Friday, February 22, 2008
The U.S Financial System, the Debt
Bubble and the Cancer of Excessive Deregulation
"It's...poetic justice, in that the people that brewed this toxic Kool-Aid found themselves drinking a lot of it in the end."
Warren Buffett, American investor
“By a
continuing process of inflation, government can confiscate, secretly and
unobserved, an important part of the wealth of their citizens.”
John Maynard Keynes (1883-1946)
"New
money that enters the economy does not affect all economic actors equally nor
does new money influence all economic actors at the same time. Newly created
money must enter into the economy at a specific point. Generally this monetary
injection comes via credit expansion through the banking sector. Those who
receive this new money first benefit at the expense of those who receive the
money only after it has snaked through the economy and prices have had a chance
to adjust."
Friedrich A. Hayek
(1899-1992), Austrian economist
When Fed Chairman Ben Bernanke says the economic situation is
worsening, you'd better believe him. In fact, the U.S. credit markets are
collapsing under our very eyes, and there is no end in sight as to when this
will stop, let alone reverse itself. 1- Leading economic indicators for the U.S. economy are falling; 2- Consumer confidence sentiment is falling as mortgage equity withdrawals are
drying up; 3-employment numbers are falling; 4- the January 2008 report on the
U.S. service economy
indicates that it contracted early in the year for
the first time in 58 months; 5- the number of new jobless claims is still dangerously high; 6- The housing crisis is getting up
steam; banks have to place larger and larger subprime losses on their balance
sheets, thus undermining their capital bases and bringing many of them to the
brink of insolvency; 7- the credit-ratings agencies are under siege;
8- bond guarantee insurance companies are in the process of loosing their
triple-A ratings and some are on the brink of bankruptcy; 9- the $2.6 trillion municipal bond market is about to take a nose
dive, if and when the bond insurers do not pull it through; 10- the leveraged corporate loan
market is in disarray; 11- the more than a trillion dollar
market for mortgage- and debt-backed
securities could
collapse completely if the largest American mortgage insurers continue to
suffer crippling losses; 12- large hedge funds are losing money on a high scale and they are suffering
from a run on their assets; 13- in the U.S., total debt as a percentage of GDP is at more than 300 percent, a record level (N.B.: in
1980, it was 125 percent!); 14- and, finally, the worldwide hundreds-of-
trillion dollar derivatives market could implode anytime, if too many financial institutions
go under during the coming months, as most of these transactions are
inter-institution trades.
There are a few positive straws in the
wind, such as the fact that manufacturing output seems to be holding up pretty well, as the devalued dollar stimulates
exports, but the overall economic picture remains bleak. This is a tribute to
the U.S. economy's resiliency.
This mess all begun in the early 2000s,
and even as far back as the early 1980s, when the Fed and the SEC adopted a
hands-off approach to financial markets, guided by the new economic religion
that "markets can do no wrong." What we are witnessing is the failure
of nearly thirty years of so-called conservative debt-ridden and
deregulation-ridden economic policies.
It must be understood that the most recent
subprime problem really began in 2000, when the credit-rating agency of Standard &
Poors issued a pronouncement saying that "piggyback" mortgage
financing of houses, when a second mortgage is taken to pay the down-payment on
a first mortgage, was no more likely to lead to default than more standard
mortgages. This encouraged mortgage lending institutions to relax their lending
practices, going as far as lending on mortgages with no down-payment
whatsoever, and even postponing capital and interest payments for some time.
And, with the Fed and the SEC looking the other way, a fatal next step was taken.
Banks and their subsidiaries decided to follow new toxic and risky rules of
banking.
Indeed, while traditionally banks would borrow short
and lend long, they went one giant step further: they began transforming long
term loans, such as mortgages, car loans, student loans, etc., into short term
loans. Indeed, they got into the alchemist business of bundling together
relatively long term loans into packages that they sliced into smaller credit
instruments that had all the characteristics of short-term commercial paper,
but were carrying higher yields. They then sold these new "structured investment
vehicles" (SIVs), for a fee, to all kinds of
investors who were looking for higher yields than the meager rates that
alternatives were paying. And, since banks were behind these new artificial
financial assets, the credit-agencies gave them an AAA-rating, which allowed
regulated pension funds and insurance companies to invest in them, believing
they were both safe and liquid. —They were in for a shock. When the
housing bubble burst, the value of real assets behind the new financial
instruments began declining, pulling the rug out from underneath the asset-backed paper market, (ABCP) which became illiquid and toxic. With hardly any trading on the
new instruments, nobody knew the true value of the paper, and thus nobody was
willing to buy it. This crisis of confidence has now permeated to other credit
markets and is threatening the entire financial system as the contagion
spreads.
As late as 2003-04, then Fed Chairman Alan Greenspan was not the least worried by the
subprime-financed-housing-mortgage bubble but was instead encouraging people to
take out adjustable-rate mortgages, even though interest rates were at a
thirty-year low and were bound to increase. Even in late 2006, newly appointed
Fed Chairman Ben Bernanke professed not to be preoccupied by the housing
bubble, saying that high prices were only a reflection of a strong economy.
Mind you, this was more than one year after the housing market peaked in the
spring of 2005. History will record that the Fed and the SEC did nothing to
prevent the debt pyramid from reaching the dangerous levels it attained and
which is now crushing the economy.
On a longer span of time, when one looks
at a graph provided by the U.S. Bureau of Economic
Analysis (BEA) and which shows the relative importance of total
outstanding debt (corporate, financial, government, plus
personal) in relation to the economy, one is struck by the fact that this ratio
stayed around 1.2 times GDP for decades. Then, something big happened in the
early 1980s, and the ratio started to rise, with only a slight pause in the
mid-1990s, to reach the air-rarefied level of 3.1 times GDP presently, nearly
200 percent more than it used to be.
The adoption of massive tax cuts coupled with government deficit spending policies, and
deregulation policies, by the Reagan and subsequent GOP
administrations, all culminating in a grotesque way under the current
administration, contributed massively to this unprecedented debt bubble. It took many years to
build up the debt pyramid, and it will take many years to unwind it and to
reduce this cumulative mountain of debt to a more manageable size.
That is the big picture behind this
crisis. It is much bigger than the S&L crisis of the 1980s, which looks
puny in comparison with the current one. That is why I think this crisis will
linger on for at least a few more years, possibly until 2010-11.
Rodrigue Tremblay is professor emeritus of economics at the University
of Montreal and can be reached at rodrigue.tremblay@yahoo.com
He is the author of the book 'The
New American Empire'
Visit his blog site at: www.thenewamericanempire.com/blog.
Author's Website: www.thenewamericanempire.com/
Check Dr. Tremblay's coming book "The Code for Global Ethics" at: www.TheCodeForGlobalEthics.com/
Posted, Friday, February 22, 2008, at 5:30 am
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http://www.TheNewAmericanEmpire.com/tremblay=1082
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