September 22, 2007

The Era of Global Financial Instability

“Scientists say they have discovered a hole in the universe. We’re not surprised. We knew something was wrong.” Bill Bonner, “The Daily Reckoning”


By Mike Whitney
09/20/07 "ICH" -- -- Wall Street loves cheap money. That’s why traders were celebrating on Tuesday when Fed chief Ben Bernanke announced that he’d drop interest rates from 5.25% to 4.75%. The stock market immediately zoomed upward adding 336 points before the bell rang. The next day the giddiness continued. By mid-morning the Dow was up another 110 points and headed for the stratosphere. Everyone on Wall Street loves Bernanke. He brings them candy and sweets and lets the American worker pay the bill.

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We are now seeing the first signs that this enormous debt-bubble is beginning to unwind. There’s very little the Fed can do to affect the inevitable crash. As defaults in housing continue to rise; the swaps and derivatives in the secondary market will implode. Trillions in market capitalization will vanish in a flash.
US GDP for the last 6 years has largely depended on transactions involving the exchange of massively over-levered assets. Production in the real economy has remained flat. The investment banks are at the epicenter of this controversial new system called “structured finance”. We continue to believe that the banks that depended on mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) (as well as asset-backed commercial paper) for the bulk of their income; are in deep trouble. Robert E. Lucas alluded to potential bank-woes in an article in the Wall Street Journal, “Mortgages and Monetary Policy”:
“There is an immediate risk of a payments crisis, a modern analogue to an old-fashioned bank run. Many institutions -- not just banks – HAVE PAYMENT OBLIGATIONS THAT ARE FAR IN EXCESS OF THE RESERVES TO WHICH THEY HAVE IMMEDIATE ACCESS. Against these obligations they hold short-term securities that they believed could be liquidated on short notice at little cost. If some of these securities turn out not to be liquid in this sense (and especially if no one is sure who holds them) then everyone wants to get into Treasury bonds.”
It‘s rare when we are in agreement with the far-right viewpoints of the WSJ’s Editorial page, but in this case, Lucas nailed it. The banks have “obligations that are far in excess of the reserves to which they have immediate access.” This is a direct result of the new market architecture of “structured finance” which stacks debt on debt until the whole system is pushed to the breaking point.
Low interest rates can’t fix this “systemic” problem. Only fiscal policy can soften the blow of a deflating credit bubble. Economist Henry Liu offers this constructive “New Deal-type” proposal which is a sensible (and ethical) way to address the prospect of growing unemployment and increasing economic hardship for the middle and lower classes:
“A case can be made that what is needed under current conditions is not more cheap money from the Fed, but full employment with rising wages by government fiscal stimulants to boost consumer demand. The US government should make use of the money that the banks cannot find worthy borrowers to lend to, with money-cautious investors seeking to lend to the government, creating jobs for infrastructure rehabilitation and upgrading education to get the economy moving again off the destructive track of privatized systemic financial manipulation.” (“Either Way, It could be an Unkind Cut” Henry C K Liu, Asia Times)
Americans will be forced to wean themselves off debt-spending but---at the same time---the current market system must be completely transformed and re-regulated. The financial innovations of the last decade have created an opaque system that rewards clever debt-schemes and ignores productivity. Structured finance promised to use capital with greater efficiency while distributing risk more evenly throughout the system. Instead, it has polluted world financial markets and pushed the global economy to the brink of disaster.
Author Gabriel Kolko summed it up better than anyone in his article “The Predicted Financial Storm Has Arrived”:
“We are at an end of an era…Now begins global financial instability. It is impossible to speculate how long today's turmoil will last-but there now exists an uncertainty and lack of confidence that has been unparalleled since the 1930s-and this ignorance and fear is itself a crucial factor. The moment of reckoning for bankers and bosses has arrived. What is very clear is that losses are massive and the entire developed world is now experiencing the worst economic crisis since 1945, one in which troubles in one nation compound those in others.
Internationalizatio n of finance has meant less regulation than ever, and regulation was scarcely very effective even at the national level….. Greed's only bounds are what makes money. Existing international institutions- of which the IMF is the most important--or well-intentioned advice will not change this reality.”

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