Bubble economics
The Fed's relationship with Wall Street has led to a high-risk policy that is blowing up a recession
Larry Elliott
Friday January 18, 2008
The Guardian
Six months ago the Federal Reserve, the US central bank, was supremely relaxed about the American economy. It had raised interest rates 17 times in succession to puncture a bubble in the US housing market but was adamant that the downturn in real estate was contained.
That was then. Containment has become contagion, with fears that the malaise from the housing market will not only push the world's biggest economy into recession but will turn it into a carbon copy of 1990s Japan, a country that took more than a decade to recover from the speculation mania of the late 1980s. And arguably still hasn't.
The Fed is doing its best to give the impression that it is still in control of the US economy, but its reassurances are as hollow as that given by Herbert Hoover - on the weekend after Black Thursday in October 1929 - that the fundamentals of the economy were sound. If anybody is running economic policy, it is the big banks and investment houses on Wall Street, which are being bled dry by the losses they have sustained as a result of imprudent lending to borrowers with poor track records.
Two of the biggest banks - Citigroup and Merrill Lynch - announced massive writedowns (decreasing the book value of their assets) this week, and had to be bailed out by foreign-owned sovereign wealth funds - the state-owned investment arms set up by countries like China, Singapore and Saudi Arabia, who run big trade surpluses.
Wall Street is telling the Fed it will only be able to staunch the losses from the subprime market when the recession in house prices is brought to an end. That, on present evidence, will take some doing, but in an election year, the Fed will make the best of a bad job.
The chairman of the Fed is Ben Bernanke, a former academic who had the unenviable task of taking over from Alan Greenspan - the man primarily responsible for the current crisis. Greenspan, always accommodating to the needs of Wall Street, worked on the principle that the best way to cope with the collapse of one bubble was to blow another one. In 2003, the Fed cut interest rates to 1%, prompting the biggest housing boom in US history. Loans were extended to subprime borrowers in the belief that the boom would go on for ever, and the loans were bundled up into big packages and sold off to financial houses around the world.
The new chairman arrived in office desperate to prove that he would be no pushover. That, in retrospect, was in a mistake. Having been left too low for too long, rates were left too high for too long, resulting in a slowdown in the real-estate market turning into a slump. Instead of making big profits on subprime mortgages, financial markets were left staring at huge and unquantifiable losses.
Bernanke, who made his academic with a study of the Depression and wrote a paper earlier this decade on how America could avoid being the new Japan, rapidly ditched the donnish approach. His promise of "substantial action" yesterday stems from his determination not to repeat Japan's error in cutting rates too slowly in the early 1990s. The buzz on Wall Street now is that if pushed hard enough, the Fed might eventually cut rates back to 1%, despite the risk that it could trigger a collapse in the dollar, add to inflationary pressures and create the conditions for another bubble.
As things stand, it is not too late to prevent the US becoming the new Japan, but it is certainly too late to prevent a long, painful recession in the housing market that will probably last for the rest of this presidential term and the next. And before anybody in the UK is tempted to feel smug, it's worth pointing out that the British housing market is also a bubble just waiting to be popped.
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