Monday, February 23, 2009

Changing Momentum?

I have been pondering the comments from a friend about the economy. He basically argues that there is a massive downward momentum and the government is the only institution which can change the momentum. I have been uncomfortable about the analysis but couldn't quite decide why (other than the obvious that I don't trust government spending).

The real issue is that there was a bubble and it needed to burst. In recent history, there was a tech stock bubble, a crude oil bubble, a food price bubble (corn, wheat, rice, etc.), a farm land price bubble (this is related to the food bubble), and a housing bubble. I may have missed some, but those are the big ones.

A bubble specifically means that an item is inaccurately valued by the market and it increases in value. Those investors trying to ride the next wave buy, buy, buy. The increase in buyers drives up the price. Prices are determined by the expectations of future gains. Everyone bought houses because they could get cheap money and the value was appreciating.

Whenever there is a bubble, there must be a correction. That is because the market learned that it had made wrong assumptions about the value of the future earnings from an asset. Any attempt to prevent the correction will prolong the downturn.

Looking specifically at the housing bubble, there were several contributing factors.
  • Cheap money from abnormally low interest rates (the Fed was fighting inflation without watching other things),
  • An increase in the supply of buyers (they were attracted to the quick profits),
  • Separating loan origination from the risk of loan default (liar loans came from mortgage agents being paid ONLY for signing up a person for a loan, not their ability to pay it back - people didn't have their income verified),
  • Government over-regulation that forced banks to loan money to those they knew wouldn't pay them back (home ownership is viewed as a good thing for society, so they used Fannie Mae, Freddie Mack, and the Community Reinvestment Act to get people in homes their credit worthiness and income didn't justify),
  • Congress accepting massive political contributions from the institutions they "regulated" (Chris Dodd, Barney Frank, and others - yeah, no conflict of interest there),
  • Financial institutions packaging mortgage-backed-securities as high quality investment vehicles for hedge funds (banks had no way to value the liar loans and the securities only work in a perpetually appreciating housing market - oh, and by the way, there are credit card backed securities too. If the recession is long enough and income decreases enough, people will default on credit card payments just like their mortgages. Then all those financial instruments will have to be written off the balance sheets, too.)
All of that to say that the decrease in asset values is necessary at this point. Government bailouts are just propping up the inaccurate values and prolonging the bubble. The real issue in my view is a debt bubble. And debt makes us slaves to our creditors. This bubble has to burst. Consumers need to live within their means, and government needs to stop borrowing from future generations to buy votes now.

The money to pay for corporate bailouts is either borrowed or printed out of thin air. The obvious problem of this new money is that inflation is next. The last time we had high taxes and inflation was not a time of economic growth in this country.

Every time one of these asset pricing bubbles has burst, economic prosperity was on the other side. The time to bail out this economy would have been about 5 years ago. Now it is too late. This needs to run its course so the world can get back to work.

UPDATE: I added a link above to a New York Times article predicting the bailout of Fannie Mae from back in 1999.

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