Why is the United State's economy in trouble?

Answer 1

Because the government spends like crazy and doesn't cut spending. Plus we think we're the police of the world. There are many strong and angry opinions surrounding this question. The sanest answer I've found and discussed with a few economists follows: The story is long, so I omitted details, and made a few generalizations for the sake of simplicity. I also broke the story down into sections.

1. THE GOOD TIMES AND THE HOUSING BUBBLE

The problem with the US economy is rooted in the early 1980s, when Ronald Regan's administration deregulated the investment industry in the USA. Deregulation helped to get the US economy out of a recession initially, and very good times followed in the 1990s during Bill Clinton's run as president. Besides a few bad months after the so called "dot com" crash in 2000-2001, more good economic times followed, so nobody questioned the rightness of having less rules for investment firms.

The good times of the 1990s created a higher demand for housing. More people were buying homes, and the increased demand started to raise the prices of homes all across the country. Based on a few years of increases, and predictions of continuing increases in housing prices, the sub-prime mortgage became popular. These mortgages are given to people who would normally not qualify for a loan due to their bad credit or low income, in exchange for a higher interest rate. A very typical sub-prime mortgage contract would offer a very low payment structure for the first year or so, something that could easily be maintained by the home buyer, after which the actual high interest rate of the mortgage would kick in, rendering many people unable to make these payments. Lenders could justify such a mortgage due to the ever increasing value of homes, so even if the home owner was unable to make the mortgage payments, he could sell the house, pay off the mortgage, and still make some profit on the sale. The long-term problem with this type of business is that eventually, houses will be so expensive, that nobody will want to buy them, which is what finally started to happen in 2005, and many of the sub-prime mortgage holders were left with a loan they were unable to afford and a house they were unable to sell, resulting in defaults and foreclosures on a massive scale.

2. SECURITIZATION

All while money lending institutions were giving away sub-prime mortgages, various investment banks and Wall Street firms were buying them from these money lenders, and bundling them together into debt securities, that is, financial instruments that could be traded on the Stock Market, or sold directly to investors. In the process of securitizing these mortgages, credit rating agencies become involved. Each agency is essentially a corporation, and one way that it makes money is by providing a service that rates debt. Debt securities are rated according to risk of default. A debt rating of AAA, is the best rating possible, usually reserved for governments and huge, profitable corporations like Microsoft. AAA rating means that it is very safe to lend money to that corporation, or it is very safe to buy that debt. Most people holding sub-prime mortgages would have a debt rating of C or D. While the mortgages were being securitized, they were also being sliced into components of various rating. Imagine, on one hand, you have a whole bunch of mortgages, prime rate mortgages, sub-prime, etc. going through a meat grinder of lawyers and investment bankers, and on the other hand you get a mortgage pie that's sliced into pieces with various ratings. There's the AAA slice, the AA slice, the A-, B, C, D slices, some other ones in between, and so on. Keep in mind that both the AAA and the D slices have both the good mortgages, and the bad sub-prime ones grinded together, and the only differences between AAA and D is who loses their money first when one of the meat-grinded mortgages fails to be paid. Let's say that there are 100 mortgages in our pie. When the first mortgage in the pie defaults, all the people who bought the D rated slice lose a part of their money. When more and more of the mortgages in the pie go into default those who bought the C and B slices start losing their money. I'm not quite sure what the exact number is, but I think that when around 25% of the mortgages in the pie go into default, the AAA slice starts losing value.

AAA rated debt and securities are supposed to be a very safe investment to put your money on, but in exchange for safety, they offer a relatively low rate of return. You will normally not make a big interest rate on AAA investments. The AAA rated slices of mortgage pies were bought up by investors, retirement pension funds, investment banks and other large banks all over the world. They were hugely popular and successful because they were rated AAA and offered a much higher rate of return than other AAA rated investments.

3. THE BEAST ON LEGS OF CLAY

The Federal Reserve made money cheap to borrow by keeping its interest rate at less than 6% for most of the decade. Credit cards were easy to get by anyone. Almost anyone could buy now, and pay later, and deregulated credit companies were not required to keep to any rules or standards regarding who they lent money to, and how much. By 2005 hundreds of thousands sub-prime mortgages were loaned out, and through securitization ended up being owned by investors and banks all over the world. Also by 2005, the US housing marked started to slump, and many sub-prime mortgage holders started to default. Banks started to take over homes, but they were unable to resell them due to lack of demand. Then house prices started to go down. When house prices start to drop, few people want to buy them, expecting to get one cheaper later, and a cascade of problems starts. By 2007 enough people in the mortgage pie have defaulted to start eroding the value of the AAA rated pie slices, and investment banks who have invested billions of dollars in these securities started to bleed money. This problem became so huge that banks worth $50 billion a year earlier, were down to less than $10 billion. Insurance companies, such as AIG, further insured these securities against default, and were being dragged down along with investment banks. Fannie Mae and Freddie Mac, which insure mortgages against default were bled dry of money by September 2008, and that's when the problem became fully apparent to the media and the public. Few days after a government bailout of Fannie and Freddie, reputable and well established Wall Street investment firms started to approach bankruptcy, and all hell broke loose.

4. THE CREDIT CRUNCH

Here is the real deal (simplified). In the US we have commercial banks on one side, and every other type of financial institution on the other. Commercial banks, such as Bank of America, or Citibank, hold people's money, that money is guaranteed to be there no matter what by various government agencies, and because of that, the banks are regulated. There are laws governing what they can do with your money, how much of it they can loan out, etc. The other types of institutions are largely free to do whatever they want, with the exception of commiting any fraud ofcourse. Through regulation, it is very hard for a bank to do anything that jeopardizes its existence. In fact, since the regulation that came into effect during the 1930s, no US commercial bank has bankrupted. However, many commercial banks have come to own investment banks, and other unregulated financial companies. In late 2008, the problems with the unregulated side of their business became so severe, that they threatened to drag the protected, regulated side down with it, and banks got scared.

When banks get scared, they stop loaning money. When banks stop loaning money to everyone, normal people, who can afford a mortgage, or car payments can't go around buying houses, cars, and other things. When people don't buy things, businesses don't make money, and have to lay workers of, which prevents them from earning money and buying things. When businesses who laid people off can't get loans to help them through tough times start going bankrupt, even more people don't make money and can't buy things. A vicious cycle is created. If you let this cycle continue, before you know, half the country has no job, no house, and no food to eat, and the USA is in very serious trouble.

5. CONCLUSION

The US government is spending money and giving huge bailouts to troubled banks so that the money keeps flowing. Government gives grants to banks to loan out to people who buy things and keep businesses running. When the economic stimulus package passes, it should lubricate the gears of the economy, and get the whole financial system moving again... so it is hoped. People love to blame the rich bankers for the problems, but the bankers did not break any laws. The truth is that the whole country is responsible for the troubled economy. Over the last few years, Americans spent more money than they made, all borrowed money. It is now time to start paying some of it back, and it hurts.