Storm Clouds by CoreBurn / © Some rights reserved.
Licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives license
Many people had given dire warnings about the serious problems the economy would be facing. Some even knew it would extend far beyond the United States. But few predicted the severity, scope and timing simultaneously, because of the complex commingling of the events. With hindsight, things become that much clearer.
Three factors--all of which were major contributions--were the reason why the world economy is now facing a global economic downturn of this level of severity. Any of the three occurring on their own would not have caused as much damage as we will now see in the coming months. All three are of course interconnected, but few specialists knew enough about one, let alone three to accurately predict the damage that this storm would cause.
The Road: Questionable Lending Practices
There was of course, Fannie, Freddie and the irresponsible lending practices promoted by government coalitions with free markets. This built a road that led to the edge of a cliff had been construction for decades only to be completed by about 2005. Warren Buffet who is often lauded as the World's best value-oriented investor, divested his entire position in both Fannie and Freddie all the way back in 2000. Buffet said he felt "uncomfortable with certain aspects of the business." It's also clear that many Washington insiders knew a problem was brewing here. In 2006, several Republicans (including John McCain) sent a letter to the majority leader which warned that "if regulatory reform for housing-finance government sponsored enterprises (GSEs) is not enacted this year, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole." The list doesn't end there, many others knew about fundamental flaws and an inappropriate risk profile for these quasi-government enterprises.
The Vehicle: Energy Price Shocks
Then there was the lack of a stable and sufficient energy supply (particularly oil), which served as the vehicle that had also been assembled over the course of several decades. Peter Tertzakian had some very impressive and accurate foresight with regards to oil 'breaking' the economy. In his 2005 book, he says that the world economy would stop, "'firing on all cylinders' in 2007," and in 2008, "a confluence of events [would force] the public and our nations' leaders to finally realize how vulnerable [the economy] had become [to oil prices]." He goes on to predict a plunge in SUV sales and automaker mergers, acquisitions and consolidations we are now seeing (his forecast calls for Toyota partnering with or buying GM). What he didn't foresee is how high gas prices would catalyze a collapse in suburban home values. With this, the assumption which was held by so many now troubled financial institutions--that home prices always go up--also failed.
The Fuel: Monetary Policy
Lastly, there was the fuel: credit money. Because markets are based on a fiat currency (based on a perceived value) rather than the gold standard (based on intrinsic value), the system is subject to bubbles, sometimes resulting very large corrections (the gold standard has its own drawbacks of course, which is why the two standards have been swapped many times throughout history).
Instead of going into too much into detail about how the world moved from the gold standard to a system of credit, I'll give a brief synopsis here (google it if you want to know more). Following the World Wars, the United States was in a very strong economic position (much like China today), as it was spared widespread damage on its own shores while Europe's infrastructure had been devastated. The country was extremely productive relative to other countries and awash in natural resources. Because they were in a position to lend money for the rebuilding of Europe, they formed the Bretton Woods Agreements (1944/1945). Essentially, the U.S. pledged to maintain a stable dollar by pegging its currency to gold, and all other currencies were in turn pegged to the United States Dollar. Several decades later, when the U.S. started to become a borrower rather than a lender as well as overextending itself with several wars, the hybrid gold standard to become incredibly unstable. It was officially abolished in 1971 and all major currencies were subsequently unpegged from the USD by 1976. No politicians in any of the major economic power had the political leverage to go back to the gold standard because fiat money allows for inflation and inflation makes the economy look good. Instead, national banks pledged to control inflation using imperfect price inflationary indicators, such as CPI and later core inflation.
It's not hard to see from the chart that soon after the gold standard was abandoned, the bubble era had begun. Deflation is considered political suicide and therefore the market corrections are always artificially stopped by government (meaning the problems simply build upon themselves). Former 2008 Republican presidential candidate Congressman Ron Paul can offer more on this subject, but the point is it hasn't worked.
It was not oil that was in a bubble at $147; it was the entire economy that was overvalued (homes, cars, equities, etc.). It was not price manipulators, speculators pushing oil prices upward but merely investors moving money from U.S. dollars into commodities to hedge against global inflation. This is why neither gas prices nor equities rooted in these commodities increased by nearly the same amount. Ironically, we now call this a "credit crisis".
In The End: A Terrible Concoction
As I've said, any one on its own, the flawed road, the vehicle or the fuel, doesn't really present instantaneous systemic danger. Had gas prices stayed low, consumer sentiment may have stayed high and home prices may not have plunged with Americans reconsidering the value of homes situated in very distant suburbs. Had monetary policy been better managed, oil prices would have increased more linearly rather than exponential volatility shocking markets (unlike the oil shocks of the 1970's, 2008 had no major supply squeeze). All three would still have presented a very serious threat individually of course, but the "perfect storm" as Bernanke puts it, is why the economy has weakened far more than many of the partitionary experts had predicted. I would caution that conditions are likely to continue to get worse even if global financial markets can be stabilized. Political instability has become one of the spillover effects and history has shown it is very difficult to maintain peace in the case of poor countries (or bankrupt ones). And yet I remain optimistic for the future, because after the storm, nature always rights itself. Always.
Usain Bolt raised eyebrows with his come-from-nowhere gander into the title of "world's fastest man". Three months ago, he raced in his first adult international competitive 100m event. The morning of the Olympics he woke up at 11, ate some chicken nuggets, watched TV, ate lunch, more chicken nuggets, then jogged his way into a new world record and gold medal in the 100m. He could have run faster were it not for his pre-finish celebration and an untied shoelace. This may seem suspicious, but even if he had used performance enhancers a good pharmacist knows how to circumvent drug testing; we may never know whether or not he really did wake up one day realizing he's the worlds fastest person. If he ran clean, it would be nothing short of impressive. Or maybe he wanted to run clean but someone slipped something in his Chicken McNuggets. Either way, the Olympic spirit and excellence more than offsets the less desirable sides of the games. 'Communist' China has thus far hosted the games without anywhere near the level of controversy many of the alarmists and human rights extremists had predicted. Canada topped its Athens podium count with 13 medals.
Mortgage guarantor Freddie Mac had mixed success with a high-yield debt sale today. Freddie Mac was able to raise over $3 billion in capital. Shares fell another 6% in addition to yesterday's 25% plunge. The likelihood that the mortgage GSE's will require explicit taxpayer backing is a bit of a psychological self-fulfilling prophecy--as investors are told by analysts not to invest in these companies, it makes it very difficult for them to raise capital. As a result, they must do so by offering a very high yield incentive (as was the case in today's sale). The premium will keep them afloat for longer, but it also hurts longer term profitability, which is why equity shareholders continued their sell off. Inflation data from the past week did not help, as it raises speculation that the Fed may need to raise rates sooner rather than later--a move that would likely force Freddie and Fannie to seek public funding if a rate increase were factored in this year..jpg)