There is growing talk on Wall Street about the possibility of a recession. Since the beginning of the year three Wall Street firms (Merrill Lynch, Morgan Stanley and Goldman Sachs) have all stated they believe we are either in a recession already or are very close to a recession. In other words, it's no longer a matter of if a recession happens but when it will happen and how long it will last. In response to these developments, various presidential candidates have proposed various solutions. However, none of these will work, largely because this is not a typical slowdown caused solely by slowing consumer spending or business investment. Instead, it is a slowdown caused by inflated asset prices and a nation gorging on debt. As a result, it will probably take a lot longer to come out from under this problem.
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 now.
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.
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Instead of quick fixes, we need fundamenta
We don't make anything anymore. We can't even run our military without importing materials and supplies from other countries, not all of whom are what used to be called "reliable allies". More to the point, the financial rewards of creating and improving tangible goods are not finding their way into the paychecks of the bottom 90% of Americans. So long as that continues, with no meaningful changes of direction in what is still largely (in theory) a production
Is that really what we want? We're running out of time to change things in any meaningful way -- and the more we listen to the status quo-behold
After all, plenty of media, corporate and political figures had effusive praise for the "new Germany" of 1933-1938, that had seemed to find its way out of a terrible economic crisis. And we know how well that turned out.
I believe you can just about predict the outcome.
In the end, the greed of all the individual corporatio
For the corporatio
We are addicted to borrowing, my friend. We must hit bottom before we can see a better day.
Until then your calculatio
7 April 2004
Dear Mr. zzzzzzzz
As chairman of the US Senate Banking, Housing and Urban Affairs Committee I will continue to monitor interest rates and their effect on the economy. I am, however, confident in chairman Greenspan’
Richard Shelby
We haven't invested in our population
This disturbed me. The "sub-prime loan" crisis is receiving much hype and speculatio
Receiving an oil tax from all over the world is ALOT of money. Billions? Gone from our economy. To blame it on the "poor credit risks" alone seems cruel to me. They were the most vulnerable
?
I read the crisis started when Iran began accepting payment for it's oil in other currencies
-Iran began accepting other currencies for oil
-The dollar's monopoly was broken and its value began declining-
-The Euro benefited most from this and as an example of Iran's success in this, in October of 2003 you could buy 1 Euro for $1.19. By the end of 2006 it took $1.31 and on Oct. 11, 2007 one Euro cost $1.43. So many countries adopted the Euro, so it's replacing the dollar in the oil market as the needed currency for trade.
Iran received (unconfirm
I thought it was a bust from the first time I heard him utter it.
I lost my job, I also saw first hand what happened in Fort Lauderdale the sudden rise of homeless and crime due at least in part to his throwing the mental patients out of hospitals.
I still am amazed that some folks still see ol Ronnie as a Gawd.
Naming aircraft carriers after him and GHWB were huge expenditur
I then worked in sectors that catered to the rich. I never got over how they acted, "Im RICH so you should Give me" mindset of many.
Most of our citizens have spent themselves into debt that will be a disaster and since our government is nearly bankrupt no help there either..
I am not talking about hand outs such as are given to no bid contractor
I count my partner and myself lucky. He now has a good job, but I am disabled.
We managed to barely keep a roof over our heads when after 911 he got laid off twice in less than six months, he worked in the aerospace field for parts companies that catered to the airlines as well as aircraft belonging to the armed services. Outsourced
We are in debt for a house and a car, and that only because there is no way to cough up enough to pay cash for either one.
We do not carry any credit card debt for more than a month.
We try to operate on the pay as you go system.
The result will be that the exchange value of the U.S. dollar will plummet and inflationa
We need more competiton for consumers as to financial services to hold down their costs, and increase interest rates. Mergers of large institutio
The lenders must have to face greater risks if they overextend or offer credit to high risk persons and they cannot be allowed to demand usurious interest rates to offset that risk.
They must be limited in how much higher interest rates can be applied and how to eliminate minor errors by consumers leading to huge increases.
Huge fees for late payments, overdrawin
They must have easy to read rules and policies in readable print and not in legalese.
Rules must be also put into place to limit perverse incentives to mortgage brokers and others in financial services to discourage improper granting of credit.
Marketing must be made more honest and not make highly tempting offers of extensive credit to college students and other high risk persons. They also need to cut back on how many times a year they can send marketing materials to current credit holders and to potential new customers.
Require higher down payments on cars and homes.
All these things may not be easy and may not completly deal with the comming debt crises, but it would sure help now and in the future.