Let me first start off by saying that I’m not an econ genius. I have limited knowledge in this field, but I’ve always been interested in how econ works. I am writing this as a quick jumble of thoughts, I need to go back and correct a lot of the “theories.” But at least, by writing it, I can reread and correct as needed.

Economists have been talking about this way before I even thought about this concept, just do a quick search on “Stagflation” and you’ll find a lot of information dated more than a year before this writing. I wrote this in bursts from the last two weeks so some info may be dated.

You know the saying; a little knowledge is more dangerous than ignorance? Remember this and take what I write with a grain of salt. I’d be more than happy to edit any part that anyone wants to challenge.

So let’s begin….

Housing Crisis

Let’s talk about the “crisis.” I have crisis in quotes because this actually happens on a regular basis. The last “crisis” we’ve fathomed was the dot com bubble. This actually needs to be put in perspective and looked at from afar. There are always parallels between bubbles!

What caused this problem in the first place? Back in 2000, many people decided to buy homes with low interest rates. The problem with this was that the interest rates were teasers and were of course adjustable. Because many people bought houses, the industry looked to be thriving and in a “boom.” Construction began on new houses to meet this demand. As new houses entered the market, people were continuing to buy these houses that probably could not afford this in the long run. Some were banking on the fact that they could sell their house for more than it was worth in a few years because the market was so hot. Unfortunately, guess what? The market overcompensated, and built too many houses. A greater supply means that prices will drop on homes.

Let’s look at this crisis in parts. First is the supply and demand. Back in 2000, the real estate market was roaring. People wanted houses, but there weren’t enough houses to go around. So the market decided to increase the supply of houses. I mean, houses were going for more than their market value, so why not build more houses! Fast forward seven years, and where are we? The marketplace over compensated and built too many houses too quickly, causing prices to drop. All of a sudden, it’s not lucrative to build houses anymore!

The second part to this is the key. Why was the real estate market roaring? The heart of the matter lies in the sub-prime mortgages. People were enticed to buy these houses with low starting rates. They heard that the market was on the rise and they wanted a piece of action. With sub-prime mortgages, they could buy a house and some owners were banking on the fact that they could sell their house for much more than it was worth in a few years! But guess what? The interest rates for these loans started to rise. People who were only paying 6% were now suddenly confronted with a three to four point increase. People were now losing their homes because they could not pay the difference. People wanted to get out of the marketplace as quickly as possible. Some were successful, however because they bought a home during the boom, they paid much more than “retail” value. This made it hard to sell their home to break even. Many people lost their homes, ruined their credit, and were forced to claim bankruptcy. That’s not the worst part though. Because the marketplace overcompensated and built too many houses, it was difficult to get rid of the houses that were bought. The supply of houses went soaring, thus dropping the worth of the home.

So where are we today? We’re still in the same situation, where people who built their “castle in the sky,” are starting to fall. This creates an opportunity for others however. People who have postponed their purchase of a home can now profit. People are now getting rid of their homes at losses. The buyer is back in the driver’s seat and can really look for some good bargains. This is where you can really make money, because the housing market will recover. There is no doubt that there will be another boom in 10-12 years. All that is required is patience and the willingness to ride out the storm. (Just look at what actually happened to stock prices after the bubble burst compared to today.)

What’s puzzling to me is the fact that the housing market has not recovered! With all of these homes that are going up for sale for much less, I would have assumed that at least some of the people would take advantage of the situation. I believe that part of the reason for this is that the government says that we have not bottomed out yet. They are predicting prices to continue to drop throughout most of 2008. That makes buyers weary of entering the market place. Who wants to by a home that’s going to be worth less?

But the fact is this. When a person buys a home, it’s not for the short term. Why are buyers staying away?

Government Economic Stimulus Plan

I’m not one to pass up free money, but I don’t agree that this plan will help the economy in anyway. The economy is like a cycle, it will have its ups and downs. Any time there is a long period of growth, the economy will always pull it back. We are now in the pull back stage (otherwise known as a recession! HAH)

So the government wants to do something about this, to spur consumer spending, by offering an additional rebate for people who paid federal taxes. Unfortunately, the problem will be that the average person will probably save this money. The media is hyping the doom and gloom outlook. Who would want to spend money when the future is so uncertain?

Hidden Agenda

The reason why I think this rate cut is actually bad news is because the people that are voting on the Economic Stimulus Plan are not economists. Sure, these people probably have others to look into it, but what’s the real agenda? I’m sure you know what year this is! Yup, it’s election year! So why is this bill getting passed through so quickly? So certain officials have a better chance at winning a re-election. The president, while he can’t re-run for office, needs to leave something behind for the record books. What better way to look good than to pass a plan that gives money to the people? After all, this won’t be his problem in only a few months. What does he care?

The Federal Rate Cut

In just a few hours, the Feds will probably announce another rate cut, allowing people to take out loans at a lower percentage rate. By lowering it even further, the Federal Reserve runs the risk of overcompensating. The result of overcompensation would be inflation, or worse; stagflation.

So this is the dilemma. First, let me tackle recession. In a broad view, a recession is basically a period of time where we start slowing down. As consumers we start spending less, and as a result, companies scale back their production. When companies slow down production, they do not need as much money, so they hold onto it. Because production slows down, the unemployment rate rises. As unemployment rises and money becomes scarce in the marketplace, consumers spend less and the cycle continues.

The Federal Reserve believes it can spur economic growth by dropping interest rates. So what does that mean to the average consumer? A micro-view is that by dropping interest rates, the consumer would be less tempted to save money! First, the interest rate controls how much money it takes for a big loan, say a car. So if you’re in the market place to buy a car or refinance a house, now is the time to do it. Second, a lower interest rate takes away any incentive to put money into a savings account. That’s right, the lower interest rate means less money in certain accounts.

OK, this is the second problem. By lowering the interest rates too low, the government introduces too much money in the market place. When the supply of money rises, guess what? The value of money drops. When the value of money drops we call that inflation. In a nutshell, because the supply of money is up, the cost of an item will generally rise.

Both of these problems together create something called stagflation. Stagflation is a horrible place for the economy to be. For example, in the 1970s, the United States was in stagflation. To counteract this, the past head of the Federal Reserve had to raise the interest rates, thus making money scarcer in the marketplace. This raised unemployment rates for a good 6+ years. But eventually, the economy corrected itself.

So What Do We Do?

My recommendation right now would be to take advantage of the lower interest rate. Make sure you can lock in a low rate for the coming years. Obviously you do not want to have a variable mortgage. Start paying off your variable credit cards because in the future, we will probably see a bigger interest hike than we’ve seen before. Don’t worry so much about the stock market. Time has proven that this is still a financially sound investment. You may even want to take advantage of buying some stock at a lower rate. Make sure you diversify so your upcoming losses (And there will be a lot of losses) won’t be as hard to swallow though!