Adventures in Global Finance [Part IV]

Coming towards Conclusions


Basically, my only real aim with all this financial writing is to point out that...

-- the economy is not a scientific, rational, proven thing run by experts who know what they are doing... but a wild, human experiment
-- the ways global finance operates now are quite different from even a decade ago, and nobody knows what effect the changes will have: this is all new
-- there is a great amount of public ignorance or misunderstanding, which (whether intentionally encouraged or not) works to the advantage of the people manipulating/profiting off the system-- and to your disadvantage.

There are four obvious factors that will make times ahead tougher, economically, than what the last two generations have known. In this piece, we'll look at each in turn, and then in in a final part (I know I said there would be 4, but I lied) we'll wrap things up with a picture of the future... and how to make it rosier despite some challenges.



The Four Horsemen of Economic Gloom

-- Bad financial policies
-- Debt
-- Shifting demographics
-- Oil


the horseman on a stupid horse: Financial mismanagement

Even if these policies weren't enough to force us into a crisis, they will certainly make it harder to deal with the other factors in the crisis: the shifting demographics, for example, could have been forseen and planned for with smart financial policies.

We've already began to look into bad financial policy (that's so vague-- "irresponsible policy", maybe?) in the last post, where we examined the role of speculation in the food crisis.

Let's briefly attempt to understand another example-- the subprime loan lending mess. (If you already grasp what happened and are sick of hearing about it, please skip ahead, but if you're wondering what that was all about, here's another chance for a readable explanation.)

Basically, lenders got borrowers to take out mortgages without taking into consideration whether or not they could pay it back -- sometimes hoping, in fact, they wouldn't pay it back, but that they would have to refinance into mortgages that would generate even more money for the lenders. These customers were called "subprime" because they were in more difficult financial situations, but at this time, lenders loved them because they could charge them more than "prime" customers.

Credit comes from the latin creder -- "to trust, believe". (Like "creer" in Spanish; like "credible.") Credibility costs-- the price of credit (the interest rate) -- is based on alender's belief in the borrower's willingness or ability to repay the debt.

(It is worth noting that 61 percent of subprime loan customers could have qualified for less expensive conventional loans -- they just didn't know it, which is another reason we need better education & understanding of finance.) (See this Washington Post article, which I will paraphrase below.)

How did this irresponsible practice how did this turn into a major upset in the global economy?

It was caught up in another irresponsible practice: that of selling these shaky subprime mortgages to other transglobal investors. From the Post article:

Mortgage finance giants Fannie Mae and Freddie Mac -- companies chartered by Congress to finance home lending -- bought home loans from banks, then bundled hundreds of them together to secure a bond, called a mortgage-backed security. Wall Street investment bankers bought the securities, which then traded freely in the bond market. For a fee, Fannie and Freddie guaranteed the mortgages behind every security against default, so they required lenders to assess each borrower's ability to repay a loan -- a prudent practice known as underwriting.

Fannie and Freddie's underwriting rules are the gold standard by which lenders evaluate the creditworthiness of "prime" borrowers, people whose strong credit histories make them a low risk and therefore eligible for the lowest borrowing charges.

Fannie and Freddie competed fiercely with each other to create these bonds at the best price, paying less and less for the loans they bought from banks. Securitization became so efficient that it shaved profits in the prime market paper-thin. In response, by 2000, a market had sprouted to lend to "subprime," or higher-risk, borrowers, who could be charged more for loans.

...

The private-label, subprime bond market grew from $18 billion in 1995 to nearly $500 billion in 2005. Wall Street sold subprime everywhere: to public and private pension funds, foreign governments and financial conglomerates, even fishing villages in the Arctic Circle.

(How did this happen? Well, it wasn't just commodity trading that was recently deregulated--
in 1999, the Clinton administration repealed the depression-era Glass-Steagall Act. The act had made sure that banks wouldn't use the money of depositors for investments other than loans, but after the repealing of the act, banks could form superconglomerates and diversify into other investments (see this PBS article about how the act was dismantled, with Citicorp playing a lead role in this.)

What happened, of course, is that the housing boom (which had in many ways driven this whole thing) slowed. Home appreciation and refinances of mortgages slowed, and eventually people who took out these loans couldn't pay them back, and the investment funds and banks who had bought their risk lost lots of money.

And what happens when a bank loses a phenomenal amount of money?

This topic is an article in itself, so let's be brief: British bank Northern Rock lost big on the crisis, and got nationalized by the British government. Swiss bank UBS saw its shares drop by half. In the case of New York investment bank Bear Stearns, it got bailed out for 30 billion dollars in a transfer to J.P Morgan Chase, arranged by the federal government. It wasn't that Bear Stearns was a super-important bank, but its collapse would have had reverberations throughout the infrastructure... however, we can't count on the Fed to step in and save all the banks. Let's talk about the Fed for awhile...


the horseman on a lame horse: Debt

Let's examine for a moment how the federal government handles its money.
Or, your money, our money -- we should seriously start thinking of this as our money, and take an interest in what's done with it.

You probably know that the government is in debt.
Do you know how much debt?

About $9.4 trillion dollars.

Aside from being a really big number, this signifies two notable things:

-- We have to pay interest on this debt. Yes, people have been investing in America because they get interest payments on the Treasury bonds they're buying. This year, the interest we owe comes to an estimated $459 billion, $244 billion of that which has to be paid out this year. (For comparison, we spent $583 billion on defense, $68 billion on education, $23 billion on energy, $52 billion on housing and urban development, $7 billion to the Environmental Protection Agency. So just the interest on this debt was far more than education, energy, housing, and the environment combined.) Plus, when the economy slips, we still have to pay our interest... so all the other stuff is what gets cut.

-- If confidence in America's economy falls (it is right now), investors might stop wanting to hold our debt and our dollars. (So much seems to depend on mood... & our brand name isn't the hottest this year.)

Who are these investors, and what happens if they don't think it's a good idea to finance our debt anymore?

About half of the debt is owned by our own government, bought with money that's supposed to be used for Social Security (which is a situation too weird for my limited powers of explanation; apparently there is $2.2 trillion dollars in a Social Security Trust Fund, but debate exists over whether or not this money is fact or fiction).

However, lots of people besides our own government own our debt-- foreign governments, foreign corporations, foreign individuals; also U.S. citizens who have bought treasury bonds, etc. (See the Treasury Statistics).

(MSN, not my favorite media outlet, but... has a very readable article on this topic. Also see the Debt Clock. Also, there's a funny (fake? real? legit government or pseudogovernment) government FAQ about the debt that tells you where you can send a "gift" to reduce the public debt [shady, no?])

How do we deal with this debt? Well, we could print more money.
Here I'm going be dubious and quote wikipedia's entry on the U.S. public debt, because it's quite well-done:

United States Dollars are essentially a commodity on the world market and the value of the dollar at any given time is subject to the law of supply and demand. In recent years, the debt has soared and inflation has stayed relatively low in part because China has been willing to accumulate reserves denominated in U.S. Dollars. Currently, China holds over $1 trillion in dollar denominated assets (of which $330 billion are U.S. Treasury notes). In comparison, $1.4 trillion represents M1 or the "tight money supply" of U.S. Dollars which suggests that the value of the U.S. Dollar could change dramatically should China ever choose to divest itself of a large portion of those reserves.

So, if investors did decide to stop financing our debt, all of a sudden the dollar could drop. (They probably won't do this, because they have a lot to lose when the dollar drops, too).

But what happens when the value of the dollar drops? It results in more than you having to cancel your European vacation, because your dollars don't mean anything over there... Though people who have lived their whole lives in this country have no experience of rapid currency devaluation, one can look at the experience of Russians or Argentinians to see what it's like when your money sharply declines in value. Not only can you not buy much at the store, but all the savings you've worked your life to earn are suddenly worthless.

As we read above, dollars are a commodity which is driven by the rules of supply-and-demand. We just briefly considered what a demand-dropoff would do to our economic situation. Who controls the money supply? That would be the Fed, or the Federal Reserve System, which you've probably heard a lot about. It was created in 1913 and serves as our central bank, tasked with monitoring the money supply and maintaining financial stability.

The Fed has this monolithic building at 33 Liberty Street, NY.
Apparently, 26m beneath it there is a vault
that bears the largest gold repository in the world,
with 500 metric tons of gold bullion.
It rests on the bedrock of Manhattan Island
(as the Fed says, "one of the few foundations considered
adequate enough to support the weight of the vault, its door,
and the gold inside." -- "To protect their feet from dropped bars, the stackers
wear strong, yet lightweight, magnesium shoe covers.")

On the building you can also read a nice story
about the farm of Mr. Jan Jansen Damen that used to be there.

There are basically two ways the Fed influences the economy: by manipulating the federal interest rate, and by printing money.

Through these actions, it influences the rate of inflation-- it has a legal mandate, by the way, to maintain stable prices. Not an easy job!

Congressman Ron Paul discusses what's going on with the dollar:

This decline in the value of the dollar is simple to explain. The dollar loses value as the direct result of the Federal Reserve and U.S. Treasury increasing the money supply. Inflation, as the late Milton Friedman explained, is always a monetary phenomenon. The federal government consistently wants to spend more than it can tax and borrow, so Congress turns to the Fed for help in covering the difference. The result is more dollars, both real and electronic-- which means the value of every existing dollar goes down...when the Fed sets interest rates artificially low, the cost of borrowing becomes cheap.

Individuals incur greater amounts of debt, while businesses overextend themselves and grow without real gains in productivity. The bubble bursts quickly once the credit dries up and the bills cannot be paid...the Fed steadily increased the monetary supply throughout the 1990s by printing money. Recent Fed numbers show double-digit annual increases in the M2 money supply. These new dollars may make Americans feel richer, but the net result of monetary inflation has to be the devaluation of savings and purchasing power.



But there's also other things influencing inflation and the worth of the dollar right now besides the actions of the Fed, such as supply/demand issues over oil, which we'll discuss later...



the horseman on an aging horse: Demographics

How much is the debt, really?
I just told you it was $9.4 trillion dollars.
But, in another way of thinking, it is actually $55 trillion. [See this article]

... the true national debt figure: $55,146,513,890,000.00.

This calculation of the national debt includes all the "off balance sheet" liabilities of the government, such as its promises to pay benefits to Social Security and Medicare recipients far into the future, as well as military and civilian government workers' pensions.

In other words, the true liability of the United States of America is not only the Treasury bills, notes and bonds we sell to finance our annual deficit and past deficits. To get to the true liability, you must include all the promises we've made to make payments in the future.

What happens when those payments come due? The demographic situation is the only economic factor that no-one really disagrees that we're facing: we know that the baby boomers will get older. When they do, we will have way more people retiring and needing health care-- making demands on the system-- that we will have people working and contributing to the system. This is a huge issue, and to give it a cursory treatment doesn't do it justice, but because I'm getting mired in this whole essay, I'm going to keep moving on.

horseman on a black steed: Oil

We're all pretty clear on the relationship between the cost of a barrel of oil and the cost of filling up a gas tank.
But besides driving... in what ways can oil really effect the entire economy?

-- The "green revolution" which enabled modern mass agriculture was born on oil: not just the huge agricultural machinery, but the fertilizers & chemicals used to produce the increase in crop yields, depend on oil. Higher oil prices = higher food prices.

-- Not just fertilizers, but all kinds of chemical products are made from petroleum derivatives: medicines, plastics, tires, and more. Higher oil prices = higher prices for plastic chairs, carpets, paint, etc.

-- Most of our goods -- not just food -- are moved around by ships and trucks and planes that run on oil. Higher oil prices = higher prices for everything that gets moved around.

-- A lot of our electric power comes from oil. Higher oil prices = more expensive to heat your home in the winter.

So far, merchants have been eating the cost of these increased expenses, but eventually they will have to pass them on to consumers. [Look to this NY Times article for more.] But basically, we will no longer have access to the cheap goods we are accustomed to.

For the small percentage of Westerners that currently are in the grips of a throwaway society, this will have good elements. We will owner fewer goods, of higher quality, and value them more: nothing wrong with that. Life could be enhanced. But for most of the world's population, the shock of dramatically higher prices for food, transportation, electricity, and goods will be impossible to absorb. Already, there are riots in many less-developed countries, and they could get much worse once countries like China, Egypt, and southeast Asian nations can no longer afford to subsidize gasoline costs. This situation will only grow more grave as the supply of oil declines (I'm not going to get into peak oil too much since I already wrote about it in 2005: suffice it to say that the situation's only become more evident). Can we transfer our infrastructure to something non-oil-dependent before oil gets scarce enough to be completely unaffordable? These are the great questions in life...

If you're concerned that all this is the wacky hallucinations of some girl on the Internet (I wonder from time to time myself), I would refer you to the updated UN report, "World Economic Situation and Prospects 2008". You can download the whole pdf, and it is quite readable for a governmental report. Here are the first two paragraphs:

In the wake of numerous challenges, the world economy is teetering on the brink of a severe global economic downturn. The deepening credit crisis in major developed market economies, triggered by the continuing housing slump, the declining value of the United States dollar vis-à-vis other major currencies, persisting global imbalances, and soaring oil and non-oil commodity prices all pose considerable risks to economic growth in both developed and developing economies. Additionally, the unfolding food crisis, which is not only a grave humanitarian issue, but also a serious threat to social and political stability in some developing economies, endangers the achievement of the millennium development goals (MDGs) by reversing some of the progress towards those goals made so far.

As with climate change, the poor & relatively "unseen" will get screwed the worst. While any of the things I've mentioned in these pieces could trigger a global economic crisis -- a stock market crash, a burst of the derivatives bubble, a loss of confidence & unwillingness to finance the American debt, etc. -- it is the oil-dependence situation that will be the hardest to recover from. I think we could mitigate the other things, even the demographic situation, with smart financial policy and open discussion... but to get our society off oil will require intense effort in all sectors.

At talks in Jeddah yesterday, Gordon Brown called the oil crisis "the biggest crisis facing the world" [The Guardian].

Coming next... looking at the future.