The typical recession is like a nasty hangover after a great party.  During the party, participants get drunk and have a good time. Or as former Fed chairman Allen Greenspan was fond of calling it, they become irrationally exuberant. But when the party is over, society pays for its thrills with a recessionary morning after.

While each recession has its own particular causes, the typical recessionary cocktail consists of one part decline in GDP, one part slowdown in manufacturing orders, one part falling housing prices and sales and one part drop in business investment. Add a dash of rising unemployment and a slowdown in retail sales.  Shake vigorously and wait a few years (hopefully) to feel better.

In the case of the current recession, party-goers got drunk on the liquor of irresponsibly low interest rates, which the Federal Reserve failed to raise when the economy started to surge in 2004. Low interest rates in 2004 and 2005 created the irrational exuberance of the housing boom, with investors taking advantage of low interest rates by buying houses solely to resell them for a profit. Many bought houses they couldn’t afford on no down payment, balloon mortgages.

When higher interest rates kicked in during 2006, falling housing prices caught those people who bought homes they couldn’t afford and would lose money by selling. So they were foreclosed on. As foreclosure rates rose, many banks that bought mortgaged-backed securities were facing huge losses and became afraid to loan to other banks because of worthless loans as collateral. This led to the collapses on Wall Street, in the banking system and the infamous $700 billion bailout.

Maybe the moral of the story is that every good party needs a responsible bartender to announce last call before things get out of hand. In the case of the current recession, neither the government nor the Federal Reserve were ready to enforce closing time before it got too late.

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