John McDonald

Blogging about politics, life, and the web

The Federal Reserve and the Credit Crunch

May 11th, 2008

Unless you’re living in a cave or you work for the government, you’ve probably noticed that prices are going up much, much faster than wages. This isn’t necessarily an accident or unplanned market event, this is the result of many decades of specific monetary & fiscal policies designed to drive consumption and “expand the economy” with use of an ever-devaluing currency. The fundamental premise they teach would-be central planners in the modern university economics system is that low interest rates spur investment, promote job growth, and drive debt-funded consumer purchases that increase net demand. Its true, to a point.

The downside is the mounting debt – and the relative value of a currency that isn’t tied to any hard commodities. As the currency becomes more available, demand for it declines and this is reflected in its reduced purchasing power. There is no actual limit to how many dollars could be printed (or more accurately these days: digitally transferred), but there is a limit to the amount of goods they can buy. As the quantity of money increases, the global markets respond in near-immediate time the new value of the dollar in terms of oil, gold, rice, or whatever you might want to buy.

Thanks to an “independent” Federal Reserve, we’ve enjoyed 90+ years of a fairly easy money supply. It promises to be one of the most generous currencies in modern history (click here for the full history of the federal reserve and central banks in the U.S.). The only side effect is debt and higher prices, I mean, the next generations can worry about that, right?

Well, it seems the time has come. Today, debt-servicing alone consumes more of the federal budget than the entire New Deal program did before the outbreak of World-War 2. The dollar is dropping at double-digit rates, and the central planners at the federal reserve don’t know what to do but make the flow of cash even easier to trigger.

After 9-11, record-low interest rates were instituted to prop up a staggering economy – easy money and herd mentality led to a huge inflation in home prices. We called it wealth. People started taking this “wealth” and borrowing against it, thinking they could just get into more debt chasing this paper inflation “wealth.” It seemed like such a great idea that the banks did, too. Trillions of dollars built out of an accounting trick started chasing after real assets with real value, prices could only go up…

Then at some point in 2006, it seems like everyone who was going to buy a house already had one. The dead-beat renter of five years ago now had his own sub-prime mortgage. With no one to rent and home prices at a record high, it was a great time for landlords to start unloading.

But wait – who is going to buy? And the houses sat on the market. And the talking heads said “buy buy buy!” But no one was buying anymore.

Enter the credit crunch:

In a year, housing prices would crash double digits. The Federal Reserve responded again with even more rate cuts, bringing the interest rates down on some securities to a negative range. It couldn’t create buyers. The banks held these mortgage promises as reserves, and by early 2008 the bank reserves were negative. To keep the banks in line with law and to keep your debit card & check books working, the federal reserve decided to trade more dollar-denominated securities for those bad mortgage promises.

Of course, global investment markets realized that the dollar had just literally become an instrument of sub-prime debt. The dollar reached a new low. Some manipulated job numbers and CPI figures were thrown around to ease the bloodletting, and today we’re just a few notches above that last low.

Nothing has changed about our strategy of devaluing our way out of this debt to ourselves, but we seem to be at an eye in this storm. If we’re lucky, things might actually bottom out after another 10-20% drop in currency and real estate.

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