The events of last week have increased the probability of hyper-inflation or a depression. Both scenarios can still be avoided. It will require deft handling by financial authorities in USA and the rest of the world.
Causes of the current crisis
Some of them are known to everyone. Some of them might not be obvious.
New Deal era regulatory structures – they regulate Fannie Mae and Freddie Mac. But they was no oversight of Bear Stearns and Lehman Brothers – big players in fixed income markets.
Richard Nixon for eliminating the gold standard
Reagan's supply side economics – ran huge debts and made it seem like it does not matter. The public remembers his optimistic side.
Alan Greenspan’s coddling of the stock market – he eased liquidity whenever the stock market was in trouble. He created the tech market bubble. He kept interest rates too low too long after 2001.
George W. Bush – one of the most intellectually challenged Presidents. I am not sure if he got lucky appointing Paulson.
Fannie Mae and Freddie Mac – cooking the books, using their muscle to intimidate Congress
Congress – a bunch of crooks interested in their own welfare
Ratings agencies – they never bothered to examine the mortgage backed securities
Wall Street – Lehman Brothers, Citicorp, Bear Stearns, Goldman Sach and countless others. They were happy making money off these MBS. I do not think the punishment is hard enough for these guys.
Home buyers - lied about their income and creditworthiness. They lacked the financial savvy to avoid buying overvalued homes or avoiding exotic loans.
Mortgage brokers – they made ALT-A, Liar and sub-prime loans happen
Government actions last week
This is a short summary of what the US government did last week
The government started out allowing Lehman to fail. They had to intervene in AIG’s case. It was an $85 billion loan.
They introduced rules banning short selling of 800 financial companies.
List of companies that cannot be shorted
http://sec.gov/rules/other/2008/34-58592.pdf
They announced plans to insure money markets. This should prevent run on money market accounts which have $3.5 trillion in cash.
They announced plans for an entity that would purchase troubled mortgages.
What do you do?
What do you do in case of hyper-inflation? Cash will be wiped out in hyper-inflation. Own a garden where you can grow some fresh produce. I believe grains like rice and wheat would be relatively cheap at least in United States unless we were forced to export it to pay off our massive foreign debt. Get a gun and plenty of ammunition to protect yourself. Get precious metals and see if you can find foreign currencies linked to gold.
What do you do in case of a depression?
Ask yourself what types of business would do well in a depression. What do people have to buy? Ask yourself how people will react in a depression. There are going to be a lot of unhappy people if we enter a depression. Anything that relives the unhappiness is going to be welcome. Consumer staples, liquor, tobacco, gambling would do relatively well. Any stocks you own now will drop in value.
What do policy makers do?
In the short run they should try to prevent bank depositors and money market holders from losing money. They should try to ease up credit for credit worthy companies and individuals.
The policy makers should make the point of moral hazard – inflicting the maximum punishment on bad actors. It has to be balanced with the delicate task of restoring economic growth.
In the long run the big question for the policy makers is that free markets are not as efficient as we would like them to be. The question is how much regulation is needed for the fair, efficient and transparent operation of our markets.
Historical parallels
In the case of 1930 depression the government drained liquidity from the economy. In the current crisis the government’s response has been to inject massive amounts of liquidity. One of the plausible scenarios is a long period of contraction like what Japan experienced in the 1990’s. I think while the government may prevent a catastrophic crash they might prolong the pain over an extended period of time.
Cost of the bailouts
It is not clear how much this bailout will cost. That is the honest answer you will get this week. No one can place a bottom on the housing prices. No one can predict how many underwater homeowners will walk away from their properties and loans.
A lot of these mortgage backed securities are held by international entities. The failure of American mortgage backed securities will make foreign buyers be selective in what they buy. The worst case scenario is that foreigners ask for a risk premium for all things American.
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