"Credit booms do not end in
inflation as most people believe. Credit booms ARE inflation that end in
deflation. This credit boom is no different.� --Mike Shedlock, �Mish�s Global
Economic Trend Analysis�
The days of the dollar as the world�s �reserve currency� may
be drawing to a close. In August, foreign central banks and governments dumped
a whopping 3.8 percent of their holdings of US debt. Rising unemployment and
the ongoing housing slump have triggered fears of a recession sending wary
foreign investors running for the exits. China, Japan and Taiwan have been
leading the sell off which has caused the steepest decline since 1992.
To some extent, the losses have been concealed by the
up-tick in Treasuries sales to US investors who�ve been fleeing the money
markets in droves. Investors have been trying to avoid the fallout from money
funds that have been contaminated by mortgage-backed assets. Naturally, they
bought US government bonds which are considered a safe bet. But that doesn�t
change the fact that the dollar�s foundation is steadily eroding and that
foreign support for the dollar is vanishing. US bonds are no longer regarded as
a �safe haven."
The dollar slumped to a 15-year low against six of its most
actively traded peers and set the stage for an early morning market rout on
Foreign investment and currency deregulation has been a real
boon for the stock market, which thrives on a steady flow of cheap capital.
It�s also been good for ravenous consumers who like to borrow boatloads of low
interest cash for their toys, SUVs and McMansions.
Of course, when things seem too good to last, they usually
don�t. The economy is contracting, credit is getting tighter, and the stock
market is flailing about aimlessly. Worse still, the world is quickly losing
confidence in American leadership on everything from human rights to global
warming. In many ways, the US appears to be tragically out-of-step with its
epoch. The world is looking for innovative solutions to species-threatening
problems, while the Bush Administration insists on following an agenda that
seems more suited to medieval warlords in the Dark Ages. The social and
economic consequences of their shortsightedness are obvious. Its been a
As capital flight accelerates; interest rates in the US will
rise, unemployment will mushroom, and the dollar will fall. It can�t be
avoided. American markets and consumers will be compelled to curb their
gluttonous appetite for cheap foreign credit. The free lunch is over.
Overseas investors own more than $4.4 trillion in US debt in
the form of bonds and securities. Even if they sell only 25 percent of that
sum, the US would feel the pinch of hyper-inflation. For the last decade
foreigners have been eager to by our Treasuries and equities -- gobbling up
America�s enormous $800 billion current account deficit and keeping demand for
the dollar artificially high. But just like the subprime mortgage holder whose
�teaser rate� has suddenly expired; the US now faces the painful adjustment of
higher payments and less discretionary income for indulgences.
Maybe the charade could have carried on a bit longer if not
for the belligerent Bush foreign policy that has alienated friends and foes
alike. But, then, maybe not. After all, the Fed�s loose monetary policies added
to Bush�s extravagant spending -- $3 trillion added to the National Debt in
just six years -- doomed the country from the beginning. Deficit spending has
been the central organizing principle from day one. Now comes the hangover.
Federal Reserve Chairman Ben Bernanke is expected to drop
the Fed funds rate on September 18. The move will provide more �easy
credit-crack� for the addicts on Wall Street but it could also trigger a run on
the dollar. That�s what keeps the Fed chief up at night.
The Bush Team was warned repeatedly -- by the BIS, the World
Bank, the IMF and the European Central Bank (ECB) -- that their policies were
�unsustainable� and would end in an economic meltdown. But they brushed aside
the warnings with the same casual indifference as they did the critics of the
war in Iraq.
Why would they care if the country suffered? Their friends
would still get their massive, unfunded tax cuts. Their private armies and �no
bid� contractors would still get their payola. The Democrats would still cave
in on the enormous �off budget� war spending. And, they�d still be able to
print as much counterfeit money as they chose until every last farthing was
drained from the public till.
No worries. Besides the media would mop up the mess they�d
made with their usual �happy talk." As the economic calamity unfolds, we
can expect to see the usual parade of lacquer-haired phonies on the Business
Channel singing the praises of �free markets� and the poisonous culture of
overspending and consumerism.
The problems we�re now facing should have been easy to spot
for anyone willing to look beyond the empty rhetoric of the TV Pollyannas or
their cheerleading co-conspirators at the White House. Instead, we were
anesthetized by Alan Greenspan�s low-interest snake oil and Bush�s
�tax-slashing� mumbo-jumbo, thinking that they�d found a new path to
It was a hoax. And the seven years of sleepwalking has cost
us dearly. Unemployment is up, consumer spending is down, the housing market
has slipped into recession, and the stock market is lurching back and forth
like an overloaded washing machine. All of this could have been foreseen by
anyone with minimal critical thinking skills and a healthy dose of skepticism
Consider this: US GDP is 70 percent consumer spending. That
means that wages have to increase beyond the rate of inflation OR THE ECONOMY
CAN�T GROW. It�s just that simple. So how is it that 50 percent of the American
people still believe Bush�s supply side baloney that cutting taxes for the
uber-rich strengthens the economy? How does that increase wages or build a
healthy middle class. If we want a strong economy wages have to keep pace with
productivity so that workers can buy the goods they produce.
Greenspan knows that. So does Bush. But they chose to hide
it behind an �easy credit� smokescreen so they could weaken the dollar,
offshore thousands of industries, outsource 3 million manufacturing jobs, fund
an illegal war, and maintain the lethal flow of the $800 billion current
account deficit into American equities and Treasuries. In truth, there hasn�t
been any growth in the economy since Bush took office in 2000. What we�ve seen
is an ever-expanding bubble of personal and corporate debt amplified by a
�structured finance� system that magically transforms liabilities (subprime
loans) into securities and increases their value through leveraging.
That�s it. No growth -- just a galaxy of debt-instruments with
odd-sounding names (CDOs, MBSs, CDSs, etc) stacked precariously on top of each
other. That�s what we call "wealth" in America.
It�s all smoke and mirrors. The financial system has
decoupled from the productive elements of the economy and is now beginning to
show disturbing signs of instability. That�s why the big blow-off in the bond
market. The halcyon days of supplying our armies, funding our markets and
building our subprime �ownership society� empire on the backs of foreign
creditors is over. The stock market is headed for the landfill and housing is
leading the way. Economic fundamentals can only be ignored for so long.
Greenspan�s bloody fingerprints
The problems began when Greenspan dropped interest rates to
1 percent in 2003 for more than a year, pumping trillions of low interest
credit into the economy. This created the appearance of prosperity but it also
inflated a massive equity bubble in housing which is now in its death throes.
The Fed �rubber stamped� many of the �creative financing� scams which lowered
lending standards and turned the subprime fiasco into a $1.5 trillion doomsday
The devastation in real estate is almost too vast to
comprehend. The mortgage bubble is roughly $5.5 trillion, and yet, prices have
just begun to fall. It�s a long way to the bottom and there�s bound to be
plenty of bloodshed ahead. Two million homeowners will lose their homes. 151
mortgage lenders have already gone belly up. Many of the hedge funds, which are
loaded with billions of dollars in �mortgage-backed� securities, are struggling
to stay alive. Perhaps the most shocking projection was made by Yale University
Professor, Robert Schiller, who believes that home prices could decline as much
as 50 percent in some of the �hotter markets." (Schiller�s book
�Irrational Exuberance� predicted the dot-com bust before it took place) The
effects on the US economy would be considerable. If other factors come into
play -- like a stock market crash and a subsequent period of deflation -- we
could see housing prices descend 90 percent as they did between 1928 and 1933.
Typically, housing bubbles deflate very slowly, over a
period of five to 10 years. Not this time. Credit problems in the broader
market are speeding up the pace of the decline. The subprime sarcoma has spread
to all loan categories and filtered into the banking system. This is forcing
the banks to hoard reserves to cover their potential losses (from CDOs and
mortgage-backed bonds �gone bad�). Now, even credit worthy applicants are being
turned away on new mortgages. At the same time, �nearly half of borrowers with
adjustable rate mortgages were not able to refinance their loans. That�s a
major concern for policymakers as an estimated 2.5 million mortgages given to
borrowers with weak credit will reset at higher rates by the end of next year.�
Think about that. It�s no longer just a matter of 40 percent
of loan-types disappearing overnight (subprime, Alt-A, piggyback, negative
amortization, interest only etc). Even people with good credit are being
rejected because the banks are hoarding capital. That suggests the banks are in
dire straights and hiding losses that are kept off their balance sheets (more
on this later).
So, it�s harder to get a mortgage. And, if you already have
one you may not be able to roll it over. This will greatly accelerate the rate
of the housing crash. (In fact, the LA Business Journal reported on Sunday that
home sales plunged 50 percent in one month. We can expect to see similar
numbers in all the hot spots.)
The troubles facing the dollar are as grave as those in
housing. The stock market and the teetering hedge funds are counting on an
interest rate cut, but they�ve ignored the effects it will have on the
greenback. If Bernanke lowers rates -- as everyone expects -- the bottom could
drop out of the dollar. We�re already seeing gold soar to new highs (above $700
per ounce); that�s an indication of dollar-weakness and a potential sell-off of
US Treasuries. If Bernanke lowers rates, the greenback will nosedive.
Author Gary Dorsch explains the potential hazards in his
recent article, Hopes for an Easier Fed Policy Boost the Euro and Copper: �Interest rate differentials have
played a key role in determining exchange rates. Since the ECB (European
Central Bank) began its rate hike campaign in December 2005, the US dollar�s
interest rate advantage over the Euro has narrowed from 240 basis points to as
low as 70 basis points today. Thus, the Fed can only afford a small rate cut to
bail out Wall Street bankers who hold toxic sub-prime debt and avoid tipping
the dollar into a free-fall. But that might not be enough to prevent a housing
led recession in the months ahead.�
After years of abuse under Greenspan -- an $800 billion
current account deficit, a $9 billion per month war, and a 13 percent yearly
increase in the money supply -- the poor dollar has run out of wiggle-room. If
the Fed slashes rates, the mighty greenback will be a dead duck.
Commercial paper: What you don�t know can hurt you
Commercial paper is something that is rarely understood
outside of the investor class. It is, however, a critical factor in keeping the
markets operating smoothly. �Commercial paper is highly-rated short-term notes
that offer investors a safe haven investment with a yield slightly above
certificates of deposit or government debt. Banks use the money to purchase
longer-term investments such as corporate receivables, auto loans credit card
debt, or mortgagees.� (Wall Street Journal 9-5-07)
Commercial paper has been vanishing at an alarming rate in
the last month. $240 billion has been drained in just the last three weeks.
(There is $2.2 trillion of commercial paper in circulation in the US.) Because
CP is �short term," hundreds of billions of dollars need to roll over (be
refinanced) regularly. CP is at the very heart of the credit crisis which has
spread through the financial markets and it could result in a massive
catastrophe. The large investment banks are in a panic -- and that is probably
an understatement. Consider this article in the September 10 UK Telegraph which
provides an eye-popping summary of what is going on behind the scenes.
U.K. Telegraph, Banks
Face 10-Day Debt Time Bomb:
�Britain's biggest banks could be forced to cough up as much
as �70bn over the next 10 days, as the credit crisis that has seized the global
financial system sparks a fresh wave of chaos.
"Almost 20 per cent of the short-term money market
loans issued by European banks are due to mature between September 11 and
September 19. Senior bankers fear that they will have to refinance almost all
of these debts with funds from their own coffers, putting a further strain on
bank balance sheets.
"Tens of billions of pounds of these commercial paper
loans have already built up in the financial system, because fear-ridden
investors no longer want to buy them. Roughly �23bn of these loans expire on
September 17 alone.
"Fears of this impending call on bank credit lines are
the true reason that lending between banks has ground to a halt, according to
senior money market sources.
"Banks have been stockpiling cash in preparation for
this 'double rollover' week, which sees quarterly loans expire alongside
shorter term debts -- exacerbating a problem that lies at the heart of the
Fortunately, the British have a few newspapers -- like the
Telegraph -- that still report the news. That is not the case in the US.
There�s roughly $1.3 trillion in �asset-backed� commercial
paper filtering through American markets. These are the notes that are
connected to mortgage-backed securities (MBSs) that no one wants and which have
NO MARKET VALUE. They are referred to as �toxic waste." (No one is buying
anything remotely connected to real estate CDOs)
Hundreds of billions of dollars of CP has been issued
through SIVs (structured investment vehicles) and �conduits� which are
affiliates (subsidiaries) of the large banks. The banks have kept these
operations hidden from the public, but now they are in the spotlight because
they cannot meet their obligations and are stuck with billions of CP that they
cannot refinance. (The reader may recall that Enron kept similar �off balance
sheets� operations secret from the public before it declared bankruptcy)
The banks are now forced to assume responsibility for the
commercial paper held by their affiliates, which means that they need
sufficient capitalization to cover the losses.
The bottom line is this: The banks are responsible for
hundreds of billions of dollars in commercial paper that probably won�t be
refinanced. AND IT IS BEGINNING TO LOOK AS IF THEY DON�T HAVE THE RESERVES TO
COVER THEIR LOSSES.
That�s why we continue to believe that the banks are in
According to the Wall Street Journal: �So do the banks and
their shareholders have nothing to worry about? Not quite . . . Negligible
losses in August were enough to force the banks to run to the authorities for
help. Regulators may decide that the best way to prevent a recurrence is to
require banks to hold more capital. They might even limit some types of
transactions. Such moves might be good for the economy, but would reduce the
banks' returns on equity.� (�Banks Seem Fine -- For Now," WSJ, 9-8-07)
Read carefully and I think you will agree with me that the
WSJ is letting on that the banks needed �more capital� even after �negligible
losses.� The predicament is much more serious now.
Bank troubles are never minor. That�s why there�s been a
concerted effort to cover up the real source of the problem. When people lose
confidence in the banks, they lose confidence in the system. That leads to
Don�t think they�re not aware of that at the White House.
The likelihood of a hard landing
Even if a shakeup at the banks can be averted, the path
ahead is still filled with obstacles. The reckless policies of the last seven
years have edged us ever-closer to the inevitable day of reckoning.
Professor Nouriel Roubini summed it up best in a recent
blog-entry, The Coming US Hard Landing: �Indeed, the forthcoming easing of monetary policy by the Fed
will not rescue the economy and financial markets from a hard landing as it
will be too little too late. The Fed underestimated the severity of the housing
recession, its spillovers to other sectors, and the contagion of the subprime
carnage to other mortgage markets and to the overall financial markets. Fed
easing will not work for several reasons: the Fed will cut rates too slowly as
it is still worried about inflation and about the moral hazard of perceptions
of rescuing reckless investors and lenders; we have a glut of housing, autos
and consumer durables and the demand for these goods becomes relatively
interest rate insensitive once you have a glut that requires years to work out;
serious credit problems and insolvencies cannot be resolved by monetary policy
alone; and the liquidity injections by the Fed are being stashed in excess
reserves by the banks, not aimed at the parts of the financial markets where
the liquidity crunch is most severe and worsening.�
Soup kitchen USA
Roubini is right. The Fed doesn�t have the tools to fix this
problem. It needs to be addressed on the policy level. The �structured finance�
model has proved to be an abysmal failure. It has created an unstable and
opaque market full of bizarre named debt instruments -- CDOs, CDSs, CLOs, MBSs,
etc -- which collapse under stress. Congress needs to step up and force
regulators to ban these poisonous bonds and swaps and restore the market�s
We also need to address the expanding wealth gap that is the
result of 20 years of wage stagnation. Personal savings can only grow if wages
keep pace with productivity, otherwise workers will try to meet their needs by
increasing their debt-load. That�s why we�re in the fix we are now. Working
families are having a harder time making ends meet. It�s only natural they
would try �speculating� in the real estate market to get ahead. After all,
everyone wants a piece of the �American dream." Unfortunately, many
homeowners stand to lose more now than when the dot-com bubble burst. The
downturn in housing is certain to wipe out trillions in market value.
There are no quick fixes or �silver bullets� as Bush likes
to say. These issues will require a fundamental change in our political
consciousness. Nobody�s going to fix this for us. It�ll take organization,
energy and an unwillingness to accept failure.
It�ll take years to dig our way out of this mess. In the
meantime, we need to close ranks and prepare ourselves for tougher times ahead.
The dollar will weaken, housing prices will fall, and economic conditions will
continue to deteriorate. We can either organize and meet the challenges we face
head-on or form a line and wait for the soup kitchens to open.
Whitney lives in Washington state. He can be reached at firstname.lastname@example.org.