The year of the rat certainly seems bleak for the American economy. The US economy seems to be in one of the worst crises in the recent times, and pundits are working hard to save the US economy from the brinks of recession. 2007 in many ways saw the beginning of the end of the übercurrency. At the beginning of the last century, the Great Britain pound had the status. The United States of America was just emerging then. The story of how USA became a leader is history and the US economy is now in a mess, with a consumption boom fuelled by borrowed money. The wheel of fortune has turned, and time is running out for the dollar. Here’s why.
Web 1.0 at it’s time was considered revolutionary. The late 1990s was characterized by frenzy over dot-com. It promised to take lesser mortals into the land of milk and honey. What followed was the busting of the dot-com bubble, taking the American stock exchanges through the doldrums. Alan Greenspan was at the helm of affairs in the Federal Reserve, and he promptly trimmed down the interest rates. Lower interest rates set in motion a consumption boom, which seemed to have set the economy right. The subtler ramifications though weren’t palpable until late 2006.
Dozens of interest rate cuts post dot-com and September 11th had increased the money supply. Interest rates were slashed from 4.5% to 1% in two years[1]. Think of monetary supply as a string wound over a pulley. Too loose is of no use. Too tight and it will snap. Gradually the Fed took up the slack, but far slower than it had let it out. Monetary policy was too loose, and created the perfect conditions for the next bubble.
The growth of the US Economy post the dot-com bubble is interesting, and in hindsight is responsible in a way for the current turmoil. Lower interest rates meant borrowing was cheaper (cheap credit). This kicked off a quest for higher returns. Financial engineering was used, and the availability of advanced computers made, complex calculation easier. Diverse asset classes were combined to create financial instruments like collaterized debt obligations (CDOs). The risk was ‘measured’ using complex mathematical formulae. The methods were perceived to be sound because the mathematics was elegant. Pundits suffered the ‘man with a hammer syndrome’ – to the man with a hammer, every problem looks pretty much like a nail. This enabled banks to lend customers with poor credit rating.
Poor housing credit was shielded by innovative structures and rising home prices. This made credit cheaper. Loans to borrowers with poor credit history (subprime) accounted for almost 15% of all loans in 2006, that’s 1.2 trillion dollars.[2] Consequently home prices rose, leading to a consumption and investment boom, thus increasing the GDP. Subprime credit kept escalating to dangerous levels till August last year, when realization finally dawned. Much of the perils of the US Economy can be attributed to the subprime crisis, and more bad news is yet to come. The crisis has the potential to start of a dangerous chain reaction.
Loan defaults by subprime borrowers have already happened – chain initiation. Credit standards inevitably need to be tightened, EMIs will increase as interest rates reset upwards. Apart from increasing the number of unsold homes, it will increase defaults (the chain initiating step). Now unsold homes cause housing prices decline. No one buys when prices are set to decline, so investment in housing declines. Recalling that poor credit was shielded by rising home prices, it is easy to see that falling home prices takes you back to the first step. Jobs are lost due to both declining housing prices and falling investment in housing. This leads to lower consumption, and the GDP growth slows. Wow!
The subprime crisis can’t be rubbished as a mere housing crisis considering that the US housing market accounts 20% of world GDP, and 60% of US GDP. Secondly it is also a banking crisis – a crisis of liquidity and a crisis of collateral. It has been each of these and also a crisis of central banking. Central banks were very much present at the genesis, as asset prices swell and credit markets hypertrophied. What was spectacular in America was the ability of a large number of subprime borrowers – those with poor records – to take out mortgages and buy homes, lured by cheap credit and the delusion that home price could only go up.
Authority: “Credit and asset-price booms can leave an awful lot of wreckage behind them. The casualty list after America’s housing crash includes: an overhang of unsold property; a huge fall in construction; the risk of weakening consumer spending as house prices falls; a trail of bankruptcies; big write-downs among the investment banks; and the unprecedented seizing up of some financial markets on both sides of the Atlantic” - The Economist
If we seek to examine, if the actions of the Fed after the crisis are going to do anything to help, the picture seems dismal. Not so long ago, the Fed announced a rate cut, ripples were felt here and the Sensex sure did respond with a smart gain. It’s hard to fathom how it’s going to help solve the crisis. Lower interest rates were one of the contributing factors for the crisis.
Then there was an American version of populism. Mr President’s office decided to keep initial teaser rates frozen for a ‘certain’ category of subprime borrowers. Firstly that’s akin to heralding “it’s ok if you default, the government will bail you out”. Secondly the idea spells trouble for lenders, and they will factor the risk of freezing in the future, leading to higher interest rates. The idea was to prevent homes from going into immediate foreclosure that would accelerate price declines, but law of nature says that ‘what has gone up by irrational exuberance has to come down’.
There was also a plan of providing low interest loans to holders of mortgage backed securities – the banks. This however is the wrong sort of protection, and a misplaced idea to bail out the banks. Such a measure would have been necessary if the banks were suffering from insolvency, but the problem is one of liquidity. This actually amounts to increasing the money supply – a causal factor of inflation. The housing bubble was a symptom of inflation. So it’s hard to see how inflation can be tackled with more inflation.
The newly created credit will help borrowing by institutions at low interest rates, and help investing at higher yielding currencies like the INR. Something similar happened in Japan and was christened the “Yen Carry Trade”, looks like it’s going to happen in America. The correct thing to do would have been raise interest rates, and curb money supply. This would have created a bigger crisis at that time, but would have averted serious future problems. The Fed in my opinion just lacked the conviction to put its foot down and take bold actions.
It looks like the outlook for the American and the world economy is bleak, but there is a silver lining. We can hope that the emerging markets like China and India will come to the rescue by growing at a rapid rate. Global economies are highly intertwined, so if the Asian juggernaut keeps rolling, it could be America’s aspirin. However this also means that Asian dependency on America is reducing, and the world would soon need the dollar less.
India can thrive on this chaos. The turmoil in the debt market and the US economy, would slowly lead to the easing of oil prices. The rupee is rising so imports will become cheaper. There will be a global realignment of currency which would benefit India. The slowdown in US will begin to script a domestic consumption story. India may actually benefit after a small transition period.
It’s too simplistic to conclude that the Fed did all the wrong things. Instead all moments of choice were catch-22 situations. What would have happened if the Fed reacted differently is anybody’s guess. My hunch is that the American economy would recover after a slowdown without going into a recession. However, one thing is clear – the dollar’s hegemony is shaking.
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