Here is a timeline of how the economy got to where it is today. It was all based on a flawed assumption by the Federal Reserve regarding the possible affects from Y2K on the banking system computers. The FED thought Y2K would crash the computers of the financial system. So it pumped massive liquidity into the banks just in case. The liquidity spilled over into the real economy and created the DOT-COM bubble because banks are in the business of lending and lent the money the FED was providing. This created a massive bubble of wealth that has since been creating bubble after bubble.
When Y2K came and passed, the FED realized everything was ok and withdrew liquidity from the banking system. This caused the stock market to begin to crash in 2000. As the stock market was crashing, the bubble wealth quickly moved into bonds as a safe haven investment. But the increased demand for bonds sent bond prices higher and yields lower, causing interest rates to fall across the board. Lower interest rates made homes very affordable.
The bubble money then moved into the housing market. But home prices quickly rose to the point where they were no longer affordable. So the investment banks convinced Congress to remove the last vestiges of the Glass-Steagal act set in place after the Great Depression. It was Hank Paulson the former Treasury Secretary (wolf in the henhouse) and at the time CEO of Goldman Sacks who convinced Congress to do this. This allowed banks to lever up their debt by creating off-balance-sheet accounts known as SIV accounts (sounds like the Enron SPE account doesn’t it?). The banks claimed that the credit default swaps, interest rate swaps, and other derivatives could not be marked to market until they reached maturity. As such, the banks would not need to hold reserves against these off-balance-sheet derivatives, thus increasing their leverage.
At the same time the monoline insurers (MBIA for example) wrote policies covering CDO tranches (mortgage-backed-securities “MBS’s” are split into collateralized-debt-obligations “CDOs” based on actuarial timelines of early payoff of the mortgages). Now that the CDOs were insured they were deemed triple-A (AAA) rated securities. As a result, the market gobbled them up like candy. In particular, China purchased massive amounts of these and other U.S. securities in order to sterilize the effect of its trade imbalance with the U.S. on its currency. If China allowed its currency to rise, its exports would be chocked off. So the trade imbalance with China added to the demand for triple-A securities.
The increase demand for Triple-A rated securities allowed home prices to increase further because the CDO insurance allowed banks to relax lending standards and gave the market the incentive to buy the debt. Home prices quickly appreciated beyond reason. When at last home prices began to fall the mortgage back securities market disappeared entirely.
The bubble money now moved into the commodities market causing prices to rise dramatically ($150/barrel oil, corn feed, and fertilizer, copper). In fact, two days after the banks received their first TARP funds, oil rose by $25 in one day because the banks were not lending out the money. The banks were using the TARP funds to buy commodities instead.
When commodities peaked the bubble money began shorting the stock market. The shorting morphed into writing naked credit-default-swaps (CDS) against banks and other vulnerable companies. A naked credit-default-swap is a derivative where neither the writer nor buyer has possession of the underling asset, and as such is nothing more than a bet. The writer has to cover his bet by buying shorts and PUTs against those companies. The volume of CDSs rose dramatically and in turn caused credit spreads to widen, leaving the market to believe the risk of default for these vulnerable companies had increased. The market reacted by piling on even more shorts and PUTs. This helped to drive the stock market down to where it is today. Congress needs to act now, to protect the banking system in particular and stop all naked CDS writing. There is a self-reinforcing negative feedback loop occurring that must be stopped.
The final bubble in this story in now inflated and has the ability to destroy our government. This is the bubble in government bonds. When our economy begins to recover, money will flow out of government bonds causing interest rates to rise (maybe dramatically). This is because the Federal Reserve has taken $2.2 trillion of mortgage back securities, commercial paper, and CDOs onto its balance sheet and intends to increase it to at least $3 trillion. When the economy heats up, the FED removes liquidity from the banking system by exchanging its treasury bills for the banks cash, leaving the banks with less money to lend. Unfortunately, the mortgage backed securities, commercial paper, and CDOs will prove to be illiquid because the underlying assets are impaired and worth less than par. Essentially, the FED will have lost much of its ability to slow down the economy. Inflation might quickly rise causing interest rates to soar.
Much of the new debt taken on by the Federal government is on a short-term basis. As the government attempts to roll over that debt it will have to pay more in interest. Currently, the interest on this debt is $580 billion per year. The Federal government intends to borrow a lot of money in the next 2 years. The interest on a total debt, of say $16 trillion, may exceed $1 trillion per year. An exponential rise in Federal, State, and Municipal debt and interest would surely cause taxes to rise. This massive transfer of money from the private to the public sector might crowd out private investment. As private investment is crowded out, GDP begins to shrink, tax revenues fall, the government borrows more and pays ever more interest. This feedback loop repeats itself and provides the trigger that implodes our debt-based form of capitalism.
As the economy shrinks debt is defaulted. Under a fractional reserve banking system, wealth is created through a multiplier effect on debt. A bank loans money, the money is used to buy something, the firm receiving the money deposits it in their bank account, their bank lends out part of that money because they only need to hold a small reserve against it, and the cycle repeats itself until all of the multiplier effect is used up. The multiplier effect works equally well in the reverse direction where it destroys wealth as debt is defaulted.
But the Federal government can never default on its debt because it can simply print the money it needs to pay the debt. This is why our currency states quite clearly on every note “In God we trust.” We live under a faith-based system of capitalism - faith in the belief that debt will be paid off and faith that our currency will hold its value. If this faith is destroyed so too will be our society.
Your Friendly Neighborhood Economist,