Tuesday, June 24, 2008

The Debts of the World: The Story So Far

This author gives an excellent summary of events from summer 2007 to date - nearly 1 year ago.

The simple facts

Since August 2007, the US Fed, by pursuing an aggressive re-inflationary policy in a bid to bailout large financial institutions and prevent debt deflation, has sent oil prices racing to $140 per barrel and the dollar falling from $1.27 per euro to $1.60 per euro. The injection of abundant liquidity in the banking system, together with the setting of real interest rates at negative levels, have led to a speculative boom in commodity markets. Low yields on bonds have pushed investors to seek higher yields in speculative commodities and currency markets. Fed policy is known to reward speculation and penalize the real sector of the economy.

Following the collapse of hedge funds and the stock market bubble, the Fed has followed an overly expansionary policy during 2001-2007, setting the federal funds rate at 1%, the lowest level in the post-World War ll period. Such an expansionary policy has created a speculative boom in housing markets and unchecked expansion of credit. The massive expansion of liquidity led to pushing of loans in subprime markets irrespective of the creditworthiness of the borrower, with underwriting standards reduced to nothing at all.

Typical housing loans are "NINJA" loans, rated high-grade assets by rating services yet extended to no income, no job and no asset borrowers. This policy turned out to be highly inflationary; housing prices increased up to fourfold and became misaligned with household incomes; and oil prices and other commodity prices rose at unprecedented rates during 2003-2007.

The Fed has been trapped in a vicious circle of cheap money inducing a speculative boom followed by financial collapse, which necessitates a new round of bailouts and cheap money. The more expansionary is monetary policy, the more widespread the ensuing financial crisis, the larger the scale of bailout operations, and higher and longer the inflationary episode.

Bailouts socialize private losses that have resulted from speculative booms. By acting as a lender of last resort and re-inflating the economy in order to support banks to stay afloat and prevent a debt deflation, the Fed is making the public pay for errors it did not make and sustain the high salaries of bankers and financiers. In other words, the homeless, by consuming much less food, are paying for the lavish salaries of bankers and financiers and for the gains reaped by speculators during a speculative boom.

Massive bailouts have always caused rapid inflation, yet those operations have been afforded the highest priority, regardless of their inflationary and exchange rate impact. At best, the Fed has been expressing its strong stand against inflation, words that are not backed by action to stem the huge cost in terms of loss of real incomes and protracted period of sluggish growth and rising unemployment.