The Faster You Go, The Bigger The Mess

Lots of people are saying that this recession is "different".But why?

Our national income is a bit like a river. We can usuallymeasure the amount of water (i.e. money) in it by looking at how high the watercomes up the riverbank. When times are good and the rivers are full, we can easethe pressure by letting some water out. The Government does the same thing withthe economy – when it is growing too fast, the Government takes money out. Theydo this indirectly through the Reserve Bank raising interest rates (which meanswe all pay more for mortgages) or directly by taxing more than they spend –i.e. saving money. When the river gets low, we put more water in. Before allthe farmers out there get too excited we can’t usually do that with a river,but we can with the economy. The Reserve Bank drops interest rates and Governmentspends more than it taxes (i.e. runs deficits).

So surely the answer to our current dilemma is simple. We havea recession, i.e. the water levels have dropped. We need to measure how far thewater has fallen, and get Government to pump more water in to equal what wehave lost. Right?

The only problem is this isn’t working, and it probablywon’t. There is more going on beneath the surface of the water in thisrecession. You can’t always measure the amount of water in the river by lookingat the height of the river. The speed of the flow of the water also matters. Alot. And actually the economy works like this too. How much income we all haveis partly determined by how quickly money flows around the economy.

In recent years this flow accelerated, and commercial banksplayed a big part in this.

Banks make loans, which people spend or invest, and most ofthe money ends up deposited in someone else’s bank account. Banks can then loanthis money again. In the past however, banks made sure that a bit of that moneywas set aside for every bit deposited or lent out. They made sure you had adeposit to buy a house, and they kept a portion of all deposits on hand incash. This meant that every time the bank made a loan, it got less of the moneyback, and in turn could lend out less of the money to the next person. It was abit like the banks made little reservoirs along the riverbank. This slowed the flowof water down the river, but made sure there was enough water set aside for timesof drought.

In the last boom however, banks relaxed these restrictions.They reduced the deposit needed for a house. They sold off their loans toinvestors so they could make more loans. One by one, banks emptied thereservoirs they had made along the river bank. This happened here, but evenmore so overseas. The river flowed faster and faster, and we all felt richer. Wewent white water rafting on the international rapids of cash. We didn’t needdeposits for a house, and interest rates were low, so we paid higher prices forhouses. House prices rose, we all felt rich and so we took money out of ourhouse and bought a new car.

Now the white water ride is over. Banks have realised theyneeded those little reservoirs along the riverbank, and they are trying to fillthem up again. Households are also realising they need a reservoir too – ahouse is no longer enough because they are losing value. So banks andhouseholds are refilling their money reservoirs. This is reducing the waterlevels in the river, and slowing the river down. Governments around theworld are furiously trying to pump water to raise the river levels, but this isgetting absorbed by the reservoirs.

No matter how much money the Government pumps out, the moneyriver will never flow as fast as it did in the past. It was unsustainable, aman-made flash flood. That is why the current recession hurts so bad, we got addictedto a speed of money flow that cannot be repeated. And as we all know by now,the faster you flow, the bigger the mess.

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