What caused the economic crisis?

By Brian

First off, there are probably very few people who lost more during the “economic crisis” than I did.  At the time that it hit in September 2008 I was running a small real estate investment company.  What happened to us was that the banks we relied on to make loans to our investors either completely stopped loaning money or completely changed their rules on who they would loan to and how much they would loan.  Basically, this meant we were left holding the bag on over 30 homes which now could not be sold.  Within the span of a few short months I had lost everything I owned – my house, my car, and my life savings.

After this happened I spent the next several months investigating the crisis and more importantly it’s causes.  Here is where my investigations led me, and this is what I found:

Suspect #1 – Subprime Mortgages

This week, Alan Greenspan testified before congress that “subprime mortgages”, and “adjustable rate mortgages” were (a least partially) to blame .  In fact, pushing the blame on “greedy mortgage brokers” and “incompetent regulators” and on subprime lenders and borrowers seems to be the most popular way to identify blame in the economic crisis.

After all, giving loans to people who couldn’t and wouldn’t be able to afford to pay them doesn’t seem like a very good idea.  The system itself was set up so that during each stage of the process the risk could always be passed on to the next guy.  The broker who arranged the loan would pass the risk to the bank.  The bank would then sell the loan and pass the risk to another bank.   The second bank would package many loans together in incredibly complex and confusing ways as CDO’s and sell them to just about everybody – pension funds, cities, countries, and even other banks. 

When the overextended borrowers were unable to pay their loans the CDOs and the banks who owned them went down – hence the economic criss.

But the truth I found was that subprime mortgages did not cause the crisis

Suspect #2 – Derivatives

In 2008 the subprime loan default rate went from something like 2% to 2.5% (don’t quote me on the exact numbers).  So how could a small jump in defaults cause the world wide economic system to grind to a halt?

1 Word – Derivatives

So, what are Derivatives?  “Derivative” is a fancy word for a bet.  A derivative is any financial instrument which is “derived from” an asset but is not the asset itself.  For example a stock is not a derivative because it’s a piece of a company.  A “stock option” which gives you the option to buy the stock, however, is a derivative.  It’s a bet that the stock value will either go up or down.  If it goes the way you want it to you can acually “win” many times more than your original bet amount (or investment).  Futures, mortgage backed securities, and credit default swaps are all examples of derivatives.  A derivative itself isn’t inherently bad, but what happened preceding the crisis was that the total amount of derivatives in existence ballooned to incredible amounts.  Some estimates had the total face value of the derivatives market to be in excess of $140 Trillion dollars which is many times larger than the entire GDP of the world.

Where derivatives differ from traditional gambling is that when you gamble there is always a winner and a loser and the loss is equal to the win.  When the bet that real estate prices would increase forever didn’t pay off, the directives markets began to crash and there were many more losers than winners.   Trillions of dollars then simply vanished into nothingness – and hence the economic crisis.

But the truth I found was that derivatives did not cause the economic crisis

Suspect #3 – Money created out of thin air

Did you know that banks can create money out of thin air?  I didn’t.  Talk about changing the way you see the world – this was definitely the most surprising and disturbing piece of information I came across during my investigation of the economic crisis.

Think about this statement: When a bank makes you a loan it is not loaning you money from existing deposits.  It is creating that money out of thin air.  It’s called fractional reserve banking and is the cornerstone of the entire worldwide economic system. 

How does it work?  It’s slightly complicated but in its basic form it’s somewhat akin to a sleight of hand magic trick.  When a bank makes you a loan of say $100,000, the bank simply puts an entry into its computer saying that your account now has $100,000.  And there you have it – $100,000 of “new money” has just come into existence.  When you go to another bank to deposit that loan money the two banks simply transfer the balance.  No “real money” ever has to go anywhere.  You never actually saw the $100,000 in cash did you?  In this way the banking system has created as much as 97% of the money in existence today.  It’s almost unbelievable isn’t it.

I know… you’re confused.  Watch this video which explains the process quite well:

 

Back to the economic crisis – During the “boom years” banks were in fact loaning themselves and each other billions upon billions of dollars to guess what…  INVEST IN DERIVATIVES!  In other words not only were banks investing in derivatives (gambling), but they were creating billions (and probably trillions) of dollars out of thin air to do so!

When their bets went bad, trillions of dollars suddenly disappeared!  That’s right, I said it – the money disappeared – evaporated into the thin air from whence it came.  The main problem with this is that in order to make up for this disappearance much of the missing money now had to be made up by taking it from other parts of the economy, this of course led to billions of people (like me) and business (like mine) around the world being short on the cash they needed, and hence “the economic crisis” was born.

But the truth is that money out of thin air did not cause the economic crisis

So what REALLY caused the economic crisis?

We’ve had a “money created out of thin air” banking system for well over 200 years now. And, while there is an important debate on whether this system is sustainable, it certainly could have continued for a while longer and was not what caused the crisis. 

What really caused the crisis was something much more fundamental – We, as a society, confused money with wealth.  This confusion has been around since the beginning of money.  In the 1500s when Spain returned from the new world with piles of gold, the Spaniards soon found that instead of everyone being richer (because they had more money) everything of real value (food, labor, goods) simply became more expensive.  This confusion was evident all the way from the governments money guru Alan Greenspan to the CEO’s of the biggest corporations in the world, all the way down to Joe the Plumber who took that new mortgage knowing he was biting off more than he could chew.

It turns out that MONEY which is little pieces of paper and numeric computer entries – IS NOT WEALTH which is food, housing, transportation, and we cannot create more wealth by creating more money.

Think about it: how could the entire wealth of the United States (as represented by the value of our homes and our stock market) virtually double in the span of 10 years (as they pretty much did from 1995 to 2005).  Did we become twice as efficient at producing food?  Did our homes get twice as nice?  Did the quality of our lives double?

No, there was simply twice as much money in existence in 2005 as there was in 1995.

Real wealth creation takes hard work, it takes innovation and efficiency improvements.  It takes people making things, and doing things.

The tragedy of Wall Street and of the American Dream, and yes even of Capitalism itself – is that the people who do all of the real work and create all of the real things that we use day to day – the miners, the construction workers, the restaurant workers, the factory workers,  and the farmers – are the lowest paid among us and are now suffering the most during the economic crisis.

And then there are the bankers who create trillions out of thin air and wonder why their thin air money doesn’t make us all rich.

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Hello, my name is Brian and I am the creator of the Dreamer Search Engine.  We are a revolutionary new way in which citizens and companies interact to make the world a better place.  You search, and we donate 100% of our profits to good causes that you help choose.  It’s a way you can give for FREE.  I encourage you to try it out.