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December 16, 2007

"Reckless" Lending By Central Banks and Its Consequences
by Jas Jain

On Wednesday, December 12, 2007, leading Central Banks surprised the markets by promising to "rain money" on American and European banks. After years of Fed facilitating the pushing of debt on households by private financial institutions, including turning blind-eye to obvious abuses in the mortgage market, it suddenly is pushing debt on banks (ready money, or reserves, in exchange for questionable collateral) with the hope that they would continue lending to households. Would it work? Hell no. How do I know? I happened to listen to Alan Greenspan, during a question answer season in London few weeks ago, midnight California time, in which he said, "During early 1990s the money supply numbers stopped working [money supply was growing but banks were reluctant to lend]. We [Fed] put buckets of money out there [in the banks, similar to what the Fed is trying to do now] and it didn't work. It was only after Wall Street came up with more [or newer] CDO products ["innovations" in securitization of debt] and took debt off the banks' balance sheets that banks started to lend again and the economy began to respond." Presently, the securitization of debt is in trouble due to its abuses. The process that took debt off banks' balance sheets is clogged. Pouring rapid water in a clogged sink doesn't work too well. It makes a mess.

Central banks' announcement also ignited one of the biggest gains in crude oil price, which was working its way down due to prospects of the weakening US economy and was having hard time staying above $90/barrel, up almost $5 at one point and closed up $4.37 for the day. A trader in the futures trading pit commented that most of the increase in price was due to the surprise action taken by the central banks. The net result was that most of the announced money to be showered by the central banks was expected to be siphoned off to the petroleum exporting countries, many of which are what I call Al Qaeda nations.

Let us take this thought one step further. Let us hypothesize two scenarios for the US economy for the 12-month period, 2007Q4-2008Q3; one in which the US economy grows by 2% a year (an optimistic case) and one in which the US economy contracts by 1% a year (somewhat pessimistic case, but not the most pessimistic by any means). It is a reasonable assumption that the average crude oil price for the year would be $20-$40 per barrel lower in the second case despite all the talk of global decoupling. Assuming a $30 per barrel difference in the crude oil price between the two growth scenarios, a conservative estimate I might add (it could be $100 versus $40 per barrel under the two scenarios), Al Qaeda nations and their friends, or supporters like Venezuela, would take in $100B more from Americans under the 2% GDP growth scenario compared with 1% contraction scenario. It could even be as high as $200B.

Where would the money come from to produce 2% GDP growth if that were possible? Continuation of the debt-push on households, by private financial institutions, to the tune of $900-$1000B. The historical pattern of growth in the household debt versus growth in the GDP, since 1950, suggests that a household debt growth of $500-$600B would be necessary to keep the US economy out of recession during 2007Q4-2008Q3. If the growth in the household debt, mortgage debt being the overwhelming component, is limited to  $400B then we are certain to have a 1%, or larger, contraction in the GDP. This clarity, in GDP growth versus household debt growth, is what is missing in the recession versus no recession debate.

It is undeniable that something big has happened in the US mortgage lending business since September 2007, mostly due to full recognition of the falling home prices, i.e., end of the denial, and its direct contribution to the sharp increase in foreclosures and losses in the US mortgage debt "securities" being experienced around the world (the collateral underlying the "securities" being lot less secure than imagined!). Assuming that the consumer credit (it excludes the mortgage debt) growth remains around $100B a year, if you were a betting man, or woman, would you bet on the mortgage debt to grow by $300B, or $500B, or $800B annual rate? Depending upon your answer you are indirectly predicting a deep recession, or mild recession, or 1.5-2% growth, respectively, for the 12-month period, 2007Q4-2008Q3. If the outstanding US mortgage debt stops to grow, led primarily by defaults in the existing mortgages, then we are talking about a depression. Pure and simple. That is how much addicted to debt the US economic growth has been turned into. Withdrawal of the addiction substance, or stimulus, means depression!

Now, do you see why the US Federal Reserve is panicking? Fed wants the private banks to keep lending money to the households (businesses are not much in the need of borrowing except for commercial real estate, which is suddenly turning down). Since most of the lending to the households is in the form of mortgage lending, the banks and other mortgage lenders are gun-shy.

I am sure that most people by now know how we arrived at the situation called "the mortgage mess." Many also know that the mess is far deeper than what the "sub-prime" mantra suggests. Amazing part is that we got here despite terms like "reckless mortgage lending" being applied to it by Stephen Roach of Morgan Stanley some three years ago. This from Sprott Asset Management in July 2005: "...combined with rampant speculation and lax (even reckless) lending standards, has added a further leg to the housing bubble. However... there is only so much that housing prices can go up from here, and only so reckless that lenders can get, before the housing bubble collapses under its own weight." (Emphasis added).

Some of us cranks and kooks have known about the mortgage insanity, or the evil practice of pushing debt, for some five years. I have put the term reckless in the title in quotes because there was nothing reckless about what the Fed did last week or it ever does, just as there was nothing reckless about the mortgage lenders' pushing of debt and securitization by Wall Street (it was extremely profitable while it lasted). Long-term, there is no business as profitable as the debt business. The mortgage debt-push was a premeditated and fully thought out process.

There is nothing else that the Fed can do to keep the economy from slipping into recession, or depression, than to keep the debt-push going at an elevated pace. Unfortunately, Fed can't directly push debt on households (no helicopter drops!). It needs banks as conduits and banks are in trouble. As Schumpeter noted, bankers' mischief leads to catastrophes (his term for depressions). And he was talking about the private bankers. The role of the private bankers in causing the Great Depression is kept very quiet. Federal Reserve exists to get the blame! We have arrived at the juncture where the Fed becomes impotent. It has reached level of impotence beyond the economic equivalent of VIAGRA. That is what gross abuse of a function can lead to.

Finally, I turn to the unintended and very harmful long-term consequences of Fed's policy of facilitating debt-push on the US households for the past five years - greatly strengthening Al Qaeda nations and creating a formidable economic and political rival in China. (Yes, China has been the biggest beneficiary of the debt-push on the US households that has gone on all thru the Greenspan-Bernanke years and accelerated during the past five years).

From a website on US energy consumption problem: "Q: Who controls the price of oil - OPEC or the Big Oil companies? A: NEITHER. It's you and me." How about the Fed and the private bankers?! The price is determined at the margin and a large segment of American population will borrow and consume as long as, and as much as, there are bankers ready to lend to them. It is like putting candy in front of a kid. Without the debt-push for the past five years the crude oil today would be more like $20-$30 a barrel and Chinese economy would be 3/4th its size. Anyone who believes in decoupling theory would soon find out that China will suffer from the US households' withdrawal symptoms.

For those of you who are worried about inflation, the total household debt growth below $300B annual rate will lead to outright deflation within months (inflation always lags). Household debt growth is inflationary in the present and deflationary in the future. Fed has been fighting deflation for the past five years by maintaining elevated rate of household debt growth! Controlled inflation, around 3%, has been Fed's policy for the past 25 years, after Volcker tamed inflation. There is no such thing as "corrosive deflation," Mr. Greenspan; there is only corrosive inflation. The policy of controlled corrosion in purchasing power is a bad one for the American workers and, especially, the poor. Sen. Bernie Sanders was right when he said to Greenspan, "that you see your major function in your position as the need to represent the wealthy and large corporations." Who helped Greenspan get the appointment?!

It Is the Debt, Stupid!

PS: With the industrial base shrinking, America's Military-Industrial Complex of the Eisenhower Era has been exported to China to make way for today's Financial-Military Complex with military ready to serve bankers and financiers' interests.

Jas Jain, Ph.D.
the Prophet of Doom and Gloom

Copyright © 2004-2007 Jas Jain

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