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The Roots Of The US Economy's Collapse

John de Roe analyses the American economic crisis, the credit crunch and the collapse of the sub prime mortgage markey and looks at how the American government's efforts to solve the crisis and avoid a recession may affect the global economy.

The Roots Of The US Economy's Collapse
by John de Roe.
2008-09-20
CREATIVE COMMONS: Attribute, non commercial, no derivs.
KEYWORDS: economy, economics, finance, america, bush, washington, federal exchange, mortgage, loan, interest, bonds, election, crisis, recession, slump

After a faltering start and some hamfisted official atempts to deny there was a problem, Washington is at last showing signs that it understands how much economic trouble America is in as the government and the Federal Exchange thrash about like Octipi on speed trying to prevent the unfolding mortgage crisis from pushing the country into recession during an election year. There is an inescapable sense of doom however, a feeling that the government will need to do more than cut interest rates to avert a financial disaster, more perhaps than even the government of the world's most powerful nation is capable of doing.

One former Treasury secretary advocates temporary tax cuts and emergency spending on the order of $50 billion to $75 billion. Such action could help the U.S. from slipping into what Lawrence Summers, who served under President Clinton, fears could become the worst downturn since the steep 1981-82 recession.

It is not just Democrats who are increasingly sure their candidate will take The White House in November who are worried about what kind of economic mess they will inherit. Republicans too are worried, about the nation and about their businesses and investments.

Both Martin Feldstein, who was President Reagan's top economic adviser, and former Federal Reserve Chairman Alan Greenspan have called for government intervention to deal with the threat.

Before it is all over, the US government may have to resort to measures last used in the savings and loan (equivalent of the old UK Building Societies) crisis of the 1990s. Then the solution was to create a new agency to take over failing savings schemes sunk by bad loans. Todays much greater crisis could need a government agency to buy up billions of dollars of mortgage-backed securities (collateralised debt obligations or "toxic debt" that investors are shunning now that the worthlessness of these financial products has ben exposed.

The Bush administration has so far opted for less dramatic measures. In fact, the administration was reluctant to reluctant to take its biggest step so far, the "teaser freezer".

A deal with the mortgage industry will freeze the low introductory "teaser" rates for five years on some subprime mortgages; loans to people with dodgy or downright unsafe credit histories. The mortgage deal was designed with the intention that rates were to escalate over time, making the mortgages unaffordable for many people and putting their homes at risk of repossession.

The hope was this measure would buy time for the housing market to rebound. That would make it easier for these homeowners to refinance to more affordable fixed-rate loans.In fact only about 250,000 people will end up getting a rate freeze a fraction of the 3.5 million home loans that could go into default over the next 2 1/2 years.

The administration is also exploring with Congress ways to increase the $417,000 cap on the size of loans that the big mortgage companies Fannie Mae and Freddie Mac can handle. This step could help in high-cost housing areas such as California. On top of that the administration is pushing through legislation that would boost aid to lower-income homeowners by increasing the scope of mortgage insurance programs handled by the Federal Housing Administration.

These efforts only tinker about at the margins of the problem. They do not address one of the biggest threats to the economy: a spreading credit crisis triggered by the soaring defaults on subprime mortgages. Some of the biggest names in finance have suffered multibillion-dollar losses as a result, and critical segments of the credit markets have frozen up. Banks and investors fear making further loans or buying securities underwritten by debt because they do not know how many more loans might go into default.

Ben Bernanke, facing his first major test as Fed chairman, is getting mixed reviews. The Fed was embarrassed when the credit crisis hit in August. That happened only two days after the central bank had decided to keep interest rates unchanged and pronounced inflation was a bigger risk than low economic growth.

The Fed has cut interest rates by a full percentage point since that time. But only the September cut a bigger-than-expected one-half of a percentage point elicited cheers on Wall Street. The two quarter-point moves brought about market declines as investors worried the Fed did not recognize the severity of the problem.

If the problem was confined to sub prime mortgages and domestic debt it might yet be manageable but the credit crunch has occurred at the same time that a huge rises in energy prices are increasing inflationary pressures.

And that is the dilemma.

If the Fed cuts interest rates to keep the economy out of a recession, it will lmost certainly trigger higher inflation and perhaps give the country the worst of both worlds, bringing back that 1970s economic bogey, "stagflation," in which growth is stagnant and inflation is getting worse. In a novel approach, the Fed is auctioning off money to the banks through bond auctions in an attempt to get them to open up their loan mechamsnis. The first two auctions, for a total of $40 billion went well. But the amount of the cash provided by the banks paled in comparison with the $500 billion from the European Central Bank. The irony here is that wile the government is cutting the interest rates at which it lends to banks, the banks are charining higher interest on government borrowings. In effect the government is lending the money to banks and borrowing it straight back again at a higher rate than it was lent. Nice business for the banks but of course not so good for taxpayers.

Many economists are saying the Federal Exchange will have to cut its federal funds rate, the interest that banks charge each other, at least three more times and strengthen the wording of its statements. In that way, the markets would know the Fed will do whatever is needed to fight economic weakness in spite of its lingering worries about inflation.

"The difference between a soft economy and a recession is confidence. If the Fed appears reticent to do what is needed, like they did at their last meeting, that does not help confidence," Mark Zandi, chief economist at Moody's Economy.com said of the problem.

Whatever approach the US government decides to take, it will take time for the current problems to resolve themselves and because the US economy is the powerhouse that drives the global economy that means we can all expect a rough ride for some years to come. In Britain the housing crash which followed the collapse of mortgage lender Northern Rock last year followed a five-year boom. Property markey analysts expect housing to flat line or fall further through most of next two years even if Europe, which has its own imminent sovereign debt crisis and the USA can engineer a solution that avoids a recession that looks as if it might be a slump.

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