Friday, September 26, 2008

Oh JK, Here's Economics 101 From Papa Roy

Hi Jess,
sorry we got cut off.
Here's economics 101:

Banking - banks make money by charging a price (interest rate) for making loans. If loans get paid back, Bank gets original loan amount back PLUS interest (profit) and everyone is happy. If Bank makes lots of risky loans that don't get paid back - you get . . WaMu.

Investment Banks - invest other people's money in variety of things - stocks, bonds and also buy loans from banks. For example, say A loans B 10,000.00 plus interest. For A, that loan is an asset - it represent something of value (just like a car). And, just like a car, A can sell that loan to C. C decides to buy the loan from A and plans to make money when B pays back the loan plus interest. Everything works unless B does not pay back.

Now, picture bundling millions and billions of dollars worth of mortgages (loans) and selling to investors. In the bundle are some good mortgages that will get paid back. But, also in the bundle are high risk mortgages (because banks loaned to people who they knew probably couldn't pay back). If I buy a bundle - and the risky loans go bad - I lose.

Here's the trickiest part - I probably didn't use my own money to buy that million dollar bundle of mortgages. I (as invesment bank) took other people's money to buy the mortgages. When the bundle fails, now I can't pay back my investors . . .and so it goes through the economy.

Money - money is like a commodity. Take oil - the more there is, the lower the price (assuming demand stays even). The less there is, the higher the price. The Fed can print money to buy up all these bad debts on wall street /banks. But, putting more money into circulation causes the value of money to go down. If a dollar is worth less, businesses charge more to get the same value for a product. So, prices go up = inflation. Again, think of it this way. If there are 100 dollars in circulation and I have fifty of them in my pocket - i'm pretty damn rich. If there are 100 billion in circulation - big deal that I have 50.
Basic money point - an increase in the supply of money (money in circulation) leads to inflation.

Now, back to banks. At this points, banks are being incredibly careful about who they loan money to. That means many businesses and people can't get a loan now. Why is this bad? Let's say I am a home builder with variable cash flow - I need a line of credit (loan) from my bank so I can pay my workers when my cash flow is low. Then, when I sell the new houses we are building - I pay back the bank. MANY MANY businesses operate this way. If my bank decides they can't loan to me now - I can't pay my workers - they get laid off. Picture this happening tens of thousands of times across the country. Now we have many more people without jobs - which means they spend/buy less - which means more businesses have to lay off workers which means there is even less spending and down we go into a great big recession.

the economy depends on the availability of credit (meaning, people can get loans). No credit = no loans = economic meltdown.

Then short term answer is for Fed to buy up the risky debt of banks and investment houses - this takes that bad debt off of the hands of the banks. They then can focus on making new, safer loans.
Finally, the long term risk is this - the Fed will have to borrow money to buy up the bad debt. But the market for borrowing money/loans is like any other market - when demand goes up prices (interest rates go up). So, when gov borrows too much, it drives up interest rates which makes the cost of loans too much for some businesses and people and then we loop back to the point where credit is tight.
so, it's a dangerous tight rope we are walking. Print money instead of borrowing money and the Fed causes inflation. Borrow money instead of printing money and the Fed causes high interest rates. Either way - it ain't good for the economy.
In the end, this financial disaster is the ultimate outcome of 20-30 years of Republican philosophy - deregulation, focus on wall street and the rich. Deregulation led to bankers and wall streeter taking unreasonable risks for short term gain and now resulting in long term disaster. This nightmare lays squarely at the feet of Republicans - will the Democrats make that clear?

The test is on Thursday.
feel free to blog about this email


Marshall said...

Joe Roy, Obama's Treasury Secretary?

Jess and Josh said...

I know, right? I actually kind of understand it now, particularly the part about money being a commodity like any other commodity. My Dad should go back to teaching.

M said...

Thanks Jess's Dad. Clear explanation in lay terms for all us non econ types. Best, clearest sum up I've heard yet! (Yes, your dad should teach, or write, if he doesn't already.)