Economic Collapse?

In the post “Future Uncertain” last June, one commentator named Mike wrote:

“An economic collaspe is not only concieveable but it is HIGHY likely. The mainstream media is not telling people the full extent of the credit market woes. Ten of billions (Possible up to a trillion) more dollars will be wote down by banks in the coming months. It would one thing if the toxic watse dumping was finished but these banks are going to flood the market with a lot more of these bad loans. The markets can’t withstand any more…. The Dow will most likely be below 10,000 by the end of July…”

Now, Mike’s prediction of the Dow below 10,000 by July turned out to be wrong, but as we watch the markets wobble over the problems at Lehman, it is becoming painfully clear that Mike may have been off primarily in his timing.  The United States could be facing the most severe economic crisis since the Great Depression.  We just can’t tell how deep the problems are, or how they’ll play themselves out.  But consider the drama of the past couple weeks.  First, Freddie Mac and Fannie Mae are literally taken over by the government.

We’re talking about nationalization of the most important financial backers of home mortgages, seized by a Republican pro-market government, obviously without enthusiasm.  The reason they took over these giants is that they had no choice — if they failed, the mortgage market in the US would have ground to a halt, unleashing tremendous economic hardship to just about every sector of the economy.  Why this happened was clear: close ties between these two corporations and government had led to laws that made it progressively easier for them to back mortgages without oversight.  That’s fine when the market is booming and home values soaring.  But when the bubble bursts, it was disaster.

Is this a domino effect that could reck havoc throughout the entire banking sector?  Is this a limited problem?  Nobody knows, but as with Enron a decade ago, it’s possible that the financial sector has been skating buy the last few years with accounting tricks and short term book keeping shemes to avoid having to publicly admit how bad things are.  Consider: you might be making a decent salary, but yet due to purchases and poor spending habits, be in severe debt.   For a long time you can keep this secret from your closest friends and in some cases, even a spouse.  You can kite credit cards (get a new card to make minimums on the old), do home equity loans, find ways to make that debt something that isn’t felt in your day to day life.  It may drive you crazy when you think about it, but you can usually find ways to get by another day.  This can go on for years.

But when things start to go south, they go south fast.  Soon you’re missing payments.  Then suddenly interest rates jump from below 10% to above 20%.  Suddenly you can’t get new loans, your house has negative equity and the result is personal financial collapse or bankruptcy.  Now, what if the banking sector as a whole has this sort of problem?  Drunk on the easy money and loose credit of the early part of the decade, they got themselves in over their head, perhaps expecting continued economic growth to simply allow them to go on making large short term profits.   It wouldn’t be consumerism in this case, but “buying” more interest-bearing loans, with the idea that the money will be paid back and profits would rise.   When the bubble bursts, then the whole thing implodes, as happened at Freddie Mac and Fannie Mae, and now Lehman.

One hopes that the other financial giants are on solider ground, but we’re not sure how solid, or who might be next.  The fact that it’s so difficult to find other firms to buy Lehman and limit the scope of this credit shows the relative weakness of the entire financial industry.   Add to that the troubled economic conditions: continued high oil prices (even if not as a high as mid-summer), a current accounts deficit, a weak dollar, and high unemployment.   The result is an economy as vulnerable as ever.  When we had our last major recession, the period of stagflation from 1979-81, the fundamentals were sound, but there was a real financial risk there as well.  The US still had a current accounts surplus, the oil price increases were artificial, due to tension in the Persian Gulf that would soon be allayed, and the dollar was healthy.  The credit markets, still mostly national and regulated as this was the ‘pre-globalization’ period, had only one glaring problem: the debt crisis.

The debt crisis emerged due to the way oil rich states invested “petrodollars” into major western financial institutions.  Those institutions in turn loaned money in vast amounts to third world states, on the premise that without strings attached these states could allow the market to lead investment and growth, and the loans would be paid back easily.  It didn’t happen.  Much of the money in fact went to buy oil, and the rest usually went to failed projects or into corrupt coffers, divied it between various bureaucrats and bigwigs.  When the truth came out that third world states might default, thus putting the entire western financial system in crisis, people panicked.  At the time, the prognosticators also speculated about financial collapse.  Is this another one of those crises we can get through?

Time will tell, but the way out of that crisis was: A) Buy time.  Short term loans were made to third world states so they could make interest payments, thus keeping the loans on the books as assetts for the banks; political pressure kept third world states from defaulting.  If they had defaulted, they may have lost aid, short term credit (necessary for trade), and access to markets; and B) Diversify risk.  Loans were sold at a loss to other banks, spreading around the risk rather than centralizing it with the major banks.   To be sure, high debt levels still exist, despite forgiveness of a lot of government debt.  But the threat to the western banking system has been mitigated.

This crisis is different.  It’s not one so easily controlled, as it is more than just a few states, and the sources of the crisis are the fundamentals of the credit markets, not just really bad decisions by banks on loans to third world states.   Still, no doubt the movers and shakers on Wall Street are in board rooms and on conference calls, trying to figure out the best way to handle this.  Perhaps they can come up with solutions, like in the late 90s when the ‘contagion’ in Asian currency markets threatened the world economy, or the response to the debt crisis.  Perhaps they cannot, like in 1929 when, after several short term efforts to steady the stock market succeeded, it finally crashed.

So while the political junkies argue about lipstick wearing pigs, who’s gaffe is up next, or who lied about what, the US economy stands in the balance.   The next few months may decide if we recover from these problems with a reformed, but able credit market, or if this is the start of a collapse that may profoundly harm our quality of life and material conditions.