Now that the world´s economy is moving forward again in spits and spurts we can look at what happened.

To begin we must remember one truism, if not axiom of the economy, growth depends on growing demand. No growth in demand, no growth in the economy.

In today´s world demand requires lots of credit to buy homes, cars, washing machines, televisions, and, in my case, my next trip. By 2008 we came to realize that the largest soucre of credit was “securitized” or “collateralized” debt. Collateralized debt was just that, debt that had collateral. The main debt was mortgages with property as collateral. These were bundled into bonds that were sold to investors.

As home prices rose rapidly in the 2000s, probably due to investors fleeing the stock market to other investments, people began to borrow against the growing equity in their homes to buy home number 2 or 3 and other items. And this borrowing was all “collateralized.”

When home prices hit a wall and began to fall, this source of extra cash dried up. It would have caused a modest correction in the economy. However, the situation was made worse by analists who saw massive defaults on mortgages undermining “securitized” debt. In spite of the fact that foreclosures never rose above 3% of all mortgages, these analists devalued “securitized” debt instrumtents as much as 90%. The result was a massive freeze in credit supply since almost all institutions had invested in “securitized” debt. This led to falling demand, thus falling supply, thus falling production and large scale loss of jobs.

But wait, the money that was being leant out did not vanish, there is no drain plug for the world´s economy where the funds pass to the ether. No, the money moved to “cash” investments and, since you learned at your father´s knee that cash is not a good investment, since it loses value to inflation, the funds moved to Treasury Bills that are, “as good as cash.” The bucks in your pocket and T Bills are backed by the “full faith and credit of the USA.”

What happened is that private debt passed to becoming public debt. The boys in charge led by Paulson and Bernanke took advantage of this to use this massive inflow of funds to rescue our financial system. Now the funds will go to President Obama´s stimulus plan.

Is it over? In my book, yes. But there are those who still see gloom since they refuse to understand the role of “securitized” debt in our economy. This source of credit is slowly recovering and in the process giving the means for demand to grow again, and, as I said at the start, growing demand means a growing economy.

Leo Cecchini
July 2009