The Consumer Problem

The first part of the problem comes from the situation of consumers. Consumers get the majority of their money from wages, government entitlements, and credit and spend most of their money buying goods and services, paying taxes, or repaying credit.

Simply looking at the numbers tells the story. For the poorest 80% of Americans real wages have remained almost stagnant since the 70's. For the economy to continue to grow, consumers have needed to spend more money each year. With taxes and wages remaining the same, that extra spending has had to come from the richest 20% (who have seen rises in income) and credit.

Credit has grown significantly over the past 20 years. Credit cards have become almost ubiquitous among the American population. Other kinds of loans have seen tremendous growth as well including pay day loans, title loans, car purchase loans, and home mortgages. The explosion of home mortgages in the past few years has allowed consumers to pay off credit card debt, so that they can spend more on their credit cards and take money out of their home so that they could spend it.

The big problem with all these loans is that consumers had to repay them with interest. This was okay initially, but the amount of payments that consumers had to make back to credit providers has grown larger and larger. Eventually, consumers could not continue increasing the amount of spending on goods and services as well as make payments back to credit providers. As a result, consumers began defaulting on their mortgages and credit cards. At the same time, consumers also began to cut back on spending.

Facing the prospect of a recession due to falling consumer spending and rising defaults, investors stopped making as many loans to consumers and businesses. This meant less consumer spending as fewer consumers could get loans and less corporate investment as fewer businesses got loans. This also caused more consumers to default when they could not refinance their homes or take out more debt to make debt payments.

Finally, to make matters worse, consumers began getting laid off from their jobs. This meant that consumers had less wages and would spend less and default more. Meanwhile, the wealthiest 20% of consumers lost money from stock market declines, loan defaults, and layoffs as well. They have also reduced their spending. As a result, US GDP has declined over the second half of 2008.

The process is very similar to what happened in the great depression according to Franklin Roosevelt's Federal Reserve Chairman. Wikipedia has a quote here. Among other things, he says:
"We sustained high levels of employment in that period [the 1920's] with the aid of an exceptional expansion of debt . . . . The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption . . . . Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle."