Second, the
housing boom.
Abnormally low interest rates in the U.S., but also elsewhere because
of the interconnections between money and capital markets, fed a
housing boom world-wide which was unsustainable because partly based on
price speculation. Indeed, mortgage rates in the U.S. remained low,
even after the Fed started to raise the Federal funds rate from 1% in
mid-2004 to 5.25% in June 2006. This was brought about by Americans
borrowing huge amounts abroad. — In 2006, the U.S. current account
deficit even reached 6% of GDP. China, Japan and oil-producing
countries were the main buyers of U.S. Treasury bills and bonds.
Third,
new banking rules.
With ever rising house prices, lending institutions relaxed their
lending rules as the housing collateral behind the loans was gaining in
value. Mortgage banks and other lenders began to accommodate subprime
borrowers with dubious credit by extending mortgage loans to homebuyers
who would not have qualified in other times. Nontraditional home loans
were advanced to borrowers who had no documented incomes. Some loans
were interest-only loans with down payments of 5% or less. Some were
adjustable rate loans
(ARMs), with low rates for one or two years to be reset later at much
higher rates. In 2006, about 25 percent of American mortgages were
subprime and close to 20 percent were adjustable rate loans.
Fourth,
new financial instruments.
With the demand for mortgage loans increasing, large banks resorted to
some inventive financing of their own in order to economize their
capital. They began repackaging loans and slicing them into some exotic
new types of securities, and in so doing, shifted their lending risk to
the buyers of such securities. Thus came into being a new class of
securities — often rated AAA by
credit rating agencies — that money market funds, insurance companies, pension funds and other investors could purchase.
These new "structured investment vehicles" (SIVs) came under various
names such as "Collateralized Bond Obligations" (CBOs) or
"Collateralized Debt Obligations" (CDOs). They had the characteristics
of unfunded short-term
asset-based commercial paper(ABCP).
It is this ABCP market which is unraveling presently in the United
States and elsewhere, and which is at the center of the current
financial crisis. At its peak in the summer of 2007, the U.S. ABCP
market was valued at some $1.170 trillion. It has fallen now to some
$900 billion and is still contracting, as banks write down bad debts.
[N.B.: This process of financial disintermediation may last many years.]
The
savings-and-loans crisis of
the early 1980's was also a serious blow to the U.S. economy. Over
1,000 savings and loan financial institutions failed, and losses were
estimated to have totaled around $150 billion. As well, the crisis was
a contributing cause to the 1990-1991 recession. This time around, the
financial crisis is at the very least as bad, if not worse, because it
involves the integrity of the entire American banking sector. The
extent of the losses this time is not yet fully known, but everybody
agrees that it will be very substantial.
[Another 1990 example is the near failure of the hedge fund
Long-Term Capital Management
(LTCM), in September 1998. The Federal Reserve (FED) had to intervene
in panic and provide liquidity in order to prevent a forced liquidation
of the large positions held by LTCM, which would have depressed bond
prices and hike interest rates, at a time there was a financial crisis
in Asia. — N.B.:
Hedge funds
are essentially speculative private entities that take risky financial
positions in interest rate, currency and commodity derivatives, and in
financial markets in general.]
Question No 2- How will the average American be affected?
Dr. Tremblay: Since home ownership is a large portion of the
average American's net worth,
declining house prices and foreclosures on delinquent mortgage loans
are bound to reduce private consumption spending in the coming months
through a negative "wealth effect". The loss of jobs and incomes in the
construction and financial industries is also going to negatively
impact consumption spending. Above all, the average American may have
to reduce his debt load. Together, mortgage debt and consumer debt
account for some 125 percent of disposable income. These are
historically high levels.
Question No 3- How do you assess Fed's policies after the outbreak? What is your opinion about the scepter of inflation?
Dr. Tremblay: Well, as I wrote on my
blog of last September 21,
I think the Bernanke Fed panicked when it announced a larger than
expected half percentage point cut in both the federal funds rate and
in the discount rate, and this after having slashed its discount rate
by a half point, on August 17 (2007). The purpose was to facilitate
distress borrowing by America's largest banks and to facilitate the
bailout of their affiliates (known as conduits) and other operators,
such as hedge-funds, caught in the sub-prime loans crisis. In so doing,
the Bernanke Fed is, to a certain extent, following Walter Bagehot's
advice for aggressive discounting in a situation of financial crisis.
The only problem is that Bagehot's rule calls for the central bank to
lend copiously in times of critical credit stringency ... but at a high
rate of interest. By lending to troubled lenders at reduced
preferential rates, the Fed has been acting as their "government" or
their 'insurer", i.e. subsidizing their risky loans operations and
innovative finance, while taxing anybody else who holds American
dollars. It is not only attempting to make the banks more "liquid", but
also more "solvable" and less likely to fail.
In so doing, and especially with its policy of
abandoning the dollar in
foreign exchange markets, the Bernanke Fed is sowing the seeds of
future inflation. All the new money that has been injected into the
financial system will be difficult to retrieve and inflationary
pressures should begin to show in a few years, after an expected
economic slowdown. The more so that the 54-year average long
inflation-disinflation-deflation Kondratieff cycle is about to run its
course by 2010-11. A new inflation phase should begin thereafter.
Question No 4- When the US coughs, the world gets flu, they
say. What will happen when the US gets a flu such as this? What are the
prospects for emerging market such as Turkey, which rely on exports,
plus have seen massive foreign capital inflows during the past 5 years?
Dr. Tremblay: The U.S. economy accounts for about one quarter of the world economy,
so it is reasonable to expect that an American slowdown will impact
other economies. As of now, Europe and Asia are still booming. However,
the decline in the U.S. dollar and the concomitant appreciation of the
euro and most other currencies, coupled with the rise of the price of
oil, is bound to have a negative impact on these economies. In fact, it
can take as much as two years for a currency over appreciation to
impact the real economy.
The danger for
Turkeyis
to be caught with an overvalued currency while pursuing an export-led
growth strategy. Indeed, in the last few years the (new) Turkish lira
has risen against the U.S. dollar and even against the euro. This has
had beneficial effects in the fight against inflation, but this also
could hurt future growth. The most recent example of such a predicament
was Argentina, in the late 1990's, which was forced to abandon its peg
to the U.S. dollar.
Question No 5- Do you perceive a difference of approach
between the Anglo-Saxon economies and continental Europe economies,
which have, for the most part, come out unscathed?
Dr. Tremblay: As you know, some European banks had to be bailed out after suffering
huge losses coming from their asset-backed commercial paper operations.
As a consequence, the
Bank of Englandand the
European Central Bankhave
injected huge sums of new money in their banking sectors. In the U.S.,
the Fed has a double mission, which is to contain inflation but also to
accommodate economic growth. In Europe, the ECB's central mission is to
contain inflation. This does not mean that there are not political
pressures to abandon the fight against inflation in order to spur
growth, as Mr. Sarkozy's campaign against Mr. Trichet's policies well
illustrates. On the whole, however, it would seem that the rush toward
irresponsible banking practices was less prevalent in Europe than in
the United States, and that the negative impact should be less
prevalent in Europe than in the USA.
Question No 6- What is the lesson to be learned from this crisis, and what kind of precautions should be taken?
Dr. Tremblay: Obviously, there was a lack of diligence and supervision on the part of
central banks and of other regulatory agencies, especially in the
United States. Former Fed Chairman (1951-1970) William McChesney Martin
once said that "The job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting."
— As the subprime financial crisis was getting up steam, the Greenspan
Fed seemed to have been too close to the Bush administration and its
political objectives and not enough aware of the danger that new
financial rules were creating for the health of the financial system
and of the economy as a whole. The Fed should have taken the monetary
punch bowl away in 2003-04, but it did not. We still do not know the
extent of the damage that has been done to the real economy. I hope it
can be contained and will not spread.
Question No 7- Do you foresee a US recession?
Dr. Tremblay: Fed Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson do
not see a recession in the U.S. in 2008. As for myself, I think an
economic slowdown is unavoidable in 2008. I do hope that the worst-case
scenario will not materialize. However, I expect nevertheless a mild
American recession in 2008, to be followed by a more severe one in
2010-2011 (at the trough of the 10 year cycle).
Question No 8- What will be the impact on
a. The dollar?
Dr. Tremblay: Well, the U.S. dollar has been declining for many years and is hitting
all-time lows against the euro. In 2000, the euro was worth less than
83 cents, but it is now close to $1.50, a 45 percent depreciation for
the dollar. I think the current phase of the dollar decline is close to
have run its course. Baring some big geopolitical shock, the U.S.
dollar could rebound in the months ahead. It is presently very much
oversold.
Over the long run, we have entered a period where the demand for energy
and resources is going to be strong relative to supplies. This should
favor the currencies of resource-based economies, such as Canada,
Australia and the emerging economies in general.
and b. On oil prices?
Dr. Tremblay: Oil prices have been the mirror image of the decline of the U.S.
dollar. At close to $100 a barrel, the oil market is either close to a
top, or is factoring in a Bush-Cheney bombing of Iran and a resulting
serious disruption in oil shipping in the gulf of Hormuz. If there were
to be a conflict between the United States and Iran, oil prices could
go much higher, before plummeting down due to a worldwide recession. If
it turns out that there is no hot conflict with Iran and no disruptions
in the supply of oil, the present high prices would logically ratchet
down.
Dr. Rodrigue Tremblay is emeritus professor of international finance at
the University of Montreal, Quebec, Canada and has a Ph.D. in economics
from Stanford University, California, USA.
He is the author of the book "Yeni Amerikan †mparatorlu›u", published
this year in Turkey by Nova Publishing Co, Ankara [ISBN:
978-9944-119-39-9 ].
The book "The New American Empire" is also available in English at Amazon.com, or in French "Le Nouvel Empire Américain" at Amazon.fr.
The book is also available in Canada, in the U.K., in Germany and in Japan.
Rodrigue Tremblay is a Canadian economist who lives in Montreal; he can be reached at rodrigue.tremblay@yahoo.com
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/
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