Question: What are the underlying issues causing the current recession in our economy? And what do you think our government should do to try to repair it?
Answer: Since at least the mid-1990s, consumer spending has been a powerful driver of the U.S. economy. To put the matter simply, the value of peoples’ homes has been steadily increasing, making them feel wealthier and thus more comfortable spending their income, to the point where the aggregate savings rate out of current income for the U.S. has been, amazingly, close to zero.
But now the era of confident consumer spending buoyed by rising home prices has been threatened by a growing crisis in housing markets which has led to a dramatic decrease in new home building and a significant increase in foreclosures on existing homes. At the root of this crisis are so-called “subprime” mortgages supplied to homebuyers who would not traditionally have had sufficiently strong credit ratings to qualify for home loans. These mortgages offered the prospect of first-time homeownership to millions of people, but, as with all things economic, they came at a cost: the interest rates charged in these mortgages were set higher to cover the greater risk of lending to those with poor credit histories, and these higher interest rates were often hidden in “adjustable rate” packages that started at misleadingly low interest rates, only to balloon later in the payment cycle.
These features help to explain the rising foreclosure rates. The negative economic impact of this phenomenon has been amplified by financial practices in which these mortgages are bundled with other financial assets and sold to investors, who end up holding securities underpinned by an indeterminate amount of what will eventually become bad debt. Financial institutions holding such asset bundles are then understandably reluctant to increase their risk exposure any further, so they are less willing to make loans. Fewer loans mean fewer resources provided for investment and large-scale purchases, thus less spending pumped into the economy, thus increasing the threat of recession.
What should the government do about this? Arguably three things: first, encourage refinancing arrangements that will allow people holding such mortgages to hold on to their homes, even if this implies some loss of interest income in the short term. Second, stimulate demand by lowering interest rates and providing income to those most likely to spend it—that is, lower-income people—through such means as unemployment compensation and higher earned income tax credits. And third, looking forward, draft effective regulations for the provision of subprime mortgages and to increase the transparency and viability of “mortgage-backed” securities.
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