Many families have been asking their personal financial planning advisor what factors contributed to the great recession that we are currently experiencing. This is a very good question because there are a lot of contributing factors, many of which have been brewing for years. This three part series will discuss the major factors.
The North America Free Trade Agreement (NAFTA) went into effect on Jan 1, 1994. This was an agreement between the United States, Canada & Mexico that was meant to open up trade between these countries. The idea of this globalization was that if we bought products from Mexico we would raise their standard of living, and eventually they would all start buying more products from us. While this agreement did increase trade between the countries, the long term effects have been somewhat damaging to us. Currently we buy as a country about $1 Trillion in goods per year from other countries, and we sell about $200 Billion of our good to them. That’s a trade deficit of about $800 Billion per year. Why is this? Because we don’t really have anything to sell to them. Everything is now made in other countries like Mexico, China & India where labor costs are so much cheaper. Why would they buy things from us when they already have it, and they make it, and it’s cheap. This has made our country very dependent on other producing countries for goods that we need. It has also weakened us financially.
Currently the United States is the richest country in the world, but we have the lowest personal savings rate in the world. In China the personal savings rate is 30%, in Japan it’s 16%, and Germany saves about 12%. Up until 1989 our savings rate was 11%. Today we are at -1%. That’s right, people are spending ALL of their income and then some every year. Because of inflation, today’s wages are the same as they were 20 years ago. Yet our standard of living has increased dramatically. How is that possible? Today about 90% of couples under the age of 50 have both spouses working. We’ve also been using home equity, credit cards, and our savings to maintain our standard of living.
It used to be that people set up sinking funds to pay for purchases like new cars, vacations, Christmas, etc. They would set aside a little money into their separate sinking fund account each month so that when it was time to go on the vacation the money was there. Today, people just put it on the credit card or get a loan for it, and then make monthly payments on it (with interest). This lack of savings has made our country very vulnerable to financial crisis.
The Federal Reserve started making it very easy to borrow money when they reduced interest rates to near zero levels. This was an effort to “prime the pump” and get money flowing, and it worked. Banks were able to borrow money from the government at 1% interest rates, and then lend it back out in the form of home mortgages at 5 – 6% rates. They were making money hand over fist, and Wall Street was getting flooded with mortgages. So many mortgages in fact, that something had to be done to deal with all of them.
During this same time there was much less reguation going on in the banking industry. With a lack of regulation, many banks got greedy and started giving loans to people who really shouldn’t have had them. People got really good at falsifying loan documents in order to get a loan. This is where the NINJA loans started to run wild. NINJA stands for No Income, No Job or Assets. Here’s how they worked. Lets say a person comes in looking for a loan to buy a house and they have an income of $5,000 per year. The mortgage officer might have said something like, “Well lets just put an extra zero on the end of that income and make it $50,000, since a zero isn’t worth anything anyway.” “And you don’t have a job, you just watch TV all day? Let’s put down that you’re an entertainment executive with Dish Network.” and so forth. These were the kinds of people who the banks were lending out cheap money to on a daily basis. Can you see how this was setting us up for the big crash?
Look for “The Perfect Storm – Part 2” for more on this topic.