I wrote this on INTPCentral in response to a thread and thought I would share it here. This is how the financial crisis makes sense to me, and I have heard or read few people who explain it similarly (except, perhaps, Peter Schiff, who saw it coming!) It was partially born from discussions with my economics professor from a few weeks back (also from working for two mortgage brokers over the last few years.) Any feedback would be appreciated.
When someone borrows money they are redistributing income across time.
Suppose that you are currently earning $10,000 per annum, and expect to earn $500,000 over the next ten years ($50,000 per annum on average.) But you want to increase your income now, and decide to borrow $30,000 from those expected earnings. This raises your current income to $40,000, and only decreases your expected earnings to $470,000 ($47,000 per annum on average.) By redistributing your funds across time you can achieve a steadier and more equitable income. An investment, meanwhile, would increase expected earnings. Suppose, for example, that without the $30,000 loan you only expect to earn $300,000 over the next ten years (perhaps it is going to pay for an education.) In such a case, the loan would qualify as an investment.
Interest and lending criteria (capital requirements, credit checks, employment provisos, etc.) are the price of enabling this redistribution of income across time. One person's loan is another person's investment; what one person is expected to pay in interest another person expects to receive.
Suppose that a loan is sold on false expectations, and moreover, it is predominantly spent on consumption (not investments.) A loan of $30,000 is given to you with the false expectation that you will earn $500,000 over the next ten years (in fact, you will only earn $300,000--or $30,000 per annum on average.) But you begin to adjust your consumption to your new $40,000 income. GDP is booming (production is effectively paid for by 'IOUs') and the economy looks in great shape according to the "experts." Eventually, the 'next ten years' begins, and your expected income was mistaken. Rather than having $47,000 per annum on average (down from $50,000 because of the loan) you only earn $30,000, and moreover, you still need to payback your loan!
With a $27,000 income you cannot sustain the same consumption habits that you had with $40,000. Perhaps you even default on your loan. But remember, one person's loan is another person's investment. When you default an investor somewhere discovers that his expected earnings were also mistaken (since they were calculated on yours), and he cannot sustain the same consumption habits that he had with his previous income. Imagine that this occurs to hundreds of thousands of debtors and investors across the country, each linked to each other via the financial markets, dependent upon each other corrrectly predicting their future earnings. Suddenly, everyone is earning less than expected, while also paying for past consumption.
Be wary of politicians who suppose to "fix" this problem--although its consequences are being felt now, the opportunity to avoid it has already gone. Too many people wrongly predicted future earnings, that was a mistake, but some, such as Obama, might try and change that mistake into a delusion.