|
The US Federal Reserve’s desperate attempts to keep
America’s economy from sinking are remarkable for at
least two reasons: Until just a few months ago, the
conventional wisdom was that the US would avoid
recession. Now recession looks certain. And, the
Fed’s actions do not seem to be effective. Although
interest rates have been slashed and the Fed has
lavished liquidity on cash-strapped banks, the
crisis is deepening.
To a large extent, the US crisis was actually made
by the Fed, helped by the wishful thinking of the
Bush administration. One main culprit was none other
than Alan Greenspan, who left the current Fed
Chairman, Ben Bernanke, with a terrible situation.
But Bernanke was a Fed governor in the Greenspan
years, and he, too, failed to diagnose correctly the
growing problems with its policies.
Today’s financial crisis has its immediate roots in
2001, amid the end of the Internet boom and the
shock of the September 11 terrorist attacks. It was
at that point that the Fed turned on the monetary
spigots to try to combat an economic slowdown. The
Fed pumped money into the US economy and slashed its
main interest rate “the Federal Funds rate” from
3.5pc in August 2001 to a mere one per cent by
mid-2003. The Fed held this rate too low for too
long.
Monetary expansion generally makes it easier to
borrow, and lowers the costs of doing so, throughout
the economy. It also tends to weaken the currency
and increase inflation. All of this began to happen
in the US.
What was distinctive this time was that the new
borrowing was concentrated in housing. It is
generally true that lower interest rates spur home
buying, but this time, as is now well-known,
commercial and investment banks created new
financial mechanisms to expand housing credit to
borrowers with little creditworthiness. The Fed
declined to regulate these dubious practices.
Virtually anyone could borrow to buy a house, with
little or even no down payment, and with interest
charges pushed years into the future.
As the home-lending boom took hold, it became
self-reinforcing. Greater home buying pushed up
housing prices, which made banks feel that it was
safe to lend money to non-creditworthy borrowers.
After all, if they defaulted on their loans, the
banks would repossess the house at a higher value.
Or so the theory went. Of course, it works only as
long as housing prices rise. Once they peak and
begin to decline, lending conditions tighten, and
banks find themselves repossessing houses whose
value does not cover the value of the debt.
What was stunning was how the Fed, under Greenspan’s
leadership, stood by as the credit boom gathered
steam, barreling toward a subsequent crash. There
were a few nay-sayers, but not many in the financial
sector itself. Banks were too busy collecting fees
on new loans, and paying their managers outlandish
bonuses.
At a crucial moment in 2005, while he was a governor
but not yet Fed Chairman, Bernanke described the
housing boom as reflecting a prudent and
well-regulated financial system, not a dangerous
bubble. He argued that vast amounts of foreign
capital flowed through US banks to the housing
sector because international investors appreciated
“the depth and sophistication of the country”
financial markets (which among other things have
allowed households easy access to housing wealth).
In the course of 2006 and 2007, the financial bubble
that is now bringing down once-mighty financial
institutions peaked. Banks’ balance sheets were by
then filled with vast amounts of risky mortgages,
packaged in complicated forms that made the risks
hard to evaluate. Banks began to slow their new
lending, and defaults on mortgages began to rise.
Housing prices peaked as lending slowed, and prices
then started to decline.
The housing bubble was bursting by last fall, and
banks with large mortgage holdings started reporting
huge losses, sometimes big enough to destroy the
bank itself, as in the case of Bear Stearns.
With the housing collapse lowering spending, the
Fed, in an effort to ward off recession and help
banks with fragile balance sheets, has been cutting
interest rates since the fall of 2007. But this
time, credit expansion is not flowing into housing
construction, but rather into commodity speculation
and foreign currency.
The Fed’s easy money policy is now stoking US
inflation rather than a recovery. Oil, food, and
gold prices have jumped to historic highs, and the
dollar has depreciated to historic lows. A euro now
costs around 1.60 dollars, up from 0.90 dollars in
January 2002. Yet the Fed, in its desperation to
avoid a US recession, keeps pouring more money into
the system, intensifying the inflationary pressures.
Having stoked a boom, now the Fed can not prevent at
least a short-term decline in the US economy, and
maybe worse. If it pushes too hard on continued
monetary expansion, it won’t prevent a bust but
instead could create stagflation - inflation and
economic contraction. The Fed should take care
to prevent any breakdown of liquidity while keeping
inflation under control and avoiding an unjustified
taxpayer-financed bailout of risky bank loans.
Throughout the world, there may be some similar
effects, to the extent that foreign banks also hold
bad US mortgages on their balance sheets, or in the
worst case, if a general financial crisis takes
hold. There is still a good chance, however, that
the US downturn will be limited mainly to America,
where the housing boom and bust is concentrated. The
damage to the rest of the world economy, I believe,
can remain limited.
|
