Wednesday, September 17, 2008

The Credit Crisis in Simple Words, Part 2

At Good magazine their is an easy to understand infogram, clearly explaining how the Credit Crisis was created.

For more detailed information try reading an article at the Ludwig von Mises Institute website. David Saied has written and interesting article “America's Economic Myths”. Here is one of myths that has helped me understand what caused the Credit Crisis.
Myth # 4: "Consumption is the most important element of the economy."

Consumption is indeed important in a free economy: particularly the freedom of consumers to buy their goods in unhampered markets. However, key to long-term economic growth is investment (savings), which is the opposite of consumption. Public policies that promote consumption — such as low interest rates — do so at the expense of savings. Less savings means less investments; an economy that does not save or invest will consume all of its resources and eventually end up bankrupt.- David Saied, America’s Economic Myths
In this article I will summarise my thoughts explaining what caused the Credit Crisis.
The Credit Crisis was created by bad loans. Banks lent money with zero-down financing and let spending on credit got out of hand. Individuals were borrowing money to buy a car, the latest in electronic equipment and borrowing to investment in the stock market. This surge in demand was great for companies, it increased business and created higher profits.
Eventually the debt bubble imploded, everything changed. Too many people were over their heads in debt and banks had reached their limits and couldn't lend more money. The shortage of credit meant people had to withdraw money from investments to service existing debt. This grew to many people selling investments to service their debt. Banks stopped lending so people couldn't get new credit so they stopped buying. Companies started to see their profits shrink as consumption decreased. With diminishing profits, share prices started to fall and so did the value of assets, making it hard to repay loans; there became a shortage of money.

What do you think? Let's discuss.

more reading The New Economist

Photo by Rob Owen-Wahl