Richard Whalen

We can see clearly the beginning of our economic and financial troubles, but not yet their outcome. Last summer, the financial crisis in subprime mortgage debt that had been bundled into complicated U.S. financial assets called derivatives was revealed and shook the world’s confidence. Private demand for U.S. government debt fell, and that caused the dollar’s exchange value to sink. The U.S. credit crunch quickly turned into a credit squeeze. Big banks, whose excessive speculation had triggered the subprime crisis, have belatedly turned extremely selective in rolling over existing loans and making new ones. Big banks are afraid even to lend to each other, worsening the crunch.

For the first time since 1991, when the last U.S. recession officially ended, the “R” word is heard on Wall Street, Main Street and in global financial markets. On September 18th, the Federal Reserve cut short-term interest rates by one-half percent, the Fed’s first policy cut in four years. On October 31, the Fed cut another one-quarter percent. Each time, markets rallied, and then slumped again. On Tuesday, the Fed met again and announced another quarter-point rate cut, reducing the fed funds rate to 4.25 percent.

The Fed’s policy committee meets again on January 30th and further rate cuts are expected, perhaps even before the scheduled meeting. “If financial conditions don’t improve dramatically,” says a former New York Fed official, “they might have to cut before the meeting.”

With the Fed cutting rates to head off a recession, the dollar’s value, which has fallen 40 percent against the Euro so far this year, steadily weakens. For their own reasons, many of the world’s largest foreign dollar-holders – the largest, China has about $1 trillion in dollar reserves – are buying greenbacks. They want to manipulate the value of their own currencies to remain at more competitive exchange rates (“pegs”) against the dollar. The Fed can directly intervene in the currency markets only when the Treasury orders it.

Treasury Secretary Hank Paulson, who came to Washington after making a $750 million fortune at Goldman Sachs, has proposed a top-down rescue of the economy beginning with the mega-banks and a very costly bailout of their unmarketable assets – so-called derivatives stuffed with junk mortgages that are known as structured investment vehicles (SIVs). That proposal fell flat. Now Paulson is faced with soaring mortgage delinquencies, defaults and perhaps almost one million foreclosures in 2008 and after.

Paulson has drafted and President Bush has proposed “temporarily” freezing interest rates on selected troubled sub prime residential mortgages. As many as an estimated 1.8 million adjustable mortgage loans are due to reset at higher rates in 2008. As Alan Abelson commented in Barron’s (December 3): “…an awful lot of the problem with sub prime mortgages is that the folks in the houses who are in arrears or are being foreclosed can’t meet even existing interest payments, much less higher ones.”

Paulson’s plan is sketchy. Nothing will happen on Capitol Hill, say our sources, until after the November 2008 elections. So that pushes the realistic time-frame for serious debate to begin on “emergency” actions by the executive and legislative branches well into the first quarter (or later) of 2009. That’s a very long time to trust our luck.

Stress fractures from failing U.S. credibility radiate across the global financial and geopolitical landscape. While the subprime mortgage mess drags on year after year, the effects will constrain the U.S. consumer economy. So will other forms of consumer debt now going sour, such as student loans and auto loans. All kinds of American debts are becoming suspect.

Brad W. Setser, Fellow for Geo-economics at New York’s Council on Foreign Relations, believes the U.S. should look beyond sectoral crises and focus on maintaining broad domestic economic stability. “…I would put a great deal more emphasis on concerns that U.S. weakness may be the leading edge of a broader global slowdown,” he says. He is referring to the big “R” word.

As we are always reminded, 70 percent of the America’s GDP is consumer spending, most of it financed by debt. The rest of the world has invested its savings in America’s public and private IOUs. An American default would rub the world overnight; rising U.S. inflation is lower but just as deadly.

In the next phase of the expanding crisis of the American political economy, the rest of the world will form a de facto creditors’ committee and attempt to negotiate with Washington through Wall Street – a 19th century approach to a 21st century problem.