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What is happening with the economy?

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"Madness is rare in individuals - but in groups, political parties, nations, and eras it's the rule." (Friedrich Wilhelm Nietzsche)

No madness is worst than greed. Every so often people assume that somehow they can make money out of the thin air. The most famous one was the Tulip mania of 1636-1637 in Netherland and the most recent one was the “dotcom” bubble of 1995-2001 (on March 10th, 2000 the NASDAQ peaked at 5132.52). Today we are witnessing the beginning of the end of the real estate bubble.

In every case, the madness begins with those who have high tolerance for financial risk. That is to say they are rich and can afford greater financial loss than others. They speculate and make money, lots of money. Soon the less wealthy see this and join the crowd and before you know it the whole country is involved.

When President Bush entered office he gave one trillion dollars (tax cut) to the wealthy. In effect he increased the tolerance for financial risk of the wealthy individuals and companies even further. Later, he started the Iraq war, pouring billions of dollars into the economy. One should not forget that when the US government spends about $2 billion a week in Iraq, most of that money finds its way back into the US economy (salaries, armament, etc). But all these monies were borrowed money (deficit spending), and all the growth and feeling of well being was illusory.

The money pumped into the economy had to find some channel for investment. So banks and financial institutions began to push money in hope of getting incredible returns. Easy credit was the solution. You want to buy a house? No problem, we finance 90% of it. You want to have a new car? No problem, we give you a loan. This push suddenly made it possible for millions of people to buy houses, putting pressure on the housing market. House prices sky-rocketed, increasing the illusion of increasing wealth, which in turn allowed people to borrow more money. All the time, banks and credit institutions were jubilant at the sight of extraordinary returns on their investments. A normal credit company charges around 18% to 23% on the dollar while they borrow the same money for 8% to 9%.

It is a great business. The banks also had a good time. Cheap money was lent to people backed by assets that were appreciating in value. The risks were spread by selling mortgages to other banks and institutions. Before you knew it every bank, insurance company and god knows who else were rushing in to take their piece of the action.

Growth in housing construction represents a substantial part of general US economic growth. So with easy credit and continuing increase in housing prices, US showed a good growth rate, giving the illusion of well-being.

But as with Tulips and DotComs manias, there comes a time when there is no more room for illusory growth and demand. The bubble bursts and asset prices crash. The banks are left with depreciating asset guarantees for their loans and before you know it the whole financial system is in trouble. Usually when this happens, it takes a few years for the companies and individuals involved to go bankrupt, after which the cycle starts anew. Hopefully with lessons learnt.

But this time it is different. When a recession starts, the government has a few tools at its disposal to deal with the economic downturn: Interest rate, the budget and war. It reduces interest rates to stimulate economic growth. It can also start large infrastructure projects such road building, constructing bridges etc, to reduce unemployment and stimulate the economy (deficit-spending). There is another sure way of kick starting the economy and that is WAR. Wars are good for businesses and reduce unemployment and stimulate (for US) important parts of the economy.

However, all three tools have been already used prior to the recent recession. US has huge trade deficit and is involved in two wars (Afghanistan and Iraq). It has also reduced its tax revenues by giving huge tax-cuts to the rich. Large trade deficit, low tax revenue, tremendous debt, wars and low interest rates make it extremely difficult for the government to do much to help the economy.

If this was not enough its currency “the mighty dollar” is losing its position as the preferred international reserve and trading currency. The Federal Reserves keeps pumping dollars into the market, while at the same time keep reducing interest rates. This means only two things, a devaluation of dollar and an increasing inflation. Countries such as China, Japan, oil producing countries and others keep their reserves in dollar. These reserves are in the order of trillions of dollars. Imagine a 15% decline in value of dollar will translate to $150 billion dollar loss for the Chinese government alone. How long will these countries tolerate this loss is anyone’s guess, but surely there comes a time when these countries will react and begin to switch to other currencies. It is then that we will see the real collapse of the US economy.

There is already some ominous sign of this. A few days ago, Venezuela declared that it will no longer sell its oil in dollars. Currently there are Iran, Venezuela, and Russia that have decided to trade their oil and gas in other currencies. In addition, some Arab countries have started to de-peg their currencies from dollar. For these countries peg to dollar has meant importing inflation and they are trying to stabilise their economy. As dollar decreases in value and more and more raw-material producers switch away from dollar, this de-pegging will only increase.

Let us look at why this happens. China buys oil in Euro from Iran. It then produces gadgets and sells it in dollar. Naturally the dollar prices of Chinese goods increase. The US and others that use dollar or are pegged to dollar will see an increase in prices of their imports which is passed to the consumers. This means importing inflation. The countries that have pegged their currencies to the dollar naturally do not wish to import inflation and cut their loss. (Please note: raw materials in general are increasing in value, regardless of the currency. There is not enough space here to discuss this matter in detail)

This will put further pressure on the dollar contributing to its decline. This, of course is not good for the US consumers. When times were good (illusory) US kept its inflation in check by importing goods from countries such as China, India, and other places; where imports were paid with dollars. Now some stuff has to be paid for in Yen and Euro both of which are appreciating in value against the dollar. At the same time oil and gas prices have increased tremendously, not only in dollar term but also in other currencies. All these things mean that US has to pay many more dollars for the goods that it imports. In simple terms, US’ inflation is rising rapidly. In my opinion, the US government is not telling the American people the real truth, fearing further collapse in confidence.

The outlook for the US economy

When recession hits, the government usually starts deficit spending to increase employment. At the same time the interest rates are reduced to stimulate economic growth. United States is now in an unenviable position of entering recession with very low interest rates, huge deficit and declining dollar.

Already in August 2006 I warned about the coming financial crisis (please read “U.S. and The Coming Financial Crisis”). The following is an excerpt from that article:

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Dr. Abbas Bakhtiar lives in Norway. He works as a management consultant.He is also a contributing writer for many online journals.
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Don't forget the South Seas Bubble, where inve... by Guitar Chris on Monday, Mar 17, 2008 at 1:03:36 PM
Also, we don't know just how far down we will ... by Guitar Chris on Monday, Mar 17, 2008 at 1:10:07 PM
As you point out the dot.com bubble was bursting. ... by Margaret Bassett on Monday, Mar 17, 2008 at 1:25:29 PM
"Let us hope that he will be busy with other ... by Mr M on Monday, Mar 17, 2008 at 4:53:58 PM
Excellent Abbas Bakhtiar. You could have helped us... by aberamsay on Monday, Mar 17, 2008 at 4:57:39 PM
I was listening to Chris Whalen at Bloomberg's and... by Bernard on Monday, Mar 17, 2008 at 5:25:48 PM
What's happenig is not quite madness but a dee... by TomK on Monday, Mar 17, 2008 at 8:33:47 PM
"When a recession starts, the government has ... by August Adams on Monday, Mar 17, 2008 at 8:36:46 PM
A very straight forward, no nonsense explanation o... by Rabbi on Tuesday, Mar 18, 2008 at 8:12:20 AM
Capitalism 's basic operational mechanics ...c... by on Tuesday, Mar 18, 2008 at 8:18:26 AM
What would be examples of 'suitable models&quo... by TomK on Tuesday, Mar 18, 2008 at 12:23:06 PM
 america has no body to blame but our fearles... by vincent passiatore on Tuesday, Mar 18, 2008 at 7:26:54 PM
Read this: http://www.informationclearinghouse.inf... by aberamsay on Wednesday, Mar 19, 2008 at 6:36:00 PM