The Credit Bubble has Popped. What can be done?
Posted on January 22, 2008
Filed Under Economic Crisis, stock market
Pop! Sssssssss. Â
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That’s the sound of the credit bubble deflating. The Federal Reserve, acting as an enabler, has kept rates too low for too long allowing an obscene credit bubble to inflate. Now we are feeling the pain. This abnormal policy created a distortion in capital flows making credit nations with low propensities for consumption our “dealersâ€, by taking their excess savings in the form of capital and channeling right back into the US economy, essentially allowing us to spend their savings as if it were our own. This created the illusion of prosperity, allowing Americans to maintain their high standard of living despite Washington’s lush spending habits.Â
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An unintended outgrowth of this debt subsidy was the creation of an underground financial system in the form of sub-prime loans, SIVs, CDOs, etc, bringing capital to places it wouldn’t otherwise have reached. This helped perpetuate a housing boom with prices rising by more than 20% annum. Homeowners were thus able to tap into their newfound riches in the form of home equity loans, funneling the money back into the economy and fueling the economic boom. As is want to happen in any bubble, excess ultimately built up in the system.Â
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Rather than letting the system unwind and allow the market to work the excesses out, the government stuck their beak in and created a far more serious problem, highlighting the problem with government intervention in financial markets. Â The combination of cutting interest rates (when they should have been raised) and a bringing forth a stimulus package (when spending needed to be curtailed), has put us right at the precipice of catastrophe.
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The result of these policies has been predictable – the dollar has continued its plunge and commodity prices have surged, bringing gold to near record levels. Global markets, displeased with the direction our monetary policy has taken, have been crashing and the bear has been mauling our own equity markets
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Rather than cutting rates recklessly, the fed needs to earn back the trust of global markets as an inflation fighter first and growth protector second. So much good was accomplished in the 80’s by the steely hand of Paul Volker with the blessing of Ronald Reagan. The price paid was a steep recession in 1982, the result of 22% interest rates, but it was those rates that strengthened our currency and brought the scourge of inflation to its knees, setting the stage for decades of unprecedented growth. We need to get back to the mindset of Volker and Reagan instead of mimicking the policies of the Nixon/Carter years, lest we wind up having to pay $1000 for a package of American cheese.
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