Lemme explain the readers of this blog, the current global economic meltdown in simplest examples. I presume the reader of this article to be a complete noob of economics. Those a bit more expert in economics, might wanna read this article written by Robert Murphy, days before the financial meltdown occurred.
The worst recession in 25 years

What I am trying to explain you here is called Austrian theory of business cycle, the only theory which consistently explains every recession and economic boom. If you want detailed and exhaustive discussions on it, you are free to surf through Mises Institute’s forums.

Lets presume a family of 4 people, Steve’s family. Steve’s father works in a Multinational firm on a regular salary with performance based bonus. Steve every week gets some weekly allowance from his dad, so his sister.

Every week upon receiving the allowance of $100, Steve goes on his usual to spend on his needs, he is a very economically efficient person, he budgets all the money he receives very accurately with no wastage of money.

The Booming Years

One day, his father’s boss calls his father into his office and tells him that they are going through a business deal which will get them massive amount of profits, and his father will receive 50% increment on his yearly salary. That is, instead of receiving $50,000 that year, his father will now get $75,000 every year.

Steve’s father is really excited about this news. Since the Boss assured that the deal will go through, Steve’s dad goes to the local bank and takes a loan of $25,000. He plans that as soon as he will get the increment he will pay the loan back.

He walks back to his home, and tells the news to everyone. Since he already has the cash in hand, he gives the proportional extra allowance to Steve, his sister and Steve’s mom.

Now this small economy of 4 people has extra cash flow(which technically nobody is sure of), and people are ready to spend. Steve’s father goes and buys that new car he wanted. Steve’s mom, gets new cell phone connections and hands the phone to Steve, his sis, and herself.

Steve on the other hand, is now able to make a flashy girlfriend, since now he realizes that he can clearly afford to take her to expensive restaurants, to holiday on a beach, etc etc. He also gets a used Car for himself since now he will be able to afford the monthly fuel and maintenance expenditure.

Months pass by, but there is no sign of deal going through. And soon a year passes by. The family has done large amount of expenditures, all perfectly economically calculated, adjusted for the $75,000 salary of Steve’s dad.
Since Steve’s dad’s boss ensures that the deal will pass through and he will get his deserved increment, his Dad goes to another bank and takes another loan for $25,000. Now the total loan on the family is $50,000 + Interest from the first loan.

The family consistently gets another extra $25,000 this year. So everything continues the way it is. Another year passes by, and now Steve’s dad is worried about the financial liquidity of the family. The bank which gave his dad the first loan got in touch with him and somehow Steve’s dad convinced them that he will be able to pay their loan back to them.

The Bust

Now at the end of third year, when Steve’s dad gets his salary of $50,000, he needs $25,000 immediately to adjust the family budget, but now his Credit history has gone so bad that he cannot get any more loans from any bank. So his Dad is now only able to allocate $100 per week to Steve, similarly, the rest of the family gets less money. This $50,000 is simply not sufficient to cover the various ventures, and new investments family has started. For example, there is no way the Cell phone bills can be paid now. Steve cannot fuel his Car anymore, he cannot spend on his girlfriend anymore.

The Meltdown

And just when they thought that they have faced all the problems, they seem to be just started. The banks from which Steve took loan, are now knocking on their doors demanding their money back. Steve’s family is now in big trouble. After days of consideration, Steve’s Dad comes up with two possible solutions.

1) Cut back all the excess expenditures, sell Steve’s car(that means Steve must dump his girlfriend), sell his Dad’s car, cancel all the Cell phone subscriptions, mortgage the house they live in, for Loan, return all the previous loans, and slowly buy their house back over the years.

2) Go to the local Mafia boss/Loan Shark who does not need credit checks, take $75,000 loan from them and continue on their life and hope that they will pay the loan back once their life goes back to normal. This way Steve gets to keep his car, girlfriend, his cell phone, and nobody cuts down any expenditure. Steve terms it as the “Bailout Plan”.

Steve’s Mom’s arguments

We cannot go to the local Mafia boss for loan, there is no way we will be able to pay that much amount of loan with our current expenditures. We must go for the first plan, let Steve’s car be sold, his girlfriend dumped, cell phones connection canceled, and over the years we will be able to pay all our loans back.
If we choose the “Bailout option” we will not be solving the problem but only postponing it to eventually come back at us at even bigger level.

Steve’s arguments

You have gotta bail us out Dad. I need more liquidity. I have to pay my gas bills, phone bills, restaurant bills. If you don’t pay me, I will have no social life ever, I will become the most unpopular kid in the school, and surely you don’t want that, do you?
So bail me out dad please, you know that I will pay you back that money as soon as you get that increment, and my allowance actually increases.
If you don’t bail me out, then my social life will go to hell, I will be much more stressed, and won’t be able to concentrate on my studies, so I will not be able to become a successful man in future, if you don’t bail me out right now.

Steve’s Sister’s arguments

This problem is all a result of Steve’s greed. Only if Steve was less greedy. What was the need for him to go and get a new girlfriend, and a car.
Look at me, whenever I needed the car I just used Steve’s car. Whenever I had to dine out somewhere, I just tagged along with Steve on his date. Look how much savings I have done. We must choose the first option.
…..
[After she does some thinking that if Steve gets to keep his car she will also benefit from this]
…..
On second thoughts I support the Bailout option. Lets bail Steve out with his situation, after all we need to maintain our social status too.

Well here the story ends.

Now lemme explain you who is what in real world. Steve’s Dad is the Government. Steve’s Boss is Federal Reserve. Steve is the Market. Steve’s sister is the general public.

So what really happened?
The Federal Reserve inflated the money supply believing that it will result in more economic growth. It does not. So all that extra money resulted in massive economic malinvestment. When all that investment eventually failed to balance the books all hell broke lose.
Now the only solution is to let these companies fail and lets start from scratch, but as you might know what has happened, that govt has taken EVEN MORE loan, they are going to sustain all those malinvestments by pumping even more money in the economy.

Its like solving the problem by overdoing the cause of the problem.