The conventional wisdom says the 1999-2006 residential real estate "bubble" in the U.S. and the subsequent collapse of global financial markets were caused by a failure of the free market. What's wrong with that assertion?
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The nation and the world have not seen such a financial downturn since the Great Depression of 1929. History can be a great teacher of those who lead look back to see what did and did not work. The crucial factors involved in the great depression were:
1. Stock Market Crash
2. Bank Failures
3. Reduction in Purchasing Across the Board
4. American Economic Policy with Europe
5. Drought Conditions
Reference link - http://americanhistory.about.com/od/greatdepression/tp/greatdepression.htm
Sound familiar? Yes. These five causes of the Great Depression of 1929 generally equal the current economic downturn America and the world are current experiencing.
Let's go back to 1999. The economy was doing well and unemployment was down. If we look at the timeline of events, it will explain how this occurred and most importantly, why it occurred.
When society is employed, society makes purchases. When big business observes the purchasing strategies of the consumer, big business conforms to the spending habits. When big business sells its product or products, big business increases revenues. The cycle is not new, but when the cycle is abused - financial factors become significant.
In 1999, housing prices began to increase. A home that was purchased in 1996 for $130,000 was now selling for $200,000. By the time that 2004 came around, the 1996 $130,000 home was now selling for in excess of $350,000. The ...
The solution discusses the real estate bubble that caused the banking sector to come close to folding.
1. Go to the St. Louis Fed's web site and look at the graph of target federal funds rates
over the last few years:
Notice that from January 2001 until June 2003, the Fed lowered the target federal
funds rate in steps from 6.5% all the way down to 1% and left it there for a year;
then between June 2004 and June 2006 they raised the rate back up to 5.25%; and
then finally from September 2007 until now, they lowered the target federal funds
rate again in steps down to almost zero.
WHY did the Fed do this? What is the intended effect of either lowering or raising the
federal funds rate?
2. Explain the mechanism: what does the Fed actually DO (beyond making public
pronouncements about their intentions) to lower or raise the federal funds rate from
wherever it is?
3. What are the side effects, in the short run and the longer run, when the Fed does
what you described in (2)?
4. We have recently had a major nationwide boom (a "bubble") in residential real estate
and in the financial markets in general, which has come to an abrupt and painful
end. Is there any connection between this bubble and its end, and Fed actions as
shown in the graph you looked at in (1)?