The bubble that nudged the global economy to the brink

In 2001, two ingredients blended into the American economy, making it go sour: a previous stock bubble that had gone bust, and the attacks of 9/11 which seeped fear into the minds of consumers and investors. Alan Greenspan, the Chairman of the Federal Reserve, duly lowered interest rates to a 40-year low in the hopes of spurring a flagging economy. Unbeknown to him and many Wall-Street pet economists, the 1 percent interest rate would indirectly induce a housing bubble-and-bust that now threatens the livelihood of millions. Who do we blame and how do we solve this crisis?

There is a saying, that, when you point a finger at someone, your three other fingers are pointing back at you. This caution might apply to those who accuse Greenspan entirely for the sub-prime crisis and the potential real economic turmoil that trails behind it. Once the balance of faults is weighted, perhaps only the man’s naivety should stand trial, for he believed low-interest money would cascade down into productive sectors of the economy. For all its seductiveness, cheap money has an intrinsic vice: because it doesn’t cost much to acquire, borrowers are less worried about how smart their investments are. Little suprise than that it wound up being spewed by commercial banks into the most unproductive and risky sector of the economy: real estate. The partners in crime include the mortgage lenders, Wall-Street and small-time investors. All played a game all too familiar to history, the game of the gold rush.

For some reason humans like to entertain the belief that a treasure lies buried somewhere; with a little diligence it can be discovered. And so every century seems specked with irrational exuberants that makes people run after fantasies weaved together by myths of hidden treasures. Regrettably, most of these discoveries end up ruining not the finders, but the flocks of ecstatic sheeps that ruminate behind . In such matter unfolded the story of the real-estate rush, a stampede of thousands of self-proclaimed average-Joe investors who discovered a gold mine in the very house they lived in.

Following the turmoils of World War II, the house regained its reputation as a good store of value; home owners could invest in it without the fear of losing money. With the post 9/11 era of uncertainty, its position strenghtened. This is one piece of the puzzle. Comes the role of interest rates. A fall conjured by the Feds adds liquidity to the banking system, allowing commercial banks to lend money at a cheaper cost. Because they borrow in big chunks, mortgage lenders become popular clients of banks. These unregulated middle-men engage in predatory lending to not-so-financially-stable home-buyers in the sub-prime market. The demand for housing takes off. Eyeing the steady increase in housing prices, Joe dons his investor suit and enters the stage. He chats with the mortgage lender, who offers him all too willingly a loan to buy a house. A few months later, Joe sells the now pricier house, repays the loan, and makes a handsome profit. Get a house, get rich. The copy cats that proliferated from this bonanza spurned the biggest demand for housing (the bubble) in the history of the United States. According to the Economist Robert J. Shiller, the average price of a house nearly doubled from 1997 to 2006.

What made this bubble unprecedented was not only its height, but also its width: financial innovation of the past decades has allowed this debt to be gift-wrapped by Wall Street into mortgage bonds as to spread the risks of defaults to many owners. With a large chunk of the world’s foreign capital seeking high returns on U.S assets, these hot mortgage bonds were being stockpiled by investment banks across the world. From Chinese farmers in the hinterlands to ordinary mom’s and pop’s, many were banking on these notes to reap financial rewards.

In 2004, the make-up started wearing off. With a looming inflation, The Feds had to put a squeeze on the supply of money. This meant that the interest payments made by home owners on their mortgage was going to be bumped up. Soon, some found themselves making 13 percent interest rate payments on their mortgage, up from the 8 percent offered to them just a while back. Worse,  compound interest, the greatest force in the Universe according to Albert Einstein, was now wreaking havoc on repayments. Too eager to distribute the loans, mortgage lenders had done an abysmal job at checking the balance sheets of their clients. Within a span of a few months, defaults on payments were skyrocketing. Eyeing once again the falling price of his own home, Joe was now better off abandoning his home than paying off a loan that was more expensive than his house. In some neighborhoods in Los Angeles for instance, one of the epicenter of the boom, 1 in 4 houses lays abondoned and foreclosed. Mortgage bond owners –the likes of Bear Stearns, Northern Rock, BNP Paribas- were now waving deflated bonds, frantically trying to sell them off as they inched towards the brink of bankruptcy.

The real threat to the global economy is not the billions of evaporated money. It is the fear instilled in the veins of the financial sector, and the perceived loss of wealth the housing market had wrought on the consumer’s spending habits. In the first place, banks become wary of lending to one another. This mistrust creates a credit crunch. Credit is the grease that makes the motor run smoothly. Without it, the engine convulses and the whole contraption faces the possibility of a break-down. Secondly, consumption represents 70 percent of the American GDP, and by association an important chunk of global consumption, considering Americans consume much more than they produce. With housing prices creeping ever so higher, Americans were themselves high on wealth. They saw no need for saving their income, feeding the consumption beast with loans after loans and counting on their ever-expensive house to rescue them from debt. But with the housing gone bust, their consumption frenzy might also follow the same route. And this can have a huge repercussion on GDP growth and employment, not only in the United States, but in countries heavily dependent on trade with the economic powerhouse.

In the 1930’s and 40’s, global calamities followed the bursting of economic bubbles in the United States. Some economists argue that the great depression could have been averted had the government acted to suppress the aforementioned threats. Ben Bernanke is one of them. Now Chairman of the Federal Reserve, he is frantically pulling out all the cards up the Reserve’s sleeve. Pumping billions of dollars into the economy, reducing interest rates to almost 0 percent and by acting as lender of last resort, he is trying to rescue the entire banking system from bankruptcy. But lowering interest rates in a shaky economy is dangerous in a liberalized capital market: With a large share of the U.S. debt in the hands of foreigners, a rush to sell low interest-yielding government bonds and other American assets (such as the U.S. dollar) may stifle the inflow of capital from abroad and propel interest rates to crippling heights. With limited remedies to the crisis, the stakes are high and the future uncertain. What is sure is the tinge of irony that floats to mind. The money being pumped is extracted from taxpayers to rescue those principally responsible for the mess: the investors, from the big boys to the little Joes. Worse, the lowering of interest rates, in an environment of higher inflation, may be further encouraging Americans to continue their rampant spending, sinking them into a debt that already represents 140% of their yearly income.  The banking sector and consumers’ habit, instead of getting a thrashing for their bad behavior, receive a pat on the shoulder. Lessons might not be learnt.

The American economy cannot grow solely on the basis of interest rates tweaks, even if accompanied with proper regulations in the financial sector. In the long run, the U.S. must reshuffle its priority from being a consumer society to a producing one. Investment in education and health, in research and development and the promotion of competitive sectors, now that’s the type of grease that keeps any engine healthy.

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One response to “The bubble that nudged the global economy to the brink

  1. Pingback: Economics » Never mind the past - lets look to the future

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