Monday, February 18, 2008

An Economy on FIRE

As you may realize by now our economy does not rely on producing finished goods of high value for trade anymore. Our last merchandise trade surplus was way back in 1975. Our new economy is described by an acronym: FIRE for finance, insurance and real estate. The FIRE economy's life blood is easy credit and lots of it. After World War II the dollar was allowed to float in value against other currencies according to the Breton Woods Agreement. The dollar was still redeemable in gold, however. By 1971 the US had accumulated a tiny trade deficit by today's standard ($3.8 adjusted versus $204 billions). Nixon was faced with a run on US gold reserves when de Gaulle demanded that the trade deficit be payed for in gold and not depreciated dollars. Nixon unilaterally ended the US legal obligation to back the dollar in gold; in effect, he defaulted.
In the 1980s less credit worthy companies were able to finance their expansion through the corporate junk bond, a new class of investment securities. Under the leadership of Alan Greenspan the Federal Reserve set about deregulating the banking and securities markets in the 1990s. The Glass-Steagall Act of 1933 which prevented commercial banks from entering the securities industry was repealed. The Fed provided cheap capital by keeping interest rates low. The US has thus been able to finance its mounting trade deficits with it's own depreciating currency, a truly "exorbitant privilege" to use de Gaulle's words. Trade partners such as Saudi Arabia, Japan and Taiwan balance their trade surpluses by purchasing US financial assets. This process becomes self-reinforcing because our largest creditors are now stake holders in the value of the dollar and the health of the underlying national economy. If they reduce their holdings of dollar instruments, the dollar's trade value will fall thereby reducing the value of their remaining holdings even further. If they stop buying our debt altogether, the US cannot afford to keep buying their exports. A double think worthy of repetition is the title of a neoconservative Cato Institute report, "America's Record Trade Deficit: A Symbol of Strength". And war is peace; liberty is treachery.

According to Eric Janszen, a former venture capitalist writing in Haper's Magazine, the FIRE economy is about to have it's first near-death experience. The agent de mort is the what is commonly called the "subprime mortgage crisis", but is more accurately described as the home price hyperinflation or bubble. The real estate bubble was inflated by easy credit. After the .com bubble burst in 2000, the Fed reduced the discount rate from 6% to 1.24% which led to inexpensive adjustable-rate mortgages (ARMs). When the mortgage credit industry ran out of credit worthy borrowers, they made it even easier to buy expensive homes by creating an investment derivative known as a collateralized debt obligation (CDO) in which pools of lesser quality loans were repackaged and given lower risk ratings. The idea was to spread the risk of some non-performing loans beyond banks throughout global financial markets. But as in past bubbles, greed got ahead of the game [1]. Home loans were even given to borrowers who gave no proof of their stated incomes, so-called "liar loans". Since the housing bubble burst in 2007 and home prices are falling towards their historic trend (about 3.3% annual increase since WWII, close to the rate of monetary inflation) the poisonous risks of hyperinflated prices and loan defaults are becoming known like a receeding tide uncovering carcases on a beach. One clear indicator of the global spread of this toxic tide is the announcement that UK's big mortgage lender, Northern Rock, will be nationalized after suffering a stock decline of 87% [2]. The estimate is $12 trillion of fictitious value in the US real estate market. If real estate prices decline at a rate of 6% to 7% a year, it will take about six years before the economy is stabilized again (currently house prices are declining nationally at a 10% clip which translates to American households loosing $2 trillion in value per year). This lost money has to come from somewhere. Frederick Mishkin, a governor at the Federal Reserve, suggests that for every dollar lost in value a typical family will cut spending by 7 cents. That adds to about $155 million less consumption nationwide. Keynesian re-inflation--the first installment is the tax refund just approved--probably will not be enough as it was after the .com collapse. Then the Federal funds rate was 6%, now it is 4.25%. Then the dollar was trading at a multi-decade high, now it is at multi-decade lows. Rather than a balanced national budget, the federal deficit is at a record high while we simultaneously finance two wars and grant tax breaks to wealthy Americans. If foreign investors do not buy even more of our depreciating debt, the government will be forced to print more money just to fund it's operations. Avoiding a depression will take an economic miracle, or another bubble. Now that I have your attention, may I direct it to these fine nuclear power plants we have for sale over here?

[1] See the 1961 theory of Dr. Hyman P. Minsky, "financial-instability hypothesis", previously thought to be crackpot by mainstream economists.
[2] The market for an arcane derivative, default insurance swaps, is also being roiled by the crisis. The market is so obscure and unregulated that experts do not know if losses will be catastrophic or insignificant. What is clear is that trading volume is straining the contract clearance system to it's limits.