What Just Happened?

Anyone else still left scratching their head because of the last year in economics. I think only a handful of people really understand what we just went through.

In short, what just happened was a severe and painful deflationary event. It's the first one we've felt since the 1930's, so it's not surprising that we were walking in blind.

Everyone's heard of inflation, right? It's when our money is worth less and less every year. Deflation, however, seems a more rare animal.

To understand why we experienced this sudden surge in the value of money, you have to understand fractional reserve banking...which is no easy subject to wrap your head around. I can sum it up very quickly.

Fractional reserve banking is how banks around the world do business. They are allowed to simply "invent" money that never really exists. For all of the money they claim to have, they only have to have about a dime on the dollar.

When you bought a house and took out a mortgage, the bank lent you money they did not have. They did this because other banks will take this money as payment, so it's as real as a dollar in your pocket. So you borrowed 200 grand to buy your house, but in reality the bank only really had to have 20 grand to invent that money.

Seriously...this is really how it works.

Fastforward us to 2003. We were still reeling a little from the dot.com crash, and the Federal Reserve had interest rates really low for a long time in an effort to stimulate a faltering economy through the housing market. In sum, they printed a whole lot of money in a really short period of time, and this drove the markets artifically high.

Eventually, all booms must end, and the housing boom began to fail in 2006, and really hit full momentum in the summer of 2008.

The suddenly falling property values, along with mortgages written by true blood sucking morons, caused a massive amount of mortgage defaults...people just walking away from their homes and their obligations to the bank.

The banks then suddenly became stuck with more and more homes, and less and less real money. They began scrambling in the spring of 2008 to unload as many homes, and as many investments tied to homes as they could. This resulted in a logjam, because you had so many sellers and no buyers, the mortgages were essentially worthless.

If you remember that banks must keep a dime to back up a dollar of fake money, many of these banks were getting perilously close to falling below this. When this occurs, the FDIC seizes the bank and it fails.

The result of all of these banks experiencing "liquidity issues" is the value of money begins to rise. Suddenly, banks were offering unthinkable interest rates on savings accounts, they weren't making any home loans. Basically, in a banking way of thinking, there wasn't enough money to go around.

The Fed was certainly throwing new money at the problem as fast as possible, even inventing the TAF...which is a faster way to print money for banks...but they could not get ahead of the problem.

This deflationary pressure finally popped a growing commodity market, which had the added bonus of popping the crazy oil prices (thank god!)

All of this deflation came to a head in late September/early October...when Lehmen Bros. finally failed. This was the first indication that the American public felt something was wrong.

So the President goes on TV and talks of grave danger, Bernanke's on TV, and so is Paulsen saying that we're moments away from disaster if we dont' do something quick.

So what do we get? A massive bailout package...followed by the expected outrage. How can they bail out so and so if they can't help me???

What was the bailout package anyway? In short, the Feds allowed banks to write more fake money into their books, so they wouldn't get below the dime on a dollar rule. Nothing else...we didn't ship massive amounts of printed money into bank vaults, we didn't give them gold bullion...the system doens't work that way. We simply gave the banks permission to fake it for the time being.

It's certainly more complicated than that...but in a nutshell, that's what occured.

Since then, we've seen a gradual return to normalcy. Credit unfroze in early December. The pain we've seen in the economy had nothing to do with the credit situation, but more teh result of everyone panicking at once.

I'll say it again...the recession we're in was simply caused by consumers panicking over a situation they didn't understand, they stopped spending and started saving in a hurry. This broke the camel's back for a lot of manufacturers already teetering.

Things are improving, because people believe things are improving. Don't give too much credit to the meistro's that bailed out out banks...it was a cleverly orchestrated ballet, and we bought it.

"People often confuse economics with mathematics. In reality, economics is a study of psychology with a little math." Jzneff