How money is created?

Imagine you go to a bank, and bring 50$, now the economy has 50$, in a deposit in your bank.

Imagine the bank lends your 50$ to a person, for mortgage purposes, now the economy has 50$+50$=100$

Imagine the person buys the house and pays the 50$ to a home builder, and he (and all the people who benefits from this money) bring the money back to the bank, now we have 50$+50$+50$=150$ in the economy....

Can this be done indefinitely?

No, the bank has to keep a certain percentage (i.e called Fondo de Garantia in Spain) in the Central Bank , thus from every 50$ the bank receives it can only borrow i.e 49 the first time, 48 the second, 47 the third... etc..

It's a fact that banks can rotate the money, more than 20 times, this means that, for every 1$ they can "create" 20$, or what's the same, that for every 50M$ cash that reach the bank, they can create 1000M$ out of it....!!!

 Isn't that a bubble?

Well, there are assets (houses, industrial projects, etc) that are taken as guarantee for the bank in case one of the borrowers doesn't comply with its debts...

So as long as the price of the goods/houses is steady, the bank can recover the debts of the unpaid debts, by selling the goods that are backing those mortgages or loans...

What happens if the prices of the goods are not real? (we thought they were never going to drop)

When the prices drop, as it happened with the housing market, nothing should happen if the people could keep paying for their interest rates and so on... but if you consider the construction sector accounts for more than 10% of the GDP in many countries, if this sector suddenly gets paralyzed... what is the effect? First of all, many of those companies had asked for loans to build houses, which suddenly they can't return, making them sell their properties, and thus feeding the price drop. Secondly those sectors employ a lot of people who also have mortgages and who might end up being unemployed...

So is the unemployment created the needle that burst the bubble?

Well, it's true that banks depend on the payments of the loans, but we can say that many of the banks don't have so many "unpaid" loans... so where does this panic come from? well... some banks in US, they sold mortgages to the so called "NINJA's" (No Income No Job) since they were confident they would be able to return their debts or sell the house at a higher price... but it never happened.... thus when they saw they had those "toxic assets" they managed a way to make more money: they packed those loans into "financial structured debt funds" and sold them around the world.

So why do banks buy those "repacked debt" instruments?

Imagine the bank that created 1000M$ out of 5M$ cash... and imagine that this bank is one of the most exposed banks to the NINJAs, and you have 5% of the loans unpaid? What does that mean? 5% of 1000M$ = 50M$ , thus it means, by law, the bank is uncapitalized, it has 50M$ - 50M$ = 0$ to borrow... so how do they have to collect more money to borrow? the housing market is not feeding the banks anymore... so what can they do?

They sell financial instruments... of repacked debt... so that they can rise the 50M$ that they miss in their balance...

So what's happening now? what does it mean that the "housing bubble" is now a credit crisis?

Banks don't lend to each other, since they have no capital, and don't trust the banks that have borrowed them "toxic” debt packages... thus the government had to start buying those "toxic" packages, in order to "give" some fresh blood (=money) for the banks to keep on doing their business: intermediate between lenders and borrowers...

What had the Central Banks done to palliate the credit crisis? And is the credit crisis over now?

Well, it took a few banks to crash, and some little countries to nationalize (=buy all the toxic shares) of their banks before they completely collapsed and got into bankruptcy... but finally last weekend the EU members and all the Central Banks (G-7 countries) decided to simultaneously stabilize the market: the banking sector. They injected $1,5 Trillion (Europe) and $700billionto buy bank assets (repacked debt and shares) in order that 1) they can be backed by government money 2) they can't be traded (sold) down and keep on downsizing the stock exchange markets.

So it pretty looks like the bottom of the crisis has been reached...

So what next? what is the next crisis?

As I read in an article, at the beginning of the year, before we the housing bubble was officially and globally announced, the Former Secretary of the Treasure, wrote an article, saying that there would be 3 crisis "sold" to us, in this order: 1) housing crisis 2) liquidity crisis 3) productivity crisis

So we have seen the first 2 crisis, but what does the 3rd one mean? well, it means, that we have been producing the same output, with the same or more workforce, thus decreasing the productivity (=product/hour or $/hour every employee creates). It means, that we have been borrowing lots of money, but there was no real economy behind, it's like we are using the credit card to buy many things we won't be able to pay in the future...

What can happen in this crisis?

Just to mention the effects in few words, in order of what could happened (along next decade):

-unemployment rates rise

-consumption drops

-companies that are not crucial for economy close

-more unemployment is created

-prices drop (as nobody is buying)

-companies are reducing stocks, since they loose money for every mark down product

-hard to find goods in the shelves

-government subsidizes the companies and families that can't pay their bills.

-new emerging markets gain power

-dollar and euro depreciate, and loose most of their power

-yen or Yuan become strong currencies in the world

-the little money left on European and American consumers pockets is worth as little as Argentinean pesos in 2001.

-Extra points added on may'09:

-Agricultural sector may survive better than others, many farmers will find ways to distribute directly to the low-price-high-quality-demanding market, while their intermediators are sinking they will find ways to distribute directly in a more globalized world, without intermediation.