A look at the causes of the worst U.S. recessions
Somewhere some time something must give in in the world of supply and demand. That’s recession pushing into our collective heads that free market is imperfect, and when the chips are down at once across various industries and sectors, we have a nationwide economic bust. Recessions are a normal part of the economic cycle when demand stagnates or supply runs out on a wide scale. Often, it’s the severity of the recession—how far across industries is the impact—that we read it in the front page.
The Business Cycle Dating Committee defines a recession as a significant economic contraction for a few months resulting in lower gross domestic product, which can be the accumulative result of lower income, less production, declining sales and increasing unemployment rate. Or it goes this way—people spend less. Businesses make less. Investors lose money. Employers cut jobs. People earn less. People spend less. It’s a vicious chicken and egg dilemma.
Ironically, looking back at the worst U.S. recessions reveals some major causes that kept recurring. You wonder, why do we still get caught with one hand in the cookie jar? That’s because the underlying reasons may be the same, but the economic dynamics have changed over time. We still miss the forest for the trees because where before we see sequoias, we see pines now. And the trees keep changing. For example, who would have thought of the Internet, smartphones, iTunes, or budget airlines just a couple of decades ago?
Still, some patterns, like a forbidden fruit, stuck out across the worst U.S. recessions. Rest assured they don’t clue us in much when the next recession will take place, but they give us a good slap in the face to diversify our investment portfolio.
Land bubble
Land is a stable asset that builds value over time. But when it’s sold like overflowing with milk and honey, creditors are drawn to it like bees because land is attractive collateral. Never mind that the honey may soon run out and the value can dip drastically. It’s a scenario straight from the 2006 sub-prime housing bubble, but we might as well be talking about the Panic of 1797, one that involved a familiar house in Pennsylvania Avenue, Washington, D.C.
America was a frontier for business opportunities and land was a prime commodity. Speculators like Robert Morris would sell securities backed by land claims with supposedly good returns. One of these “promising” properties was the new national capital under construction and needing private funds, the White House. Speculators were quick to secure loans to claim their property shares, only to sell to fearful European buyers wary of war in Europe and America. Failing to raise funds, Morris and the speculators defaulted, bringing down with them a slew of investors and the economy.
Yet another land speculation featured in the 1815 recession. The United States fought England in 1812 and war production racked up the fledgling country’s debts. The banks needed to call in their loans, but many defaulted and attracting buyers was hard when they only saw a country of small towns and a fledgling government, creating a string of unpaid loans and bank closures.
In 1837, America was moving westward claiming Indian lands. Suddenly, real estate was cheap and seemingly endless with money to be made. If the Indians prayed for revenge, it came not in a rain of arrows but a flood of unfulfilled debts that led to a recession. The lands didn’t attract the expected buyers—maybe out of moral ground or fearful of an Indian comeback?—debtors defaulted, investors lost money, and 40% of American banks folded up.
Make no mistake, we all need land and that makes it an attractive investment. It’s only when real estate is backed by mortgage with weak income sources or a promise that may be too ahead of its time—a farmland booming into a city takes generations—that real estate becomes risky.
Lending spree
It’s generally pooling loans into investment products and reselling them for a new round of promised returns. The tricky part is when the tranches are sold many times over on the foundation of debtors with vulnerable incomes, so is the risk of spilling over the loss to other industries multiplied. The 2006 subprime mortgage crisis would have been contained had the banks didn’t’ lend out wantonly. But they did because they could repack the loans into many layers and sub-layers and investors around the world wolfed them down. When the bubble burst, the shockwave cut across industries and countries that at one form or another were holding a subprime housing-based portfolio.
Lending spree is nothing new. In 1907, America was enjoying an economic boom on the heels of railroad, oil, steel, and banking monopolies. Banks were already decentralized and the lure of seeing the Rockefellers and Carnegies expand the economy to bursting encouraged banks to lend out more. Until one day, the Knickerbocker Trust Company, its treasury filled with bank loans, failed to corner the copper market and started a chain reaction of bankruptcies to a stock market crash.
Banks make money by lending. When they fail to recoup the interest, they lose profits. But when they can’t recover the principal, they lose their business. And the other businesses hooked to the banks also lose money, if not their business, too.
Stock market speculation
Like land, stocks can be speculated to a crash. Speculators buy loads of stocks to prop up their value. As more investors join in, stock value increases to a point when it becomes ridiculously disproportionate to the company’s real market value. Once speculators start to sell their stocks and reap their margins, the chain reaction sets in resulting in more investors pulling out their money. This in turn leads companies to bleed and default on their bank loans. The banks lose liquidity and are forced to close, creating yet a more vicious round of companies cutting on costs and driving consumer spending down when unemployment rates skyrocket. This type of speculation is argued to have led to the Great Depression, which historians traced to the Black Tuesday when Wall Street collapsed in October 1929 out of successive stock speculations. The recession was exacerbated when countries started putting up protectionist tariffs, leading to trade imbalances. People lost their jobs. Countries were sent to the brink of conflict. Communism surged up as an attractive alternative to the failed capitalist model.
Without doubt, the stock market is built on speculation. It is when shrewd investors manipulate the speculation that a crash becomes imminent; thus, today the government is quick to investigate sudden stock movements without a clear underlying reason.
CONCLUSION
Recession is a normal part of an economic cycle and it’s ugly in every side. But its ugliest part is that when rich people start to lose money, poor people stand to lose more, their living and even life. That’s probably because the rich has other revenue sources. When recession hits, it pays to have different sources of income. Your salary may be great. Now build up your personal finance.
WHAT OTHER INCOME SOURCES DO YOU HAVE?