One of the better illustrations for why we saw an economic collapse – from The Foundation for Economic Education:
[T]he post-2001 boom [generated] the financial crisis and Great Recession. The Austrian economist Israel Kirzner has long used traffic lights as an analogy for prices. In the case of the boom and bust, the key price was the interest rate. In a free market, interest rates and the banking system coordinate the plans of the cross-traffic of lender-savers and borrower-spenders. If saving increases, it means consumers are more willing to wait for goods. Their saving leads banks to offer lower interest rates, providing a traffic signal (and an incentive) for borrowers to borrow for longer-term projects that match the greater patience of consumers. If consumers are more impatient and save less, banks raise rates, leading borrowers to go more short term to match this preference. Each side’s behavior is consistent with the other’s, thanks to the traffic-signal role of the interest rate.
Central Bank Tampering
When the central bank intervenes, however, it turns all the lights green. […]
[B]orrowers were not irrational during the boom. They simply responded rationally to an irrational signal. The source of that irrational signal was the Federal Reserve System. The next time a friend blames the boom and bust on irrational investors, you might recall our protagonist’s city and say: “The irrationality, dear friend, is not in our markets but in our government, that is, the central bank.”
Speaking of the dysfunctional banking system…from the Independent Institute:
Ever since the 2008 financial collapse, Americans have directed their anger at the banking system, identifying “systemic” problems with the finance industry and demanding wiser and more powerful regulators to curb the destructive effects of a sector allegedly characterized by excessive greed and irresponsibility. Yet little attention has fallen on the politicians and bureaucrats and their hand in making the banking system dysfunctional in the first place. In his appearance on MSNBC’s “The Dylan Ratigan Show,” Research Fellow Vern McKinley, author of Financing Failure: A Century of Bailouts, took aim at government’s role in facilitating the crisis.
“The big banks and the other banks are in two different universes,” McKinley argues. “The big banks have the support of the government [and] don’t have to pay for their failure because they just get bailed out.”