The Great Recession and what’s to come

Economists are now calling this period the Great Recession. In this post I will explain the major forces that came into force leading up to and after the burst of the housing bubble, as well as those measures taken afterwards and what this implies going forward.

To fully understand what happened we must go back to 1999, the dotcom bubble burst. This crash was limited in its size for two reasons.

Firstly, it was limited to the stock market and secondly, the Fed, in an unprecedented move cut interest rates to 1%. In case you are not familiar with how this works, the Fed, ECB or any Central Bank can lower interest rates by printing money. This money is normally destined towards purchasing government debt (bonds), supposedly, this money ends up at a bank, therefore increasing the liquidity in the system and pushing interest rates lower.

I think much of what happened later can be attributed to this. What you might call “artificially” low interest rates spurred demand for mortgages. Suddenly, at 1% interest it was the best time to buy a house. The best time to borrow. Another way of looking at this “cutting of the interest rate, is as a line of cheap credit extended by the Central Bank. The problem is this cheap credit is used inefficiently and spurs malinvestment.

We had in conjunction with this the development of a credit bubble, spurred by the common belief that house prices would increase forever. This is what created the phony wealth which boosted consumption above what was normal. Millions of consumers, were spending way too much because of all the home equity they were receiving, or thought they were receiving. During the bubble, lots of people made more money from their houses appreciating, than they did in wages.

So on the one hand we have a credit bubble occurring. This is actually a phenomenon that can appear in the free market. There are many examples of bubbles in history, from the famous Tulip bubble in the 1600 to the more recent Florida housing bubble of the 20s.

Credit bubbles can appear by themselves, but it is undeniable that artificially low interests and many other government plans put into practice to “facilitate” home-ownership (look up Fanny and Freddy Mae) were crucial elements that exacerbated the bubble. In fact, in 2005 when the over-inflated stock market burst, the Fed and ECB lowered interest rates further (they had been somewhat increased before) until they hit rock-bottom and the illusion could be kept up no more. It was this phony creation of wealth, that lead people, for example, to max out on their mortgage loans, and also for governments to accumulate so much debt. Debt which possibly might have been sustainable, given the growth at the time, but which would become unsustainable in a recession.

So what happens next? Banks go bust. There has been a prolonged and generalised period of malinvestment. Resources have been misallocated and the inefficient projects and businesses must be liquidated. But NO! What a calamity it would be to let the irresponsible banks fail, we must come to the rescue.

So if the first example of bad policy was manipulating interest rates before the recession, the second would be massive bank bailouts.

What banks should have done is simply recapitalize, again, it’s nothing new. It happens in business all the time. The bank would enter a creditor contest, the senior creditors, those who are the less risky investors, this means mostly depositors and such who don’t actually buy financial assets and things like that, those would be the first to recover their money. Then, the junior creditors, those holding high risk assets, the risky investors, get what they can, when the bank can’t pay anymore it pays off the rest of the debt with shares. Needless to say the current shareholders would lose everything, why shouldn’t they, they lead their company to bankruptcy. Tadaaa! The bank is ready to function again,  maybe not all of the money has been recovered, some of the junior debt holders may have got 50 cents on the dollar, but the world keeps turning.

What happened instead, sadly, was massive government bailouts. The Banks privatize their gains and socialize their losses, the irresponsible owners continue to run the banks and we are left to deal with their mess.

In fact that’s exactly what happened in Europe, first we had the bank crisis, followed by the sovereign debt crisis, a big part of this was because the banks had shifted their losses to their countries, but hey, it was for the sake of the economy….

So interest rates were lowered to near zero, nothing more could be done there, then banks were bailed out, finally we had quantitative easing.

The Fed and to a much lesser extent fortunately, the ECB, began to buy financial assets straight from banks. The kind of assets they didn’t want like mortgaged-backed securities and also bonds. In fact when the Central Bank begins to buy government debt directly, we can firmly say the debt is being monetized. Money is being created to pay for the new debt that is issued and they are buying it themselves, and they are also doing the same for the bankers, funding themselves at our expense by printing more money and effectively robbing us of our purchasing power. In extreme cases, the currency could become worthless. That’s hyperinflation my friend.

So as for what is going on now, and what’s to come, I think much of the recovery seen today, specially in the U.S. is phony. It’s a result of the QE measures put into practice, which is sustaining asset bubbles, a stock market bubble and a housing bubble, but you can’t expect the economy to function properly without this stimulus. If anything as you go on the economy becomes more reliant on the stimulus.

Overall I think Europe is doing better than the U.S., having been marginally less irresponsible with their actions. However, a reduction in the stimulus will cause turmoil in the American markets, which will affect Europe too.

Conversely, if the Fed were to continue with the stimulus we might see the dollar declining more in value, energy prices shooting through the roof and hyperinflation will ensue.

The question is, when the time comes, will the Fed cave to the desires of wall street and let the currency fall (prolong the stimulus)? Or will it fight for the currency, stop the stimulus, and let the recession happen?

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