No Nonsense
Is another Great Depression looming?
IN several dinner parties surrounding the Eid celebrations, many of my friends asked me if -- with the Wall Street's September 29 loss of over $1.2 trillion -- we were witnessing the breakdown of laissez faire economic order like a falling house of cards and tiptoeing into the symptoms of the Great Depression of the 1930s.
House of cards indeed: The Wall Street debacle was so staggering that the Dow Jones Industrial Averages (DJIA: Stocks of 30 of the largest US companies) plummeted 778 points -- a record one day loss.
What has happened over a span of just two weeks is that the engine of American economic growth has derailed, and is slowly dragging the rest of the global financial markets and economies along.
The culprit is the American model of less government intrusion in the private sector -- in particular, less regulation of the financial sector -- while turning a blind eye to unbridled growth of greed and deception of the CEO's of large corporations and the Wall Street manipulators.
The demise is essentially a reflection of the absence of ethics and morality in Wall Street. People's sense of responsibility for their own actions -- paying their bills or keeping their promises -- has plummeted.
Greed and deception of executives of financial institutions have skyrocketed, because the Bush administration and the politicians in the Congress unleashed deregulations while partying with Wall Street millionaire CEO's.
"What we are witnessing, in the broadest sense, is the bankruptcy of modern economics. A hallmark of the crisis has been the stark contrast between the 'real economy' of production and jobs and the tumultuous financial markets of stocks, bonds, banks, money funds and the like," said Robert Samuelson (Newsweek, September 29).
To survive this crisis, the already debt-ridden America would need more borrowing from the rest of the world. This will indubitably hamstring the next president's ability to act unilaterally on anything other than critical national security issues. Foreign aid to developing economies is also bound to be tight-fisted.
To slow the bleeding, a bailout package of $700 billion was proposed by the US Treasury, and a modified version of it was passed by the Congress on October 3 amid opposition from many lawmakers and public outcries.
Harvard University economist and former Treasury secretary, Lawrence Summers, argues that the ultimate cost of the bailout is impossible to predict -- this will depend primarily on the economy as well as the quality of oversight and execution of the bailout provisions.
However, the ultimate cost will be less than $700 billion since the bailout is an asset swap -- government bonds for banks assets.
The public cried "no" to the package as they saw it, in part, as a way of bailing out the crooked CEOs of Wall Street who will walk away scot-free with millions of dollars of their benefit contracts while the law abiding tax payers take the burden of debt for no fault of their own.
The modified bailout plan's provisions made $250 billion immediately available for purchasing bank assets, leaving $100 billion to the president's discretion and $350 billion subject to congressional review.
The concern, though, is about burgeoning budget deficits resulting from financing the bailout by issuing government bonds to be held by investors, which will crowd out other, more productive, investments.
One may plausibly argue that as long as the government buys banks assets -- such as mortgage-backed securities (MBS) -- with new issues of government bonds -- there is no crowding out effect. It's essentially an asset for asset swap -- although some losses (estimated to be 20 - 30%) are bound to be passed on to tax payers from some of the worthless MBS.
The loss is inevitable, given that Wall Street bankers leveraged $1 trillion worth of MBS, which are valued at approximately 40 cents or less on the dollar.
Martin Wolf of The Financial Times noted that US household indebtedness jumped from 50% of GDP in 1980 to 100% in 2007, while financial-sector debt increased from 21% of GDP to 116% over the same period. People boosted their standard of living well beyond what their income and wealth could support.
The potentially crippling problem now is the short-term credit markets, where banks are hoarding whatever cash they have in an effort to ride out the crisis and, thus, loans are few and far between.
This hoarding is creating a larger credit crisis that could begin to squeeze every business that needs cash flow -- from department stores financing inventory to credit card companies juggling millions of purchases every day.
The credit crisis has already crossed the Atlantic to the Euro Zone. In UK, the overnight bank to bank lending rates (LIBOR) doubled to 6.87% on September 30 from 2.57% from the day before.
The concerns in the US are the migration of the crisis from Wall Street to Main Street, where the pain is only beginning to be felt. The government and the Federal Reserve are focusing on keeping money flowing in the credit system -- and thereby limiting layoffs, shutdowns and bankruptcies.
In his Market Watch commentary, Irwin Kellner said: "We are nowhere near a depression, so let's stop talking ourselves into one. […] Now, don't get me wrong, I am not saying things aren't serious out there, but another Great Depression? I don't think so."
Some pertinent statistics reveal more differences than similarities between the 1930s and today:
- The 1929 stock market crash caused the DJIA to plunge 40% in two months compared to 22% over a year now.
- The unemployment rate jumped to 25% by 1933 compared to 6.1% today.
- The GDP shrank by 25% during the early 1930s; it is up over 3% during the past year.
- Consumer prices fell by about 30% from 1929 to 1933; and it is rising now.
- Home prices plunged more than 30% during the Depression versus about 16% today.
- By 1934, some 40% of all mortgages were delinquent versus 4% today.
- More than 9,000 banks failed in the 1930s compared with fewer than 20 over the past couple of years.
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