i've been reading a bit about the financial crisis and i have two unrelated questions that i would be thankful if they could be answered. before i ask, i'm a bit of an economic noobie and apologise if they have already been covered.
1) this is the austrian idea that by lowering interest rates the fed created the housing bubble and drove malinvestment in sub prime mortgages. i don't really understand the mechanism behind this. firstly, when the fed lowered the funds rate, did the banks have to pass this on to customers through lower interest rates? not only this, but the banks still chose to give loans to people with poor credit history despite the lowered rates. i don't really understand how lowering interest rates caused banks to invest more in sub prime mortgages. i understand why it would increase the demand for loans because of easier access to credit (assuming banks pass on the lowered fed funds rate) but can someone explain this further, as surely this would not affect whether the bank deems the person not worthy of the loan.
2) this is to do with increasing real wages in an economy. i understand how firms can increase wages of their employees over time, with increases in technology, efficiency etc. meaning costs are lower, so of course in the long run they will be able to improve wages but here is where i am stuck. by increasing efficiency, the money they would have paid to say an electricity company (or any unnecessary thing) they obviously no longer pay. this means that their (electricity company) employees lose out if others gain (if revenue falls then they cannot have increased wages). i know that the answer will be 'but its not a zero-sum game', but i'm stuck as to where this new money comes from. if everyone gets paid $2000 extra from one year to the next with inflation taken into account, how is this new money created?
thanks again and i apologise if these have already been answered but i've been stuck on them.
Thanks for your questions.
1) When the Fed increased the money supply through the banking system, the banks had to lend out the money in order to maintain competitive profits. If Bear Stearns is acheiving a certain return on investment, the other banks have to maintain a competitive return in order to attract investors. Of course, if the government-regulated securities rating agencies had done the job that they were supposed to be doing, the bank with higher profit margins but more risk would have been penalized by the investment markets for the higher risks, but this wasn't the case.
2) Depending on economic conditions, the firms that are increasing their efficiency will either produce more with the same amount of labor or the same amount with less labor. If they are producing more, they will need more of the other factors of production. If they are producing the same amount, the employees that they no longer need can produce other things. Of course, this assumes that onerous laws and regulations don't prevent them from doing so.
1. Whenever the Fed lowers interest rates, it pays off for banks to lend out the additional money. If they don't, then they're bypassing a profit opportunity. When the money supply is expanded as much as it was, then banks have to look for new customers. The money supply was expanded so much that "subprime borrowers" became the new customers of choice. Banks wouldn't have lended to them if credit were more restricted.
2. Say Company A develops a new machine that every business can put in its buildings, in order to save 50% of energy costs. Obviously, power plants will be making less money, however, all other companies will increase their productivity. So, even if/when power plant workers are laid off, the increased productivity in the economy has increased real wages for everyone, on average. Of course, that doesn't change the fact that the power plant workers might be screwed. But this highlights the "creative destruction" of capitalism. Great progress often comes at the expense of the few. But that's better than limiting progress altogether, which is something that most governments apparently want to do.
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RonPaulLol: not only this, but the banks still chose to give loans to people with poor credit history despite the lowered rates. i don't really understand how lowering interest rates caused banks to invest more in sub prime mortgages.
not only this, but the banks still chose to give loans to people with poor credit history despite the lowered rates. i don't really understand how lowering interest rates caused banks to invest more in sub prime mortgages.
One part was Fannie Mae and Freddie Mac reducing down payment requirements for mortgages.This was due to the American Dream Downpayment Act passed in 2002 by George W Bush. For some home buyers, there was no down payment required at all. Subprime loans rose from 7 percent of all loans to nearly 14 years in 5 years. There was even quotas for subprime lending set for Fred and Fannie by their regulators.
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http://www.mortgagestarloan.com
1. No the banks did not have to pass on the lower rates. It's just another case of the wonders of a free market [=competition] lowering the price of something as much as possible.
The banks did not have to make sub prime loans, although of course they were encouraged to. There is some law on the books that if you don't lend to enough minorities, you can get into trouble. Besides which, the govt created conditions [guarenteeing the loans though freddie and fannie, see later] which made such loans irresistible to the banks. Heads I win, tails the gov picks up the tab. Finally, there was so much new money sloshing around in the coffers, given to the banks by the Fed, that all the "normal" people got their loans long ago. To whom can we lend all this? I know, to just anyone.
The banks did not care if the person was worthy of the loan. Fannie and Freddie told the banks, you guys make the loans, then sell them to us.
I like Peter Schiff's entertaining videos that explain it quite well. Here's one: http://www.youtube.com/watch?v=HStFXa63Ghk
2. The new money is not created. That is inflation, printing money, and causes real wages to fall, not rise. Wages rise as the purchasing power of the same old money rises. Look at the real world to see how this works. When computers were very expensive, computer companies made money. When computers became cheap enough to sell to anyone, they made huge fortunes. And everyone benefited as well, by being able to get a computer for his money, something undreamed of in the past. So that everyone got richer. With the computers getting cheaper, businesses could start using them and thus could offer better service to ttheir customers for the same price, i.e increasing the purchasing power of everyone. And they did it because it made them more money.
It may be easier to grasp if one remembers that pieces of green paper are not wealth. Tangible things are wealth. If there are more and superior tangible things in the world, and everyone has to work less hours to get them, the nation is wealthier.
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