We have heard so much about the subprime crisis, but here's the simplest and easiest-to-understand piece I have come across. And it is relevant to Singapore, where — as in the US — the property market plays a major role in the economy.
Washington is pumping money into banks to avoid a recession, but that is wrong, says Charles R Morris, a former investment banker and author of Trillion Dollar Meltdown, reports Bloomberg.
He urges the U.S. to instead engineer a recession, as former Federal Reserve Chairman Paul Volcker did when he slew runaway 1970s inflation by raising interest rates as high as 20 percent.
Americans can't go on piling up debt by buying things on easy credit, he says, so a recession is needed.(He doesn't mention that Volcker's recession also led to the highest US unemployment levels since the Great Depression, but read on.)
Solvency, not liquidity
Morris says the current US bank bailout perpetuates the misconception that "we have a liquidity problem, not a solvency problem".
To explain the difference, Morris cites two precedents: The rise of U.S. grain futures in the 19th century and the tulip bulb mania that gripped the Netherlands in the 17th century.
"In the 19th century, we had these huge wheat fields in the Midwest,'' he says. "But it was very risky to send grain to the East, let alone abroad.''
That was a liquidity problem, and the development of grain futures markets solved it by allowing future deliveries to be sold for cash. As this “fire hose of investment'' flooded the grain belt, “we became the Saudi Arabia of food,'' Morris says.
Tulip bulb futures
During tulip mania, by contrast, traders leveraged up their bulb holdings, taking ever more risk until the bubble burst and prices collapsed. No amount of lending could have restored them, Morris says; the episode was "a parable of insolvency".'
"It wasn't a liquidity problem,'' he says. “You don't solve that by lending more against tulip bulbs.''
U.S. houses, in short, became tulip bulbs. Banks that forked over cash for a claim on a home's unrealized value were in essence “selling tulip bulb futures.'' The more cash they extended, the more U.S. consumers spent.
"Between 2000 and 2007, total U.S. gross domestic product was $92.5 trillion in current dollars,'' Morris says. "Our gross domestic purchases were $97 trillion, a $4.5 trillion overrun.''
Where did the $4.5 trillion come from? Consumer debt –almost all of it secured by houses, Morris says.
"Between 2000 and 2007, homeowners borrowed $4.2 trillion on their homes that they didn't invest in their housing or use to pay down their mortgages,'' he says.
Personal consumption jumped to an unprecedented 72 percent of GDP by 2007 from a long-term average of about 66 percent, Morris says. The upshot: "a false prosperity based on a huge waterwheel of money, fueling a debt-financed, import-driven consumer binge''.
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