A recent Los Angeles Times Article
stated the basic problem thusly:
What makes bubbles so dangerous is that their consequences, when they burst, are wider, often more damaging, and
certainly more unpredictable than those of ordinary downturns.
"We are more prone to bubbles than
we used to be," said John H. Makin, a former senior Treasury official with several Republican administrations and now a scholar
with the conservative American Enterprise Institute in Washington.
"The old-fashioned recession, where
the consumer ran out of gas or there was an economic policy mistake, doesn't seem to occur much anymore," said Alice M. Rivlin,
a former vice chair of the Federal Reserve and Clinton administration budget director. "As we've seen from recent events,
bubbles seem to be playing a bigger role."
The basic problem faced by the US
economy right now is excessive debt caused by recklessly low interest rates from the Federal Reserve. Here is a chart from
the St. Louis Federal Reserve of the effective Federal Funds rate since 2000.
Notice the US had record low interest rates for a
period of nearly three years. This led to a debt binge of mammoth proportions. Here is a chart of total household debt outstanding
from the St. Louis Fed:
Notice the amount outstanding increased
from around $8 trillion to a little shy of $14 trillion within a period of seven years. That's approximately a 75% increase
in total household debt outstanding.
All of this debt has to go somewhere;
it doesn't just exist in a vacuum. To accommodate this increase in total debt, we've seen a huge increase in structured financial
products. In and of themselves, these are not bad devices; they have been around for approximately 25-30 years. However, they
were used very recklessly over the last 7 years, and especially over the last 3-4 years. The short version of what happened
is simple: lending standards deteriorated to the point where literally anyone could get a loan. These loans were then sold
to investment firms, who pooled them together and carved them into various bonds, which were in turn sold to large institutional
investors like pension funds, insurance companies and hedge funds. The idea underlying structured financial products was that
risk was spread out to the point where the bonds were more or less insulated from default problems. However, when defaults
skyrocketed higher than anticipated, we discovered that the risk wasn't contained nearly to the degree we thought. Instead,
everybody started getting hurt.
Right now the Federal Reserve is treating
this situation as a "liquidity crisis", meaning they are literally throwing money at the problem. They are hoping that by
flooding the markets with money the money will get spent in the form of loans and credit. However, the market has ample liquidity.
The problem is we are in the middle of a debt crisis:
During a liquidity crisis, the issue
is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences. Mr. Practical,
writing on Minyanville's Buzz & Banter, characterized it this way:
Suppose there is a rumor that a large
bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve
banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because
the bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in
and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then
the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels
better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.
Similarly, the issue today is not
one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt
supported by too little value and income generation. As a result, time preferences are retreating, risk aversion is growing,
and access to credit is diminishing.
Here's the basic problem. All of
that debt in the household debt chart assumes a certain asset value. Here's a simple example. Suppose a bank makes a $100,000
loan for a home valued at $100,000. If the home appreciates in value, everything is fine. However, let's assume the home's
value decreases to $90,000. Now the loan is inherently less valuable because the underlying asset has decreased in value.
If this situation persists or worsens, the lender will have to devalue the loan to some degree to reflect the lower asset
value. Now, take this situation and apply it to the entire US economy and you get an idea for what exactly is going on right
To make matters worse are two inter-related
issues. First, the US economy is very much based on credit creation. As a result, the financial sector sits at the center
of the US economy. Here is an overly-simplistic (and poorly drawn) demonstration.
Basically, the financial sector acts
as an intermediary between consumers and business, pooling deposits and investments and funneling those to business in the
form of credit. Also note the financial sector provides credit to consumers in the form of credit card, consumer and mortgage
loans. In other words, when the financial sector takes a bit hit, it impacts the entire economy.
The second problem is the accounting
nature of the financial system. It is essentially based on a "fractional reserve" system. All this means is financial firms
have to have a particualr asset to loan ratio. For example (and hypothetically) this means financial firms must have say 10%
of their total outstanding loans in assets. Now, suppose the value of the assets on their books starts to decrease. The financial
firms ability to make loans is diminished. This is why all of the writedowns announced by literally every financial firm out
there is so important. It means their ability to extend credit is diminished. As a result, the ability to borrow in the economy
at large is diminished, which is devastating to an economy like the US' which is heavily dependent on credit creation to function.
In summation, the US economy is at
the beginning of a huge problem. The economy depends on credit creation. However, the financial sector is hampered in that
ability right now because the value of assets backing outstanding loans is decreasing. This lowers the value of outstanding
loans, which in turn limits the financial sectors' ability to extend credit. So long as the US economy is experiencing deflation
this process will continue.
Hale “Bonddad” Stewart: Hale "Bonddad" Stewart is a former bond broker with several regional firms. He has been involved with the
financial markets since 1995. He currently practices law in Houston, Texas and is a graduate student in taxation at Thomas
Jefferson Law School, working towards an LLM in international and domestic (US) taxation.
George of Arabia:
Better Kiss Your Abe 'Goodbye'
By Greg Palast, Jan 16, 2008
Bend over, pull out your
wallet and kiss your Abe ‘goodbye.’ The Lincolns
have got to go - and so do the Hamiltons and Jacksons. Those bills in your billfold
aren’t yours anymore. The landlords of our currency—Citibank, the
national treasury of China and the House of Saud - are foreclosing and evicting all Americans from the US economy.
It’s mornings like
this, when I wake up hung-over to photos of the King of Saudi Arabia festooning our President with gold
necklaces, that I reluctantly remember that I am an economist; and one with some responsibility to explain what the
hell Bush is doing kissing Abdullah’s camel.
Let’s begin by stating
why Bush is not in Saudi Arabia. Bush ain’t there to promote ‘Democracy’ nor
peace in Palestine, nor even war in Iran. And, despite what some pinhead from CNN stated, he sure as hell
didn’t go to Riyadh to tell
the Saudis to cut the price of oil.
What’s really behind
Bush’s hajj to Riyadh is that America is in hock up to our knickers. The sub-prime mortgage market implosion, hitting a dozen banks with over
$100 billion in losses, is just the tip of the debt-berg.
Since taking office, Bush has doubled the federal debt to more than $5 trillion. And, according to US Treasury figures,
on net, foreign investors have purchased close to 100% of that debt. That’s $3 trillion
borrowed from the Saudis, the Chinese, the Japanese and others.
Now, Bush, our Debt Junkie-in-Chief,
needs another fix. The US Treasury, Citibank, Merrill-Lynch and other financial desperados
need another hand-out from Abdullah’s stash. Abdullah, in turn, gets this financial juice by pumping it out of our pockets
at nearly $100 a barrel for his crude.
Bush needs the Saudis to charge us big bucks for oil. The Saudis can’t lend the US Treasury and Citibank
hundreds of billions of US dollars unless they first get these US dollars from the US. The high price of oil is, in effect, a tax levied by Bush but collected by the
oil industry and the Gulf kingdoms to fund our multi-trillion dollar governmental and private debt-load.
The US Treasury is not alone
in its frightening dependency on Arabian loot. America’s private financial institutions are also begging for foreign treasure. Yesterday, King
Abdullah’s nephew, Prince Alwaleed bin Talal, already the top individual owner of Citibank, joined the Kuwait
government’s Investment Authority and others to mainline a $12.5 billion injection of capital into the New
York bank. Also this week, the Abu Dhabi government and the Saudi Olayan Group are taking a $6.6 billion chunk of Merrill-Lynch. It’s no mere coincidence
that Bush is in Abdullah’s tent when the money-changers made the deal just outside it.
Bush is there to assure Abdullah
that, unlike Dubai’s
ports purchase debacle, there will be no political impediment to the Saudi’s buying up Citibank nor the isle of Manhattan.
So what? I mean, for the
average American about to lose their job and their bungalow it doesn’t matter a twit whether it’s Sheik bin Alwaleed
who owns Citibank or Sheik Sanford Weill, Citi’s past Chairman.
It’s the price paid
to buy back our money from abroad that’s killing us. Despite the Koranic prohibition on charging interest, the Gulf
princes demand their pound of flesh, exacting a 7% payment from Citibank and 9% from Merrill. That hefty interest bill then
pushes adjustable rate mortgages into the stratosphere and pushes manufacturing into China by making borrowing and energy costs impossible to overcome.
Forget the cost of health care: General Motors’ interest burden quintupled in just two years.
As the great economist Paddy
Chayefsky wrote in the film The Network:
“The Arabs have
taken billions of dollars out of this country, and now they must put it back. … It is ebb and flow, tidal gravity….
There are no nations, there are no peoples. There is only one vast and immense, interwoven, multi-national dominion of petro-dollars.
… There is no America. There is no ‘democracy.’ The world is a business, one vast and ecumenical holding company, for whom all
men will work.”
The Arabs took $252 billion
in 2005 of OPEC’s oil and put back $311 billion by purchasing U.S. Treasury bills.
Latin America borrowed $277 billion at high interest-while lending the U.S.
$379 billion at low interest. Americans bought $243 billion in stuff from china—while
China holds nearly a trillion in reserve to up the U.S.
In 2005, the US consumer paid Arab and OPEC nations a quarter trillion dollars ($252 billion) for
oil - and the USA
received back 100% of it - and then some ($311 billion) via Gulf nations’ investment in US Treasury bills and purchases
of US businesses and property. Bush’s trip to Abdullah’s tent is all about this vast business of keeping this
petro-dollar treadmill spinning.
The Bush Administration, rather than tax Americans to cover our deficits or make the banks suffer the consequences
of their predatory lending practices, is allowing the Saudis to charge us big time at the pump with the understanding they
will lend it all back to us - so the party never has to stop.
It has been reported that
the President’s Secret Service men traveling with him seemed embarrassed by the eye-popping loads of diamond and gold
gifts which they have to carry back for President Bush. They need not feel they have taken too
much from their hosts: Bush has assured Abdullah that the King can suck it back out through our gas tanks.