Wednesday, September 17, 2008

Financial Three Card Monte

Just a bit ago I came across this gem in Yahoo! news:

How We Got Here: It's Housing, Stupid
by Chris Isidore

Thursday, September 18, 2008

The Wall Street crisis has been caused by plunging housing prices. So despite the billions of dollars being thrown at the problem, experts say more trouble lies ahead.

The nation's financial system is in the midst of a massive shakeup and many on Wall Street and in Washington are pointing fingers and looking for someone to blame.

But in the end, it all comes back to one issue - housing.

Earlier this decade, it was much easier to get a mortgage. Home prices soared about 85% from 1996 through 2006 in inflation-adjusted dollars, creating a bubble.

Then the bubble popped. And the fallout isn't over yet, experts say.

In the past two weeks, the government took over Fannie Mae and Freddie Mac, Lehman Brothers filed for bankruptcy and Merrill Lynch sold itself to Bank of America.

If all that weren't enough, the Federal Reserve announced late Tuesday night that it was loaning $85 billion to insurer American International Group....

"The housing correction poses the biggest risk to our economy," Paulson said the day he announced the Fannie and Freddie seizure. "Our economy and our markets will not recover until the bulk of this housing correction is behind us."

I agree that housing, right now, is the most immediate financial problem we face. However, I do not believe it will only take a "housing correction" to set this right. The housing problem is significant of deeper flaws in our economy.

The United States government recently accepted liability for the debt previously owed by Fannie Mae and Freddie Mac, to the tune of some $5.4 trillion. That's 'trillion' with a 't'. Most recently, AIG group became the recipient of government generosity, to the tune of an $85 billion loan. If the government already fails to meet its own debt obligations each year and has to borrow money in order to fully fund the budget, how can it provide the funds for these enterprises? Short answer: it can't.

So, the Federal Reserve has to fire up the presses and throw another $85 billion in cold cash into the system. When this much added "liquidity" enters the system, it makes every other dollar out there worth a little less. Which, in turn, makes most goods and services cost a little bit more.

What happens as the government has to fulfill Fannie Mae and Freddie Mac's obligations? Is it safe to predict that they will service this debt the same way they service all others -- by printing more money? What impact will that added "liquidity" have on our currency?

Furthermore, it's not as if the government is spending this money on anything actually utilitarian. We're neglecting our bridges. We're not investing in upgrades to our outdated and overstressed electrical grid. We're not rebuilding our rail network to help cushion long-distance freight from rising and volatile fuel costs. Instead, we're using it to bail out an industry -- high finance -- whose primary concern seems to be creating money out of nothing.

I can appreciate another side to this argument -- that by the government (meaning taxpayers, you and me) taking on this debt, it is more widely dispersed throughout our financial system. Think of this debt as water -- if you pull the plug from a large pool of water, the level goes down gradually and doesn't pull under nearby. However, in a small pool a vortex can form and pull other objects into it. Taxpayer liability is like the large pool, while corporate liability is like the small pool. If AIG were to fail, then it might pull others down with it. By spreading the risk, serious damage is averted.

However, this assumes that our economy and currency are in good order, and able to weather the storm. I don't think they are, nor do I believe they can. Our national financial pool is getting shallower with each passing year. We're taking on increasing debt every year, at every level from the federal government to individual households. Most of our currency is just that -- debt. This arrangement can persist so long as creditors can expect to get paid. However, if creditors begin to suspect that they might not get paid, all hell can break loose.

Think about it:
A current national debt of $9.6 trillion
Fannie Mae and Freddie Mac debt of $5.4 trillion
War costs of Iraq and Afghanistan, $3 trillion (est.)
estimated by Joseph Stiglitz
includes deferred and future costs
Future unfunded Medicare and Social Security obligations, $50 trillion (est.)
Total U.S. household debt, $50 trillion (est.)

That's a total of $118 trillion of future and current debt in the United States. What happens if more of this debt starts to go into default, as has happened in the popping of the housing bubble? What guarantees that a nation that only produces about 5 million barrels of oil per day will continue to use 20 million in perpetuity? What happens if creditors increasingly lose confidence in our currency?

Confidence is what's keeping us afloat anymore. That confidence appears to be unraveling a bit. Of course, most confidence schemes eventually unravel, whether they be three-card monte or paper currency.

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