (demand goes up), and vice versa. The price of a house that a person can afford is tied to their income. As I said, if their income increases to make up for the drop in their net worth, then they'll be ok.

 

[rchiu]

Originally posted by: LunarRay

Originally posted by: dirtboy

Originally posted by: rjain
This pushed interest rates amazingly low. When they go up, people will go bankrupt quickly, especially people who just bought and mortgaged houses.

How does a rise in interest rates cause people to go broke? Seeing how the rates have recently been at a 30 year low, that would lead me to believe that for the last 30 years we've been broke??

The price of a house is contingent upon the income of the individual... usually. The ratio of (I think) 40% earnings gets a monthly payment that affords a house given some down payment. If the mortgage is a fixed rate long term one... no problem (not exactly) but, if it is a ARM that ties to the Tbill or some indicator and the indicator goes up to the maximum that the ARM can adjust to, the mortgage payment can jump hundreds of $ and when it does this the Selling Price of that same house just lost a lot of potential buyers in its previous price range. So the 'comps' go down and the person in question has a home worth less than he bought it for. But, the bigger kicker is higher interest rates stiffles buying. This causes a slow down in the economy and jobs get lost and the payments must be made. This guys house has no equity so he says the heck with it and files for bankruptcy. Maybe he goes bowling.

I don't think rising interest rate hurts people who pays mortage as much. Most of the people, at least the smart ones, takes advantage of fixed interest mortage during this period of extremely low rate and is protected against rising interest. The value of the house is determined by supply and demand and yeah high interest rate hurts the demand but that only hurt you if you are selling the house.

What is really dangerous is the amount of money people put on their credit card today. American are borrowing like crazy these days because bank are giving out credits easily and the rates are low. Most of credit card interest rate is variable and once interest rate goes up, there are gonna be tons of people who can't cover the monthly payment and declare bankruptcy. That's gonna cause lots of bank to close their door and the ripple effects goes on. Not to scare you, but company like Sears , Ford and many other non-financial companies got into credit business and now it is big part of the business because American consumers put everything on credit. A huge interest rate hike is gonna damage both the consumer and those companies and that will not be good for this economy.

 

[rjain]

The value of the house is based on what it would sell at right now. Your debt-to-equity ratio is a measure of how well you can pay off your debt in an emergency. Increasing interest rates causes your equity to go down if it's mostly held in your home.

Your point about credit cards is important, as that's variable rate, and will really cause bankruptcies if rates go up. Also, poeple who have credit card debts probably don't have much, if any, home (or any other) equity. If they did, they would have refinanced now and paid off the high-rate debt. They need income in order to have any chance to pay off the debt. I wouldn't be holding any stock in COF when the rates start to go up if I were you...

 

[dirtboy]

Originally posted by: rjain

Any increase in interest rates will cause their house values to drop, and their debt-to-equity ratios will drop similarly. They've mortgaged a $300,000 house which is now worth $200,000 because of the change in interest rates. With Freddie and Fannie, a house these days is basically equivalent to a bond. In fact, mortgage bonds are called asset-backed securities. This change will have a major impact on their credit rating.

I'll take it you're not very familiar with the housing market. Higher rates will not cause a $300,000 house to drop to $200,000. Houses hold their values quite nicely. Only during long periods of time where people aren't buying house, will house prices dip. Note that I said dip. It's rather rare that prices drop at all. It's true. This change will have zero effect on their credit rating. ZERO.

Of course, if their cash flow (salary) goes up to keep pace with the interest rate increases, everything will be fine.

Meaningless.

The problems occur when the changes are sharp and drastic. People don't have enough time to adjust their financial plans to account for these changes. Also, wage increases and hiring occur very slowly, as there is much risk associated, especially with new hires, as it is so hard to fire someone and that person doesn't have a proven track record with you, so you don't know if you'll need to fire them. Therefore, it's not likely that wage increases will apply to most people.

Huh? Wha?

If changes occur to the general economy based on those changes, then those people who didn't cause the change will suffer dramatically. I suppose this is why the government is so afraid of rapid inflation. It doesn't give time for the wealth increases to be spread out evenly.

The goverment is afraid of rapid inflation because it devalues the currency. Government's don't want to see their own currency be devalued.

 

[dirtboy]

Originally posted by: LunarRay
The price of a house is contingent upon the income of the individual... usually.

How about never.

The ratio of (I think) 40% earnings gets a monthly payment that affords a house given some down payment. If the mortgage is a fixed rate long term one... no problem (not exactly) but, if it is a ARM that ties to the Tbill or some indicator and the indicator goes up to the maximum that the ARM can adjust to, the mortgage payment can jump hundreds of $ and when it does this the Selling Price of that same house just lost a lot of potential buyers in its previous price range.

Do some research on ARM's. One, during a time of historically low interest rates, it doesn't make much economic sense to get an ARM. Two, those who get it understand the exposure. Three, ARM rates can only go up so much per every 6 months or year, depending on the ARM. Usually it is like a max of 2%. Fourth, ARM's have a cap. Fifth, the only mortgage rate that could fluxuate monthly is an interest only rate and nobody usually gets those.

So the 'comps' go down and the person in question has a home worth less than he bought it for. But, the bigger kicker is higher interest rates stiffles buying. This causes a slow down in the economy and jobs get lost and the payments must be made. This guys house has no equity so he says the heck with it and files for bankruptcy. Maybe he goes bowling.

Wrong, wrong, wrong. Comps don't go down. Equity is not lost

High interest rates don't stiffle buying. People bought cars when rates were 10%. Jeez people. Think for a minute before you post. If house prices are high and rates are high, people will go buy other things. People are buying houses like mad right now because rates are low.

 

[dirtboy]

Originally posted by: rjain
House prices still fluctuate with interest rates. If rates are low, everyone is buying houses (demand goes up), and vice versa. The price of a house that a person can afford is tied to their income. As I said, if their income increases to make up for the drop in their net worth, then they'll be ok.

House prices don't fluctuate much. Right now they are going up, but once they get up, they will ratchet and stay there. Watch and see. They may stagnate, but they don't go down hardly ever, and when they do, it's not that much. That is why you will hear people say that a house is a good investment and it generally is.

 

[dirtboy]

Originally posted by: rjain
The value of the house is based on what it would sell at right now.

The value of a house is based on it's appraisal. It has nothing to do with what it would sell at.

Your debt-to-equity ratio is a measure of how well you can pay off your debt in an emergency.

Err...ummm...sorry, that's not true either. Perhaps you are confusing it with debt-to-income, which isn't what you are describing either.

Increasing interest rates causes your equity to go down if it's mostly held in your home.

Wrong again.

Your point about credit cards is important, as that's variable rate, and will really cause bankruptcies if rates go up. Also, poeple who have credit card debts probably don't have much, if any, home (or any other) equity. If they did, they would have refinanced now and paid off the high-rate debt. They need income in order to have any chance to pay off the debt. I wouldn't be holding any stock in COF when the rates start to go up if I were you...

The smart people refied to get their debt paid off. It's one of the wisest things you can do with your equity, if you have it. Tax deductible loan. I have seen many people restructure their debt in to their house and due to the low interest rates, end up with the same house payment and no credit cards. I have also seen people go from a 30 year fixed to a 15 year fixed with no change in house payment. All of those things are good.

 

[dmcowen674]

5-13-1996 Main Causes of the Great Depression

Money was distributed disparately between the rich and the middle-class, between industry and agriculture within the United States, and between the U.S. and Europe. This imbalance of wealth created an unstable economy.

Maldistribution of wealth within our nation was not limited to only socioeconomic classes, but to entire industries. In 1929 a mere 200 corporations controlled approximately half of all corporate wealth.

Through such a period of imbalance, the U.S. came to rely upon two things in order for the economy to remain on an even keel: credit sales, and luxury spending and investment from the rich.

The "roaring twenties" was an era when our country prospered tremendously. The nation's total realized income rose from $74.3 billion in 1923 to $89 billion in 19291. However, the rewards of the "Coolidge Prosperity" of the 1920's were not shared evenly among all Americans. According to a study done by the Brookings Institute, in 1929 the top 0.1% of Americans had a combined income equal to the bottom 42%2. That same top 0.1% of Americans in 1929 controlled 34% of all savings, while 80% of Americans had no savings at all.

Automotive industry mogul Henry Ford provides a striking example of the unequal distribution of wealth between the rich and the middle-class. Henry Ford reported a personal income of $14 million4 in the same year that the average personal income was $7505. By present day standards, where the average yearly income in the U.S. is around $18,5006, Mr. Ford would be earning over $345 million a year!

A major reason for this large and growing gap between the rich and the working-class people was the increased manufacturing output throughout this period. From 1923-1929 the average output per worker increased 32% in manufacturing8. During that same period of time average wages for manufacturing jobs increased only 8%9. Thus wages increased at a rate one fourth as fast as productivity increased. As production costs fell quickly, wages rose slowly, and prices remained constant, the bulk benefit of the increased productivity went into corporate profits. In fact, from 1923-1929 corporate profits rose 62% and dividends rose 65%.

The federal government also contributed to the growing gap between the rich and middle-class.
Andrew Mellon, Coolidge's Secretary of the Treasury, was the main force behind these and other tax cuts throughout the 1920's. In effect, he was able to lower federal taxes such that a man with a million-dollar annual income had his federal taxes reduced from $600,000 to $200,00012. Even the Supreme Court played a role in expanding the gap between the socioeconomic classes. In the 1923 case Adkins v. Children's Hospital, the Supreme Court ruled minimum-wage legislation unconstitutional.

 

[Ferocious]

Republicans controlled the Presidency and both houses of Congress for 12 years from 1918 till 1930...........Hence the Great Depression.

 

[rjain]

dirtboy: do you know what debt-to-equity is? Income doesn't help if you default on your loan. Debt-to-equity is relevant when you need to liquidate.

House values do go down. If no one is buying them at the price they were at before and someone needs to sell their house, do you expect the person who needs to sell to just sit on his hands? Who cares what it's been appraised at for tax purposes. That's about as relevant to the functioning of a business as their earnings statement. The only thing that affects is your tax return. If you need to sell, you need to go down to the price of the highest bidder or wait indefinitely.

 

[rjain]

Hey, look. Growth in the manufacturing industry caused the great depression. Dave, why do you want the country to have another depression?

 

[rchiu]

Originally posted by: dirtboy

Your point about credit cards is important, as that's variable rate, and will really cause bankruptcies if rates go up. Also, poeple who have credit card debts probably don't have much, if any, home (or any other) equity. If they did, they would have refinanced now and paid off the high-rate debt. They need income in order to have any chance to pay off the debt. I wouldn't be holding any stock in COF when the rates start to go up if I were you...

The smart people refied to get their debt paid off. It's one of the wisest things you can do with your equity, if you have it. Tax deductible loan. I have seen many people restructure their debt in to their house and due to the low interest rates, end up with the same house payment and no credit cards. I have also seen people go from a 30 year fixed to a 15 year fixed with no change in house payment. All of those things are good.

Unfortunately there are not that many smart people out there. American are putting debt on their credit card more than anytime in the history again because the credit is so easy to get and the bank and retailers are tempting consumers with low/zero initial interest rate. There are not that many people restructuring their mortage to payoff credit card bill, even if some did, they'd borrow more after that. This is a factor we never have to deal with in the past economy when we had high interest rate, and this will be a major issue when and if the interest rate hikes unexpectedly.

 

[dirtboy]

Originally posted by: rjain
dirtboy: do you know what debt-to-equity is? Income doesn't help if you default on your loan. Debt-to-equity is relevant when you need to liquidate.

I've seen debt-to-equity used in a business sense, but not at an individual. It's rather meaningless, because nobody is liquidating!

House values do go down. If no one is buying them at the price they were at before and someone needs to sell their house, do you expect the person who needs to sell to just sit on his hands?

Wrong. Yes, people from time to time dump a house when they are desperate, but it doesn't happen as much as you think. Housing prices tend to rise and rarely fall.

Who cares what it's been appraised at for tax purposes. That's about as relevant to the functioning of a business as their earnings statement. The only thing that affects is your tax return. If you need to sell, you need to go down to the price of the highest bidder or wait indefinitely.

You've obviously never owned or sold property, have you? Houses hold their value. Maybe you don't want to believe it, but it is true.

Besides, why are people going to be selling all of a sudden? Oh wait, they aren't.

 

[rjain]

If a measure applies to a business, it applies to an individual, in general. As far as the bank is concerned, your $1,000 is as good as Microsoft's $1,000. When you default on your mortgage or need to desperately pay it off now, where are you going to get the money to do that?

You can't predict when someone is or isn't going to need to dump their house. If you could, you could stop the problem in the first place.

People aren't selling all of a sudden because rates haven't gone up too sharply. It's not the fact that people aren't selling in any case. The problem is when people stop buying. Hopefully the homebuilders will scale back at that point, but their stellar performances recently may make them overconfident, and the current gov't policy isn't going to stop that.

 

[LunarRay]

The price of anything is based on supply and demand. Demand for property at a particular price drops as the interest rates go up and increases as the rates go down (among other factors). This can be mitigated by those other factors but, set apart by it self (all other things being equal) this is only obvious.